Initiation of Insolvency Proceedings against a Personal Guarantor of a Corporate Debtor: Navigating the Uncertainties
Diksha Kumari & Mohak Agarwal
5th Year, B.A. LL.B (Hons.), National Law University, Jodhpur
Introduction
The Ministry of Corporate Affairs [“MCA”] published a notification on November 15, 2019 [“Notification”] which activates the provisions for initiating insolvency resolution process against personal guarantors under the Insolvency and Bankruptcy Code, 2016 [“IBC”] effective from December 1, 2019.[1]
Though the Notification was challenged, the Supreme Court upheld it on May 21, 2021, in the case of Lalit Kumar Jain v. Union of India[2] [“Lalit Kumar Jain”] ruling that personal guarantors, despite being part of a wider group of individuals, were to be treated differently due to their inherent relationship with Corporate Debtors [“CD”]. The court also determined that the acceptance of a resolution plan and the borrower’s discharge from the debt through an involuntary process, i.e. operation of law in insolvency proceedings, does not release a personal guarantor from its obligations under the independent contract of guarantee.
The Insolvency and Bankruptcy Board of India [“IBBI”] has also introduced the Insolvency and Bankruptcy (Application to Adjudicating Authority for Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Rules, 2019 [“Rules”] and the Insolvency and Bankruptcy (Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Regulations 2019 [“Regulations”]. The Rules establish the method for commencing the Insolvency Resolution Process against Personal Guarantors, while the Regulations outline the procedure to be followed after initiating the process.
History
Prior to the Notification the insolvency regime was governed by the Presidency Towns Insolvency Act, 1920 and the Provincial Insolvency Act, 1920 which allow the creditors to bring insolvency proceedings against all individuals, including personal guarantors, in locations within and beyond the former presidency towns respectively. However, the laws were debtor-centric and lacked a time-bound approach. There were significant delays that rendered it impossible to protect the interests of all parties involved. Other methods of recovering dues included filing a civil suit to enforce contractual remedies or submitting applications to the Debt Recovery Tribunal under the Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 [“SARFAESI”].
Consequently, Parliament enacted the IBC in 2016 with the intention of establishing a unified and streamlined system for initiating insolvency and bankruptcy cases against people and corporations in a timely manner. Instead, Section 1(3) granted the Central Government the authority to implement these provisions through notifications in the Official Gazette, allowing for the phased introduction of different sections of the IBC on varying dates. Initially, the provisions of Part II of the IBC, concerning the settlement and liquidation of corporate insolvency, were put into effect. Additionally, Parts IV and V which address the fast-track Corporate Insolvency Resolution Process [“CIRP”] and the voluntary liquidation of corporate entities, were also activated. Nevertheless, the provisions in Part III were not enforced, leaving personal guarantors to CD excluded from any ongoing resolution processes before the Adjudicating Authority [“AA”].
Recognizing the imminent need to enforce Part III, the Notification was issued to promptly initiate insolvency processes concerning corporate persons. However, it is important to note that the Notification exclusively applies to personal guarantors, while other individuals and partnership organizations remain governed by the Presidency Acts.
Procedure to initiate the resolution process
A defaulting debtor or a creditor can initiate CIRP against personal guarantors either directly or via a resolution professional by filing an application under sections 94 and 95 of the IBC respectively.
An interim moratorium will commence immediately with respect to all debts and will end once the application is filed. This differs from the moratorium under Section 14 of the IBC, which begins only after the application has been admitted following a comprehensive evaluation by the AA.
The AA has the jurisdiction to admit an application filed under sections 94 or 95 only after a resolution professional, appointed per section 97, submits a report following section 99. Following the expiration of the interim moratorium, the moratorium outlined in section 101 will take effect. During the moratorium period under section 101, the debtor is barred from alienating, transferring, encumbering, or disposing of any of their assets, legal rights, or beneficial interests.
The moratorium under section 101 expires 180 days after the date of acceptance of the application or when the AA issues an order on the repayment plan pursuant to section 114, whichever occurs first. The Supreme Court, in the case of Surendra B. Jiwrajika and Anr. v. Omkara Assets Reconstruction Private Limited[3], upheld the constitutionality of provisions pertaining to the insolvency resolution of personal guarantors.
