Yash Sinha

Introduction

Easy loans for a company are facilitated if the company appears sincere about its repayment. To lower perceptible credit-risk, it may present its personnel as ‘guarantors’ for the loan. This demonstration of sincerity is also prescribed by the Reserve Bank of India (‘RBI’). Yet, such ‘insider-guarantors’ land in a soup if the company becomes insolvent.

The present piece argues that such guarantors are unduly asphyxiated by the insolvency and contract law framework. Summarily, this unhealthy phenomenon is demonstrated to be a product of three occurrences. The guarantors’ personal assets are exposed for insolvency-based recoveries. In spite of this, them named as sureties will not pause either the insolvency-based or the contractual obligation. All of this is only compounded if they do act on their surety-based promises. It is likelier that there may be no reimbursement for amounts doled out as surety payments, regardless of the outcome in the insolvency proceeding.  

Part I describes the pursuits of a matter being considered by the Supreme Court. It will demonstrate that the present piece is in no way circumscribed by it due to the former’s extremely disconnected concern. The said matter deals with the alleged dilemmas of insolvent guarantors. Whereas, the problem of the present insolvency law is situated in a part which drives solvent guarantors towards it. Part II then lays down the process dealing with insolvent companies and its impact on the outgoing personnel. Independent of the surety-based obligations, insider-guarantors have an obligation to help an insolvent company financially. If the company which employs them goes insolvent, their personal properties may be utilised for its recoveries. This exposure does not grant them any respite from their roles of a surety. All these circumstances apart, there exists no certitude of any compensation for them on fulfilled sureties.  In parallel, payments made prior to or towards the recovery are dead options for such personnel. Part III then argues that ‘moratorium’ for insider-guarantors is reserved for when they become insolvent. This has a debilitating impact. The mere existence of a surety-obligation exposes them to dual recovery mechanisms. These are capable of being invoked in parallel. A lender does not have an elective, but a whimsical, choice to chase them using all at once. Parts IV and V are devoted to highlighting incongruities of this position with desirable objectives. Firstly, insider-guarantors are prioritised in other parts of the insolvency regime itself. Secondly, the position is an extreme misfit in the larger banking regime, which incentivises the emergence of insider-guarantors. Lastly, there exist clear policy-based objections against this position, regardless of the statutory manifestations they have/are yet to take.    

To begin with, it is necessary to understand what a ‘guarantee’ entails. The lending-entity always seeks conditional possession of security for the loan it offers. This security may be in the form of a titular belonging of the borrower. The borrower’s house, for instance. If things get worse, the bank will sell it to recover its dues. In lieu of a security, the lending arrangement may instead involve a person. This person offers to repay a loan if the borrower does not. In legal jargon, they are called ‘sureties’. A guarantor is a surety who repays when the borrower ‘cannot’.

I. The Ambani problem

Recently, Anil Ambani moved to the Supreme Court (‘SC’), feeling victimised by the insolvency regime. He had guaranteed gigantic loans for his Reliance Infratel Ltd (‘RIL’) and Reliance Communications Ltd (‘RCom’). The companies came to be dragged in insolvency proceedings. Loans remained unfulfilled, as did Ambani’s guarantee. Fortune came to favour the aggrieved lending-banks on November 15, 2019. This was when Part III of the Insolvency and Bankruptcy Code, 2016 (‘IBC’) came into force. This part of the law allows recovery from bankrupt guarantors. Deeming RIL and RCom as too broke to repay, they went after Ambani.

Ambani claims that these proceedings commenced without hearing him out. The several check-boxes to be ticked off before its trigger similarly disengage him, he states. Claiming that this asymmetry pervades all of Part III, he is now before the SC. What is not before the court is a more pertinent question: does Part III lead in asphyxiating such insider-guarantors?

The proposedly obvious answer is “no”.

II. The problem and its seedbed

The weighty core of the problem appears to reside in Part II of the IBC. It deals with bankrupt companies which default on debts created by themselves. The foremost attempt is to help bring the company back on its feet, with a ‘resolution professional’ at the helm. Else, it squeezes recoveries out of its assets. The SC and the NCLAT have further ‘eased’ the process. Personal properties of the company’s key personnel may be used to make these recoveries. No qualifications were coupled with this direction. Suppose some personnel repaid the loans of a company of which they were the guarantors. Their properties may still be used for repaying the company’s other debts.

