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LIABILITY OF PERSONAL GUARANTORS UNDER THE INSOLVENCY AND BANKRUPTCY CODE, 2016



Introduction:

The Insolvency and Bankruptcy Code, 2016 (“Code”) has brought about a significant transformation in India's insolvency landscape by establishing a comprehensive framework for resolving corporate insolvencies. In addition to addressing corporate insolvencies, the Code has also introduced substantial changes in relation to the liability of personal guarantors under insolvency. The Code, which came into force in December 2016, was further amended in December 2019 to include provisions for individual insolvency concerning personal guarantors to corporate persons. This article aims to shed light on the provisions of personal guarantors to the corporate debtors under the Code.

Part III of the Code classifies individuals into three classes, namely:

  • personal guarantors to corporate debtors,

  • partnership firms and

  • proprietorship firms, and other individuals,

Chapter III of Part III of the Code decodes the provisions of insolvency process for personal guarantors to corporate debtors enabling the implementation of individual insolvency in a phased manner.

The term personal guarantor has been defined Clause (22) of Section 5 of the Code, and Clause (e) of Rule 3 of Insolvency and Bankruptcy (Application to Adjudicating Authority for Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Rules, 2019, which is reproduced herewith respectively for reference:

“personal guarantor” means an individual who is the surety in a contract of guarantee to a corporate debtor;

 “guarantor” means a debtor who is a personal guarantor to a corporate debtor and in respect of whom the guarantee has been invoked by the creditor and remains unpaid in full or part.

 Recent amendment in the Code [1]

The latest amendment related to individual insolvency came into force by way of a notification dated November 15, 2019, to support better insolvency resolution to personal guarantors to companies. Prior to this amendment, personal guarantors were not directly subjected to the insolvency process. The impugned notification dated 15.11.2019 (“Notification”) reads as under:

"In the exercise of the powers conferred by sub-section (3) of section I of the Insolvency and Bankruptcy Code, 2016 (31 of 2016), the Central Government hereby appoints the 1st day of December 2019 as the date in which the following provisions of the said code only in so far as they relate to personal guarantors to corporate debtors shall come into force:

a. Clause (e) of section 2;

b. Section 78 (except with regard to fresh start process) and section 79;

c. Sections 94 to 187 (both inclusive);

d. Clause (g) to clause (i) of sub-section (2) of section 239;

e. Clause (m) to clause (zc) of sub-section (2) of section 239;

f. Clause (zn) to clause (zs) of sub-section (2) of section 240;

g. Section 249."

 

The said Notification also empowered the National Company Law Tribunal/s (“NCLT/s”) in the country to act as the adjudicating authority for insolvency proceedings against personal guarantors to companies. Further, the Notification inserted sub-clause (e) to Section 2[i] which provides that the applicability of the Code shall extend to the personal guarantors to corporate debtors. The Notification brought into force certain other provisions, namely, Sections 78, 79 & 94 to 187 of the Code (Part III) which provides for insolvency and bankruptcy of individuals, along with Section 239 (Power to make rules), Section 240 (Power to make regulations) and Section 249 of the Code (Part V) in so far as they relate to personal guarantors to a corporate debtor.

The said Notification was challenged before the Hon’ble Supreme Court in the case of Lalit Kumar Jain vs. Union of India[2], where a two-Judge Bench inter alia, held that the liability of a personal guarantor is not discharged merely on the discharge of a corporate debtor. The Hon’ble Supreme Court validated the Central Government's authority to enforce specific sections related to personal guarantors in the context of corporate debtors. Pertinently, the judgment clarified that the approval of a resolution plan does not automatically absolve personal guarantors of their liabilities, emphasizing that the surety's obligation remains despite the principal borrower's discharge under the Code.

The Indian Contract Act, 1872 (“Act”), provides for the definition of a 'contract of guarantee’ under Section 126 of the Act. The section states that a ‘contract of guarantee’ is a contract to perform the promise or discharge of liability, of a third person in case of default. It is a tri-party agreement wherein the person who gives the guarantee is called ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’. Section 128 of the Act states that the liability of surety is co-extensive with that of the principal debtor unless it is otherwise provided by the Contract.

