Liability of Director as Guarantor for Debts of the Company

As you are aware that a company is a legal entity and run by persons known as directors. They are collectively called Board of Directors and are appointed by the shareholders of the company. A director is in a fiduciary relationship with the company and sometimes treated as trustee as well as an agent of the company. They are the minds behind the success and failure of an organization.

It is necessary for a company to have adequate finance to run its day to day business and for procurement of its raw materials, payment of wages, taxes etc., finance is also needed for expansion, capital expenditure , increase in production capacity etc. The banks and financial institutions ,while advancing any loan to a company looks on the person behind the company and the persons who are managing affairs of the company. The banks and financial entities also access the creditability of directors of the company ,while advancing loan to the company. They generally insist personal guarantee from directors of the company to secure their loan.

As company is a separate legal entity from its shareholders as well as directors. It has its own name, assets, liabilities , can be sued or sue in its own name and its liabilities and assets cannot be considered as liabilities and assets of shareholders and directors.

A personal guarantee by a director is a contractual promise to pay the debts of the company in the event that the company is unable to pay the guaranteed debt. If there are multiple guarantors, liability under the guarantees is normally joint and several, each person signing a guarantee can be pursued for the full debt in the event of a default by the company.

Typical areas where liabilities might be personally guaranteed are

• Bank loans and overdrafts.
• Finance leases on equipment and motor vehicles.
• The lease of the premises.
• Invoice discounting facilities.
• Supplier credit application forms.

In the current climate, we are likely to see many instances of personal guarantors being called on to satisfy company debts. In difficult circumstances, this will inevitably lead creditors to seek court approval for mandated and priority claims on the guarantor or their personal property and income.

Please note that: In the context of loan transactions of the company, it was held that the directors who had not given any personal guarantee for the loan could not be made liable merely because they. Were directors of the company at the time advancement of loan.

• Bank of Scotland Vs. Write (199) BCLC 244(QBD)- where a director guaranteed his company's debts, as his company become liable for debts of its subsidiary company, it was held that the director's guarantee would cover the debt of subsidiary also. The terms of guarantee also covered the contingent liability of the holding company for the debts of its subsidiary company as theses liability crystallized.
• Please note that : even where a director consciously enters into a guarantee there is room for him being confused as to the degree of his exposure. The case indicate a potential trap for directors of subsidiary companies. Where such a director knowingly guaranteed the debts of the company of which he was a director , but unfortunately ,because of a failure to appreciate the complexities of the guarantee document, he did not realise that he in effect guaranteeing debts. For the whole group.
• Tirupati Plywood Products Pvt. Ltd. Vs. Pradeshik Industrial Investments Corp. of UP Ltd. (1998)29CLA67(All)- it was held that the guaranteeing director cannot say that the creditor should first proceeds against the borrowing company. The borrower and the guarantor are equally liable by virtue of the provision of Sections 126 and 128 of the Contract Act, 1872.
• Indian Overseas Bank Vs. AB Senan (1999)96 Com Cases 839(Kerala) A bank granted a temporary overdraft accommodation to a company for the purpose of meeting its working capital requirements. The advance was granted on the strength of a specific undertaking or promise made by the respondents, who were a Managing Director and director of the company ,to liquidate within one month the entire outstanding account involving costs and expenses. A decree passed against the director and the Managing Director personally held liable was justified. They could not get an order that recovery should not be out of their Personal assets.

Please Note That

1. Where certain directors who had guaranteed the companies' debts had retired and new directors have been appointed on their place ,who also signed the guarantee bonds and there is no such agreement to show that earlier guarantee agreement had ceased to be operative then all directors including retired were liable jointly and severally under guarantee.
2. If a director had made himself as a party of a contract of guarantee for debts of his company during his directorship and after his resignation he had failed to secure release letter from the bank of the company from guarantee given , then in this case the guarantee survived and he become liable in case of default after his departure.
3. Even an informal undertaking to pay company's debts may make a director liable.

LIMITATION PERIOD TO CLAIM AMOUNT FROM DIRECTOR

Maharashtra State Financial Corporation Vs. Ashok K Agrawal (2006) 131 com case1 AIR 2006 SC 1584 -realisation from sale of the company's assets were not sufficient to discharge the whole liability of the company under a loan, and therefore directors were sought t be made liable as guarantor. The Court said that the limitation period. For proceedings against directors was three years and not twelve years.

The above decision has been countered in below mentioned case;

Sitcom Ltd. Vs. Anandprasad G. Shrivastava (2005) 127 Com Cases 541(Bom); a guarantee was executed in favour of State Financial Corporation on a stamp paper. The guarantors were promoters and directors of the company. The guarantees were found to be valid. The court allowed invocation the company was in industrial sickness. The twelve year pension was allowable from the date of invocation. The petition for enforcement of guarantee was therefore maintainable.