Add to this their inability to recover sums paid towards resolving those loans. Traditionally, a surety could recover from the company upon its financial revival. In the SC’s opinion, this opportunity evaporates forever if the Lazarus Pit was the IBC. It proffers two justifications for this position.

Firstly, the IBC swaps the company’s history-sheet with a ‘clean slate’. Put simply, an insolvency ‘resolution’ denoted a conclusive end to all its financial liabilities. Removal of bankruptcy is futile if any of the past transactions could still haunt the company.

Secondly, the code forecloses the application of contract law in these cases. This law deals with sureties in general. This law governs the life of a surety’s obligation. The IBC may not interfere in its application, in theory. Its implications tell a different story.

Apart from performance, the law of contracts releases a surety under two other circumstances. The first is a consensual ‘change’ to the original loan agreement by the lender and the borrower. The other release comes about if the two enter a new ‘agreement’ altogether. The undergirding rationale has a simple premise. The goings-on in between two should not affect the clueless third. The emphasis is on the all parties’ equal awareness.

The IBC has engineered such circumstances wherein these releases may never apply to the guarantors of an insolvent company. The defining feature of an agreement is the consensual essence suffusing it. Contrarily, a successful insolvency proceeding culminates in a blueprint for reinstating solvency. Dubbed as a ‘resolution plan’, it may cudgel dissenters into accepting it. This makes it the antithesis of consent, thus becoming dissimilar to an agreement. Similarly, the resolution process is not deemed as a ‘change’ for this scheme. The reason is that the parties knew the laws of the land before-hand, and such an outcome was factored in as a possibility. The loan agreements remain intact, only its implementation is judicially supervised.

Hence, insider-guarantors find themselves in a strange quandary. They may pay the company’s loans, only to find their properties squeezed anyways. The IBC further negates the possibility of any reimbursement, if they do.

This is not to say such guarantors are remediless. Since they are involved in the process due to a security interest, they may become operational creditors. However, the limitless proposition on their properties again makes for a paradoxical situation. Their properties may remain exposed to other creditors for the company’s bankruptcy resolution.

III. No snooze button

The tale of the insider-guarantors’ criminal disregard does not end here. The IBC supplies the bankrupt company with a protective aura as long as it convalesces. Known as the ‘moratorium’, it has a miraculous function. It snoozes any legal developments that may be antithetical to the recovering company. This was supposed to simply help in replenishing its assets. Later, the courts broadened its scope, gleaning a much larger objective. Namely, this was to pre-empt an attack on the company’s resuscitating finances. Resultantly, the moratorium puts a pause on law suits, arbitrations and other legal remedies with the company as a participant. The reach thus became impressive, even grappling criminal investigations and trials.

The law strips insider-guarantors of this protection. The judiciary found this bar built into the statute. Soon, the government mirrored the view by amending the text and incorporating Section 14(3)(b). The justification was simple. Part II of the code makes exclusive references to the company and its assets, not the guarantors. The consequences are deeply problematic. The guarantors are open to insolvency proceedings themselves. Alternatively, they may face the wrath of the bank-friendly law, the SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002). As a part of its process, their assets will be attached and put up for sale. In either case, the guarantors cannot wait for the company to sort out the matter first.

IV. Aberrant behaviour

An elliptical view of the IBC’s purpose captures the absurdity in this position. ‘Stakeholders’ include those to whom the company owes its debts. One fragment of this category are resolution applicants. This, in fact, envelopes a very wholesome recognition by the IBC: debts may not always come into being due to plaintive ‘give and take’ transactions. A company may owe sums to people without those. Management-personnel belong as such, insofar as the IBC permits them to be resolution applicants. Arguably, this is also an extension of the very episteme of the ‘corporate incentive to business’:  companies and their personnel form two exclusive beings. The company’s liabilities befalling its individual constituents is an assault on business. Concurrently, this exclusivity also denotes that certain acts of the personnel may oblige a company to return the favour in the same form or any kind. Their recognition as ones capable of triggering the company’s insolvency, thus, comes with this very clear denotation.

