Personal Guarantors under Insolvency and Bankruptcy Code, 2016

Research Objective:

The objective of this paper is to analyze the developments related to the insolvency of personal guarantors to corporate debtors under the Insolvency and Bankruptcy Code, 2016 (IBC, 2016).

Statement of Problem:

When the Insolvency and Bankruptcy Code was introduced in 2016 in India, all the provisions under the same were not made applicable at once but in a phased manner. One of the important aspects of the code was the provision related to insolvency of personal guarantors to the corporate debtor, which, though not made applicable immediately, was notified by the central government in 2019. The constitutionality of the same was challenged, and the Supreme Court in Lalit Kumar Jain v. Union of India & Ors.[1] upheld the constitutionality. However, since the code is rapidly evolving it is pertinent to assess the impact of notifying such provisions and

Research Methodology:

The research is of a doctrinal and analytical nature. The study aims to propose a descriptive and in-depth analysis of legal provisions obtained from primary sources such as cases, statutes, or regulations.

This study aims to collect, arrange, and describe the law while also offering commentary on the sources used. To substantiate the claim, the author conducts a critical, qualitative study of the bare judicial text. They then discuss the legal significance of the provisions, the principles guiding the provisions, and decision-making under the provisions (if cases interpreting the existing laws fit together in a coherent system or not). The author also attempts to identify legal ambiguities and criticisms, as well as provide solutions.

Parliamentary Scheme of Enforcement of IBC:

IBC is a comprehensive code of insolvency resolution, liquidation, bankruptcy, etc. that governs both corporate entities as well as individuals and partnership firms. It was approved by Parliament in 2016. At the time of enactment, it did not, however, enforce the IBC’s rules directly. Instead, it provided the Central Government the authority, under Section 1(3), to notify the Official Gazette of IBC provisions to be enforced, allowing it to implement various IBC provisions at various times.

As a result, the Central Government periodically on various dates, starting as early as in 2016 and 2017, published various notifications implementing various provisions contained in Part II of IBC that related to bankruptcy resolution and liquidation for corporate entities. The notices also brought into effect a few related rules from IBC Parts IV and V that were essential for Part II to function. For the purpose of making Part II functional and operational, these provisions dealt with the creation of regulatory bodies, the establishment of adjudicating and appellate authorities, the removal of civil court jurisdiction, the overriding, repeal, and amendment of various laws, the power to make rules and regulations, and other topics.

The government did not, however, execute Part III of the IBC’s regulations regarding bankruptcy and insolvency for individuals and partnership firms at the same time as Part II. As a result, the Presidency Towns Insolvency Act of 1909 (PTA) and the Provincial Insolvency Act of 1920 (PIA), both outdated insolvency statutes, remained to regulate individuals and partnership firms. The contemporary mechanisms, agencies, and regulatory organisations established under Part II IBC in accordance with UNO-advised international norms, such as NCLT under Section 60, NCLAT under Section 61, and so forth, had no impact on them.The Debts Recovery Tribunal (DRT) was designated by Section 179 (Part III) as the adjudicating body for such companies. However, as Part III (Sections 78 to 187) as a whole was not enforced, even Section 179 (DRT) offered creditors nothing more than a formal, silent remedy.

The “individuals” covered by Part III included the aforementioned class of PGCD, or those who had provided personal guarantees to lenders in order to secure funds for legal entities known as “corporate debtors,” or CD. Therefore, Section 179 (DRT) remained a silent remedy on paper with relation to PGCD, as previously explained. Even while Section 60(4) gave NCLT all of the DRT’s powers for the purposes of Section 60(2) and Part III’s Sections 78 to 187, Section 179 remained for NCLT and CD’s creditors nothing more than a far-off pipe dream in the absence of Part III’s (Sections 78 to 187) actual enforcement.

In other words, under Section 60 of Part II, PGCD really continued to be excluded from any resolution process being conducted against a CD before NCLT. Therefore, the creditors had no legal recourse against PGCD before the NCLT and were not even eligible for Part II or Part III procedures.