The Uncertainties And Judicial Rulings
While a considerable increase has been noted in personal guarantor insolvencies, there exist several uncertainties in the IBC’s embryonic jurisprudence in this new area which have been a point of contention for both the guarantors as well as the creditors.
Pending insolvency process before NCLT – A pre-condition for personal guarantor proceeding?
A pending CIRP or liquidation process against the CD is not a precondition for filing an application initiating insolvency proceedings against a personal guarantor. Section 60(1) of the IBC assigns the National Company Law Tribunal [“NCLT”] as the AA for initiating an insolvency resolution or liquidation process against a guarantor, thus settling the jurisdictional puzzlement. In a case where a CIRP or liquidation process against a CD is pending before AA, section 60(2) of the IBC allows for the filing of a CIRP application against a personal guarantor of a CD before the same AA. It is without prejudice to sub-section (1) and notwithstanding anything contained in the code.
In the case of SBI v. Mahendra Jajodia[4], NCLT had ruled that “section 60(2) was applicable only when a CIRP or Liquidation Proceeding is pending before NCLT”. However, NCLAT found this interpretation erroneous and held that while sub-section 2 is supplemental to sub-section 1, it does not prohibit the filing of proceedings under Section 95 in the absence of a pending proceeding before AA. The Supreme Court upheld the NCLAT judgment.[5] When an application is not made out under Section 60(2), it shall be presented before the AA having territorial jurisdiction as required under Section 60(1). This decision was underpinned by the well-established principle that a guarantee can be invoked before seeking the same from the principal debtor.
Issue of Double Dip
The creditor’s right to pursue against the individual guarantor is unaffected by the discharge of debt by operation of law. As established in Lalit Kumar Jain, a creditor can pursue recovery from either the principal debtor or the guarantor, or from both, until the full amount is paid. If one party has already paid a portion of the debt, the other remains liable for the remaining amount, as their liabilities are joint and several.
The rule of double dip is well established in global insolvency regimes. In Re Kaupthing Singer & Friedlander Ltd.[6] [“Kaupthing”], the Supreme Court of the United Kingdom clarified that creditors may pursue both the principal borrower and the guarantor, even if it requires double proof. However, if both parties are insolvent, the creditor can seek the total amount from each but cannot recover more than the total debt owed. Therefore, the rule of double dip allows for the initiation of CIRP against both the CD and the guarantor simultaneously. However, the rule against double proof prohibits the recovery of any aggregate amount higher than the total debt due.
The applicability of the rule of double dip in the Indian insolvency regime was, however, diluted in the case of Dr. Vishnu Kumar Aggarwal v. M/s. Piramal Enterprises Ltd.[7] [“Piramal”] The NCLAT, in this case, held that once a CIRP is initiated against a CD (whether the principal debtor or the corporate guarantor) based on a financial creditor’s claim, that same financial creditor cannot file a second application to initiate CIRP against the other CD for the same claim and default. The Insolvency Law Committee Report of 2020 [“ILC Report”] emphasized on the right of the creditor to proceed against either the debtor alone, or the surety alone, or jointly against both the debtor and the surety. It referred to Section 60(2) of the IBC which provides that when a CIRP or liquidation is pending against a CD, any insolvency resolution, liquidation, or bankruptcy proceeding against the guarantor should also be initiated before the same AA. Further, Section 60(3) requires the transfer of any such proceeding before any other court or tribunal to the AA dealing with the CIRP or liquidation process of the CD. Therefore, the framework of IBC was found to be amenable to the principle of double dip and allowing for simultaneous CIRP proceedings against the CD and the guarantor. However, the ILC did not recommend any legal changes and left the issue for judicial determination.
Subsequently, in the case of State Bank of India v. Athena Energy Ventures Private Limited,[8] the NCLAT sided with the ILC Report and held the Piramal case as bad in law.
