Drawing the Line between Corporate Debtors and Personal Guarantors

[Partha N. Mansukhani is a fifth-year B.A. LL. B (Hons.) student at Symbiosis Law School, Pune]

The Supreme Court in State Bank of India v. V. Ramakrishnan & Anr. held that an order of moratorium passed under section 14 of the Insolvency & Bankruptcy Code, 2016 (“Code”) will exclusively apply to the corporate debtor against whom an insolvency application has been admitted by the adjudicating authority. Such a moratorium shall not, under any circumstances, extend to the personal guarantor of the corporate debtor.

Position in the pre – Code era

The earliest legislation dealing with insolvencies and bankruptcies of individuals and partnership firms were the Presidency Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920. A number of special enactments such as the Sick Industrial Companies (Special Provisions) Act, 1985 (“SICA”), the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (“RDDBFI Act”) and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”) provided for forums such as the Board for Industrial and Financial Reconstruction (“BIFR”),  the Debt Recovery Tribunals (“DRT”) and their respective appellate tribunals to take action against insolvent and bankrupt companies.

The High Courts were entrusted with the responsibility of liquidation of companies under the provisions of the Companies Act, 1956 and individual insolvency and bankruptcy cases were handled by the courts under the Presidency Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920.

SICA was specifically enacted with the objective of reviving and rehabilitating unproductive enterprises that were battling economic maladies. Corrective measures were undertaken in a bid to maximise the value of assets, protect employment, realise the amount that was due to banks and financial institutions as well as preserve the fiscal interests of the Central and State Governments. However, SICA did not prove to be an effective tool in combating sick industries and institutions such as the BIFR and the Appellate Authority for Industrial Financial Reconstruction (“AAIFR”) did not live up to the mandate for which they were instituted.

Section 22 of SICA provided for suspension of all legal proceedings, suits, contracts and other actions against a sick industrial company once it had been referred to the BIFR or the AAFIR for a scheme of revival or rehabilitation. Considering the wide ambit of protection provided under the section to the entity as well as its guarantors, the creditors were on a very weak ground as far as initiating recovery proceedings against the defaulting entities were concerned.

Eradi Committee Report

A High-Level Committee under the Chairmanship of Justice V. Balakrishna Eradi (“Eradi Committee”) came up with a report on the law relating to insolvencies and winding up of companies in the year 2000. The Committee noted how section 22 of SICA was prone to abuse, considering the suspension of all proceedings with respect to a sick industrial company which was referred to the BIFR or its appellate authority for a scheme of revival and rehabilitation. Creditors could neither proceed against the company nor against its guarantors, who were cloaked with the protection provided under the umbrella of section 22. Additionally, there would be inordinate delays in disposing cases referred to the BIFR/ AAIFR, which would have a domino effect on the repayment of dues owed to the creditors and pile up litigation at the courts. In fact, considering the dismal performance of SICA as a legislation, the Eradi Committee recommended a repeal of the said legislation and to incorporate the provisions related to revival and rehabilitation within the scope of the Companies Act, 1956, which was however never done.

The Eradi Committee was one of the earliest panels constituted to develop a framework to tackle the growing menace of insolvent and bankrupt companies.  It mooted the idea of establishing a national tribunal specifically constituted to deal with the revival, rehabilitation and winding – up of companies, to take the burden off the courts.

The Advent of the Code

The Code, which came into force on 1 December 2016, is a consolidated legislation designed to specifically to deal with insolvent and bankrupt persons, both natural and artificial. The Code is divided into separate parts with Part II of the Code specifically dealing with corporate entities and Part III of the Code (which has not been notified yet) dealing with individuals and partnership firms.

Section 5(22) under Part II of the Code defines a personal guarantor as an individual who is the surety in a contract of guarantee to a corporate debtor. Section 14 of the Code deals with the order of moratorium that has been passed by the adjudicating authority specifically with respect to the corporate debtor against whom an insolvency application has been admitted, until a resolution plan has been approved by a committee of creditors as provided under section 31 of the Code.

Section 96, which is in Part III of the Code, provides an interim moratorium with respect to a debtor who commits a default once an application under section 94 or 95 has been preferred before the adjudicating authority. An order of moratorium will be passed under section 101 if an application under section 100 is admitted by the adjudicating authority against the insolvent debtor pursuant to a report filed by a resolution professional.[1]

A report by the Insolvency Law Committee, constituted by the Ministry of Corporate Affairs, was of the view that in order to clear the ambiguity over the treatment of the guarantor’s assets with regards to the moratorium over the assets of the corporate debtor undergoing an insolvency resolution process, the assets of such guarantors of the corporate debtor were not to be protected by the moratorium under section 14 of the Code.

The promulgation of the Insolvency & Bankruptcy (Amendment) Ordinance in June 2018, which was subsequently replaced by the passage of the Insolvency & Bankruptcy (Second Amendment) Act, 2018, has implemented the recommendation of the Insolvency Law Committee by amending the provision, which now explicitly states that the provisions pertaining to moratorium shall not apply to a surety in a contract of guarantee to a corporate debtor, in addition to any such transaction as may be notified by the Central Government in consultation with a financial regulator.[2]

Analysis

The Code is a mechanism aimed at combating non – performing assets (“NPAs”). This body of law is structured in a way by which it prescribes a manner for initiating action and subsequently seeking remedies against defaulting entities across different classes, such as companies, individuals and partnership firms. For this reason, the Code has been demarcated into five different parts, with Parts II and III specifically dealing with defaulting companies and individuals and partnership firms respectively.

Section 14, which is enshrined in Part II of the Code, would only apply to a corporate debtor, which in this case would be the defaulting company against which an insolvency application has been preferred by the creditors and has been admitted by the adjudicating authority, i.e. the National Company Law Tribunal. Personal guarantors, under no circumstances, can claim to be covered by the order of moratorium that has been passed under section 14.

It is a well-established principle that has been deeply rooted in corporate jurisprudence that a company enjoys a separate legal status which is distinct from that of an individual. It is known that individuals establish companies to limit their liability and, in their capacity as director in such entities, will further go to the extent of offering personal guarantees to lenders for the purposes of securing a loan. In the event of default by the company, the director who has issued a personal guarantee with respect to the loan secured cannot be absolved of his responsibility as far as honouring the contract of guarantee is concerned. This is a basic principle of contract law wherein the liability of the surety is co-extensive with that of the principal debtor.

The intent of the legislature in enacting the Code was to ensure timely resolution and restructuring of NPAs to ensure the repayment of the large volume of debt owed to various lending institutions, without which there would be a jeopardising effect on the economy. Additionally, the aim of the legislature was to plug the loophole in section 22 of the SICA, which was blatantly abused and exploited, with creditors left in the lurch once a company came under the protection of this provision.

Although Part III specifically deals with individuals and partnership firms, the same has not been notified yet. Thus, to proceed against individuals in their capacity as personal guarantors, who have defaulted in their commitment, the recourse would lie in the Presidency Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920.

 Conclusion

As correctly pointed out by the Supreme Court in its verdict, the scope of moratorium contained in Part II is distinct from that contained in Part III of the Code. The latter would apply to personal guarantors in their individual capacity against whom an insolvency resolution process is initiated under Part III (which is yet to be notified by the Central Government).  The intent of the legislature coupled with the object of the Code was to not repeat the mistake under previous restructuring legislation which was misused at the expense of the lenders and other interested parties. The liability of the surety is co-extensive with that of the principal debtor, and the recent amendment to the Code has fortified this point of law.

Partha N. Mansukhani

[1] Section 99 of the Insolvency & Bankruptcy Code, 2016.

[2] Amendment to Section 14.

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