In deciding a number of petitions challenging the constitutionality of the notification dated 15 November 2019, which brought into force provisions of the Insolvency and Bankruptcy Code, 2016 relating to the Insolvency Resolution Process for ‘Personal Guarantors to Corporate Debtors’ (“November 2019 Notification”), the Supreme Court in its order dated 21 May 2021 in the case titled Lalit Kumar Jain v. Union of India, has settled the legal uncertainty surrounding the liability of sureties upon approval of a Resolution Plan under the Insolvency & Bankruptcy Code.

Background

In a flurry of petitions filed in the Supreme Court and in various High Courts across India, individuals, particularly promoters, and managing directors of defaulting companies, challenged the constitutional validity of the November 2019 Notification. These individuals had one thing in common, they had all furnished personal guarantees for amounts borrowed by their associated companies, and such companies had since defaulted in their payment obligations. The November 2019 Notification and the related rules and regulations, allowed counter parties, mostly banks and financial institutions to commence insolvency proceedings against such individual guarantors.

Banks and financial institutions welcomed this development as it provided them with an effective mechanism to recover their advances, and who so far could only seek contractual remedies against sureties or rely on British Era insolvency laws, which were as some would argue out-dated, ineffective and time- consuming. The personal guarantors on the other hand, were outraged to say the least and rallied in challenging the November 2019 Notification.

The Challenge and Arguments

The petitioners’ challenge was built on numerous arguments, including those of competency and authority of the Central Government to issue the November 2019 Notification, non application of mind in issuing it, and the unreasonableness of the classification it creates.

It was also argued, and very forcefully, that a duly approved resolution plan (under Section 31 of the Insolvency & Bankruptcy Code, 2016) in respect of the corporate debtor — the primary borrower— would propose to extinguish and discharge the liability of the principal borrower to the financial creditor. Therefore, the petitioners’ liability as guarantors under the personal guarantee — which is co-extensive with the principal debtor — would also stand completely discharged.

The Union of India, rebutted this line of argument and argued that neither the guarantor’s obligations are absolved nor discharged in terms of Sections 133 to 136 of the Indian Contract Act, 1872, on account of release/discharge/composition or variance of contract which a principal borrower may secure by way of operation of law for instance as under the Code. Therefore, by way of approval of a resolution plan, any release/discharge secured by the principal borrower or entering into a composition with the principal borrower (reference to Section 135 of the Contract Act) cannot discharge the guarantor in any manner what so ever. It was further submitted that while the creditors were entitled to a ‘double dip’ there were enough safeguards in law, which do not permit the creditor to recover more than the total debt owed to it.

The Judgement

The Supreme Court while pronouncing its judgement, discussed its previous judgements on the issue of personal guarantor’s liability under the Code, particularly in the case of SBI v. V. Ramakrishnan, and Committee of Creditors of Essar Steel (I) Ltd. v. Satish Kumar Gupta. In the former, the court had held that the resolution plan would be binding on the guarantors while in the latter, the court had refused to interfere with pending proceedings against the personal guarantors.

The ratio of the court was however based on the judgement in Maharashtra
State Electricity Board Bombay v. Official Liquidator, High Court, Ernakulum and Punjab National Bank v. State of U.P.. The first case arose pursuant to the liquidation of the principal borrower and the second pursuant to the nationalization of the principal borrower, both involuntary acts which either extinguished or modified the liabilities of the principal borrower.

It finally held that:

…approval of a resolution plan does not ipso facto discharge a personal guarantor (of a corporate debtor) of her or his liabilities under the contract of guarantee. As held by this court, the release or discharge of a principal borrower from the debt owed by it to its creditor, by an involuntary process, i.e. by operation of law, or due to liquidation or insolvency proceeding, does not absolve the surety/guarantor of his or her liability, which arises out of an independent contract.

Whats next?

We do expect fresh petitions seeking review of the Supreme Court order, as the proposition of law would have ramifications beyond the Code. Individual guarantors continue to defend themselves in multiple proceedings before civil courts, debt recovery tribunals and criminal courts, for dues of companies who have since extinguished/restructured their liabilities and had a fresh start under a new control and management, pursuant to an approved resolution plan. This ruling will have a direct impact on such proceedings.

At the same time the creditors have got a shot in the arm, and should now be able to recover a few more cents to a dollar than what they recovered in the the resolution plan. Although asset tracing, and questioning undervalue or fraudulent transactions, will pose their own challenges.

Going forward, individual promoters and directors ought to exercise caution in furnishing such guarantees, and will be well advised to negotiate the terms of the surety keeping the Supreme Court’s judgement in mind.

For more information please contact:

Murtaza Somjee, Partner, Disputes and Insolvency, [email protected]

Rhia Marshall, Partner, Disputes, [email protected]