Liability of Personal Guarantors of a Corporate Debtor during the Corporate Insolvency Resolution Process

[Guest post by Param Pandya, Research Fellow, Corporate Law and Financial Law, Vidhi Centre for Legal Policy, New Delhi. The views expressed by the author are personal.]

On September 6, 2017, the Allahabad High Court in the case of Sanjeev Shriya vs. State Bank of India (“Sanjeev Case”) decided the question of the liability of personal guarantors of a company where moratorium under section 14 of the Insolvency and Bankruptcy Code, 2016 (“IBC“) is in force.

Facts

Lohia Machines Limited (“LML“) entered into a multi-party agreement with the State Bank of India (“SBI“) to avail a loan of INR 72.75 crores. The (ex) directors of LML, namely, Sanjeev Shriya, Deepak Singhania and Anurag Kumar Singhania were guarantors for this loan. However, in 2007, LML was declared ‘sick’ by the Board for Industrial & Financial Reconstruction.

In 2017, SBI approached the Debt Recovery Tribunal, Allahabad (“DRT“), for recovery of INR 72.75 crores under section 19(3) of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993. However, in the meantime, LML filed an application under section 10 of the IBC before the National Company Law Tribunal (“NCLT“), Allahabad, seeking the initiation of corporate insolvency resolution process.

The NCLT, Allahabad, by way of its order dated May 30, 2017, allowed the initiation of the corporate insolvency resolution process and declared moratorium under section 14 of the IBC. An Insolvency Resolution Professional (“IRP”) had also been appointed and an advertisement seeking claims from other creditors was also published. Pursuant to this advertisement, SBI also filed its claim with the IRP.

The DRT stayed the proceedings against LML (i.e. the corporate debtor) since the moratorium was operational under the IBC. However, it continued to hear the matter in relation to the enforcement of personal guarantees provided by the three (ex) directors. The DRT directed these (ex) directors to provide a list of assets among other details. The DRT also noted that LML’s application before the NCLT, Allahabad, was “as counter blast or to delay” the proceedings before the DRT. Aggrieved by this decision of the DRT, the three (ex) directors (also guarantors) filed a writ petition before the Allahabad High Court.  

Issue

Whether the personal guarantee of the (ex) directors of a company which is under a corporate insolvency resolution process can be enforced when a moratorium under section 14 of the IBC is in place?

Judgement  

In the Sanjeev Case, the Allahabad High Court has answered the above question in the negative stating that a personal guarantor of an insolvent company is not liable to pay the debt for the reasons as provided below:

(i)         The object of the IBC is categorical and as per section 60(1) the Adjudicating Authority, in relation to resolution of insolvency and liquidation for corporate persons including corporate debtors and personal guarantors thereof, shall be the NCLT.

(ii)        In the present matter, admittedly the proceedings have been initiated under the IBC and a moratorium under section 14 of the IBC has already been issued by the NCLT. SBI has also put in an appearance in the said proceedings regarding its claim.

(iii)       There is no doubt that the liability is co-extensive, but the entire proceeding is still in a fluid stage and two split proceedings cannot go simultaneously before the DRT as well as NCLT for the same cause of action.

Analysis

Banks often seek security from third parties by way of a contract of guarantee –where a director or shareholder may guarantee the repayment of advances made by a bank to its corporate customers. In other cases, one company may guarantee advances by a bank to its parent or subsidiary company.[1] Such guarantees are obtained with the primary motive ‘to ensure that the borrower (company) is operated with the interests of the lender in mind’.[2]  

In the case of Mukesh Hans & Anr. vs. Smt. Uma Bhasin & Ors (2010), the Delhi High Court had observed that it is well settled that a director of a company, though he owes a fiduciary duty to the company, owes no contractual duty qua third parties. There are, however, exceptions to this rule. One of it is where the director or the directors make themselves personally liable, i.e., by execution of personal guarantees, indemnities, etc.

It has also been held that upon the failure of the principal debtor to pay the whole or a part of the sum due, the guarantee stands invoked. “The guarantee is an independent contract and in all fairness, has to be honoured to fulfil the contractual obligation between the surety and the creditor”.[3] Furthermore, there is no requirement (unless expressly stated in the contract) that the creditor is required to exhaust all remedies against the principal debtor to enforce its rights under the personal guarantee. The Supreme Court of India in the case of Industrial Investment Bank of India Ltd. vs. Biswanath Jhunjhunwala (2009) had observed that “the very object of the guarantee is defeated if the creditor is asked to postpone his remedies against the surety. In the present case the creditor is a banking company. A guarantee is a collateral security usually taken by a banker. The security will become useless if his rights against the surety can be so easily cut down.”

