Resolution Process Against Personal Guarantors – A Violation Of Principles Of Guarantee?

One of the main grounds of challenge to the constitutionality is that the initiation of insolvency proceedings against the personal guarantors violates/extinguishes rights of the guarantor under the Indian Contract Act, more importantly, the right of subrogation

The present article seeks to address how the challenge would be unsustainable for several reasons. The provisions of the Insolvency & Bankruptcy Code, 2016 ("Code") have been structured in a way that does not take away the guarantor's rights of subrogation if the guarantor/s settle the debts of the corporate debtor during the course of corporate insolvency resolution process but before the Resolution Plan is sanctioned. At the same time, the Code also ensures that the guarantors do not escape from their liability by seeking refuge under a corporate debtor's CIRP.

Effects of continuation of CIRPs against the Corporate Debtor and Personal Guarantor:

It is a well settled position of law that the creditor can institute proceedings against the guarantor without exhausting the remedies against the principal debtor. This principle also stands reflected in Section 60(2) of the Code that allows for simultaneous continuation of proceedings against corporate debtor and guarantor.

However, the NCLAT, despite the Code permitting simultaneous continuation/institution of proceedings against the corporate debtor and guarantors, has held that the moment CIRP of either corporate debtor or corporate guarantor is admitted, the other proceeding needs to be withdrawn. The reasoning adopted by the NCLAT is that it would otherwise lead to duplicity of claims^[3]. Therefore, CIRP proceedings against borrower/corporate debtor and corporate guarantor cannot operate simultaneously. The ratio in Dr. Vishnu Kumar Agarwal v. Piramal Enterprises Ltd. is currently under challenge before the Supreme Court^[4].

Once the Adjudicating Authority approves the resolution plan under Section 31(1) of Code, the same is binding on all stakeholders including creditors, corporate debtor, guarantors, etc. Under the approved resolution plan of the corporate debtor, the financial creditor accepts the amounts offered by a 3^rd party (resolution applicant) as full and final satisfaction of the debt. The debt of the corporate debtor stands extinguished and the resolution applicant then takes over the corporate debtor.

Effects of extinguishment of Corporate Debtor's liabilities

When an approved resolution plan extinguishes the debts of the corporate debtor, it needs to be examined whether approval of resolution plan in the corporate debtor's CIRP would in any manner extinguish the guarantor's liabilities. In light of Section 134 of Indian Contract Act, 1872 the argument that could be raised here is that the guarantor's liability stands extinguished on the discharge of corporate debtor through the approved resolution plan.

The Calcutta High Court in Gouri Shankar Jain v. Punjab National Bank^[5] had considered this issue and ruled that the approval of corporate debtor's resolution plan would not automatically discharge the guarantor, until the debts are satisfied. The rationale behind the Court's decision is that the creditor (financial or operational) approaches the court to exercise a statutory right; and this does not in any manner obliterate or modify the contractual rights between the creditor, guarantor and principal borrower.

The Supreme Court in Maharashtra State Electricity Board Bombay v. Official Liquidator^[6] has also held that discharge of the borrower under the bankruptcy proceedings would not in any manner extinguish the liabilities of the guarantor.

However, the P&H High Court in Kundanmlal Dabriwala v. Haryana State Financial Corporation & Ors.^[7], while considering an approval of scheme under Section 391 of Companies Act, 1956 ruled that extinction of liability of company under the scheme would result in a discharge of surety. The Calcutta High Court in Gouri Shankar Jain, which was a subsequent decision, while holding to the contrary, observed that the decision in Kundanmlal is wrong and requires "reconsideration".

It could be argued that a scheme under Section 391 is akin to a resolution plan under the Code, thereby resulting in a discharge of personal guarantors. However, the provisions of the Code are quite clear on this aspect, i.e. the CIRP of corporate debtor would not result in a discharge of personal guarantors. This is evident from Section 60(2) and also from Section 14(3)(b) of the Code which stipulates that moratorium would not apply to the invocation of guarantees given for corporate debtor. The rationale behind such exclusion was to ensure that the personal guarantors do not escape from an independent and co-extensive liability to pay the outstanding debts^[8]. Consequently, it is clear that the CIRP of corporate debtor would not result in a discharge of guarantor from its liabilities. If the ratio in Kundanmlal were to be applied, it would lead to an anomalous situation of giving a go-by to Section 14(3)(b) and Section 60(2) that provide for an opportunity to proceed against the guarantor. Moreover, as stated above, when CIRP of corporate debtor and guarantor cannot operate simultaneously, the argument for extinguishment will not hold good if the creditor decides to proceed against the guarantor first.

