Statutory Omissions of Rights of Debtors under the Indian Contract Act, 1872 in Contra-distinction to the Insolvency and Bankruptcy Code, 2016: A Qualitative Analysis – By Anish Gupta

Statutory Omissions of Rights of Debtors under the Indian Contract Act, 1872 in Contra-distinction to the Insolvency and Bankruptcy Code, 2016: A Qualitative Analysis

Authored by:
Anish Gupta, B.A. LL.B (Hons.) II Year National Law School of India University, Bangalore

Introduction

Notwithstanding the fact that a guarantee is undoubtedly the most widely employed kind of security in today’s business world, there is still much left to explore about its implementation and legal implications. Although the parties are expected to be aware of the aim of a contract of guarantee, specific understanding of the rights and obligations flowing from such a contract remains obscure and ambiguous.

It is with regards to this context, that the author shall delve into the important, but hitherto not much explored, aspects of rights and duties arising out of a contract of guarantee. The author shall restrict himself to the following three issues during the course of writing this paper:

  1. Whether the Indian Contract Act (hereinafter ‘the Act’) of 1872[1] adequately addresses the rights of debtors under a Contract of Guarantee u/s 126? (Section I)
  2. Whether the Insolvency and Bankruptcy Code[2] (hereinafter ‘IBC’) overrides the existing provisions of the Act with respect to a contract of guarantee? (Section II)
  3. Whether the debtor holds the right to benefit out of the specific remedies provided under the IBC in conjunction with the general remedies available under the Indian Contract Act? (Section III)

Section I

Section 126 of the Act lays down the definition of a contract of guarantee.[3] Referring to this definition, a contractual guarantee can be seen as an undertaking that a debt shall be paid. The person who gives the guarantee is called ‘surety’. ‘Principal debtor’ is the person on whose default the guarantee is given and the person to whom this guarantee is furnished is the ‘creditor.’[4] A contract of guarantee is typically a promise made by the surety to the creditor that in case the principal debtor defaults on the money owed by the creditor to him, a secondary liability can be imposed upon the surety to pay off the debt on behalf of the debtor.

It is no concealed fact that the Indian Contract Act has been particularly skewed in favor of the surety or the guarantor and there are hardly any rights that have been bestowed upon the principal debtor. Firstly, section 140 of the Act gives extensive rights of subrogation to the surety to be exercised against the principal debtor.[5] According to the doctrine of subrogation, the surety takes over the rights and remedies of the creditor against his principal debtor.[6] This doctrine is in line with the principle of unjust enrichment, whereby the debtor must reasonably compensate the surety for the payment of debt by the surety to the creditor on debtor’s behalf. The basic premise of this doctrine is that “where one person makes a payment on an obligation which, in law, is the primary responsibility of another party, the person making the payment is subrogated to the claims of the person to whom they made the payment with respect to any claims or remedies which are exercisable against the primarily responsible party.”[7] It is with regards to this right that the debtor is mandatorily required to pay off his debt, if not to the original creditor, then to the surety/guarantor. Secondly, section 145 of the Act[8] talks about the implied promise to indemnify the surety. Under every contract of guarantee, the principal debtor impliedly promises to indemnify the surety of all the costs that the latter has been made to pay to the creditor under the contract. Thus, the surety can directly sue the debtor and claim the sum whatever has been guaranteed under the contract. An important thing to be noted here is that even if the surety initially agreed to become the guarantor and pay off the debt gratuitously, i.e., not expecting repayment from the debtor, nothing binds him from changing his position later and use the right of indemnity after the default has been committed. In Shri Bisiowakarma Furniture Workshop v Santanu Sarkar[9] the court disregarded the debtor’s plea that the surety had agreed to become the guarantor without any expectation of indemnity of losses. The court held that there is an existence of implied promise of indemnity and hence even though the contract of guarantee was perceived by the debtor to be gratuitous on part of the surety, the surety, after the default has been committed, can rightfully claim the repayment of sum from the debtor and the debtor shall be bound by law to make good the sum.

