Consequent on Bank Nationalization Acts {The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 & 1980} as well the law declared by the Supreme Court in the matter of Kripak vs Union of India (AIR 1970 Supreme Court 150) and in the context of project oriented financing, taking of any personal guarantee and or collateral or any such security is lacking authority of any statute on the part of Banks/FIs . The banks and public financial institutions (hereinafter collectively referred to as ‘the Banks’) have unilaterally and arbitrarily developed a practice, without the authority of law, to execute personal guarantee agreements with the directors of a company to secure the debts of the company. This view is supported by the following latest judgment of the Supreme Court. Recently, the Supreme Court in the case of Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (2008 AIOL 348 Civil Appeal No. 610-612 of 2004 Decided on 13/03/2008) has observed as follows (in para 18): “18. BANKING PRACTICE may enable a financial corporation to ask for a collateral security. Such security, we would assume, may be furnished by the Directors of a Company but furnishing of such security or guarantee is not confined to the Directors or employees or their close relatives. They may be outsiders also. The rights and liabilities of a surety and the principal borrower are different and distinct.” (capitals supplied) Therefore, it stands concluded, without any doubt, that the banks have developed the practice to execute personal guarantee agreements with the directors of a company to secure the debts of the company without the authority of law. This practice is against the principle of limited liability of the shareholders as well as directors of the company as provided in the Companies Act, 1956. Accordingly, it is clearly against the letter and spirit of the Companies Act.
In my opinion the issues are being mixed. The Companies Act 1956 is not a governing law for a person to stand a guarantee to another person. Guarantee is governed by the Contract Act 1972. It is a valid and legal contract of guarantee. The Companies Act regulates the issues related to corporate formation, regulation and governance issues related to an incorporated body. It does not prohibit a director from giving a guarantee (which is in his personal capacity) for any other person including a body corporate in which one is a director. Bringing in limited liability concept into personal capacity dealings of a director or a member of a company is just obfuscating the issue. It is legitimate for a financing institution to seek a personal guarantee from the directors of a company, on whom the success or failure of a company by and large depends, so that they comply with their fiduciary duties very honestly, and not become adventurist with the corporate funds, lest their personal guarantee is invoked.
. Evolution of concept of legal entity A division bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd (2006 134 Comp cas 106 Del. decided on 3.3.2006) observed that “the concept that a company is a distinct legal entity apart from its shareholders, vide Salomon vs. Salomon & Co. (1897 AC 22 HL) had a historical purpose. Its main purpose was to encourage entrepreneurs to start new business ventures and, thus, help in the process of industrialisation.” This background is so important that it merits consideration in detail as follows. 1.1 Delhi High Court further observed that “In every business there is a risk that the business may fail due to recession, competition, etc. Hence, businessmen were reluctant to set up new industrial ventures out of fear that if it failed, recovery would be issued in respect of the loans they had taken and thereupon even their household and personal effects may be sold in connection with the recovery. Hence, businessmen were reluctant to take risks and start new industrial ventures. To get over this hurdle and to encourage industrialisation the legal principle was created that if a company is incorporated under the Act, the liability of the shareholders becomes limited because the shareholders, directors, etc., are legally treated as being different from the company. A company was held to be a distinct legal entity separate from its shareholders and directors. This legal principle gave protection to businessmen who were otherwise reluctant to start new industrial ventures due to the risk involved. Thus, this legal principle was of great help to industrialisation in Eurpoe (where industrialisation first began during the Industrial Revolution) and there after all over the world. “
In view of aforesaid, the agreement of personal guarantee of a director being got executed by the banks as a prerequisite, amounts to making the liability of a businessman / director unlimited towards the debts of a company, which is wholly against the evolution of "the principle of concept of legal entity" and therefore, absolutely prohibited by the provisions of Companies Act, 1956.
