INSOLVENCY MECHANISM FOR PERSONAL GUARANTORS TO A CORPORATE DEBTOR: THE INDUSTRIAL ANALYSIS
[Deepanjali Jain and Prateek Khandelwal are third-year law student at Jindal Global Law University, Sonipat and Chanakya National Law University, Patna respectively]
Many businesses were shut down or experienced tremendous loss owing to the COVID-19 pandemic. Amidst such chaos, the 2021 Supreme Court judgment, Lalit Kumar Jain v. Union of India, on personal guarantors to corporate debtors has worsened the situation a bit more. The said judgment verifies and approves of the new notification by establishing a mechanism for corporate persons under which the creditors can extract the sum from the personal guarantors to corporate persons as well. This article tends to explore the case and its ramifications in much detail.
The conundrum over the liability of a personal guarantor to corporate debtor began with a notification released by the Ministry of Corporate Affairs, namely, Insolvency and Bankruptcy (Application to Adjudicating Authority for Bankruptcy Process for Personal Guarantors to Corporate Debtors) Rules, 2019 [impugned notification], which brought into provisions of insolvency of a personal guarantor to a corporate debtor. The personal guarantor to a corporate debtor is an individual who takes a guarantee when a corporate entity takes a loan. According to Section 128 of the Indian Contract Act, 1872, in the contracts of guarantee, the liability of the surety is co-extensive with that of a debtor. Therefore, this implies that the liability of a surety or guarantor against a creditor shall be equivalent to that of a debtor.
Therefore, all the guarantors, including the personal guarantor, is partially or fully liable to pay the dues to incase the debtor defaults in their payments. However, till 2019, there was no legal procedure laid under which a creditor can claim the assets of a personal guarantor when a corporate debtor defaults its payment. However, this changed with the introduction of the impugned notification, which led many citizens to claim it as ultra vires.
The Supreme Court of India has recently ruled in favour of the defendants, i.e., the Union of India. The Supreme Court identified that previously there was no procedure laid down to file a suit against the personal guarantor to a corporate debtor. They recognized that the claim that the impugned notification is ultra vires could not be upheld in this court as it was an attempt on the part of the Central Government to fill this gap in the current procedural law. The Central Government aimed to introduce the impugned notification to put all the rules, regulations, and procedures to deal with corporate debtors under one bracket, including personal guarantors to corporate debtors, to ease the judicial process. Their aim was to set up an entire mechanism to deal with the corporate persons/debtors, covered under Section 2(a) to 2(d) of the Insolvency and Bankruptcy Code, 2016 [Code].
The Supreme Court took note of various policy decisions in the Indian insolvency regime and observed that the central government has been working in the direction to achieve the objective laid down in the Code. Therefore, they started by laying down necessary mechanisms for the basic functions to kickstart the procedure and now are progressing to address other relevant matters as well, which includes the impugned notification and setting up a mechanism specific to corporate persons to establish insolvency procedures in the country and thus, the notification was not held ultra vires.
Analysis of the Judgement
As the Supreme Court has upheld the constitutionality of the said notification, all the notices received by the personal guarantor will now be deemed valid. This is a landmark judgment and will have a significant impact on the business structure in India.
Firstly, this will have an adverse effect on the businesses who are on the verge of exhausting all their capital, and now, if they fail, it is not just the company that will suffer, but the management and shareholders will also face the wrath as, they ought to be personal guarantors to corporate debtors. Moreover, now that the lenders have such powers over the borrowers, it could be used in grievous ways to seek heavy compensation in return from both the principal debtor and the guarantor when the corporate entity oversteps its boundaries.
Secondly, the practice of going after the personal guarantors could immensely impact the businesses as now the personal guarantors would be sceptical before agreeing to such discussion. This will increase the difficulties for both these entities as, generally, the personal guarantors are the members of the upper management, and prior to the impugned notification, they used to sign a guarantee form for the creditor’s assurance. However, now, after the impugned notifications, the creditors would be able to reimburse if any default in the payments occurred on the part of the debtor from the personal guarantors and their private assets or any other collateral. This practice would make them think twice before signing as a personal guarantor to a corporate entity which would not be beneficial for the corporate debtor. There can be instances wherein the creditor could refuse loans or provide them at an extremely high rate because of the absence of the guarantor. This could become the last straw for the company as they will become bankrupt and eventually wind up. This would prove to be disastrous for shareholders, employees and other companies dealing it the winding-up company.
Finally, apart from all these short-term disadvantages, this practice could benefit the country’s economy in the long run. The entities who will benefit the most out of this situation will be banks or lenders. Usually, in such cases, the creditors or banks rely on the collateral or the guarantee provided by the people or entities when they decide to give a corporate entity a loan, apart from the factors including the capability of the company to repay their money. If a company defaults and the collateral is not enough to pay them back, the banks suffer huge losses, and thus indirectly affects the people who have invested their money in the bank for interest purposes. Now, the banks will have the authority to question the assets of all the personal guarantors involved and would gain more than before.
Though the theory of liability of the guarantor is co-extensive with that of the debtor, which is laid in the Indian Contract Act for a long time now. However, due to the absence of any procedure laid down by the law-making authorities, the creditors were never able to go after a personal guarantor to a corporate debtor in case of defaults on the part of the corporate debtor. Nevertheless, this issue was resolved when the Central Government released a notification introducing a mechanism to deal with it which was also upheld by the Supreme Court. This is a landmark judgment as it will have a huge impact on how insolvency proceedings are handled and provide the creditors with an advantageous proposition to redeem losses in cases of defaults. However, while providing the rules for holding personal guarantors liable in case of a default, the provisions carved out must be more precise in their execution to remove inconsistencies. Further, this mechanism should be formulated in a way to prevent the objectives of the Code, therefore, the implementation of such provisions must be neutral in nature, providing both the parties to plead their cases and not discourage practices of business encouragement such as the practice of upper management being a personal guarantor.