With two contradictory judgments, all eyes are now on the appeal against the Piramal and other judgments following Piramal in the Supreme Court. As of now, the Supreme Court has directed maintaining the status quo in the Piramal case while staying the judgments in other matters.
Right of subrogation
Section 140 of the Indian Contract Act places the guarantor in the position of the creditor, permitting the guarantor to reclaim the sum paid on behalf of the principal debtor once the guarantor has discharged the debt. A contention arises as to whether a resolution plan that enables creditors to reclaim their debts from guarantors can simultaneously strip guarantors of their statutory right of subrogation.
The IBC does not recognise this as an absolute right, as it would undermine the insolvency process by further depleting the CD’s assets. In the Lalit Kumar Jain case, the petitioners argued that the guarantor’s creditor rights should include the ability to file a resolution plan against the corporate debtor following the resolution process. However, under Section 29A of the IBC, promoters (who in most cases are personal guarantors) are prohibited from filing, preventing them from recovering the amounts from the CD. However, the Court left the issue unattended with a reference to the decision in Kaupthing, which stated that the guarantor may not enforce its secondary right in competition with the creditor if the major debtor is already insolvent.
In the 2017 case of Davinder Kumar Ahluwalia & Anr. v. M/s Sumit Aviation[9] determined by the NCLT Delhi, the NCLT admitted the petition of the Personal Guarantor as a Financial Creditor under Section 7 of the IBC. In this instance, the Personal Guarantor discharged the CD’s obligation. Having failed to collect the debt from the CD, the Personal Guarantor started proceedings under Section 7 of the IBC against the CD, which the AA ultimately granted. It is important to note that although the NCLT Delhi admitted the petition in this case, the Bench did not discuss the provisions securing the right of subrogation. In the case of Corporate Guarantors, this right has been secured to a large extent.[10]
Asset Tracing
The IBC framework for insolvency proceedings against personal guarantors does not provide for clawback in the event of avoidance or fraudulent transactions, despite the availability of such measures for CD and people in bankruptcy.
In the case of CD, IBC allows for the recovery of transferred value through avoidance transactions. If these transactions are reversed and the lost value is recovered, it increases the assets available for creditors. The Insolvency Professional is responsible for identifying such transactions and filing applications with the Tribunal for clawback.[11]
Concerningly, no such security exists for personal guarantors. There are concerns that their assets may be misappropriated before the resolution professional assumes possession of those assets. In the absence of a mechanism to recover them, the estate of the personal guarantor would be reduced by the misappropriated or siphoned-off assets.
Concluding Remarks
Under the IBC, numerous personal guarantors to firms have been dragged before tribunals this year for the recovery of thousands of crores of debt raised by companies backed by them. According to experts, the move against promoters to recover guarantee funds will put IBC to the test. Likewise, promoters will be reluctant to provide personal guarantees for loans sought by their companies out of fear of legal action under IBC.
Notably, creditors benefit from the Notification because it allows for debt recovery by granting them access to the asset pool of personal guarantors. However, it also enhances the bargaining position of creditors vis-à-vis CD, resulting in a concentration of power in the hands of creditors. This is because creditors now have an additional avenue to recover loans, alongside existing mechanisms like the SARFAESI Act and debt recovery proceedings. This may increase the number of lawsuits involving the three parties involved: creditors, CD, and their personal guarantors. Even after a resolution plan is approved, the ruling in Lalit Kumar Jain remains a concern for promoters who serve as personal guarantors for heavily indebted enterprises, as these guarantors are not absolved of liability even after the approval of a resolution plan.
References:
[1] Notification of provisions under the Insolvency and Bankruptcy Code, 2016 relating to Personal Guarantors to corporate debtors.
[4] (2021) ibclaw.in 877 NCLT.
[6] (2011) 3 WLR 939.
[7] (2019) ibclaw.in 16 NCLAT.
[8] (2020) ibclaw.in 344 NCLAT.
[9] 2017 SCC OnLIne NCLT 10767.
[10] C.P (IB) No. 2046/KB/2019.
[11] Annual Report 2020-2021, Insolvency and Bankruptcy Board of India, (Mar. 31, 2021).