Further, liquidation of the principal debtor does not by itself affect the creditor’s rights against the guarantors. The creditor may prove in liquidation the full balance due to it under the principal debt and may at the same time proceed against the guarantors for any sums due under the guarantee, obtain judgement against the guarantor for any sum outstanding at the date of the judgement, and then proceed to enforce its judgement until it is paid in full, from all sources. The creditor is entitled to prove in the liquidation of the principal debtor, irrespective of its ability to recover against the guarantor.[4]

The Allahabad High Court has clearly disregarded the quintessential fact that a voluntary application under the IBC was made by LML, which raises a doubt of a potential misuse of the moratorium. The comments by the DRT do not, prima facie, seem baseless. Secondly, section 60(1) read with section 60(2) of the IBC only governs ‘insolvency’ of personal guarantors of the corporate debtor and not enforcement of personal guarantee per se. It is also pertinent to note that section 60 is not yet in force and hence it will be crucial to understand the manner in which the delegated legislation further elucidates the scope of the statutory provision.

Further, the Allahabad High Court has also overlooked the existing interpretation of section 14 of the IBC. The NCLT, Mumbai, while determining the scope of section 14 of the IBC in Schweitzer Systemtek India Private Limited vs. Phoenix ARC Private Limited (July 23, 2017) (“Schweitzer Case”) has clearly laid down the position that the moratorium has no application on the properties beyond the ownership of the corporate debtor. It held as under:

The outcome of this discussion is that the Moratorium shall prohibit the action against the properties reflected in the Balance Sheet of the Corporate Debtor. The Moratorium has no application on the properties beyond the ownership of the Corporate Debtor. As a result, the Order of the Hon’ble Court directing the Court Commissioner to take over the possession shall not fall within the clutches of Moratorium. Even otherwise, the provisions of The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (the SARFAESI Act) may be having different criteria for enforcement of recovery of outstanding debt, which is not the subject matter of this Bench. Before I part with it is necessary to clarify my humble view that The SARFAESI Act may come within the ambits of Moratorium if an action is to foreclose or to recover or to create any interest in respect of the property belonged to or owned by a Corporate Debtor, otherwise not.

The NCLT, Mumbai arrived at the above conclusion based on the premise that:

The plain language of the Section is that on the commencement of the Insolvency process the ‘Moratorium’ shall be declared for prohibiting any action to recover or enforce any security interest created by the Corporate Debtor in respect of “its” property. Relevant section which needs in-depth examination is Section 14(1)(c) of The Code.

The understanding as propounded in the Schweitzer Case is in line with the very object and intent of the IBC, furthers the interest of the creditors and elucidates a more reasoned position of law. Since, the personal guarantee is an alternative remedy and section 14 of the IBC does not operate against the personal properties of the directors (personal guarantors), the decision in the Sanjeev Case does not seem to hold water.

Over time, it is essential to test the validity of the judgement in the Sanjeev Case in light of the Schweitzer Case and the recent Supreme Court judgement in Innovative Industries vs. ICICI Bank which proclaims the IBC as a ‘creditor-friendly’ law. 

– Param Pandya

[1]  Paget’s Law of Banking, Fourteenth Edition, LexisNexis, p. 466.

[2]  Philip R Wood, International Loans, Bonds, Guarantees, Legal Opinions, The Law and Practice of International Finance Series, Volume III, Second Edition, Sweet & Maxwell, p. 337.

[3] Industrial Finance Corporation of India Ltd. vs. The Cannanore Spinning & Weaving Mills Ltd. and Ors., (2002) 5 SCC 54. In relation to the co-extensive nature of a guarantee, see, Central Bank of India and Ors. vs. C.L. Vimla and Ors. (2015) 7 SCC 337.

[4] Edward Bailey & Hugo Groves, Corporate Insolvency – Law and Practice, LexisNexis, First Indian Reprint, p. 1096.

About the author

Add comment

Subscribe to Blog via Email

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Recent Posts

Topics

Recent Comments

Archives

web analytics