Personal Guarantors under the IBC: A Dilution of Subrogation and Protections

The author is KV Kailash Ramanathan, fourth year student at National University of Advanced Legal Studies (NUALS), Kochi.

Introduction

In the evolution of India’s insolvency jurisprudence post the enactment of the Insolvency and Bankruptcy Code (hereinafter referred to as “IBC” or “the Code”), one of the most contentious issues has been the position of personal guarantors with reference to their rights and obligations. When Part III of the Code dealing with insolvency of individuals was made operative against personal guarantors vide the 2019 notification, the Supreme Court (“SC”) sought to delineate guarantors’ rights and obligations in Lalit Kumar Jain v. Union of India (“Lalit Kumar Jain”) where the petitioners challenged the constitutionality of the said notification.

However, through a barrage of judgements and statutory interpretations in line with them, it can be averred that the position of a personal guarantor under the Code has been rendered weak and vulnerable vis-à-vis a guarantor in a regular contract of guarantee. The guarantor enjoys almost no protection from parallel proceedings under different statutes when the corporate debtor is undergoing the corporate insolvency resolution process (CIRP) unless a similar CIRP is initiated against him. Further, even a classic right of subrogation permitting a guarantor to recover from the corporate debtor all payments made to the creditor on his behalf has been rendered ineffective.

In this piece, the author seeks to analyze and establish the vulnerabilities personal guarantors face and the implications it could have on the commercial ecosystem.

Exposure To Proceedings Under SARFAESI Act

When a petition under Sections 7 or 9 of the IBC is filed against a corporate debtor and accepted by the NCLT, it ruffles the feathers of several creditors. Given the shield of moratorium accorded to the corporate debtor, these creditors have no option but to go through the statutory resolution process under the IBC which often ends with gigantic haircuts in repayment. In such a scenario all guns are directed against the guarantor.

As per the ruling of the SC in State Bank of India v. Ramakrishnan, proceedings under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act can be initiated to take possession of the guarantor’s assets even when a Corporate Insolvency Resolution Process is commencing against the corporate debtor. The ambit of a moratorium under the IBC extends only to the corporate debtor and not the guarantor.

A guarantor is exposed to takeover and auction of his assets in accordance with the SARFAESI Act regardless of the outcome of the CIRP. Given that the guarantor’s liability in keeping with general principles of contract law is coextensive with that of the principal debtor, such a parallel action is permissible in recovering the debt from the guarantor. Therefore a moratorium both under Section 14 as well as Section 33 acts as no shield for the guarantor qua guarantor.

Non availability of remedy under Section 60(5) IBC

The guarantor being hung out to dry in the face of SARFAESI proceedings is not merely a product of exclusion from a moratorium under Section 14. Under Section 60(5) of the Code, the NCLT has the power to entertain and dispose of any application or proceeding against the corporate debtor or any other person including personal guarantor to corporate debtors.

Even a remedy from the NCLT under Section 60(5) is not available to the personal guarantor when proceedings under SARFAESI are initiated. The SC of India clearly delineated the scope of the NCLT’s authority under the provision in Gujarat Urja Vikas Nigam Ltd vs Amit Gupta. The court clearly held that the jurisdiction of the Tribunal extends only to a dispute solely related to the insolvency of the corporate debtor.

The purpose of proceedings under the SARFAESI Act against the personal guarantor of the corporate debtor is for the bank to realize its dues, whereas the object of proceedings under the IBC is to see that the company continues as a going concern or that its assets get liquidated to settle debts as per the waterfall mechanism under Section 53 of the Code. Given the independent nature of SARFAESI proceedings purely for the recovery of loans, the NCLT cannot grant any relief to the guarantor for proceedings under the SARFAESI Act. The personal guarantor, while related to the debt, is not strictly related to the insolvency proceedings of the corporate debtor.

Lack of Right to Subrogation within the Process of the Code

One of the essential rights available to the guarantor to make good their loss is the right to subrogation. All rights that an undischarged creditor held prior to settlement of his claim should, in keeping with section 140 of the Contract Act, transfer to the guarantor under normal circumstances. If payment is made by the guarantor in settlement of a secured creditor, as per Section 140 he should be invested with all the rights of a secured creditor and be treated as such when liquidation commences as per section 53 of the Code.

