Some intriguing legal questions on the effect of a personal guarantee on a business debtor facing bankruptcy under the Insolvency and Bankruptcy Code, 2016 (‘IBC’) have been brought up with the recent pronouncement in Vidarbha Industries Power Limited v. Axis Bank Limited (‘Vidarbha judgement’).
The Supreme Court (‘SC’) judgment has settled the ambiguity surrounding the liability of personal guarantors under the IBC. Nevertheless, certain issues have remained unaddressed.
So in this article, we will explore the nature of personal guarantees and their direct inclusion in bankruptcy proceedings post the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018. Further, the Vidarbha judgment will be dissected to understand its implications on Section 7(5)(a) of the IBC, shedding light on whether it is a requirement or a discretionary provision.
Furthermore, the article will unravel the complexities surrounding the interplay between personal guarantees and insolvency, emphasizing the increased power granted to creditors in collecting unpaid amounts.
And drawing from legal provisions such as section 128 of the Indian Contract Act, 1872, (‘ICA’), we will explore the extent of personal guarantors’ obligations and the potential coexistence of legal actions against both the corporate debtor and its personal guarantor.
What is a Personal Guarantee?
A personal guarantee is an agreement established by an individual (the guarantor) to pay back a debtift the corporate debtor (the borrower) defaults on its obligations to a creditor.
Personal guarantees are often required by lenders when extending credit to small businesses. It acts as a secondary source of repayment for the lender and provides an additional layer of security.
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Implication of Personal Guarantee in IBC
For those who offer personal guarantees, the IBC in India has serious implications for their liabilities. Personal guarantors are now covered by the IBC and are facing insolvency procedures. Such as a business owner can often discharge most or all of a personal guarantee in bankruptcy because personal guarantees are typically unsecured claims that are not tied to specific pieces of property.
This puts business owners in a difficult situation when a small business with personally guaranteed loans fails, potentially losing their homes or other significant assets. Further, this provision gives a creditor the ability to file for bankruptcy against a debtor’s personal guarantor.
They are now subject to the danger of insolvency, which might result in the possible confiscation of their personal assets since the procedure for them closely resembles the corporate insolvency resolution process. The proceedings are conducted before the National Company Law Tribunal (‘NCLT’).
The recent judgment has clarified the scope of the obligation imposed on the personal guarantors by the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018 and the validity of those IBC sections.
Section 7 of IBC
Section 7 of the IBC provides for the initiation of a Corporate Insolvency Resolution Process (‘CIRP’) by a financial creditor. It enables a financial creditor to file an appropriate application, either by itself or jointly with other financial creditors, for initiation of a CIRP against a corporate debtor.
The financial creditor shall make an application under sub-section (1) in such form and manner and accompanied with such fee as may be prescribed.
Further, it has to show the record of the default recorded with the information utility or such other record or evidence of default as may be specified, along with the application. Along with that, the name of the resolution professional proposed to act as an interim resolution professional should also be presented.
And at last, the NCLT may allow the application submitted u/s 7 of IBC, provided that (a) a default has occurred, (b) the application is complete, and (c) there isn’t a disciplinary action against the suggested resolution professional pending. Hence, this is stated in Section 7(5)(a) of the IBC.
The Vidarbha judgement
In this judgment, SC ruled that the NCLT has the discretion to accept an application for insolvency once the financial creditor has established the existence of default u/s 7(5)(a) of the IBC.
They referred to the decision of Innovative Industries Limited v. ICICI Bank and Another wherein the entire scope of section 7 was explained and it was held that if NCLT is satisfied there is a debt and default, it is bound to admit a petition u/s 7 of the IBC, which was reiterated in E.S Krishnamurthy also, while holding that the NCLT cannot direct parties to enter into settlement terms.
They also observed that the amount payable also included the amounts under the fund-based overdraft facilities and that the order of the Telangana High Court did not relate to all the bank guarantees given by Canara Bank nor was there any finding in the said order that the corporate debtor is not liable to pay the dues.
