Caught in The Crossfire: IBC’s Unjust Stranglehold on Personal Guarantors

[By Bhabesh Satapathy & Vatsala Tyagi]

The authors are students of National Law University, Odisha.

 

Introduction

In the intricate web of insolvency jurisprudence, the intersection of personal guarantees and the Insolvency and Bankruptcy Code, 2016 (“Code“) has recently been scrutinized by the Supreme Court (“SC”) in the case of Surendra B. Jiwrajika v. Omkara Assets Reconstruction Private Limited.  A personal guarantee, emblematic of an individual’s commitment to assume liability for a debtor’s obligations, has long been a focal point of legal deliberation. The SC’s verdict, ostensibly settling the fog of uncertainty surrounding personal guarantors’ obligations under the Code, manifests a pivotal development.

Notably, it fortifies creditors’ position by extending the reach of the insolvency resolution process to Personal Guarantors (“PG”), effectively creating a twofold safeguard for creditors seeking recourse. However, the ramifications of this pronouncement are profound, as it curtails the protective ambit afforded to personal guarantors, thereby amplifying creditors’ leverage. This shift in legal paradigm engenders multifaceted consequences for PG, leaving them with scant recourse. The judgment, though ostensibly clearing the legal waters, leaves PG caught in a crossfire of diminished protection and heightened creditor empowerment.

A Spotlight on the Essential Backdrop

The Insolvency and Bankruptcy Code (Second Amendment) Act, 2018, and Notification No. S.O. 4126  empowered the initiation of insolvency proceedings against PG independently. In Lalit Kumar Jain v. Union of India, the SC has affirmed the constitutionality of these provisions, clarifying that an “involuntary act of the principal debtor leading to loss of security, would not absolve a guarantor of its liability”.

PG’s liability under the Code remains co-extensive with the corporate debtor, as per Section 128 (“S.”) of the Indian Contract Act. In the State Bank of India v. Ramakrishnan , the SC determined that S.31 (1) of the Code does not absolve the PG of their responsibilities. Further, Essar Steel India Limited v. Satish Kumar Gupta delineated that approval of a resolution plan is binding upon the PG.

Ever since the contours of resolution plan against PGs were defined, its inherent neglect of natural justice has been criticised. In the present case, the constitutional bench addresses a barrage of 384 petitions questioning the constitutional validity of S.95-100.

Procedural Fairness: A Hollow Framework without Natural Justice

PGs have vehemently called out this blind spot as they are caught in between unfair and unreasonable screws of resolution plan.

a. Violation of principles of natural justice

Maneka Gandhi v. Union of India constitutionalised natural justice principles into Articles 14, 19, 21, and 22. The impugned provisions violate two principles of natural justice, namely; right to be heard (Audi alterum partem) and the prohibition of self-judgment (Nemo judex in causa sua).

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The court brushed aside these contentions highlighting the following:

  1. S.99(2) offers ample representation opportunity for the debtor; S.100 complies with natural justice principles.
  2. The role of the Resolution Professional (“RP”) as under S.99 (“u/s”) of the Code, is limited to collection of facts and hence is not adjudicatory in nature.

In Madhyamam Broadcasting Ltd. v. Union of India, Justice Chandrachud, observed that such principles of fairness ‘express…that to be a person, rather than a thing, is at least to be consulted about what is done with one’. However, irreversible steps from S.95-S.100 in this case lack due consultation with relevant parties. The interesting aspect of the case is, the judgement was pronounced by Justice D.Y. Chandrachud. Despite having previously integrated this procedural requirement, he conspicuously omitted it in this particular case. (Emphasis supplied)

b. Inadequacy of procedural fairness

The court balances incorporating constitutional morality in the Code while respecting judicial review constraints. Hence, it upholds validity of opportunity of representation u/s 99(2), it ignoring its rudimentary nature in view of the instantaneous moratorium.

Interpreting S.99(10) literally, the RP must share the report with the applicant u/s 94 or 95. The  IBBI’s discussion paper dated 27th September, 2023, highlights that the current scheme of the Code, does not mandate sharing of the Report with both the parties. In the Madhyamam Broadcasting case, Justice Chandrachud emphasizes the right to know about inquiries, stating that “it is sufficient if the non-disclosure would lead to a possibility of bias and prejudice”.  The Code is ignorant towards such inchoate principles of legal justice. (Emphasis supplied)

The Court tilts towards legal positivism overlooking discussion on aforementioned grounds. While it evaluates the presence of procedural provisions, it somehow failed to realise their inadequacy, leaving natural justice impotent and hence unrealised.

Putting Section 96 on Trial: Examining Legal Consequences of Interim Moratorium

Application under S.94 or S.95 triggers immediate interim moratorium under S.96, facing constitutional challenges for violating Articles 14 and 21.

a. Fundamental Rights Under Siege

Part II and II of the Code face criticism for alleged arbitrary dissimilarity, violating Article 14. The court justifies distinct stages for the AA’s involvement, citing S.96‘s debt-focused moratorium. However, the court, engrossed in doctrinal intricacies, neglects broader impacts. The debtors can exploit an automatic interim-moratorium to undermine the rights of other creditors by merely filing an application u/s 95 of Code.

