Examining the Right of Subrogation under IBC: Current Status and Implications

Adv. Yash Gupta and Adv. Vishawjeet Singh
(Pursing Graduate Insolvency Programme- IICA)

Introduction

Doctrine of Subrogation allows one person to assume the rights or remedies of a creditor against a debtor. This means that if someone else pays off a debt, they can take over the rights or remedies that the original creditor had against the debtor. Subrogation can occur in two ways: either automatically as a matter of law or by agreement as part of a contract.

Subrogation by agreement is most commonly seen in insurance contracts. When an insurance company pays out a claim, they become subrogated to the rights of the insured person and can then seek compensation from the party responsible for the damage or loss. Subrogation as a matter of law is an equitable doctrine and falls under the broader category of unjust enrichment. The basic premise of subrogation is that if someone pays off an obligation that is primarily the responsibility of another party, they are entitled to the same claims and remedies that the original creditor had against the debtor. This means that the person who paid off the debt can take legal action against the responsible party to recover the amount they paid.

Right of Subrogation under Contract

Section 140 and Section 141 of the Indian Contract Act, 1872 deals with the principle of subrogation with regard to the rights of a surety or guarantor. It states that if the debt guaranteed by the surety becomes due or if the principal debtor fails to perform a guaranteed duty, the surety, upon payment or performance of the guaranteed debt, is entitled to all the rights that the creditor had against the principal debtor.

In other words, once the surety has paid the guaranteed debt, they are subrogated to the rights of the creditor against the principal debtor. This means that the surety can exercise all the rights that the creditor had against the principal debtor, such as the right to recover the amount paid from the principal debtor, and any security held by the creditor for the debt. The surety can also take legal action against the principal debtor to recover the amount paid as a guarantee. The principle of subrogation is designed to protect the interests of the surety by ensuring that they are not left at a disadvantage after paying the guaranteed debt. It also ensures that the principal debtor fulfills their obligations and that the creditor is not left without a remedy if the principal debtor defaults.

In the case of Amrit Lai Goverdhan Lalan v State Bank of Travancore, the Supreme Court held that the surety is entitled to every remedy which the creditor had against the principal debtor, including the enforcement of every security and means of payment, and the use of all those securities against the debtor. This right of the surety is not just contractual, but also based on natural justice.

The Bombay High Court, in the case of State Bank of India v Fravina Dyes Intermediate, held that the guarantor can apply for a temporary injunction against the debtor, using the doctrine of subrogation, even before making payment to the creditor if the guarantor fears that the debtor may dispose of their property with the intention to defraud the creditor. This means that the guarantor can seek a grant of Quia Timet injunction against the principal debtor under certain circumstances.

Further the Supreme Court, in the case of State of M.P. v Kaluram, held that the term “security” in Section 141 encompasses all the rights that the creditor had against the property of the principal debtor at the date of the contract.

The Supreme Court in Industrial Finance Corporation of India Ltd. v. Canonnore Blending and Weaving Mills Ltd. and Ors. [2017] ibclaw.in 22 SC has considered discharge of liability of a guarantee under the provisions of section 141 of the Indian Contract Act, 1872. It has held that, a definite volition on the part of the creditor is required to take place for the guarantor to stand discharged in terms of section 141 of the Indian Contract Act, 1872. It has held that, the liability of the guarantor cannot but be stated to be a strict liability and even if the principal debtor is discharged from his liability unless such discharge is through the act of the creditor without consent of the surety/guarantor, the creditor’s right of action against the surety is preserved.

Right of Subrogation under IBC

The Insolvency and Bankruptcy Code, 2016 (IBC) made personal guarantors liable through a notification on November 15, 2019. Since then, their rights and liabilities under the IBC have been debated in various legal forums. The treatment of corporate guarantors under the IBC differs from the established principles of contracts of guarantee under the Indian Contract Act, 1872. The right of subrogation, which is an essential aspect of a contract of guarantee, has been a subject of discussion. This right is based on natural justice and equity and is deeply rooted in common law. However, to further the object of the IBC, which is to revive and rehabilitate the corporate debtor, the right of subrogation is sacrificed. This has raised concerns about the fairness of the IBC towards personal guarantors.

The right of subrogation allows the guarantor to step into the shoes of the creditor and recover the amount paid to the creditor from the principal debtor. This right is crucial to contracts of guarantee and is based on the principle of natural justice and equity. However, this right is not given to personal guarantors under the IBC.

The IBC prioritizes the revival and rehabilitation of the corporate debtor over the recovery of debt by the personal guarantor. This means that the personal guarantor’s right of subrogation is sacrificed to achieve the IBC’s objective. The extinguishment of the personal guarantor’s right of subrogation is a departure from the established principles of contracts of guarantee. This has led to debates and discussions about the fairness of the IBC towards personal guarantors.

If a corporate borrower is not required to pay the guarantee, the party may be unjustly enriched if their financial situation is significantly improved or the financial burden is lifted. This would be at the expense of the guarantor if their money was used to affect the improvement. However, once the Principal Debtor’s creditors have been reimbursed by the guarantor, the IBC regime does not provide for the right to subrogation, and the guarantor cannot proceed against the Principal Debtor under the IBC. Denying the right of subrogation to guarantors may have a negative impact on the credit market, as guarantors may be reluctant to participate in transactions without recovery rights. Not granting the right to subrogation may also violate the Indian Contract Act of 1872 and Section 30(2)(e) of the IBC, which requires plans to comply with the Act.