Summarily, there emerges a very contradictory position in a company’s insolvency resolution. There exists no difference between the assets of any insider-guarantors and their company for extractive purposes. Yet, the two are inexplicably cleaved when it comes to preserving assets during the resolution. This dissonance is incongruous to certain other elements of the IBC-framework. Regulations concomitant to the code govern data collection of the company’s debts. Regulation 32(f) of the same prescribes a separate mention for such guarantees. This denotes their special, or at least equal, place in the obligation hierarchy. A committee examining the statute has noted the same in so many words. Such related-guarantors bear special proximity with a company’s financial sentience, it states. Moreover, the RBI has prescribed the banks to demand insider-guarantors. In a circular issued in November, 2019, it takes this as a manifestation of certain key assurances. Firstly, the management will remain unchanged, implying the company’s business-confidence. Secondly, it may circumvent complications. The RBI gives a simple illustration of this. There are times when the company interlocks its funds with those of the personnel. With insider-guarantors, the bank’s recovery may be in less of a jeopardy.

Not protecting their assets assails all these denotative elements. Wresting the moratorium’s protection away from guarantors in all of this, denotes imprudence.

V. Blemishing a system of ‘stratified assurances’

The present state of affairs is even more baffling in light of another development. The establishment of an entire secondary market exclusively for easing corporate loans indicates an intention to facilitate them further. It is premised in simple logic. Namely, there must exist layers of assurances for the lenders, such that no one assurance is the exclusive means of recovery.

A loan for a corporate project may not be sanctioned by a simple assessment of the entity’s present viability. Its viability is but a dynamic concern which may surge or drop by the time of the repayment. While the former assures a repayment by default, the latter requires more assurance. As discussed earlier, an insider-guarantor addresses this vacuity of doubt. However, a similar dynamism may rock the guarantor’s boat. Fluctuations in either the company’s or the project’s viability may render all such assurances to be futile. This is where a secondary market for corporate loans and insider-guarantees comes in: it plays the role of a tertiary assurance. The lender ought to have the better option of selling a bad loan off to purchasers. These willing purchasers exist in the form of other smaller banks which want to correct/askew their asset-liability balance.

Hence, a more successful resolution of insolvency occurs if the guarantees are held as extinguished by or kept out of the resolution plan. This would recognise that there exists a secondary market for them, and that their resolution may take care of itself. Illustratively, their assignment and securitisation may resolve the default much faster for a lender. Initially a private initiative, the concept has received an endorsement by no less than the RBI itself. Hence, the trend is to consolidate the facilitation of corporate loans by establishing a tertiary assurance. In its midst, the judicial and legislative assault on the secondary assurance is imprudent. It is not to suggest the judiciary ought to have remade legal text in the mould of policy. Instead, the criticism is that the government has not responded to the judicial interpretation of Part II, IBC to align it with the larger objectives of the legal system. The larger objective of the law seems to be to establish layers of assurances for lenders. A layered system of assurance works to incentivise lending. Yet, it also functions to offer greater breathing space for those who facilitate lending in any one layer. Instead of letting the market solve the problem efficiently, the present position makes insider-guarantors as the one-stop solution regardless of its efficacy. Insider-guarantors have to be recognised as one and not the exclusive layer of such an assurance.

Conclusion

The present position may only propel such guarantors towards bankruptcy. Resolving questions of their insolvency when one part of the law is taking them to such a stage is most futile. Demonstrably, the walls in the form of IBC’s text were not weak to be held responsible for the same. It is the judiciary which has introduced cracks in it, with the government seeding it with creepers. Insider-guarantors are obliged to aid recoveries by contributing to the resolution plan. No parallel recoveries by a lender are prohibited in spite of this occurrence. A successful plan does not absolve them of their obligations. They are barred from asking the freshly convalesced company to reimburse them for the surety amounts paid on their behalf. Nor is their contribution to the insolvency-resolution recoverable. The one mitigating factor in all of this could have been the moratorium under Part II, IBC extending to the guarantors. Legislative and judicial responses against it are both inexplicable and deadening. This is not only an absurd reading of the law, but also an inefficient mechanism of recovering loans. 

This cumulative burden of contract and insolvency laws on such guarantors is the most repelling disincentive for their future participation. It negates the government’s hortatory declarations of easing business. Hence, if the flow of corporate loans is stemmed due to less/no insider-guarantees, Part II, IBC is more blameworthy than any anomalies that may be found in Part III of the law.

The writer is a Delhi-based advocate and an alumnus of NLSIU, Batch of 2019. Views and errors are his own. He may be reached at yashsinhaadv@protonmail.com.