Application of IBC only qua Personal Guarantors: A Reasonable Classification?
– By Ms. Sushmita Sharma,
A law student at Dr. Ram Manohar Lohiya National Law University, Lucknow
On 15.11.19, the ministry of corporate affairs released a notification wherein it notified certain sections of Part III of the Insolvency and Bankruptcy Code and made them applicable only to the personal guarantors to corporate debtor. Following the release of notification, several contentions were put forth challenging the validity of the part-application of Part III of the Insolvency and Bankruptcy Code. The constitutionality of the code has also been challenged earlier before the SC and the court decide in favour for the code.
Now once again, the question of constitutionality of IBC has been raised. It has been argued that there is no reasonable classification in applying the part III of the code only qua ‘personal guarantors.’
This article tries to argue that the application of part III of the code only with respect to the personal guarantors qualifies to be a reasonable classification.
Article 14 of the Indian Constitution talks about equality and thus, prohibits class legislation. But, as recognised by this Hon’ble SC in various cases over the years, article 14 does not restricts reasonable classification.
In order to be included within the ambit of reasonable classification, a classification must satisfy a two-fold test:
- The classification must be based on intelligible differentia which distinguishes the persons or things which are grouped together form the others which are left out of the group;
- The differentia must have a rational relation with the object sought to be achieved by the classification in question.
While examining the issue of intelligible differentia the court looks into the validity of differences and adequacy of differences. Thus, to satisfy the test of intelligible differentia, a classification must be grounded in reason and must be just and fair.
Vide the Insolvency and Bankruptcy Code (Amendment) Act,2017 the government introduced sub-clauses (e), (f) and (g) to Section 2 of the code, which talk about application of the Code.
After the said amendment, Part III of the Code is applicable to three categories of individuals: (i) Personal Guarantors to Corporate Debtors; (ii) Individuals with Partnership Firms or Sole Proprietorships, and (iii) other Individuals. This classification has come in light of the fact that, each of these individuals have distinct peculiarities, characteristics and dynamics requiring different treatment because of economic considerations.
The classification is based on the difference in liabilities of the three sets of individuals.
Personal Guarantors to a corporate debtor are liable by the virtue of a contract of guarantee entered into by them. The responsibility undertaken by them is voluntary in nature i.e., it depends on the willingness of the individual(guarantor). A person becomes a guarantor only when he willingly enters into a contract to perform the promise, or discharge the liability, of a third person in case of his default i.e., a contract of guarantee as specified under section 126 of Indian Contract Act. On the other hand, partners of a firm are liable because of the very nature of the partnership. As specified in Section 25 of the Partnership Act:
“Every partner is liable jointly with all the other partners and also severally, for all acts of the firm done while he is a partner”
Thus, unlike the liability of a guarantor, the liability of a partner is not voluntary or subject to his/her willingness. Similarly, if we look at individuals, their liability is also involuntary in nature and is binding upon them without their will.
Further, a notable difference between the liability of the guarantor and other entities in part III of IBC is that the guarantor has a right to limit to his liability. He/she can place a limit upon his liability, the same was upheld by this court in the case of Yarlagadda Bapanna v. Devata China Yerkayya. On the other hand, the partners of a firm or an individual cannot limit his liability.
Another crucial difference that needs to noted here that unlike corporate debtor, which are companies, and firms, individuals do not have a separate legal existence and therefore, insolvency procedures in the case of former is almost exclusively driven by economic concerns. On the other hand, insolvency relief for the individuals includes inter alia a component of empathy.
The intelligible differentia must have a rational nexus with the object sought to be achieved by the legal provision.
Companies are modern engines of growth. They produce goods and services, and generate income and employment. It takes years of efforts to bring up a company. Its life is precious. It dies a natural death when it fails at the marketplace on account of competition and innovation. The insolvency law tries to rescue the life of a company even form natural death. These are the words of Mr M S Sahoo, the chairman of IBBI.
He further noted that the insolvency framework aims to i) rescue a viable firm and ii) liquidate an unviable firm. Thus, it can be established that one of the objectives of IBC is to prevent the death of the company.
If we look from a larger perspective, we would realise that companies generate not only goods and services but also income and employment which fuel the economy.
In general, the liability on companies and in turn, on personal guarantors is much larger in terms of the amount as compared to the liability on a firm or an individual.
Also, these companies provide employment opportunities to a large section of the population. Thus, the death of a company has a broader implication for the entire economy; the value of the company would not be realised further, it would also lead to the unemployment of a considerable number of people.
On the contrary, if we look at the partnership firms and individuals, the liability on them is comparatively less. The same can also be inferred from the statistics of Quarterly BSR-1: Outstanding Credit of Scheduled Commercial Banks released by the Reserve Bank of India. The working committee on Individual Insolvency also used the same to show that the amount borrowed by the individuals and partnerships are relatively less and lies between few lakhs to one or two crores. While the amount borrowed by the companies could be as huge as a few thousand crores. Further, as per the Economic Survey of 2019-20, around 12 banks account for 25 per cent of non-performing assets.
Keeping the objective of the code and the said statistics in mind, the reconstituted working committee recommended phased implementation of the Part III of the code:
“In the first phase, the provisions of the Code dealing with insolvency and bankruptcy of personal guarantors to corporate debtors should be implemented. The provisions of the Code dealing with insolvency and bankruptcy of partnership and proprietorship firms may be implemented in the second phase. And, in the third phase, the provisions of the Code dealing with insolvency and bankruptcy of other individuals may be implemented.”
Further, taking into account social constraints which may be attached with the process of insolvency such as social stigma, which might have implications for the individuals and partnership firms, the reconstituted working committee also recommended certain measures which include mediation, counselling and financial literacy.
Thus, it can be established that the decision taken by the government to implement part III of IBC is in coherence with the objective of the code and qualifies the test of intelligible differentia as well. Also, among other things it takes into account the social consideration and hence, is a valid classification under article 14 of the constitution.
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