Further, Subramanian Swamy v. Union of India, acknowledged right to reputation as a fundamental right under Article 21. Insolvency harms reputation and strains commercial relationships. The Court overlooks the psychic consequences of interim moratorium. Breathing natural justice into the process is essential to avoid Article 21 violation.Top of Form

b. Adjudication of jurisdictional facts delayed is adjudication denied

Before insolvency, a “debtor-creditor relationship” is essential. Initiating resolution plan u/s 95-100 necessitates early adjudication of jurisdictional facts, which is postponed until after moratorium and RP’s report submission.Top of Form

This indicates a prima facie assumption of substantial merit in the application. The Code contemplates a presumption of civil guilt over the preferred presumption of civil innocence. The scheme of the Code presents a rare anomaly wherein the merits of the claim are decided prior to the maintainability of the claim.

Introducing an adjudicatory stage before S.100 might seem to compromise the Code’s time-bound nature, but it’s a myopic view. The Bombay High Court in, Surendra B. Jiwrajka v. Omkara Assets Reconstruction Pvt.Ltd., observed “that no such time-line has been prescribed for submission of report by the resolution professional”. Putting adjudication earlier, could streamline timelines u/s 97-99, enhancing temporal efficiency in determining jurisdictional facts and application outcomes.

IBC’s Oversight for PG’s Remedies & the Tapestry of Commercial Ramifications

The appointment of a RP u/s 97(5) of the Code empowers them with broad-ranging powers, particularly highlighted u/s 99(4). This seemingly innocuous move, however, carries weighty consequences for the debtor. The overarching powers granted to resolution professionals have a profound impact on the debtor’s creditworthiness, triggering defaults in lending agreements. In many cases, lending documents trigger a default when an insolvency notice is issued as a consequence of which collateral or independent debts may become invocable by a lending agency. This premature imposition of consequences raises concerns about procedural fairness, as debtors find themselves excluded from adjudicatory remedies.

a. Diminishing Remedies for Guarantors

The Code’s denial of the right to subrogation, a key aspect of guarantee contracts, is a significant setback. This refusal, supported by various legal precedents, highlights the sacrifice of a guarantor’s contractual rights in favour of the Code. When insolvency demand notices are issued,  it triggers defaults in the lending documents, collateral or independent debts, which may become enforceable by the lending agency.

The concept of “civil death” emerges as a poignant consequence. The appointment of a resolution professional not only affects the financial standing of the debtor but also operates as a weapon that can be wielded to shame individuals before the insolvency court. The misuse of provisions u/s 95 to 100 of the Code, without adequate checks and balances, presents a troubling scenario where innocent parties have no legal recourse against an insolvency application used as a tool for coercion. (Emphasis supplied)

b. Commercial Ramifications and Legal Challenges

Firstly, the commercial implications of this paradigm shift are vast. Financial institutions, emboldened by the verdict, are likely to tighten safeguards. Lenders may insist on negative liens to prevent asset transfers, a move that, while protecting creditors, may stifle credit flow. PGs, cognizant of their diminished remedies, may become cautious about providing personal guarantees.

Secondly, the Code allows creditors to initiate concurrent insolvency proceedings against both the borrower and guarantor, creating potential chaos. S. 60(2) necessitates filing insolvency petitions against guarantors where Corporate Insolvency Resolution Process for the borrower is ongoing. This opens avenues for double-dipping by creditors, initiating simultaneous actions against guarantors and borrowers for the same debt which will lead to multiplicity of proceedings and again delay the process. The commercial implication is heightened legal complexity and potential abuse by creditors.

And, lastly, the denial of subrogation weakens PG’s recovery and deters them from offering guarantees, impacting credit availability. This cautious stance, common in India’s promoter-led model, arises from uncertainties under the Code, affecting the credit market. India’s 63rd rank in the World Bank’s Ease of Doing Business Index is significantly influenced by credit availability, crucial for industries. While India’s subrogation stance may be justified, it risks impairing the credit market, potentially lowering the country’s global business ranking.

Conclusion

The recent judgements extends insolvency proceedings to personal guarantees, strengthening creditor positions. This exposes guarantors to increased vulnerability, characterized by reduced protection and heightened creditor authority.  Constitutional validity concerns and the risk of provision misuse add complexity to India’s insolvency landscape. Denying subrogation rights affects PGs and carries commercial implications. This incorporation significantly impacts those providing guarantees, exposing them to insolvency proceedings and risking personal assets, business devaluation, and creditworthiness decline.

Striking a delicate balance is crucial for creditor protection without disproportionately compromising PG’s rights, necessitating ongoing evaluation in India’s evolving insolvency framework.

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