(1) The Companies Act provides that the directors of a company are not liable for the debts of the company. This view has been upheld by Delhi High Court in Indian Overseas Bank v. R. M. Marketing and Services Pvt Ltd (2001 107 Comp Cas 606) and subsequently by a Division Bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd (2006 134 Comp cas 106 Del. decided on 3.3.2006). (2) It stands concluded that the agreement of personal guarantee of a director being executed by the banks as a prerequisite, amounts to making the liability of a director unlimited towards the debts of a company, which is absolutely prohibited by the provisions of Companies Act, 1956. (3) Further, the consent of a director is not free being obtained by the banks by undue influence, because the company is in need of funds for its working capital requirements and the banks have made the execution of agreement of personal guarantee by a director a prerequisite for obtaining the working capital limits from the banks. (4) Section 23 of the Contract Act provides that every agreement of which the object or consideration is unlawful, is void. Therefore, the agreement of personal guarantee executed by a director is a void agreement, because its object is unlawful as it defeats the provisions of the Companies Act, 1956.
Section 322 (1) of the Companies Act, 1956 provides as follows “In a limited company, the liability of the directors or of any director or manager may, if so provided by the memorandum, be unlimited. “ By necessary implication it follows that a director’s liability is limited. Section 13 (2) the Companies Act, 1956 provides that “The memorandum of a company limited by shares or by guarantee shall also state that the liability of its members is limited.” Further, section 270 (1) of the Companies Act, 1956 provides that if not required by the articles a director may not hold any share qualification. Therefore, a director may not have at all even a limited liability for the debts of the company, as a member, as provided in section 13 (2) the Companies Act, 1956. This view has already been upheld by Delhi high court in Indian Overseas Bank v. R. M. Marketing and Services Pvt Ltd (2001) 107 Comp Cas 606. The court observed, inter alia, that “ ……. simply because they were directors of defendant No. 1 they could not be fastened with the liability as defendant No. 1 which is a company incorporated under the Companies Act is a separate legal entity.”
In view of aforesaid, the agreement of personal guarantee of a director being executed by the banks as a prerequisite, amounts to making the liability of a director unlimited towards the debts of a company, which is absolutely prohibited by the provisions of Companies Act, 1956.
Consequent on Bank Nationalization Acts {The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 & 1980} as well the law declared by the Supreme Court in the matter of Kripak vs Union of India (AIR 1970 Supreme Court 150) and in the context of project oriented financing, taking of any personal guarantee and or collateral or any such security is lacking authority of any statute on the part of Banks/FIs .
ReplyDeleteThe banks and public financial institutions (hereinafter collectively referred to as ‘the Banks’) have unilaterally and arbitrarily developed a practice, without the authority of law, to execute personal guarantee agreements with the directors of a company to secure the debts of the company. This view is supported by the following latest judgment of the Supreme Court.
Recently, the Supreme Court in the case of Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (2008 AIOL 348 Civil Appeal No. 610-612 of 2004 Decided on 13/03/2008) has observed as follows (in para 18):
“18. BANKING PRACTICE may enable a financial corporation to ask for a collateral security. Such security, we would assume, may be furnished by the Directors of a Company but furnishing of such security or guarantee is not confined to the Directors or employees or their close relatives. They may be outsiders also. The rights and liabilities of a surety and the principal borrower are different and distinct.” (capitals supplied)
Therefore, it stands concluded, without any doubt, that the banks have developed the practice to execute personal guarantee agreements with the directors of a company to secure the debts of the company without the authority of law. This practice is against the principle of limited liability of the shareholders as well as directors of the company as provided in the Companies Act, 1956. Accordingly, it is clearly against the letter and spirit of the Companies Act.
In my opinion the issues are being mixed. The Companies Act 1956 is not a governing law for a person to stand a guarantee to another person. Guarantee is governed by the Contract Act 1972. It is a valid and legal contract of guarantee.
ReplyDeleteThe Companies Act regulates the issues related to corporate formation, regulation and governance issues related to an incorporated body. It does not prohibit a director from giving a guarantee (which is in his personal capacity) for any other person including a body corporate in which one is a director. Bringing in limited liability concept into personal capacity dealings of a director or a member of a company is just obfuscating the issue.
It is legitimate for a financing institution to seek a personal guarantee from the directors of a company, on whom the success or failure of a company by and large depends, so that they comply with their fiduciary duties very honestly, and not become adventurist with the corporate funds, lest their personal guarantee is invoked.