The denial of the right to subrogation has been observed in Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors. [2018] ibclaw.in 47 NCLAT, (an appeal against this order has been dismissed by Supreme Court without any interfere, reported at (2019) ibclaw.in 87 SC) on the grounds that it would defeat the purpose of the Corporate Insolvency Resolution Process (CIRP) by restarting the cycle of non-payment, default, and recovery, and putting stress on the company’s assets. The NCLT ruled that the guarantor cannot exercise their right of subrogation under the Contract Act in IBC proceedings, as they are not recovery proceedings. This is supported by Section 238 of the IBC Code, which gives the Code an overriding effect over all other laws inconsistent with it. It was not the intention of the legislature to benefit the Personal Guarantors by excluding exercise of legal remedies available in law by the creditors, to recover legitimate dues by enforcing the personal guarantees, which are independent contracts. The same reasoning was used in Essar Steel India Ltd. Committee of Creditors v. Satish Kumar Gupta [2019] ibclaw.in 07 SC, where the Supreme Court denied a claim for reimbursement from the resolution applicant by the guarantor.

Further in the case of State Bank of India v. Shri Ghansham Surajbali Kurmi (2022) ibclaw.in 635 NCLT, the NCLT observed that the ratios in the Lalit Kumar Case is applicable to the matter at hand. The NCLT held that once the Corporate Insolvency Resolution Process (CIRP) is completed, a guarantor does not have the right of subrogation against the Principal Debtor. This means that a guarantor cannot claim legal rights and remedies against the debtor when the guarantor has made payments towards the debt for which the guarantee was provided.

A Critical Analysis

The theory of unjust enrichment dictates that no individual should benefit from the expense of another, and it forms the foundation for a guarantor’s right of subrogation. However, the Insolvency and Bankruptcy Code (IBC) justifies denying this right by arguing that further encumbering the assets of the debtor would be detrimental to the objectives of the IBC. As a result, the corporate debtor experiences unjust enrichment. Although there is a disparity between the guarantor’s contractual rights and their liabilities under the IBC, this discrepancy is resolved by the overriding effect of section 238 of the IBC. This section establishes that the provisions of the IBC take precedence over anything inconsistent contained in any other existing law. Furthermore, if two special legislations are inconsistent, the latter enacted legislation will prevail. As a result, an approved resolution plan would supersede the contractual rights of a guarantor.

However, in the case of Orbit Towers Pvt. Ltd. v Sampurna Suppliers Pvt. Ltd. (2022) ibclaw.in 610 NCLT, the NCLT has observed that the Indian Contracts Act, 1872 contains provisions for the right of subrogation under Sections 140 and 141. This right allows another person to be substituted in place of the creditor, so that this person will have all the rights of the creditor with regards to the debt. Specifically, the right of subrogation for the guarantor allows them to be placed in the creditor’s position upon the discharge of the principal debtor’s obligation. This means that the guarantor may sue the principal debtor, having been invested with all the rights of the creditor.  It was noted that under the provisions of the Indian Contract Act, 1872, all the rights of the creditor automatically become the rights of the surety once the guarantor has discharged all the liability of the corporate debtor towards the creditor. This is because the guarantor has the right of subrogation, which transfers all the creditor’s rights to the guarantor upon discharge of the principal debtor’s obligation.

There are varying perspectives on the matter, but the approach taken by the NCLT in this instance is forward-thinking and appropriately safeguards the rights of individuals. In light of the fact that guarantors are held equally accountable for the debts of the borrower, the Orbit Towers judgement essential protection for guarantors who have fulfilled their responsibilities under the guarantee agreement.

Conclusion

Subrogation is a legal concept that provides an equitable right to recover losses incurred by a third party on behalf of another party. However, this right cannot be enforced at the expense of analogous legal and equitable rights of other parties involved in the transaction. Nonetheless, this does not imply that the right of subrogation should be disregarded entirely. Incorporating the right of subrogation into the Insolvency and Bankruptcy Code, 2016 would necessitate significant changes. Any solution that seeks to indemnify personal guarantors could potentially restart the Corporate Insolvency Resolution Process, thereby making it imperative to strike a balance between the rights of all parties concerned.

Therefore, it is important to recognize the importance of the right of subrogation in insolvency proceedings, while also being mindful of its potential impact on the CIRP. Any changes to the IBC must be made with caution and care to ensure that they do not result in unintended consequences or harm the interests of any party involved in the process.

 

References:

• The Insolvency and Bankruptcy Code, 2016
• The Indian Contract Act, 1872
• Amrit Lai Goverdhan Lalan v State Bank of Travancore – 1968 AIR 1432, SC
• State Bank of India v Fravina Dyes Intermediate- 1990 68 CompCas 574 Bom
• State of M.P. v Kaluram – 1967 AIR 1105
• Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors. – [2018] ibclaw.in 47 NCLAT
• Essar Steel India Ltd. Committee of Creditors v. Satish Kumar Gupta – [2019] ibclaw.in 07 SC
• Orbit Towers Pvt. Ltd. v Sampurna Suppliers Pvt. – (2022) ibclaw.in 610 NCLT
• State Bank of India v. Shri Ghansham Surajbali Kurmi – (2022) ibclaw.in 635 NCLT

 

 

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