RECENT DEVELOPMENTS

POSITION OF PERSONAL GUARANTORS PRIOR TO THE 2019 RULES

Before the 2019 Rules were notified, Part III of the Code was inapplicable to personal guarantors to corporate debtors. Creditors then had the option of proceeding inter alia through: (i) the civil courts under the Presidency Towns Insolvency Act, 1909 or the Provincial Insolvency Act, 1920; (ii) a civil suit enforcing their contractual remedies; and (iii) other specialized legislations inter alia including the Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002.

However, after the 2019 Rules were notified, creditors are also entitled to approach the DRT under Part III of the Code as well as the NCLT under Part II of the Code for recovery of dues from personal guarantors. Additionally, the avenues of recovery that existed prior to the 2019 Rules, continue to subsist as Section 243 of the Code, which seeks to repeal the Presidency Towns Insolvency Act, 1909 & the Provincial Insolvency Act, 1920, has not yet been notified.

Section 128 of the Contract Act states that the liability of a guarantor shall be co-extensive to that of the principal debtor. In other words, the corporate debtor and the personal guarantor being jointly and severally liable to repay the debt of the creditor, the Contract Act does not prevent a creditor from proceeding against a guarantor prior to exhausting his remedies against the principal debtor.

On 21^st May 2021, Supreme Court in Lalit Kumar Jain v. Union of India, 2021 SCC OnLine SC 396 (Lalit Kumar), upheld the Insolvency and Bankruptcy (Application to Adjudicating Authority for Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Rules, 2019 (2019 Rules) notified by the Indian Government on 15 November 2019 (effective from 1 December 2019).

The 2019 Rules inter alia notified Section 2(e) of the Insolvency and Bankruptcy Code, 2016 (Code) in relation to personal guarantors to corporate debtors, who were recognized as a distinct category of individuals vide the Insolvency and Bankruptcy Code (Amendment) Act, 2018 (2018 Amendment Act), effective from 23 November 2017.

The 2018 Amendment Act inter alia created three distinct categories of persons:

1. personal guarantors to corporate debtors;
2. partnership firms and proprietorship firms; and
3. individuals, with a view to treat each category differently under the Code.

In the Lalit Kumar, the Petitioners challenged the 2019 Rules primarily on the grounds that:

(i) the Central Government has exceeded the power conferred upon it under Section 1(3) of the Code by modifying provisions of the Code and making the same selectively applicable to a category of persons, which it was not authorized to do; (ii) initiating proceedings against the corporate debtor as well as the personal guarantor to a corporate debtor would amount to a "double recovery" which is impermissible under the Code; and (iii) in case a resolution plan extinguishes the existing debts of a corporate debtor, the liability of the personal guarantor to a corporate debtor, being coextensive by virtue of Section 128 of the Indian Contract Act, 1872 (Contract Act), must also stand extinguished.

The Supreme Court, however, rejected the contentions of the petitioner and upheld the 2019 Rules

• The above decision seen a welcome step by the creditors now they can claim their debts from Corporate Debtor as well as Corporate Guarantor under one forum;
• Creditors are entitled to claim balance amount from Corporate Guarantors if their claim is not satisfied under Corporate Insolvency resolution Plan.

CONCLUSION

If you are a director, or a business owner, with concerns about the impact of a personal guarantee, we recommend the following steps:

• Your liability under a personal guarantee will be dependent on the company's underlying obligation to pay the debt.

i) Review the primary agreement with the company;

ii) check that the agreement is enforceable and make sure you understand the company's payment obligations.

• Check that the underlying debt is immediately due and payable.
• Carry out a detailed review of the written guarantee document and make sure you understand the terms of the guarantee.
  1. Is there a cap on liabilities?
  2. Can interest be claimed on the underlying debt?
  3. Are the terms of the guarantee sufficiently clear and complete to take effect and to be enforceable against you?
  4. Do you have a right to request further information from the lender?
• Are there any co-signatories?
• Consider whether there are any grounds to challenge the personal guarantee.
  1. Does the guarantee comply with the necessary formalities?
  2. Was independent legal advice taken before you signed the guarantee?
  3. Were any inaccurate explanations provided to you by the lender at the time that the guarantee was entered?
  4. Are the terms of the guarantee fair and reasonable, or do they fall foul of Unfair Contract Terms legislation?
• Consider whether there is any scope to renegotiate terms, or agree a repayment plan, with the lender.
• Be pro-active and seek early legal advice.
• Ensure that before retire or resignation or leaving the company there should be an agreement to release yourself form the terms of guarantee.

DISCLAIMER: The above article is only for information and knowledge of readers. The view expressed above is personal views of the author. It is advisable to consult with professionals for more. Clarifications on matter.