Contributed by Nikita D’Lima

Certain intriguing legal questions have been brought up by the effect of a personal guarantee on a corporate debtor (“CD”) undergoing insolvency under the Insolvency and Bankruptcy Code, 2016 (“the Code”). A personal guarantee is a promise made by an individual (the guarantor) to pay back a debt if the CD (the borrower) defaults on its obligations to a creditor.

In matters where admitted claims exceed ₹1,000 crores, the total claims in these instances add up to a staggering ₹8.78 lakh crores, as per the quarterly report by the Insolvency and Bankruptcy Board of India in September 2023. Ultimately, if a company can’t pay back its debts, directors or promoters who provide personal guarantees may be on the hook to repay the loans. This article explains the impugned judgment and its ramifications on insolvency proceedings concerning a personal guarantor. It touches upon a previous landmark judgment that clarified the position of such guarantors under the Code and the lucrative inconvenience it rings in.

The Judgment

A personal guarantor (“PG”) is directly subject to bankruptcy proceedings, following the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018 (“2018 Amendment Act”) and Notification No. S.O. 4126, dated November 15, 2019 (“2019 Notification”), without the need for creditors to first initiate the insolvency proceedings against the CD.

The 2018 Amendment Act established the powers of the National Company Law Tribunal for the insolvency of a CD, including the PG under Section 60 of the Code.

The scope of the obligation imposed on the personal guarantors by the Act and the validity of the provisions in the Code was recently elucidated by the Supreme Court.

In Dilip B. Jiwrajka versus Union of India (“Dilip”), decided on November 9, 2023, the Supreme Court rendered a judgment that resolved some ambiguities concerning the liability of PGs under the Code. The judgment is a cautionary call to guarantors treading dangerous waters that will surely stir up a storm.

The ruling is significant because it gives the CD’s creditors more negotiating power to recover any unpaid sum that was not collected during the corporate insolvency resolution process (“CIRP”) or the personal guarantor’s insolvency resolution process (“PGIRP”).

By doing so, creditors are able to recover their debts from many sources, thus creating a ‘dual safety net.’ The Supreme Court’s decision in Dilip has reinforced the strong negotiating position of the creditors, limiting the protection of PGs under the Code.

Challenging the 2019 Notification

Following the release of the 2019 Notification, many aggrieved approached the Supreme Court, which delivered a pivotal judgment.

In Lalit Kumar Jain versus Union of India (“Lalit Kumar”), a division Bench determined the unresolved position by ruling that the release of the PG from its obligations is subject to two circumstances: first, unless the contract expressly states otherwise; and second, if it is the consequence of a voluntary action by the CD, such as a discharge, modification, release of the guarantee agreement.

Paradigm for co-extensiveness

According to Section 128 of the Indian Contract Act, 1872 (ICA), an obligation of the surety, or PG  is coextensive with that of the principal debtor, or CD, unless otherwise provided by the contract. An independent contract establishes a PG’s liability, which lays down the extent of such liability.

Thus, the creditors have the option to file a lawsuit concurrently against the CD and its PG, or they may proceed in any other order of their choice. The entire sum owed or the remainder may be recovered by legal action taken against the PG.

One can draw an inference that once a resolution plan is approved by the committee of creditors, the CD’s liability to pay the creditor ceases, simultaneously discharging the liability of the PG, too..

However, this argument which is derived from Section 128 of the ICA’, is invalid because of precedents made by the Supreme Court and the High Courts. Even if the CD is relieved from its obligation, the PG’s liability remains.

In Maharashtra State Electricity Board Bombay versus Official Liquidator, concerning Section 134 of the ICA, the court decided that a PG could be sued because the debtor was released from its liability due to an involuntary process of operation of law rather than as a result of any action on the part of the creditor. Thus, the court examined that since there is no dismissal under Section 134 of the ICA, a guarantor’s duty under an unambiguous promise persists.

It is well-established that all obligations, liabilities and payments for earlier periods are eliminated upon approval of a resolution plan for a CD. Nevertheless, this discharge is limited to the CD and does not relieve the company’s directors—who could have served as PGs—of their duty to reimburse the creditors by the provisions of the agreement they have executed.

