It was a pleasant winter morning in Hyderabad, and a young banker at a development financial institution had just finished preparing the documentation for a loan.
It was his first industrial loan, for the capacity expansion of a well-known pharmaceutical unit. He had gone to great lengths to ensure that his analysis of the project, its prospects, and the company's ability to repay were of the highest quality.
His detailed appraisal, which included researching the product, its global markets and competition, identifying risks, and suggesting mitigation and security measures to better secure the loan, had earned him praise from his bosses.
He had requested that the company and its promoters come by that day to go over and sign the documents, so that the loan could be disbursed, and the appointment was set for 11 am.
By 10.45 am, the paperwork was ready, neatly stacked in the office conference room, ready for signing, with coffee/tea on hand. At 11 am, the promoter of the company, nattily dressed in white sports T-shirt and shorts, walked into the office.
He was on his way to the club for a game of tennis when he stopped by to sign the loan documents. Without further ado, he signed the lengthy documents. The befuddled banker inquired whether he, his lawyers, or corporate secretarial staff would like to read the documentation first, given the stringent conditions, which included the promoters' personal guarantees.
Promoter Teaches A Lesson About Loans
The promoter laughed, amused by the idea. He responded that the loan had only two components, the first of which was when the company pursued the lender for the loan. The second was when the lender pursued the company for repayment. The paperwork and legalese were irrelevant to the entire process. It was a lesson in lending realpolitik that the young banker would never forget.
That story dates back to 1999. But the promoters' long-held faith in India's tortuous, manipulated, and failed loan recovery mechanisms was not misplaced. Generations of bankers have watched helplessly as companies and promoters made a mockery of contractual loan commitments, even as the fungibility of corporate and personal wealth, as well as poor law enforcement and adjudication, ensured that company promoters personally prospered, regardless of the health of the companies they managed, and often at their expense.
That Steel Magnate Is Not Alone
In many cases, the two were inversely related. Stories like a steel magnate from Kolkata lavishly spending €50 million on his daughter's wedding in Barcelona while his company defaulted on workers' EPFO dues are common. And personal guarantees have not been worth the paper they were written on.
A recent decision by the Supreme Court of India, which dismissed over 200 petitions challenging the legality of the Insolvency and Bankruptcy Code (IBC) provisions on personal guarantors, has upheld long-overdue accountability for contractual rights and the end use of public funds.
The case also shows how India's command-and-control economy, which was implemented as government policy for decades, gradually warped the fundamental principles required to build a strong financial system based on transparency and trust.
A Beast Called Promoter’s Personal Guarantee
The promoter’s personal guarantee first arose as an additional security for industrial loans made by banks and institutions in response to widespread abuse of siphoning funds and falsifying accounts by promoters while running a company.
It was then pithily observed that while there were many sick companies, it was hard to find financially sick promoters. However, instead of addressing the underlying issues of financial transparency and accountability, law enforcement, and timely adjudication, governments simply allowed banks and institutions under its control to seek personal guarantees from promoters.
The hollowness of this fig-leaf response was enough to save the government's moral face. However, its pious-in-intention but rotten-in-practice patronage system ensured that the system remained unresponsive even as more meaningless documentation was added to loans with no hope of enforcement. And promoters continued to sign documents cheerfully, with no regard for repayment or accountability.
The sham practice reached its apex when personal guarantees from a single promoter were obtained for loans worth nearly Rs 25,000 crore – without the bank or institution raising any concern about the promoters' ability to honour the personal guarantee.
Crucial Questions Forgotten
Banks forgot questions like these: Is that level of promoter net worth, or could legitimately be, attained without siphoning off funds from the company? And, if it believed funds could or would be siphoned off and had doubts about promoter intent, should it make the loan at all, and, if so, how did the personal guarantee add to the loan's security?
This form-over-substance approach to lending has long plagued India's financial system, leading to the non- performing asset (NPA) banking crisis of the 2010s.
The recent Supreme Court decision has also rekindled old debates. Promoters, as in the past, claim that this will have a "chilling effect" on the "animal spirits" of entrepreneurship, stifling borrowings and capital investment growth. Others have argued that having the right principles as the foundation for building a strong financial system is more important.
As India's financial markets mature and state-directed lending fades into obscurity, the latter argument gains weight and promise. Money is a commodity that lenders must lend, based on their risk perception and underwriting skills. Any security provided must increase the lender's confidence in the loan's repayment. If promoter guarantees continue to be unenforceable in the system, they provide no additional comfort.
In contrast, if they do become enforceable, they provide additional security that promoters can offer to lenders. Concerning the "chilling effect," it is not as if there are no promoters in the Indian corporate ecosystem who are unable to borrow without providing a promoter guarantee. In fact, some companies are so creditworthy as to borrow at rates lower than sovereign debt on international markets. This argument is frequently advanced by those seeking to borrow more than the market's assessment of their ability to repay, in an effort to maintain the old system of crony banking and patronage, which results in the same old NPA crises cleaned up with public funds. Not any longer. Of course, there will be loan defaults in the future, but hopefully with transparency, accountability, and recovery rather than gaming the system.
The Way Out
Concerning legacy promoter guarantees, simply proceeding under the IBC would not suffice. Declaring personal bankruptcy after transferring all assets into family or benami accounts would be the simplest thing to do.
Lenders must step up their efforts to follow the money trail, trace fund syphoning, and bring it before the courts. There is ample forensic expertise and intelligence available on the market. The more important question is whether they intend to do so. Lenders have traditionally prioritised new business over recoveries for obvious reasons.
As a result, the expected rigour of recovery processes, whether internal or external, has been diluted. Low recovery rates, however, not only cause lender losses, but they also distort market efficiencies and incentivise delinquent behaviour. In order for loan markets to be efficient, recovery markets must also improve their efficiency. Sending the right message through effective personal promoter guarantee enforcement would be a step in the right direction.
Sandeep Hasurkar is an ex-investment banker and author of `Never Too Big To Fail: The Collapse of IL&FS’. Views are personal, and do not represent the stand of this publication.
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