In the case of State Bank of India vs. Smt. Goutmi Devi Gupta and Ors., dt. October 15, 2001[3] the Hon’ble Madhya Pradesh High Court (Jabalpur Bench) held that "The surety contracts: "Trust the borrower I undertake to be responsible" or "if he does not pay I will". This is the basic postulate or essence of the contract of guarantee. A surety in the eye of law is a favoured debtor. Under Section 128 of the Contract Act, save as otherwise provided in the contract, the liability of the surety is co-extensive with that of the principal debtor. The surety thus becomes liable to pay the entire amount. His liability is immediate and simultaneous. It is not deferred until the creditor exhausts his remedies against the principal debtor either personally or against the property mortgaged or hypothecated by him. The creditor gets the right to recover the amount straightaway from the surety. The right of the creditor to proceed against the surety is not dependent or contingent upon his remedy being exhausted against the borrower. The creditor cannot be asked to pursue his remedies against the principal debtor either personally or against his mortgaged or hypothecated property in first instance."

Role of Debenture Trustee in individual insolvency

Pertaining to the role of a Debenture Trustee in the Code on behalf of a financial creditor, a debenture trustee can file an application for initiating a corporate insolvency process against a corporate debtor before the National Company Law Appellate Tribunal (“NCLAT”) under Section 7 (1) of the Code

However, there is no provision yet in the Code, nor have the insolvency courts adjudicated upon where a debenture trustee stands when it comes to filing an application against the personal guarantor to the corporate debtor.

In Mr. Zubin Bharucha vs. Reliance AIF Management Company Limited[4], the NCLAT considered “whether ‘debenture holders’ could be treated as financial creditors with respect to an appellant-corporate debtor, which was not the issuer itself but a mere obliger and a guarantor to the issuer company. Answering the question in affirmative, the Hon’ble NCLAT rejected the contentions of the appellant- corporate debtor, stating that: a) the debenture holders were not parties to the deed of guarantee and to the registered indenture of mortgage; b) no contract were signed between the issuer company and the debenture holders and therefore no jural relationship existed between them; and c) as no amounts were disbursed to the appellant, therefore, the appellant could not be considered as corporate debtor under the Code. The Hon’ble NCLAT held that such ‘debt’ was financial debt in nature, and therefore the Section 7 petition against the appellant was held to be maintainable.

The Hon’ble NCLAT further observed that both debenture holders and the debenture trustee could separately enforce their rights.

Challenge to the constitutional validity of personal guarantor insolvency provisions before the Hon’ble Supreme Court.

The constitutional validity of the provisions of Chapter III of the Code have been challenged by various writ petitions under Article 32 of the Constitution of India in the case of Dilip B. Jiwrajka vs. Union of India [5] before the Hon’ble Supreme Court.

Issue:

The petitioners argued that the personal guarantor was not provided any opportunity to present his case or dispute the initiation of insolvency resolution process or appointment of the resolution professional as per the Code and that the same is against the principles of natural justice.

Submissions:

The submissions made on behalf of the petitioners emphasized the need for the adjudicating authority to determine the jurisdictional question before appointing a resolution professional under Section 97(5) of the Code. The submission has been sought to be advanced from two perspectives. Firstly, it postulates that a judicial aspect is involved even before the resolution professional begins the task outlined in Section 99 of the Code, for determining the jurisdictional requirements for the existence and continuity of a debt. Secondly, following the appointment of the resolution professional under Section 97(5) of the Code, wide-ranging powers are granted by Section 99(4) of the Code, to demand information not only from the corporate debtor but also from third parties. As a result, the submission emphasizes the need for a judicial determination by the adjudicating authority before the stage outlined in Section 100 of the Code. The petitioner argues that non- incorporation of the requirement for a hearing before the adjudicating authority prior to the appointment of a resolution professional would render the provisions of Sections 95 to 100 the Code to be arbitrary and violative of Article 14 of the Constitution of India. Therefore, the submission urged the need to conduct a judicial review before the appointment of a resolution professional to ensure a fair and lawful process.

