SC: On loans to corporate borrowers, Guarantor beware

Context:

• Supreme Court has ruled that creditors can proceed against promoters of defaulting companies to recover debt if such promoters have given personal guarantees to secure funds.
• This comes six months after the Supreme Court transferred all the cases related to personal insolvency to itself.
• The SC has also said that lenders can also proceed against the promoters of a defaulting company even when the corporate insolvency resolution process of the firm itself has not been completed.

Relevance:

GS-III: Indian Economy (Growth & Development of Indian Economy, Banking Sector & NBFCs)

Dimensions of the Article:

1. What is a personal guarantee?
2. Why does the government want promoters to be more liable?
3. About the recent SC Judgement
4. What did the Supreme Court say about personal insolvency under IBC?

What is a personal guarantee?

• A personal guarantee is most likely to be furnished by a promoter or promoter entity when the banks demand for collateral which equals the risk they are taking by lending to the firm, which may not be doing so well.
• It is different from the collateral that firms give to banks to take loans, as Indian corporate laws say that individuals such as promoters are different from businesses and the two are very separate entities.
• A personal guarantee, therefore, is an assurance from the promoters or promoter group that if the lender allows them the fund, they will be able to turn around the loss-making unit and repay the said loan on time.

Why does the government want promoters to be more liable?

• Bad loans have been a major problem for banks and financial creditors over the past decade. Add to that, promoters had been able to secure funds from banks without the due diligence in most cases because of their past transaction history.

Steps taken in 2019

• In 2019, to put a stop to bad loans, the government introduced the provision which gave banks the power to move application for initiation of insolvency against personal guarantors to corporate debtors. Also, the finance ministry nudged banks to also pursue personal insolvency cases against promoters who had furnished personal guarantees for the loans taken by their firms, which later was not re-payed as per the agreed schedule.
• Both these steps in 2019 were taken to make promoters more liable for their actions and to check the practice of securing monies for a particular project but then diverting it to other projects or works.

About the recent SC Judgement

• The SC Bench was considering a clutch of petitions challenging the government’s 2019 notification that made personal guarantors a separate category of individuals who could be proceeded against under the Insolvency and Bankruptcy Code as part of the insolvency proceedings initiated by lenders against defaulting corporate entities.
• The Supreme Court judgment upholding creditors’ right to proceed against personal guarantors to loans provided by them to a corporate borrower helps lift the uncertainty over the extent to which banks and other financial lenders can pursue not only the corporate debtor but also the individuals who had furnished personal guarantees to enable the flow of credit to the company they had stood surety for.
• This ought to be of significant consequence to the financial system, already under a mountain of bad loans, by helping expedite the resolution of such stressed assets.
• In dismissing the petitions, the judges made clear that the government was right in “carving out personal guarantors as a separate species of individuals”, given the “intimate connection between such individuals and corporate entities to whom they stood guarantee”.
• Banks now stand a real chance of recovering substantially more from the resolution of a stressed corporate entity, as in most cases it has been the relatively affluent promoters who have been standing as individual personal guarantors for the loans extended to the companies they promoted.

What did the Supreme Court say about personal insolvency under IBC?

• The Supreme Court said that mere approval of a resolution plan for a debt-laden company does not automatically discharge a promoter from their liability in lieu of the personal guarantee they had given to secure the funding for the company.
• Since personal guarantees from promoters are a kind of assurance to lenders that the monies being borrowed will be returned, the apex court has said that under the contract of guarantee, the liability of the promoter will be over and above the liabilities of the company.
• Since lenders are, in most cases, forced to take a haircut on their pending dues when a resolution plan is approved for a debt-laden company, the ruling by the Supreme Court allows them to pursue promoters for additional recovery of debt.

-Source: The Hindu