Guarantees Under Insolvency Law: Good News For Promoters; Bad News For Lenders

Lenders, reeling under the pressure of recovering dues from insolvent companies, have run into another wall. The National Company Law Appellate Tribunal has ruled that lenders cannot invoke guarantees given by promoters while the borrower is facing insolvency proceedings.

State Bank of India was amongst the many lenders that initiated proceedings against guarantors to recover its dues. But the introduction of the Insolvency and Bankruptcy Code put a spoke in the wheels. In one such case, after the insolvency proceedings had started against Veesons Energy Systems, the promoter and director of the company V Ramakrishnan approached the Chennai bench of the National Company Law Tribunal to halt SBI’s proceedings initiated against him in his capacity of a personal guarantor.

NCLT Chennai’s Stance

The Chennai NCLT bench ruled in the guarantor’s favour and said that if the guarantee was to be invoked, the guarantor – in this case V Ramakrishnan – would substitute SBI as a lender of the company. This would create a fresh security interest on the company’s property during the moratorium period. But creation of a fresh security interest or encumbrance during the moratorium period affects the liability of the borrower and therefore cannot be permitted.

Moratorium period is the period between the initiation and termination of insolvency proceedings where all other legal proceedings in relation to that company and its assets stand abated.

Appellate Tribunal’s Ruling

On appeal, the appellate tribunal concurred with the reasoning and findings of the Chennai bench of the NCLT and ruled that the moratorium period for an insolvent company would also extend to the properties of the personal guarantor.

Amir Arsiwala, an independent advocate practising at the Bombay High Court said that earlier banks used to enforce securities since their primary focus was the recovery of money owed. If the company was facing insolvency, there would be an embargo on enforcing the security provided by the company and so banks and asset reconstruction companies would look to the guarantors for recovery of their dues, Asriwala explained.

But sometimes there were other reasons to rely on promoter securities, he added. For instance, if the company does not have assets while the guarantors do.

The maximum prejudice to them is that during those 6-9 months, they will not be able to do either. On the other hand, the benefit of this judgement is that by throwing in the securities that a personal guarantor has given with the assets or securities of the borrower company, the resolution plan can be made more holistic and those securities, for instance, can be used to secure any further debt that the corporate debtor takes, Arsiwala concluded.

Case Of Confusing Precedents

What muddies the water greatly is that the NCLAT judgement is contrary to its earlier rulings. In two cases – Phoenix ARC and Alpha & Omega Diagnostics – the NCLAT had held that under the IBC, the moratorium period will only extend to the insolvent borrower and not the guarantors. This allowed the lenders to invoke personal guarantees given by third parties such as promoters in parallel while the borrower was undergoing insolvency.

So which view of the NCLAT will bind future litigants?

In the past two incidents, the NCLAT categorically dealt with a technical interpretation of the text of the section that deals with moratorium period to say that it only makes a reference to the corporate debtor, Anshul Jain, partner at Luthra & Luthra told BloombergQuint. Jain was pointing to Section 14 of the insolvency law that refers to suspension of proceedings to enforce/recover/foreclose security interest created by corporate debtor in ‘its’ property.

However, since in the Veesons judgement they have applied a different reasoning altogether, there is a strong argument that the previous judgements also have precedential value, Jain concluded.

This ruling of the NCLAT raises another important question – what happens if instead of a personal guarantor, as was the case in Veesons, a guarantee has been given by a corporate entity?

Arsiwala said the same logic would hold for them as well.

Third Parties: Caught In The Crossfire?

The NCLAT ruling doesn’t just impact lenders who have now been prohibited from invoking guarantees during the insolvency period; it may also impact third parties who have nothing to do with the defaulting borrower and wish to initiate separate legal proceedings against the guarantor.

For instance, let’s assume that the properties of guarantor X are under moratorium, but at the same time a third-party Y, triggered by X’s breach of contract, tries to legally invoke a mortgage on X’s property. In that case, will Y have to wait out the moratorium?

Arsiwala added that the way this judgement is worded may lead one to believe that there is a blanket moratorium on the person guarantor. But, he explained, if one looks at the context of the judgement, it merely states that you can’t exercise your rights against a personal guarantor if they affect the liability of the corporate debtor.

A guarantor may have certain liabilities in his own capacity and in such a case, a third party unconnected to the corporate debtor, may proceed against that guarantor, recover its dues and as long as such recovery does not increase, decrease or vary the liability of the corporate debtor, there should not be an embargo under this judgement, Arsiwala said.