Amending Acts 8 and 26 of 2018:

As previously noted, the Central Government implemented various IBC requirements on various dates through numerous notifications made under Section 1(3) in 2016 and 2017. Additionally, to alter the IBC, Parliament passed Insolvency and Bankruptcy Code (Amendment) Act, 2018 (Act 8 of 2018) and Insolvency and Bankruptcy Code (Second Amendment) Act, 2018 (Act 26 of 2018). On November 23, 2017, the former revised Section 2(e), and on June 6, 2018, the latter updated Sections 60(2) and (3).

Amendment and enforcement of Section 2(e)

Understanding the legislative change and development of Section 2(e) requires consideration of the following several types of entities:

Corporate persons as debtors:

The IBC’s Part I, Section 2, originally allowed for the “application” of the IBC to various types of entities as specified in five different clauses: clauses (a) to (e). In contrast to clause (e), which referred to a combined collection of non-corporate entities as “partnership firms and individuals,” clauses (a) to (d) of Section 2 listed specific types of corporate entities. For corporate individuals, Part II Chapters I and II with Sections 4 to 54 provided for insolvency settlement and liquidation. By means of a notification dated 30 November 2016 with effect as of 1 December 2016, the Central Government enforced Sections 2(a) to (d) in Part I (titled “Preliminary”) and Sections 4 to 32 in Part II Chapters I and II (titled “Preliminary” and “Corporate Insolvency Resolution Process,” respectively). The Central Government implemented the remaining clauses, Sections 33 to 54 in Part II Chapter III (entitled “Liquidation Process”), by means of a notification issued 9 December 2016 with effect from 15 December 2016. According to Section 1(3) IBC, the two aforementioned notifications were sent out on different days.

Personal guarantors to corporate debtors (a sub-group of Individuals):

As was already established, the phrase “partnership firms and individuals” was the original translation of Section 2(e). The clause in Section 2(e) was initially not applied when the regulations for CD were implemented in 2016–2017. Part III, which contains Sections 78 to 187, is pertinent in terms of this group. Insolvency Resolution Process and Bankruptcy for Individuals and Partnership Firms are covered in Part III. Act 8 of 2018 and Act 26 of 2018 each amended the Code twice in 2018. The original united group of entities in Section 2(e), “partnership firms and individuals,” was divided into three splinter subgroups by the first amendment. Three newly drafted provisions (e), (f), and (g) in Section 2 correspondingly covered the following sub-groups: (e) personal guarantors to corporate debtors; (f) partnership firms and proprietorship firms; and (g) individuals, other than those mentioned in clause (e). Following the above trifurcation’s amendment by Act 8 of 2018, the Central Government enforced certain provisions, including the new Section 2(e) itself (Part I), Sections 78, 79, and 94 to 187 (Part III),5 and some related clauses of Sections 239, 240, and 249 (Part V),6 through the Notification dated 15-11-2019, which was later contested before the Court in Lalit Kumar Jain. The enforcement started on January 12th, 2019. Thus, the notification only applied to PGCDs involved in the same insolvency resolution procedure and appearing before the same adjudicating authority/appellate authority under IBC as the principal borrower in question, the corporate debtor or the CD. In other words, out of the larger group of “individuals”, a particular sub-group of individuals, namely, PGCD, came to be identified in the newly framed Section 2(e) and the new Section 2(e) was enforced by Notification dated 15-11-2019. The notification also enforced certain other provisions, namely, Sections 78, 79 and 94 to 187[2] (Part III) which provide for insolvency and bankruptcy of individuals and also Sections 239[3] (Power to make rules), 240 (Power to make regulations) and 249[4] (Part V) insofar as they relate to PGCD.

Amendment of Section 60

A Notification from 2016 had already put the clause in “Section 60 — Adjudicating authority for corporate persons” (Part II) into effect. It stipulated that NCLT would serve as the CD adjudicating body. Sections 60(2) and (3) were initially solely intended to apply to the bankruptcy of PGCD and the resolution and/or liquidation of CD under Part II.