. Evolution of concept of legal entity
ReplyDeleteA division bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd (2006 134 Comp cas 106 Del. decided on 3.3.2006) observed that “the concept that a company is a distinct legal entity apart from its shareholders, vide Salomon vs. Salomon & Co. (1897 AC 22 HL) had a historical purpose. Its main purpose was to encourage entrepreneurs to start new business ventures and, thus, help in the process of industrialisation.” This background is so important that it merits consideration in detail as follows.
1.1 Delhi High Court further observed that “In every business there is a risk that the business may fail due to recession, competition, etc. Hence, businessmen were reluctant to set up new industrial ventures out of fear that if it failed, recovery would be issued in respect of the loans they had taken and thereupon even their household and personal effects may be sold in connection with the recovery. Hence, businessmen were reluctant to take risks and start new industrial ventures. To get over this hurdle and to encourage industrialisation the legal principle was created that if a company is incorporated under the Act, the liability of the shareholders becomes limited because the shareholders, directors, etc., are legally treated as being different from the company. A company was held to be a distinct legal entity separate from its shareholders and directors. This legal principle gave protection to businessmen who were otherwise reluctant to start new industrial ventures due to the risk involved. Thus, this legal principle was of great help to industrialisation in Eurpoe (where industrialisation first began during the Industrial Revolution) and there after all over the world. “
In view of aforesaid, the agreement of personal guarantee of a director being got executed by the banks as a prerequisite, amounts to making the liability of a businessman / director unlimited towards the debts of a company, which is wholly against the evolution of "the principle of concept of legal entity" and therefore, absolutely prohibited by the provisions of Companies Act, 1956.
(1) The Companies Act provides that the directors of a company are not liable for the debts of the company. This view has been upheld by Delhi High Court in Indian Overseas Bank v. R. M. Marketing and Services Pvt Ltd (2001 107 Comp Cas 606) and subsequently by a Division Bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd (2006 134 Comp cas 106 Del. decided on 3.3.2006).
ReplyDelete(2) It stands concluded that the agreement of personal guarantee of a director being executed by the banks as a prerequisite, amounts to making the liability of a director unlimited towards the debts of a company, which is absolutely prohibited by the provisions of Companies Act, 1956.
(3) Further, the consent of a director is not free being obtained by the banks by undue influence, because the company is in need of funds for its working capital requirements and the banks have made the execution of agreement of personal guarantee by a director a prerequisite for obtaining the working capital limits from the banks.
(4) Section 23 of the Contract Act provides that every agreement of which the object or consideration is unlawful, is void. Therefore, the agreement of personal guarantee executed by a director is a void agreement, because its object is unlawful as it defeats the provisions of the Companies Act, 1956.
Section 322 (1) of the Companies Act, 1956 provides as follows
ReplyDelete“In a limited company, the liability of the directors or of any director or manager may, if so provided by the memorandum, be unlimited. “
By necessary implication it follows that a director’s liability is limited. Section 13 (2) the Companies Act, 1956 provides that “The memorandum of a company limited by shares or by guarantee shall also state that the liability of its members is limited.” Further, section 270 (1) of the Companies Act, 1956 provides that if not required by the articles a director may not hold any share qualification. Therefore, a director may not have at all even a limited liability for the debts of the company, as a member, as provided in section 13 (2) the Companies Act, 1956. This view has already been upheld by Delhi high court in Indian Overseas Bank v. R. M. Marketing and Services Pvt Ltd (2001) 107 Comp Cas 606. The court observed, inter alia, that “ ……. simply because they were directors of defendant No. 1 they could not be fastened with the liability as defendant No. 1 which is a company incorporated under the Companies Act is a separate legal entity.”
In view of aforesaid, the agreement of personal guarantee of a director being executed by the banks as a prerequisite, amounts to making the liability of a director unlimited towards the debts of a company, which is absolutely prohibited by the provisions of Companies Act, 1956.
If you are interested about bank personal guarantee and guarantee related more information contact me.
ReplyDeleteDeepak Kunwar 9818379626
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