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Insolvency

Guarantors Beware! – Lalit Kumar Jain v. Union of India: Case Comment

In this Article, the authors analyse the rationale and consequences of the recent judgment passed by the Supreme Court, in Lalit Kumar Jain v. Union of India, where it was held that approval of a resolution plan relating to a corporate debtor does not operate to discharge the liabilities of personal guarantors.

Ashima Joshi & Mudit Burad

Case Background

On November 15, 2019, the Union Ministry of Corporate Affairs (“MCA”) released a notification introducing provisions of Part III of Insolvency and Bankruptcy Code 2016 (“the Code”) which dealt with the bankruptcy and insolvency resolution processes concerning personal guarantors to corporate debtors. This notification enabled banks to initiate insolvency proceedings against the personal guarantor to corporate debtors. The intent was to make promoters, directors, or sometimes, the managing directors or the chairperson liable for the loans taken by their firm on their personal guarantee.

The new provisions of the notification were challenged before various High Courts as well. The Supreme Court, while exercising its powers under Article 139A to transfer cases and to settle the common question of law under Article 32 concerning the interpretation of the provision of the Code, presided on the matter. This was done to avoid contradictory rulings by different High Courts and to authoritatively settle the law. 

Relevant Facts

Lalit Kumar Jain and Others (“Petitioners”) had given personal guarantees to financial institutions and banks in different capacities i.e. as promoters, directors, or chairpersons. After the release of notification, the personal guarantees of the petitioners were invoked in multiple cases. Consequently, the insolvency proceedings of various stakeholders were at different stages; and some at the final stage. Many were issued demand notices and faced insolvency proceedings under the code.

The petitioners had two main contentions; first, that the notification was ultra vires of the powers delegated to the central government, and second, the executive (government) could not apply the provisions of the code selectively to one sub-category of individuals, that is personal guarantors to corporate debtors.

Issues

  1. Whether the notification dated 15.11.2019 (“notification”) issued by the MCA was valid and intra vires of the powers and authority of the government? 
  2. Whether the sanction of a resolution plan of a corporate debtor discharges the personal guarantor to the corporate debtor?

The Judgement

The idea of gradually implementing the law or legal principles was supported in various cases by the apex court which suggested that there is no need or constitutional requirement  to implement a law or policy at once. The discretion is given to extend an enactment by seeing the area of operation, or to determine when and how the law will be put into effect. The court relied on the report of a Working Group emphasizing the proximity of personal guarantors with corporate debtors. The notification gave rights to the central government to decide when and how the pending actions against a personal guarantor to the corporate debtor can be taken before adjudicating authority. 

The court noted that the parliamentary intent was to treat personal guarantors on a different footing from other categories of individuals. The prospect of two independent processes taking place in different forums will lead to uncertain outcomes, though the adjudicating authority was the same for the corporate debtor to whom individuals stood as personal guarantors. The insolvency process for individuals is in Part III whereas the process concerning corporate debtors is in Part II. This distinction does not lead to incongruity because the forum for adjudicating processes that were different earlier has now become common (i.e., NCLT). This would further help in considering the whole picture about the assets available and enhance the Committee of Creditors (“CoC”) framing of realistic plan keeping in mind the creditors’ dues from personal guarantors.

Prior to the impugned notification, a notification was issued under Section 1(3) which revealed that the code was implemented in stages, keeping in mind the categories of persons to whom its provisions were to be applied. The notification extends the Code’s application to another category of persons which it never intended to. The impugned notification issued under Section 1(3) is, therefore, not ultra vires of the power; the notification is valid.

The court finally observed that the release or discharge of a principal borrower from the debt, by operation of law, or due to liquidation or insolvency proceeding, does not ipso facto absolve the surety/guarantor of their liability, which arises out of an independent contract. 

And therefore, it was held that the impugned notification is legal and valid. 

Analysis

In our opinion, the decision did not uphold  the constitutional values of delegated legislation. The proviso of Section 1(3) of the Code empowers the central government to enforce various provisions of the code at different points in time, however it does not permit the government to classify a part of the provisions of the code or to apply the provisions on certain categories of persons. The “conditional legislation” permits the executive to bring the law into force at times it may decide. In such legislation, the law has been made in its completeness and with very limited scope for further legislation. The duty of the central government is to determine the time and manner for the law to apply in the country and not to choose the subjects to which the law will apply.

The second issue dealt with the sanction of the resolution plan which results in the discharge of the principal borrower. The resolution plan, once approved, becomes binding on the corporate debtor, members, guarantors, and other stakeholders involved in the resolution plan. Going by the provision of contract law as the “liability of the surety is co-extensive with that of the principal debtor” if the latter’s liability is discharged or extinguished the liability of surety should also be extinguished as the resolution plan is a contract. Section 140 of the Indian Contract Act,1872, provides for subrogation rights which the personal guarantor cannot avail of after the approval of the resolution plan. However, the court in the present case relied on the ratio of V. Ramakrishnan where the court observed that the object of the IBC was not to allow personal guarantors to evade their liability once the resolution plan is approved. This, in turn, affects the right of a third party who is not even a party to the contract by not allowing him to file for subrogation rights and not discharging him of the co-extensive liability, thereby contradicting Section 30(2)(e) of the Code. A balance has to be drawn between the interests of the corporate debtor and the rights of a personal guarantor. In most cases the directors are personal guarantors and their right to recover from the corporate debtor should not be taken away indifferently. 

Our final contention against the rationale of this judgment is that it uses the Code for the purpose of debt recovery, which, as held in various instances, is against the ethos and legislative intent of the code. The appropriate mechanisms for debt recovery are through the SARFAESI, RDDBFI, or money suits, but the code should not be used as an alternative mechanism for debt recovery.

Conclusion

In the present case, the court had to decide between two rights – the contractual right of the personal guarantor and the right of the creditors, which are generally public sector banks. The court chose the latter as a public policy decision. The court in the present case seems to have followed the Benthamite approach of justice. As the debt recovery rates of Indian banks have been abysmal in recent years, the burden ultimately falls on the taxpayers. This judgment will take some of that burden off from the shoulders of the taxpayers and will put it on the personal guarantors who are generally financially strong and have agreed to repay the sum in case of default.

The repercussions this judgement will have on the future of personal guarantors can be far-reaching. While we may see a dip in the number of defaults by personal guarantors, it might become difficult to find a personal guarantor for a business and therefore limiting the opportunities of finance. It will also increase the burden on NCLT as more cases of debt recovery will find their way to NCLT instead of approaching traditional recovery tribunals and courts.

Ashima is a 3rd Year Student at the National Law University, Odisha, and Mudit is a 4th Year Student at National Law University, Jodhpur.

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