Critical Analysis of Supreme Court (SC) Ruling That Allows Lenders To Initiate Insolvency Proceedings Against Personal Guarantors

INTRODUCTION

A Division bench of the Hon’ble Supreme Court comprising of Justice L. Nageswara Rao and Justice S. Ravindra Bhat, on Friday pronounced a ruling that is destined to have a profound impact on the entire business community as a whole. In essence, the ruling mandated that, insolvency proceedings under the Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as IBC) can be initiated by lenders against promoters who have given a personal guarantee. This mandate came in the form of the Apex judicial body of India upholding Ministry of Corporate Affairs Notification No. S.O. 4126(E) published on 15th November, 2019[1].

This Article shall take an in-depth look into the various components of this judgment, such as, the IBC, the concepts of Promoters and their legal position with regards to the Corporate Debtor and the rationale behind the Supreme Court judgment.

THE IBC & ITS RATIONALE IN THE CONTEXT OF THIS RULING

To better understand the context of the ruling, we must first appreciate the circumstances under which the current Insolvency Code came into existence. In the 1980s, there was a dire prevalence of ‘industrial sickness’ which paved the way for the Sick Industrial Companies Act (SICA). However, the Act in itself was not perfect. To fill in the legal lacunae, the Government repealed SICA and introduced the Sick Industrial Companies (Special Provisions) Act, 2003. In retrospect, it can be safely concluded that, the SICSPA did not perform at par with the expectations it had garnered prior to its enactment. And thus, the IBC of 2016 was notified.

The factum of pertinence, with respect to the aforesaid ruling of the Supreme Court, is the approach adopted by the Regulatory authorities while drafting and enacting the IBC. The IBC was inherently bestowed with a larger scope of application and the Government strived to inculcate effective provisions and procedures. Thus, the Supreme Court ruling was bound to permeate the liberal object of the code whist interpreting its scope and object.

It is also pertinent to note that, under the IBC, Section 2(g) and 78 envisage the applicability of the Code on individuals as well. The 2019 notification expressly included Personal Guarantors within the ambit of the Insolvency Proceedings[2]. Thus, it can be said that, the inclusion of Personal Guarantors might have been made via the 2019 notification, however, the inherent foundations of such inclusion were laid down from the very beginning of the Code.

THE CONCEPT OF PROMOTER AND HIS LEGAL POSITION AS TO THE CORPORATE DEBTOR

The concept of a Promoter with regards to can be better understood in the light of Section 2(69) of the Companies Act which states, a promoter is anyone who either:

a) has been named as such in a prospectus or is identified by the company in the annual return referred to in section 92; or

b) has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise; or

c) in accordance with whose advice, directions or instructions the Board of Directors (BoD) of the company is accustomed to act.

Thus, it can be understood that, a promoter is someone who has a substantial amount of leeway when it comes to the operation of the Company. Further, it must also be appreciated that, a promoter is a separate entity to that of the Company. However, the question remains as to whether; the Promoter can be held liable separately for the acts of the Company?

In the case of D.R Patel v. A.S Dimellow[3] the Hon’ble Madhya Pradesh High Court while holding a promoter personally liable to a third-party relied upon the words of D.M Ghosh stating that, “a promoter is personally liable to third parties, unless the Company takes over their liability with their consent.” To tie a nexus between the aforesaid and the Supreme Court judgment in question, we must understand the concept of Personal Guarantee.

CONCEPT OF PERSONAL GUARANTEE AS PER INDIAN CONTRACTS ACT, 1872

Section 126 of the Indian Contract Act, 1872 defines a contract of guarantee as a contract to either perform the promise, or discharge the liability of a third person in case he fails to do so. Thus, the Promoter is an ‘Independent Party’ to the Contract. Further, under Section 128 of the Indian Contract Act, 1872, the liability of the guarantor (in this case the Promoter) is coextensive to that of the Principal Debtor (in this case the Company). This means that even the Promoter is liable to be ‘sued’ or in this case can be made a party to the insolvency proceedings. This ratio is further substantiated in the case of Maharashtra State Electricity Board, Bombay Vs. Official Liquidator, High Court, Ernakulam, Anr.[4] wherein the Hon’ble Supreme Court held that the mere fact that a principal debtor has gone into liquidation would absolve the guarantors of their liability.

Thus, by a perusal of the aforementioned components of the matter in hand, we can safely conclude that, the IBC offers a very extensive reach with respect to its applicability and the fact that the Promoter is a personal guarantor means that, in light of the nature of the contract of guarantee and a promoter’s position relative to the Company, insolvency proceedings can be initiated against the promoter in case of any default of the debt.

CONTENTIONS RAISED IN THE DECISION OF THE APEX COURT

While the decision of the Supreme Court upholding the notification released by the Ministry of Corporate Affairs of November 2019 was well perceived by the banks and financial institutions considering that it gave them a dominant position, it became quite a bone of contention among the personal guarantors of corporate debtors.

