27 Nov 2017 14:07 IST

IBC: Noose tightens around promoters

Lenders will soon be able to initiate insolvency action against personal guarantors too

The recent amendment to the Insolvency and Bankruptcy Code 2016 has added huge pressure on promoters acting as personal guarantors to corporate debt.

Aside from the much-talked about amendment that prevents erring promoters from buying back their stressed assets, a less conspicuous tweak has set the ball rolling for notifying insolvency rules for corporate guarantors.

A key amendment will help commence Part III of the Code, relating to individuals and partnership firms. This part will be operationalised in phases.

In the first phase, personal guarantees relating to corporate debt will be dealt with, which industry experts believe will come into play by the end of the year. Necessary regulations have been out in public domain and consultation meetings have already taken place.

“If the personal guarantor is taken into insolvency, and eventually bankruptcy, the entire assets of the individual (excluding “excluded assets”) will vest in a bankruptcy trustee. The excluded assets include a house of minimal value, about 65 sq mts, bare minimum jewellery, clothing and domestic furniture.

“All the remaining assets of the individual are vested in the trustee, who sells off the assets to pay off the creditors,” says Vinod Kothari, a financial and legal consultant and insolvency professional.

Past ambiguities

In many of the 400-odd cases admitted by the National Company Law Tribunal (NCLT) under the IBC, it has been found that promoters, also acting as personal guarantors to corporate debt, resort to IBC to delay recovery efforts of lenders against their personal assets.

In June 2017, LML Ltd, which had defaulted on ₹73 crore in loans, had filed for insolvency. Subsequently, the Allahabad High Court stayed the proceedings filed against the personal guarantors (also directors) of LML until the finalisation of corporate insolvency resolution process.

This, in effect, allowed guarantors to escape liquidation of personal assets for 270 days (the timeline for resolution under NCLT).

The necessary amendment to the Code, which will soon operationalise the individual insolvency regime in respect of guarantors to corporates, will synchronise the proceedings of both the corporate debtor and personal guarantor.

Excessive leverage

In India, particularly in the SME sector, personal guarantors to corporate debt are mostly promoters or directors to the company, says KS Ravichandran, Managing Partner, KSR & Co, Company Secretaries LLP.

“In most cases, personal guarantees are several times the net worth of the guarantor. In the past, promoters have been able to stall proceedings by filing ingenious cases under the Debt Recovery Tribunal (DRT) or High Courts,” says Ravichandran.

He cites the HSBC vs R Subramanian (promoter of Subhiksha Trading Services) case. According to the plaintiff (the guarantor), lenders to Subhiksha had taken guarantees aggregating to ₹800 crore from him even though all of them were aware that his net worth was not even ₹5 crore.

Hence, according to Section 56 of the Contract Act, the plaintiff argued that since there was no feasibility of the guarantee being performed by him in the first place, the contract was ab initio void. While the Madras High Court had thrashed the argument, it brings to light ways in which erring promoters have been gaming the legal system.

Under the new Code, lenders will be able to initiate insolvency action against both the company and personal guarantor.

“In effect, the guarantor becomes a corporate debtor, and will be dealt with under NCLT. Earlier, lenders had to approach the DRT for tackling guarantors, which was a very long-winding process,” says Siby Antony, Chairman, Edelweiss ARC.

Not many strategic buyers

By placing restrictions on the buyers of assets, many cases could land up in liquidation, in turn triggering sale of promoter’s (in the capacity as a guarantee to corporate debt) personal assets.

While we may see some competing offers in the large cases, in the smaller accounts, there may not be many strategic investors, adds Antony.

(The article first appeared in The Hindu BusinessLine.)