Debt guarantees

Supreme Court has strengthened the IBC framework

The Supreme Court last week settled an important ongoing issue and strengthened the bankruptcy framework by upholding the constitutional validity of the Insolvency and Bankruptcy Code’s (IBC’s) provisions related to personal guarantors. A number of petitions were filed, challenging the validity of the law in this context. However, a three-judge Bench of Chief Justice of India D Y Chandrachud, Justice J B Pardiwala, and Justice Manoj Misra ruled out any relief for petitioners. The Bench noted the IBC did not suffer from arbitrariness and was constitutionally sound. The petitioners had argued that the relevant provisions violated the principles of natural justice and did not give guarantors the chance to present their case. In this context, the apex court has highlighted that the role of the resolution professional under Section 99 of the IBC is to gather information and submit a report to the adjudicating authority, with the recommendation to approve or reject the application. The resolution professional is not expected to adjudicate under the law.

The judgment has clearly tilted the balance of power in favour of creditors and is being seen as a setback for promoters of companies going through the insolvency resolution process. Promoters of companies carrying significant levels of debt often furnish personal guarantees to facilitate additional borrowing by the firm. Therefore, it should be natural for financial creditors to ask the guarantors to step in if firms default. If a guarantor of debt cannot be made to pay, there is no real value to such a guarantee. The judgment thus should be a clear message to promoters of over-leveraged firms that they will not remain insulated if their firms are piling up debt because of their personal guarantees to financial institutions. In this context, it is worth mentioning that banks and financial institutions would do well to accept such guarantees with care. As lenders seem to have learned the hard way, personal guarantees of an over-leveraged group’s promoter may not be worth much. Improved discipline among borrowers, along with better lending standards, should help improve the efficiency of credit in the economy and boost growth in the long run.

However, the overall IBC process remains a work in progress. As the latest quarterly update of the Insolvency and Bankruptcy Board of India showed, resolution plans approved for 808 corporate debtors thus far have resulted in realisation value of about 32 per cent against the admitted claims. The realisation, however, was over 168 per cent of the liquidation value. The lower realisation may partly be driven by the fact that firms had borrowed disproportionately compared to their underlying assets. Therefore, it is likely that as the quality of credit improves in the economy, the realisation will also go up for firms undergoing insolvency. Even though the realisation value remains a concern at the moment, the basic idea of the IBC, which is to rescue firms in distress, is beginning to show results. According to a new study by the Indian Institute of Management Ahmedabad, which looked at 550 firms post-resolution, sales increased 76 per cent three years after the resolution. There was also a 50 per cent increase in employee expenses, which reflected higher employment intensity in these firms. Policy efforts thus should focus on strengthening the IBC framework and improving the overall resolution process. The apex court’s judgment last week should take this process forward.