A big step by SC in allowing banks to chase personal guarantors
Last week, a two-judge Bench of the Supreme Court upheld a notification issued by the Union government in November 2019. The notification clarified that the Insolvency and Bankruptcy Code (IBC) would be applicable to companies in which the promoters had signed personal guarantees for loans in the past. Understandably, the notification was challenged by several promoters in various courts. The government notification had said that even if a resolution plan was agreed upon between the company and its creditors through the IBC process — with the lenders, presumably, taking a haircut in the course of the plan — that did not mean that the creditors could not also pursue the erstwhile promoters of the company for the remainder of their dues if the promoters in question had signed a personal guarantee for the bad loans. The Supreme Court agreed with the government, and noted that the personal guarantees signed by the promoters should be considered a separate and independent contract. In other words, the principal borrower — the company — could well stand released of its debt through the “involuntary process” of the IBC, but that did not mean that the liability attached to a personal guarantor of the company’s bad loans was similarly expunged.
This is a major step forward in bringing in a responsible credit culture in corporate India. For far too long, promoters accessed bank loans with impunity, sometimes on the basis of the vast personal assets they possessed. The long unwinding after the 2008 crash, however, exploded the myth that the personal wealth of promoters helps in making loans to their companies more dependable. The introduction of the IBC helped ensure that capital tied up in companies burdened by bad loans would be liberated. Also, promoters who had run these assets into the ground would no longer be able to retain control of these companies even after the lenders took a haircut or wrote off their loans. The next step is assigning clear accountability to those who had convinced banks to lend to their companies by offering their personal wealth as a surety. The banks have now been given a clear legal go-ahead from the highest authority to chase down these errant promoters and claw back assets corresponding to the personal guarantee given.
The lesson for promoters with little skin in the game is clear: Lenders can no longer be treated as automated teller machines without risk to their own net worth, and banks can now initiate insolvency proceedings against promoters, managing directors, and chairpersons who have signed personal guarantees on corporate loans in case the borrowers default. Banks should not, however, see this new structure as an occasion to double down on the use of personal guarantees. These have been demonstrated to be risky and complex to recover. The notification, now legally sound, is welcome, but does not change the fundamental risk to banks associated with personal guarantees. A mature credit culture means not only that promoters will be held accountable, but also that banks lend transparently on the basis of the business plans and books of the company in question, not its relationship with or the reputation and net worth of its promoters.