Consequently, any argument pertaining to the extinguishment of guarantor's liabilities in light of ongoing CIRP against corporate debtor would not be tenable. Even though the resolution plan is said to be binding on all stakeholders including creditors under Section 31(1), insolvency proceedings can be initiated against the guarantor for the remaining debts, if any.

Effects on principles of subrogation

Under Section 140 of the Indian Contract Act, 1872 the guarantor has the right of subrogation. If under the resolution process of a guarantor, i.e. corporate or personal guarantor, the debts of the creditor are satisfied, the argument that could be raised is that the guarantor would have the right of subrogation, i.e. the right to recover the same from the corporate debtor.

The objective of the Code is to ensure maximization of the asset value of the Corporate Debtor and not operate as a recovery mechanism. The issue of subrogation rights under the resolution plan was taken up for consideration by the NCLAT in Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors.^[9]. The observations of the NCLAT on this issue is significant:

"It was not the intention of the legislature to benefit the 'Personal Guarantors' by excluding exercise of legal remedies available in law by the creditors, to recover legitimate dues by enforcing the personal guarantees, which are independent contracts…….While considering the 'Resolution Plan', the creditors focus on resolution of the borrower 'Corporate Debtor', in line with the spirit of the 'I&B Code'. The present appeal has been preferred by the promoters, who are responsible for having contributed to the insolvency of the 'Corporate Debtor'. The 'I&B Code' prohibits the promoters from gaining, directly or indirectly, control of the 'Corporate Debtor', or benefiting from the 'Corporate Insolvency Resolution Process' or its outcome. The 'I&B Code' seeks to protect creditors of the 'Corporate Debtor' by preventing promoters from rewarding themselves at the expense of creditors and undermining the insolvency processes."

Therefore, it is clear that subrogation is not an absolute right; and principles of the Code do not accord primacy to the guarantor's right of subrogation, especially personal guarantors who are the erstwhile promoters.

However, this does not mean that the guarantor's right of subrogation is completely extinguished under the Code. The personal guarantor ought to be wary of the timelines under the Code and take steps to satisfy the creditor's debts prior to the approval of the corporate debtor's resolution plan. This could enable the guarantors to exercise their subrogation rights.

In the event the guarantor settles the debt prior to the conclusion of corporate debtor's CIRP, the guarantor can stand subrogated. However, if the guarantor settles the debts after the approval of resolution plan, then the resolution applicant can exercise its discretion to provide for claims relating to subrogation and personal guarantee. That said, in the event the resolution applicant fails to provide for such claims, it cannot be a ground for rejection of resolution plan. This issue fell for consideration in Committee of Creditors of Essar Steel India Limited through Authorized Signatory v. Satish Kumar Gupta^[10]. The Hon'ble Supreme Court, placing reliance on State Bank of India v. V. Ramakrishnan^[11], opined that the resolution plan is binding even on the guarantors under Section 31(1) of the Code and consequently, non-consideration of subrogation rights under the resolution plan cannot result in its rejection.

As stated above, subrogation right is not an absolute right and the same is dependent on the availability of assets with the corporate debtor^[12]. Moreover, the non-availability of subrogation rights cannot result in discharge of the guarantor's liability towards the satisfaction of the debt^[13].

In light of the above-mentioned judicial position, the challenge to the constitutionality of the personal guarantor provisions on the ground of violations of principles of guarantee is not likely to hold any water. The Delhi High Court's decision would decide the fate of a number of personal guarantors, who may be eagerly awaiting the outcome of the proceedings.

The personal guarantors are predominantly the promoters or close family members of the promoters at the helm of the corporate debtor. These personal guarantors voluntarily provide personal guarantees in order to support the business venture knowing that they may be fraught with risks . It cannot be the case that they gain from the loans advanced to the corporate debtor but shirk responsibilities at the time of invocation of their personal guarantees on the pretext that they are satisfying a debt not undertaken by them and their right of subrogation is affected.