At last, they concluded that there were no good reasons for the NCLT to exercise its discretion and reject the Section 7 petition and accordingly dismissed the appeal and upheld the judgments of the NCLAT and the NCLT.
Aftermath of Vidarbha Judgment
After this judgment, the Ministry of Corporate Affairs requested public feedback on the proposed code revision on 18/01/2023. The Proposal pointed out that the word “may” in Section 7(5)(a) of IBC has been construed by the Vidarbha ruling to mean that the NCLT retains the authority to accept or reject the application even in cases where a default has occurred.
The proposal also made it clear that the NCLT is not obliged to investigate aspects of the corporate debtor’s solvency and financial stability. To make it clear that the NCLT must accept an application after being convinced that a “default” as that term defined in Section 2 of the IBC, the Government of India has suggested to amend Section 7 of the Code.
From this, it can be seen that the legislature never intended to give the NCLT any discretion, as the Hon’ble Supreme Court determined in the Vidarbha ruling.
The Interplay Between Personal Guarantee and Insolvency
This judgment is significant because it gives the corporate debtor’s creditors more power to collect unpaid amounts that were not collected during the corporate debtor’s insolvency resolution process due to the personal guarantor’s insolvency resolution process. By doing this, the creditors can collect their debts from many sources, so creating a “dual safety net.”
Additionally, the outcome in Surendra B. Jiwrajika v. Omkara Assets Reconstruction Private Limited has also increased the creditors’ already considerable negotiation leverage and reduced the amount of protection provided by the IBC for personal guarantors.
Further, as per section 128 of the ICA, personal guarantors’ obligation is coextensive with that of the corporate debtor. An independent contract establishes a personal guarantor’s obligation, and the provisions of the contract specify the type and extent of that liability.
Thus, the creditors have the option to file a lawsuit in parallel against the corporate debtor and its personal guarantor, or they can choose to file in any other order of their choosing. Either, the full sum or the residual amount may be recovered by legal action taken against the personal guarantor.
It can be concluded that the corporate debtor’s responsibility ends upon the committee of creditors’ (‘CoC’) acceptance of the resolution plan, so relieving the personal guarantor of its liability as well.
This argument, which is derived from the ICA’s provisions, is invalid because of different decisions made by the Hon’ble Supreme Court and Hon’ble High Courts. Even if the corporate debtor is released from its obligation, the personal guarantor’s duty remains.
Conclusion
The intricate interplay between personal guarantees and insolvency proceedings, particularly under the IBC, has ushered in a new era of legal scrutiny and consequences for stakeholders.
The Hon’ble SC’s Vidarbha Judgment has brought clarity to the discretionary powers of the NCLT u/s 7(5)(a) of the IBC, thereby shaping the contours of insolvency initiation.
The significance of personal guarantees in bankruptcy proceedings has been underscored by the IBC (Second Amendment) Act, 2018, which directly subjects personal guarantors to insolvency proceedings without the prerequisite of initiating proceedings against the corporate debtor.
This paradigm shift in liability has profound implications for individuals offering personal guarantees, exposing them to the peril of losing personal assets in a manner mirroring the corporate insolvency resolution process.
As the IBC continues to evolve and undergo potential legislative amendments, individuals acting as personal guarantors must navigate these complexities prudently.
The legal developments and court decisions discussed in this article underscore the need for a comprehensive understanding of risks and liabilities associated with personal guarantees.
Seeking legal counsel becomes paramount for those facing creditors’ pursuits based on personal guarantees, ensuring a strategic approach to safeguarding their assets amidst a dynamic and evolving legal landscape.
In essence, the evolving nature of the IBC and associated legal precedents necessitate a vigilant and informed stance for all stakeholders involved in the realm of personal guarantees and insolvency.
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Authored by Pratham Tiwari, a 1st year Law Student at National Law University Odisha.