The counsel for respondent on the other hand, contended that the requirement of observing the principles of natural justice arises at the adjudicatory stage under Section 100 of the Code. The process which is followed by the resolution professional is only for the purpose of collating facts and submitting a report together with recommendations to the adjudicating authority, which does not possess the character of a submission which binds the adjudicating authority. Even during the corporate insolvency process, the Code has indicated sufficient engagement for the debtor with the resolution professional. The counsel also submitted that the imposition of a moratorium under Section 96 of the Code is intended to insulate the debtor and, unlike the moratorium under Section 14 or 101 of the Code, is of no prejudice to the corporate debtor; and is consistent with the timelines provided by the Code.

Decision:

The Hon’ble Supreme Court held that these provisions of Section 95 to 100 of the Code cannot be held to be unconstitutional for not affording an opportunity of hearing to the personal guarantors before the insolvency petition filed by creditors is admitted against them and the moratorium is automatically applied against them as soon as the insolvency petition is filed.

The Hon’ble Supreme Court states that “The statute (IBC) does not suffer from any manifest arbitrariness to violate Art 14 of the Constitution”.

The Hon’ble Apex Court held that it cannot read an adjudicatory role into these provisions and that the entire process of timelines would be rendered negatory if the role of adjudicator is changed and for the Hon’ble Supreme Court to change the adjudicatory role envisaged under these provisions would amount to “rewriting the legislative functions”.

The Hon’ble Supreme Court said the resolution professional is just making a recommendatory report and it is not binding and noted that the true adjudicating function commences at Section 100 of the Code after the submission of the report.

“...the role of adjudicating authority commences under Part III after the submission of the recommendation report of RP. This is based on intelligible differentia of insolvency of corporates and insolvency of individuals and partnership firms.... Though the ultimate report of RP is only recommendatory, the legislature has ensured that the recommendation is made after taking into account the information and explanation by the debtor…”

Following are the key takeaways from the judgement of the Hon’ble Supreme Court:

  • Principles of natural justice principles cannot be applied in a straitjacket manner.

  • The Code has sufficient safeguards regarding the functioning of resolution professional. The legislature has ensured that the recommendation is made after considering the information and explanation by a corporate debtor.

  • The role under Section 99 of the Code which is ascribed to the resolution professional is that of a facilitator who must gather relevant information and recommend acceptance or rejection of application.

  • The moratorium is primarily in respect of a debt as opposed to a debtor. The purpose of moratorium under Section 96 of the Code is protective and the respondent is correct in submitting that the moratorium was to insulate the corporate debtor from the legal actions arising out of the debt.

  • The provisions related to personal insolvency are based on intelligible differentia between the individual debtors, partnerships, and corporate debtors.

CONCLUSION 

The Code has introduced a paradigm shift in India's insolvency landscape by expanding its scope to include personal guarantors to corporate debtor and further subjecting them to the insolvency process. This amendment has significant implications for individuals who act as personal guarantors, as they are now exposed to the risk of insolvency and potential forfeiture of their personal assets.

It is important to note that the liability of personal guarantor to the corporate debtor is established through an independent contract, and the contractual terms dictate the nature and magnitude of said liability. The Code provides for insolvency proceedings against personal guarantors to the corporate debtor in the same manner as corporate debtors and the creditor can initiate insolvency proceedings against both the corporate debtor and its personal guarantor or proceed in any other preferred sequence. Since the Code is still in its evolving phase, clarifications and judicial precedents will continue to shape the liability of personal guarantors to the corporate debtors and provide a more comprehensive framework for their protection and resolution.


[2] (2021) 9 SCC 321

[3] AIR 2002 MP 81

[4] Company Appeal (AT) (Ins) No. 504 of 2021

[5] W.P. (C) No.1281/2021

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