Navigating the Conundrum: Personal Guarantors and the Insolvency and Bankruptcy Code 2016

A personal guarantee involves an individual (guarantor) committing to assume responsibility for debt repayment that the corporate debtor failed to fulfil in its obligations to a creditor. As such, the liability of the personal guarantor is defined via an independent contract and the terms and conditions as stipulated in the contract determine the nature and magnitude of the personal guarantor’s liability. As per Section 128 of the Indian Contract Act, 1872 (ICA), the liability of a surety is co-extensive with that of principal debtors unless the contract provides otherwise. Consequently, creditors have the option to pursue legal action against both the corporate debtor and its personal guarantor simultaneously, or they can choose an alternative sequence without the matter to be considered as Res Judicata.  

The Supreme Court, in Lalit Kumar Jain v. Union of India, established that the release of the guarantor from obligations hinges on two conditions: firstly, unless the contract’s language dictates otherwise, and secondly, if it results from a voluntary action by the corporate debtor, such as a release, discharge, composition, or modification of the guaranteed agreement. The Supreme Court defined the scope of liability for personal guarantors under the Code and, by dismissing the petitions, affirmed the legality and legitimacy of the 2019 Notification. 

Following the Lalit Kumar case, several petitions were submitted contesting the constitutionality of the provisions concerning the liability of personal guarantors. These challenges argued that the exposure of personal guarantors to insolvency proceedings is excessive and unreasonable. The contentions raised by the concerned party were two-fold: firstly, personal guarantors face direct insolvency proceedings, and secondly, they lack the opportunity to present their arguments when insolvency petitions are filed by creditors before the resolution professional. 

The Supreme Court rejected these petitions, affirming that the resolution professional functions as a facilitator rather than an adjudicator. The Court emphasized that the resolution professional is appointed by the adjudicatory authority based on the recommendation of the Insolvency and Bankruptcy Board of India, with the primary objective of assisting in the facilitative process of report preparation in line with Section 99 of the Code. While laying down the differences as conferred under Part II and Part III of IBC, the Court observed that the role of resolution professional as enumerated under Part III of IBC, is purely recommendatory in nature and cannot bind the creditor, the debtor or the adjudicating authority. Therefore, the report submitted by the resolution professional under Section 99 of IBC is only to access and ascertain two things: firstly, that the application satisfies the requirement of Section 94 or Section 95 and, secondly, that the applicant has provided the information and furnished the explanation which is sought under sub-section (4).   

The Court further examined the provisions under Part III of IBC considering it being compliant to the Principles of Natural Justice. It was observed by the Apex Court that the Legislature has, time and again, provided opportunity to both the corporate debtor and the creditor to present their case before the resolution professional and thereafter, before the adjudicating authority. While at the stage of performance of duty of resolution professional under Section 99, the Legislature has ensured that the recommendation provided by the resolution professional in its final report is made only after taking into account the information or, as the case may be, the explanation that is furnished by the debtor, leaves no doubt as to its fairness and equal opportunity of being heard. On the other hand, the adjudicating authority does not mechanically accept or reject applications based solely on the resolution professional’s report. Instead, it actively engages itself in a fair process, affording the debtor a fair opportunity to present their case.  

At last, the Court decided upon the constitutional validity of the said provision under Part III of IBC stating that the impugned provisions of the IBC do not suffer from any manifest arbitrariness to offend Article 14 of the Constitution. Moreover, it clarified that Sections 95 to 100 of the Code cannot be deemed unconstitutional solely due to the absence of provisions allowing personal guarantors an opportunity to present their case before creditors file insolvency petitions. 

The recent judgment marks a pivotal moment, offering confidence in the adequacy of safeguards for the effective functioning of resolution professionals during insolvency proceedings. Nevertheless, the level of protection afforded to personal guarantors under the Code remains minimal. 

The recent validation of the Code’s provisions concerning personal guarantors is expected to boost confidence among creditors. This may encourage a more proactive stance by creditors in initiating insolvency proceedings against guarantors, creating a perception of financial security. Furthermore, the judgement may induce caution among promoters and individuals providing personal guarantees, leading them to exercise greater prudence due to the highlighted risks, even in the case of solvent companies. In this creditor-centric environment, personal guarantors face challenges that underscore the importance of a thorough assessment of their financial commitments including the diligence at the time of sanction, emphasizing the necessity for clear legislative and procedural frameworks to ensure a fair and effective insolvency resolution process.