How Are Loans from Directors Treated in Bankruptcy Cases?

In bankruptcy cases under the Insolvency and Bankruptcy Code (IBC), loans provided by directors of a company can play a significant role in the resolution process. These loans, which are typically considered financial support from insiders, are subject to specific legal treatment under the IBC. The key factors influencing the treatment of these loans include the nature of the loan, the relationship between the director and the company, and the overall insolvency proceedings of the corporate debtor.

Treatment of Loans from Directors in Bankruptcy Cases:

Categorization as Financial Creditors or Operational Creditors:

Loans from directors are typically categorized as financial creditors if the loan is in the form of debt (i.e., a sum of money with interest) and is provided for a specific period with an expectation of repayment.

If the loan is unsecured, it can still be classified as a financial claim under the IBC, but it will be treated differently from secured creditors.

In some cases, if the director has provided loans or advances in the form of operational support (e.g., a contribution to working capital), it could be treated as an operational creditor. However, in practice, loans from directors are usually considered financial creditors.

Priority of Repayment:

During Corporate Insolvency Resolution Process (CIRP), loans from directors will be ranked alongside other financial creditors.

Financial creditors typically have a higher priority of repayment over operational creditors, but they are subordinated to secured creditors. If the loan is unsecured, the director's claim will be treated in the same manner as other unsecured financial creditors.

The repayment of loans from directors, like any other debt, will depend on the outcome of the Resolution Plan approved during the CIRP. The plan should ensure that creditors are paid according to their class (financial or operational) and their rank in the payment waterfall.

Personal Liability of Directors:

Directors who have provided loans to the company are generally not personally liable for the company’s debts, unless the loan is secured by their personal guarantees.

In the case of personal guarantees, if the company defaults, the director may become personally liable for the debt and can be pursued for repayment in insolvency proceedings.

Under the IBC, a personal guarantor can be subject to insolvency proceedings in the event the company fails to repay debts. Therefore, if a director has given a personal guarantee, their personal assets may be at risk in the bankruptcy process.

Repayment under Resolution Plans:

Directors’ loans will typically be addressed in the Resolution Plan submitted during the CIRP. The Resolution Professional (RP), under the supervision of the Committee of Creditors (CoC), may propose a settlement or restructuring plan for the repayment of these loans.

If a Resolution Plan is approved, the repayment terms for loans from directors may vary depending on whether the loan is treated as secured or unsecured. Directors who are financial creditors will be included in the distribution plan along with other similar creditors.

Role of Directors in Insolvency Process:

In the case of directors’ loans, the director may retain the right to participate in the CIRP process as a member of the Committee of Creditors (CoC), provided they are not disqualified (for example, due to being a wilful defaulter).

Directors also play a critical role in ensuring that all relevant financial records and documentation of the loan are available for the Resolution Professional to assess the validity and priority of the loan.

Special Considerations in Fraud or Mismanagement:

If there is any suspicion of fraudulent transactions or mismanagement involving loans from directors, the Resolution Professional or the Insolvency and Bankruptcy Board of India (IBBI) may investigate such loans.

In cases where loans are found to have been provided with the intention to defraud creditors or avoid repayment obligations, the Insolvency Court (NCLT) can annul such transactions and may impose penalties or other legal actions on the directors.

Example:

Consider a company, XYZ Ltd., which is facing insolvency proceedings. The company owes ₹10 crore to its financial creditors, and the director has personally lent ₹2 crore to the company as part of the company’s financial support.

The loan from the director is categorized as a financial creditor’s claim under IBC, as it is a debt with an expectation of repayment.

During the CIRP, the Resolution Professional (RP) examines the loan and includes it in the list of creditor claims.

Since the loan is unsecured, the director’s claim is placed alongside other unsecured financial creditors in the payment waterfall and will be repaid according to the approved Resolution Plan.

If the company’s assets are sold under the Resolution Plan and sufficient funds are available, the director, like other financial creditors, will receive a portion of the repayment based on the plan.

If the director has personally guaranteed the loan, they could also be held personally liable for the debt in the case of default.

Conclusion:

Loans from directors in bankruptcy cases are treated as financial claims under the Insolvency and Bankruptcy Code (IBC). The repayment of these loans is subject to the insolvency resolution process and may be categorized as secured or unsecured based on the nature of the loan. Directors are not personally liable unless they have provided personal guarantees, in which case they can be subject to personal insolvency proceedings. The Resolution Plan plays a crucial role in determining how such loans are treated and repaid during the Corporate Insolvency Resolution Process (CIRP).