The personal guarantors raised concerns with regards to the decision of the Supreme Court pointing out towards the non-application of mind in the notification as it would enable proceedings to be initiated against personal guarantors to corporate debtors not only under part III of the IBC Code but also under the two statutes namely- Presidency Towns Insolvency Act 1909 as well as Provincial Insolvency Act, 1920. Such action would not only cause inconvenience to the personal guarantors but would also lead to duplicity of insolvency proceedings.

The personal guarantors further contended that the notification was unconstitutional and ultra vires as it aimed to extend insolvency proceedings against personal guarantors to corporate debtors under Part III of the Code while that part remains silent on resolution against personal guarantors to corporate debtors. Part III is instead found governing only “Insolvency Resolution and Bankruptcy for Individuals and Partnership Firms”.

Another pertinent contention raised by the personal guarantors was with regards to section 128 of the Contracts Act 1872 which clearly lays down the principle of co-extensiveness. This principle enables the personal guarantor of the principal debtor to be liable only to the extent to which the principal debtor is liable and once insolvency proceedings are initiated against the principal debtor, it absolves the debtor of all claims except for the ones already admitted in the insolvency resolution process.

RESPONSES TO THE CONTENTIONS BY THE CENTRAL GOVERNMENT

The contentions raised by the personal guarantors were well-defended and elucidated upon by the Central Government to clear the air of confusion. The Government answering the contentions of the personal guarantor emphasised upon the need of maintaining separate categories of debtors for separate entities following which the amendment if 2018 introduced three classes of debtors under sections 2(e), 2(f) and 2(g) of the Code. Here section 2(e) specifically deals with personal guarantors to corporate debtors.

The Central Government further highlighted the 2018 amendment in Section 60(2) of the IBC which extended the insolvency proceedings to be initiated against a corporate guarantor or a personal guarantor to a corporate debtor anytime proceedings are triggered against the corporate debtor. This amendment thus gives immense clarity to the notification released by the MCA in 2019 and justifies the same.

RATIONALE OF THE SUPREME COURT

The decision of the Hon’ble Supreme Court in upholding the Notification is clearly based on the aforementioned legal principles. However, the Hon’ble Supreme Court has also opined that, the relationship between the Promoter is ‘intimate’ and ‘intrinsic’ with that of the Company and thus, the same adjudicatory process that is applicable on the Corporate Debtor should also be made applicable upon the Promoter.

The Apex Court further reasoned its decision relying on the judgement of SBI v Ramakrishnan[5] which lucidly talks about the three categories of liquidation and the difference in proceedings of insolvency between corporate debtors and personal guarantors. While corporate debtors and their corporate guarantors are subjected to liquidation process, personal guarantors to corporate guarantors cannot be subjected to the same and thus face bankruptcy processes.

The Apex Court further highlighted that a separate category of personal guarantors to corporate debtors was introduced keeping in mind the connection of the personal guarantors with corporate debtors. The constitutionality of the 2019 notification by the MCA was thus upheld.

Further, the IBC envisages to provide a ‘Clean Slate’ to the Corporate Debtor, however, such a luxury is not afforded to the Promoter as his relationship is the one defining the eventual state of the Corporate Debtor. In addition, the aforesaid is though to be in perfect alignment with the inherent object of the Code i.e., maximisation of the value of assets and promotion of entrepreneurship. The concept of ‘guarantee’ as defined in the Indian Contracts Act, 1872 refers to an agreement of assurance made among the debtor, creditor and the guarantor. If the debtor fails to repay the debt to the creditor, the burden falls on the guarantor to pay the amount and failing to do which the creditor reserves the right to begin insolvency proceedings against the personal guarantor.

CONCLUSION AND ANALYSIS

As already discussed, this ruling shall have a very profound impact on the entire business community. Further, this paves the way for regenerating the appeal of conducting business. Creditors now have the option to initiate insolvency against the promoter, and thus in many cases save the Company from going into liquidation.

This decision has been delivered to give the banks and financial institutions a dominant and powerful position so that they are spared from facing the brunt of losses to some extent. However, one concern which may crop up amidst this celebration of the decision is the possibility of misuse of power vested upon the banks and financial institutions with regards to debt recovery.

The banks must use these provisions wisely so that small corporate entities do not face too many inconveniences given that now this decision may impact the risk-taking capabilities of such small entities compelling the, to think twice before approaching financial institutions. However, it would not be wrong to say that the Supreme Court in its ruling has relied upon sound legal principles and has critically analysed the ambit and scope of the IBC.         

[1]  https://taxguru.in/corporate-law/provisions-ibc-2016-relating-personal-guarantors-corporate-debtors-notified.html

[2] Section 2(e), Insolvency and Bankruptcy Code, 2016.

[3] AIR 1961 MP 4.

[4] [2017] ibclaw.in 19 SC.

[5] Civil Appeal No. 4553 of 2018.

Author Bio

Qualification: Graduate
Company: Dolce Vita Trusteeship Services LLP
Location: Delhi, Delhi, India
Member Since: 01 Jun 2021 | Total Posts: 1

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