Act 26 of 2018—the second amendment of 2018—amended Sections 60(2) and (3) by specifically placing the liquidation of a “corporate guarantor” of a CD into the purview of the aforementioned adjudicating authority, namely NCLT.

While, Section 179 of Part III had initially designated a different body—the Debt Recovery Tribunal (DRT)—as the adjudicating authority for all people and partnership firms covered by Part III, but with the qualifier “Subject to the restrictions of Section 60.” In line with this, Part II’s Section 60(2) said that it is applicable “notwithstanding anything to the contrary stated in the Code.”

It became possible, in a given case, for individuals classified as a sub-group, viz. “PGCD,” in the amended Section 2(e), to be subjected to insolvency proceedings before the same adjudicating authority/appellate authority (NCLT/NCLAT) who decided matters relating to the CD, with the amended Section 2(e) and various other provisions in the Code pertaining to PGCD coming into effect under Notification dated 15-11-2019. This made it possible for all parties and concerns related to a CD to be “unified adjudicated” under one roof. The personal guarantor would not be dismissed if the CD’s obligation was not paid back notwithstanding his personal guarantee and would instead have to go through bankruptcy procedures before NCLT.

He would not, however, follow the Part II protocol intended for CD. It would be in line with the rule designed by the Parliament for unique individuals in Part III of the IBC. The class of PGCD fell directly into the lap of NCLT, much to the satisfaction of the CD creditors, with the amendment of Section 2(e) effective as of November 23, 2017, as stated in Act 8 of 2018, and as stated in the notification dated November 15, 2019, as stated in its enforcement as of December 1, 2019.

Genesis of the Challenge before the Supreme Court:

The exclusion of the persons, specifically PGCD, from the bankruptcy resolution process of CD had been considerably to the prejudice and displeasure of the lenders and creditors of CD prior to the Notification of 15-11-2019. PGCD would continue to be evasive and immune to the resolution actions taken by the creditors under IBC despite their personal assurances. With their constant litigation and deceptive techniques, they would abandon the creditors in the lurch. The creditors felt extremely wronged. As a result, the government decided to handle the problems of the creditors and effectively pull PGCD into the same IBC net as the CD.

As was mentioned above, the Central Government issued the Notification dated 15-11-2019 pursuant to Section 1(3) to enforce certain provisions of Part III pertaining to Insolvency Resolution and Bankruptcy for Individuals and Partnership Firms insofar as they related to one specific class of individuals, namely, PGCD, in order to bring them within the confines of IBC. However, it left all remaining people and partnership firms protected by Part III with the exact identical requirements still in place but not in effect.

Due to the notification, the PGCD class was recognised as a separate class of people who may now be dealt with by the creditors in addition to the Part II insolvency resolution procedure, they (the creditors) were conducting against the CD itself.

They could be held accountable and brought to justice before the same appellate and adjudicating bodies as those used by the CD, namely the NCLT and NCLAT, in accordance with IBC. IBC had no impact on the other class of people/partnership businesses covered by Part III, though. The prejudice between the aforementioned two classes of people prompted PGCD to file a petition with the Supreme Court in Lalit Kumar Jain[5].

First, PGCD questioned the Government’s ability to selectively implement IBC (Part III, etc.) rules in relation to PGCD without also involving all other people in general as provided for in Section 1(3). According to PGCD, this was not only outside of and outside the scope of the notifying (enforcing) authority granted to the Central Government under Section 1(3), but it was also unfair to PGCD. (Refutation 1)

Another significant issue that PGCD brought up in court was that, despite the fact that, under Section 31(1) of the IBC, an approved resolution plan in respect of a CD is final and binding for all parties involved, PGCD’s liability is still retained as a result of the impugned notification, which had deprived them of their legal rights and protection as a surety (guarantor) under Sections 128, 133, and 140 of the Contract Act. (Refutation 2)

In re contention 2- According to Sec1(3) the notification is ultra vires and invalid

Briefly stated, PGCD’s first argument before the Court was that when Section 1(3) granted the Central Government the authority to issue various notifications for enforcing various provisions of the Code, it only allowed the Government to do so on various “dates,” not for enforcing any particular provision only in respect of a chosen class of people to the exclusion of others. For one particular class of people, namely PGCD, the Government cannot announce the limited applicability of a provision intended for all citizens generally. The contested notification is invalid because it exceeded the authority granted to the government under Section 1(3).

