Guarantors may be vulnerable to pandemic default risks

The government recognised the economic impact of covid-19 on businesses by enacting the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2020. The ordinance, among other measures, inserted section 10A into the Insolvency and Bankruptcy Code, 2016, which suspends for six months the operation of sections 7, 9 and 10, the sections triggering insolvency proceedings, in respect of any default from 25 March. The suspension may be extended for up to a year. The legislative intention was clearly to allow companies to ride out the crisis without facing insolvency proceedings. This is commendable and, with the loan moratorium instituted by the Reserve Bank of India, eases pressure on companies.

From the perspective of financial creditors, however, the ordinance has stripped away the most efficient way to recover outstanding debts. Since the commencement of the IBC regime, increasing numbers of creditors, especially financial creditors, have taken action through the insolvency process instead of taking proceedings in such tribunals as the Debts Recovery Tribunal (DRT) or under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI). This is mainly due to the timely process guaranteed under the IBC. With the suspension of insolvency under the code, financial creditors have no option but to pursue proceedings under SARFAESI or before the DRT. These however are usually protracted. Financial creditors are therefore looking for solutions that may still be open under the code.

Most corporate debt obligations are secured not only by tangible assets but also by guarantees from other corporations or personal guarantees from the promoters. Usually a creditor will enforce the securities or go before insolvency tribunals rather than pursuing personal guarantees. However, the ordinance does not lessen the rigours of the code against personal guarantors. This has caused some confusion as to whether it is permissible for creditors to proceed against the personal guarantors of the corporate debtors even when no insolvency proceedings could be brought against the defaulting company. Even the Supreme Court has recently questioned why public sector banks have not pursued personal guarantees issued by promoters of defaulting entities.

It is a well-established principle of contract law that the obligations of a guarantor are independent of, and co-extensive with, those of the principal borrower. This general proposition of contract law is different from an insolvency which is governed exclusively by the code. Under part III of the code, only personal guarantors to corporate debtors can be the subject of proceedings. A personal guarantor under part III has been defined as a debtor who is a personal guarantor to a corporate debtor and in respect of whom guarantee has been invoked by the creditor and remains unpaid in full or part. The personal guarantor is thus considered as the debtor only once the liability of the personal guarantor arises in law, that is when the creditor invokes the personal guarantee.

It is important to understand the intent behind the notification of provisions of Part III of the IBC with respect to personal guarantors. Section 2(e) of the code applying the code to personal guarantors of corporate debtors was only brought into force on 1 December 2019. A corporate debtor is a corporate person that owes a debt to someone. This, together with the fact that a personal guarantee must have been invoked, implies that the provisions for the insolvency of a personal guarantor can be invoked only when the corporate debtor defaults on its obligations and such defaults are recognised under the code. It can be argued that the intention was to allow creditors to proceed against the personal guarantors only once it has been determined that the principal borrower has defaulted on the repayment of the debt and is in a corporate insolvency resolution process (CIRP).

The ordinance appears to be restricted to part II of the code that deals with CIRPs and the liquidation of corporate persons, but one can argue the legislative intention must be available to stakeholders equally. It can also be argued that if there is no default by the corporate debtor, there can be no default by the personal guarantor in respect of the same debt. Further, the ordinance inserted section 66(3) into the code, which provides that no director or officer of the company shall be compelled to make a contribution to the assets of the corporate debtor, if a default occurred during the period of suspension. However, in the absence of specific provisions in the ordinance in this regard, this argument remains to be tested before the courts and tribunals.

Anush Raajan is a joint partner and Swastika Chakravarti is a senior associate at Lakshmikumaran & Sridharan.

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