A recent ruling of the National Company Law Appellate Tribunal (“NCLAT”) in State Bank of India vs Jayaprakash considered the issue of whether a guarantor upon settling the whole or a part of the debt can exercise the right to subrogation within the scheme of the Code. This would entail making a claim with the Resolution Professional under Section 36 as well as being treated as a secured creditor under the waterfall mechanism for distribution of liquidation proceeds. The tribunal after poring through the various provisions and definitions of the Code held that a personal guarantor under the IBC cannot be treated as a secured creditor even if he settles a part of the claim. He can seek repayment from the corporate debtor in exercise of his right under Section 140 of the Contract Act. In order to be treated as a secured creditor under the IBC, the creation of a security interest as defined by the Code in favour of an individual is a mandatory prerequisite,. and the right to subrogation provided under the Contract Act cannot confer that status on him.

Further, Section 238 of the IBC provides for a non-obstante clause that prevails over other legislations such as the Contract Act. The SC in Lalit Kumar Jain considered the position of sureties under the Contract Act and went on to establish the precedence IBC takes over the legislation. In Sundresh Bhatt, Liquidator of ABG Shipyard vs Central Board of Indirect Taxes and Customs the SC clearly held that Section 238 of the Code prevails over previously existing legislations unless provided otherwise.

Commercial Implications

Judicial Interpretation to the detriment of personal guarantors is certain to have commercial implications. Given the minimal advantage they can derive out of the IBC and exposure to alternate proceedings under the SARFAESI Act, guarantors are more likely to adopt a cautious approach in giving personal guarantees that can be problematic. India’s companies develop in a promoter-led model, and guarantees by promoters can be stifled by the precariousness of their situation under the Code. Once a liquidation or resolution commences, the corporate debtor may lack the resources to pay back the guarantor, thereby making the remedy under Section 140 of the Contract Act infructuous. The risk quotient for guarantors gets greatly enhanced.

From a policy perspective however, this position is not seen as bereft of any upside to it. While guarantors are disadvantaged, creditors receive a sweet deal in the recovery process. They get to initiate proceedings against the guarantor independently, and more importantly, the guarantor after paying one creditor either in whole or in part cannot compete with the others during the liquidation process by exercising the right to subrogation. This creditor-friendly position, in a way, is a necessity for India’s credit market to reach its complete potential. Corporate Insolvency Resolution under the Code has led to massive haircuts being thrust upon creditors, often as inordinate as 90% or more. The IBC’s ability to ensure creditors’ claims get settled while the company remains a going concern seems dicey. In light of the same, the availability of such a recovery mechanism against the guarantor incentivizes credit flow, which is a dire need for India. If a country’s credit system remains underdeveloped and risky, the flow of credit is restricted to the privileged class having access to collateral, thereby exacerbating inequality.[1]

Despite the benefit to creditors in recovery, credit can be harder to access without guarantees to support, and that may precisely be the situation if guarantors are stifled.

Conclusion

The position of personal guarantors under the Code is one that creates enhanced risk and exposure to liability for them. A moratorium against the corporate debtor and powers of the NCLT under Section 60(5) of the Code afford no protection whatsoever to the guarantor in the face of recovery proceedings under the SARFAESI Act. Much more, the right to subrogation, a foundational principle in the common law of guarantees, cannot be exercised within the scheme of the IBC. The guarantor, post performance of the debtor’s promise will not be permitted to assume the position of a secured creditor and thereby get paid back within the process of the Code. Even the guarantor being allowed to sue the debtor as per Section 140 of the Contract Act may serve little use against an insolvent entity whose assets have already been liquidated. Such a situation dwindles the position of the guarantor under the scheme of the Code and increases their risk. The commercial implications of this stifle guarantors while aiding creditors. How this deterrence of guarantors and encouragement of creditors will impact India’s credit market is yet to be seen, but certainly this position stifles guarantees without which credit may be hard to access.

[1]Luigi Zingales and Raghuram Rajan, Saving Capitalism from the Capitalists, Chapter I