In such circumstances, PGCD recognised, the Government might be able to make notices at various “times” for enforcing the legislative provisions gradually in various territorial “regions” or “areas” of the State. However, since the provisions are meant to apply to all of them generally, it cannot do so for applying the provisions to a specific group of people, subjects, or individuals. Various precedents were used to help in the submission. It has a variety of constitutional ramifications, hues, and shades, which can be summed up as follows:

1. Such an application would amount to the administration usurping crucial legislative authority, which is illegal. As an example of “conditional legislation,” Parliament only granted the authority of notification and execution of the law at such “time” as the Government may determine after enacting the law (IBC) in its entirety with regard to “place, person, laws, and authorities.” The Government has gone beyond its authority because applying the requirements to only a specific group of people (PGCD) equates to changing the law (IBC). Parliament has not granted the Government the necessary authority.

2. Part III provisions refer to both individuals and PGCDs together as “debtors” and make no distinction between the two. But each of the provisions/sections stated in the contested notification effectively includes the phrase “as insofar as they relate to personal guarantors to corporate borrowers” as a rider. That equates to executive legislation.

There is no discernible difference or logical basis to distinguish PGCD from other people, hence the implementation of the provisions in question in respect of PGCD alone is arbitrary and discriminatory. Additionally, both types of creditors, financial and operational, who would otherwise only be entitled to different sets of procedures under Part II governing the CD’s insolvency, are now authorised to use the procedure in Part III against the PGCD. Unequal people are treated equally according to this.

3. Additionally, Section 243, which would have repealed the Provincial Insolvency Act of 1920 (PIA) and the Presidency Towns Insolvency Act of 1909 (PTA), was not put into effect. As a result, insolvency proceedings against PGCD would now be brought before the adjudicating body under Part III of the Code as well as under PTI and PIA—two legal systems that are in direct conflict with one another.

Submission by UOI

Defence arguments were made for the Union of India and other respondents along the lines that the Government or executive can always be entrusted with the task of implementing various laws according to its own wisdom and discretion at various times, in various locations, during various stages, and for various limited purposes. Both an excessive delegation of legislative power or an arbitrary use of administrative power by the government do not invalidate such an exercise. Additionally, a number of examples were provided as proof. Bennion on Statutory Interpretation: A Code was by far the most direct, topical, and remarkable authority in the context identified on behalf of the Union of India (6th Edn., at p. 257). It supports the executive branch’s use of authority under such conditions on various dates and for various “purposes.”

Court’s stance

In its ruling, the Court upheld the Union of India’s position and rejected that of PGCD. Curiously, the “Analysis and Conclusions” part of the Court’s judgment1 found in SCC paras 65 to 126 does not include the aforementioned source, even though it is extraordinarily germane to the context.

In re Contention 2 — PGCD deprived of their rights as “surety”

Provided by PGCD:

The second issue that PGCD brought up before the Court was divided into two parts. The Contract Act, 1872 and the IBC were also cited in PGCD’s remarks in that regard. Below is a summary of them:

1. Sections 128, 131, and 140 of the Contract Act that provides for Guarantor’s rights

The first argument was that because of the contested Notification, PGCD had lost their ability to exercise their legal right to discharge under Sections 128, 133, and 140 of the Contract Act. The surety has a right under Section 133 read with Section 140 to be discharged from his liability as soon as there is “resolution” under Section 31(1) IBC, especially if the resolution amounts to “variance” in the terms of the contract with the surety because the surety’s liability under Section 128 is co-extensive with that of the principal debtor.