Reason for interpretation

In State Bank of India versus V. Ramakrishnan, a Division Bench of Justices R. F. Nariman and Indu Malhotra observed that when a resolution plan takes effect, it is enforceable on both the CD and the PG and does not ipso facto discharge the PG. If there was a deviation, any alteration made to the CD’s obligation without the permission of the guarantee would exclude the guarantor from repayment.

In the above judgment, Justice Nariman further noted that personal guarantees are usually given by directors or promotors, who are actively involved in the daily operations of the company. However, guarantees for individuals and firms for their individual debts are given by guarantors who may be complete strangers to the debtor, usually a personal friend (para 23). Delhi High Court’s judgment in Kiran Gupta versus State Bank of India & Anr is one such example. Here, the petitioner, who was the wife of the promoter, stood as the PG for the repayment of a loan and subsequently, the respondent bank filed an insolvency petition against the promoter’s firm. She claimed that proceedings against a PG under the Code and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) cannot be instituted and continued simultaneously.However, the court held that the respondent bank was well entitled to initiate proceedings against the petitioner under the SARFAESI Act during the insolvency resolution process of her husband’s firm.

Since the Code is vague and silent, it is unclear whether creditors have the power to enforce assurances after a resolution plan has been authorised. In the absence of any clarity, the guarantor’s responsibility to creditors may be judged based on the circumstances at hand.

Unfettered Power for Creditors

After Lalit Kumar, aggrieved guarantors claimed that the risk for PGs to be targeted under insolvency matters is excessive and disproportionate.

They are exposed to insolvency procedures and are not given a fair chance to raise objections after the submission of insolvency petitions by creditors before the resolution professional (RP). Dismissing the petitions, the Supreme Court concluded that the RP’s job is solely that of a facilitator, not that of an adjudicator.

In Dilip, the court decided that the present statutory framework does not permit an additional adjudicatory step, and that introducing one would require “rewriting the terms of the statute.” Further, there are severe deadlines for hiring a resolution specialist and submitting a report. Adding an adjudicatory step would not only hinder the process but also complicate it.

The court held that Sections 95 to 100 of the Code cannot be declared unconstitutional only because there are no measures permitting PGs to make their case before creditors file bankruptcy applications.

Issues to Consider

While the Code ensures that creditors recover their dues effectively, it poses immoderate challenges on PGs to recover such dues. The seminal issues that emanate from judicial precedents can be summarised as:

Concurrent insolvency proceedings

As discussed above, courts have extended the liability of PGs to not just insolvency proceedings, but also in matters concerning SAFAESI, Real Estate (Regulation and Development) Act, 2016 (RERA) and the Consumer Protection Act, 2019. It is paradoxical, as res- sub judice becomes otiose when the same parties are allowed to proceed for the same issue in concurrent litigations.

Minimum threshold for PGs

Vide Notification No. S.O. 4126, dated November 15, 2019, Part III of the Code was applicable only to PGs, instead of partnership firms and individuals as provided in the Code. The minimum threshold under Section 4 of the Code to initiate CIRP against CDs was modified from ₹1 lakh to ₹1 crore. However, the threshold under Section 78 to proceed against PGs remained ₹1 thousand only.

Upon the acceptance of the application under Section 100 of the Code, a moratorium is imposed by Section 101, wherein, (i) no legal proceedings can be instituted against the personal guarantor for any debt; and (ii) the personal guarantor is prohibited from transferring or disposing of any of their assets, legal rights, or beneficial interests.

Diffusion of the right of subrogation

It is unclear whether creditors may sue a PG for the whole default amount or the balance amount after the approval of a resolution plan before it is actually paid off. The former situation will lead to an unfair double recovery for creditors, as the prohibition of the right of subrogation renders PGs toothless. The Code’s extinguishment of the right to subrogate stands out as the Achilles heel, and it emphasises the regime’s ‘pro-creditor’ approach.

Conclusion

PGs form the basis of the credit-lending regime. The provisions of the Code are undeniably tipped in favour of creditors and they must be scrutinised by the Supreme Court as they seem to infringe on constitutional requirements and the concept of audi alteram partem for PGs.

The Code aims to strengthen businesses in India but sanctions against PGs offer RPs enormous authority with little checks and balances, which may discourage individuals from giving personal guarantees, thereby causing an imbroglio.

While it is commendable that the Code has a pro-creditor approach which will elevate creditor confidence, on the flip side, it may also lead to extreme caution among promoters or individuals offering guarantees for solvent companies as well.