2. Section 31(1) that provides immunity to all concerned

Second, even though a resolution plan that has been approved in relation to a CD is final and enforceable against all parties involved under Section 31 IBC[6], PGCD’s liability is maintained. It is established law that all claims against the CD are eviscerated upon the conclusion of insolvency proceedings against the CD, with the exception of those that were explicitly acknowledged during the insolvency resolution process. Section 31 makes the resolution plan official and legally binding for everyone involved as a result (1).

After the resolution process against the CD under Part II, the creditors are now permitted to make claims in the insolvency process of the guarantor under Part III as well, without accounting for the amount already realised by them in the corporate insolvency resolution process of the CD under Part II of the Code. This allows the creditors to unfairly enrich themselves through a “double dip” process.

Decision of the Court

However, the Court rejected the PGCD’s two-fold argument above with an equally clever two-pronged justification. The arguments made by PGCD in reference to the Contract Act and IBC were fully addressed by the justification.

Regarding Sections 128[7], 133[8], and 140[9] of the Contract Act, the Court ruled that the guarantor is only released from his obligations under the provisions if the contract’s terms do not expressly state otherwise and only in the event that the major debtor voluntarily amends the guarantee agreement. The guarantor is not released when the contract is modified by the principal debtor due to operation of law, such as when a resolution plan is accepted by the adjudicating authority under Section 31(1) IBC.

Regarding Section 31(1) IBC, the Court based its conclusions on a number of prior decisions made by the Court on the matter and held that the resolution plan, even after being approved under Section 31(1), does not necessarily result in the guarantor’s discharge; instead, it may well allow the CD’s creditors to continue to pursue the guarantor in order to recover any gaps or shortfalls that still need to be made up in the recovery of their debts from the CD. Overall, the Court presented its arguments on both sides convincingly and cogently.

Conclusions and Suggestions

In conclusion, the Supreme Court has finally found a remedy in Lalit Kumar Jain for situations when CD creditors are unable to collect their debts from CD assets during resolution/liquidation procedures under Part II IBC. It has paved the way for these creditors to pursue their claims against the PGCD’s assets in accordance with Part III of the IBC, and to do so before the same NCLT/NCLAT forums that are tasked with hearing all claims involving the CD.

One of the respondents accurately described the process as one of “parliamentary hybridization and legislative fusion” before the Supreme Court. It was succinctly and aptly described in the judgment’s para 53, which reads as follows: (Case of Lalit Kumar Jain[10]).

“53. The learned Senior Counsel highlighted Sections 60(1), (2), (3) and (4) and urged that Parliament had merged the provisions of Part III with the process undertaken against the corporate debtors under Part II. The process of Part II and the provisions of Part III were legislatively fused for the purpose of proceedings against personal guarantors along with the corporate debtors. … It is contended that the hybridization achieved by the impugned notification does not create any anomaly or problem in enforcement.”

Further clarification on the right of creditors to initiate insolvency resolution process against personal guarantors of the principal borrower as well as timing and jurisdiction for excusing such a right is provided by a recent Supreme Court decision in Mahendra Kumar Jajodia v. State Bank of India (2022)[11].

[1] (2021) 9 SCC 321.

[2] S. 94-187, The Insolvency and Bankruptcy Code 2016.

[3] S. 239, The Insolvency and Bankruptcy Code 2016.

[4] S. 249, The Insolvency and Bankruptcy Code 2016.

[5] Lalit Kumar Jain v. Union of India, (2021) 9 SCC 321.

[6] S. 31, The Insolvency and Bankruptcy Code, 2016.

[7] S. 128, The Indian Contract Act 1872.

[8] S. 135, The Indian Contract Act 1872.

[9] S. 140, The Indian Contract Act 1872.

[10] Lalit Kumar Jain v. Union of India, (2021) 9 SCC 321.

[11] Civil Appeal No(s) 1871-1872/2022 SC.