These provisions, detailed in section 140 and 145 of the ACT, essentially work in the detriment of the debtor and disproportionately favor the guarantor. A bare reading of the Act may also compel us to hold that the debtors are entirely devoid of any rights that they can exercise under a contract of guarantee, and such a proposition is also true to some extent. However, a careful perusal of the Act points to the fact that even the debtor has been bestowed with some rights, regardless of how insignificant that may be. Firstly, section 127[10] states that a valid consideration of a contract of guarantee is such that it should be in favor of the principal debtor. This necessarily suggests that the surety or the guarantor cannot have any vested interests while entering into a contract of guarantee and the only person that may benefit out of this contract shall be the principal debtor. Such a provision acts as a bulwark against sureties that may have ulterior motives of earning profits through such a contract of guarantee. Consider the following example: A sells certain goods to B and B is required to pay for the goods within a month. B enters into a contract of guarantee with C whereby C shall pay the required sum to A if B defaults on the payment after a month. It is to be noted here that C can claim only the sum which has been paid by it to A and does not have a right to claim a larger amount of money from B. This provision safeguards the principal debtor, in this case B, from any unreasonable claim of sum that may be made by C, the surety. Secondly, section 128 deals with the liability of surety. It states that the liability of the surety goes hand-in-hand with that of the principal debtor. In the case of Chokalinga Chettiar v. Dandayuthapani Chettiar[11] it was held that “the liability of the surety is co-extensive with that of the principal debtor and the creditor may go against either the principal debtor, or the surety, or both, in no particular sequence.” This position was reiterated by the Supreme Court in the case of Bank of Bihar Ltd. v. Damodar Prasad.[12] The court held that the “liability of the principal debtor and the surety is co­extensive and is joint and several.” This provision shall come to the rescue of the debtor when he is not in a position to repay the outstanding debt. The surety, out of natural love and affection, or based on past cordial relationship, can be co-extensively held liable to clear the sum for the time-being and the debtor may later make good the loss undertaken by the surety when he has the means to do so.

To sum up the section, the author is of the opinion that even though there are certain provisions that safeguard the rights of debtors under a contract of guarantee, the Indian Contract Act falls short of adequately addressing the debtors’ rights. There are two noticeable reasons for this, firstly, the absence of an explicit section that lays down such rights and secondly, the overarching rights given to the surety and the creditor that inherently work in the detriment of the debtor.

Section II

This section shall contain details about the Insolvency and Bankruptcy Code, 2016 and its implications on the entire credit structure of India. The enactment of IBC was heralded as a “ground-breaking legislation that will go a long way in paving the path for economic growth and development in the country”[13] The code has overhauled the hitherto archaic debt resolution mechanism to be more structured and potent. The question, however, that has arisen over the course of years is whether the IBC is in derogation of the provisions laid down in the Indian Contract Act. This is to say that the author intends to figure out whether after the enactment of IBC, section 126 of the Act[14] (concerning contract of guarantee) has been rendered redundant and now all guarantee agreements are tried under the new legislation, i.e., the IBC. Pertaining to a lack of jurisprudence around this issue, it becomes pertinent to look at certain Supreme Court and other judicial pronouncements. In a recently delivered judgement,[15] the National Company Law Appellate Tribunal (NCLAT) upheld the NCLT order, setting aside the termination of a power purchase agreement (PPA) between the parties. It further declared that the IBC shall override existing contracts during the Corporate Insolvency Resolution Process (CIRP).[16] This order by the NCLAT asserts the IBC as an all-embracing legislation to which other laws must yield.[17] This might have ludicrous and unforeseen implications, interfering with parties’ contractual rights. Another issue that was flagged after this judgement was delivered was that whether the NCLT or the NCLAT even had the jurisdiction to adjudicate on termination of the PPA. Since the PPA is essentially a contract within the definition of section 2(h) of the Act[18] and being a sector-specific dispute, the jurisdiction would lie exclusively with the civil courts or the Electricity Regulatory Commission (ERC). However, the tribunal held that since the IBC was a special law dealing solely with insolvency and loan default matters, it would prevail over the general law, i.e., the Indian Contract Act and hence would override the provisions contained in the Act.

Courts’ intention of giving supremacy to the IBC can also be inferred by looking at certain other case laws. In Duncans Industries Ltd. v. AJ Agrochem,[19] the Supreme Court held that in a situation of any conflict between contradicting provisions of two legislations, the provisions of IBC shall prevail as a consequence of Section 238 of IBC.[20] At this juncture, it becomes pertinent to refer to section 238 of IBC. It states that “Provisions of this Code to override other laws: The provisions of this Code shall have effect, notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law.” Thus, it is conspicuous that this section is a non-obstante provision. It means that a provision or clause of IBC has the ability to override any other contradicting or conflicting provision of another act. The Supreme Court in Innoventive Industries Ltd. Vs. ICICI Bank and Ors[21] referred to the preamble of the code which conveys that the code was enacted to replace the existing framework surrounding insolvency and bankruptcy consisting of a profuse of legislations that were ineffective, deficient and “resulted in inordinate delay for resolution.”[22] The background justification behind the code, as enunciated by the Insolvency Law Committee Report[23] states that “the introduction of this legislation was done with the aim of replacing the existing framework for insolvency, which was visibly inadequate, ineffective and wrought with delays.” In context of this, it is safe to conclude that the parliament intended to enact a complete, exhaustive and a comprehensive code in itself which shall prevail over any other legislation concerning the subject around debt resolution mechanism. As a consequence, it is clear that the Code’s essential aim was to replace, enhance, and, most significantly, funnel the many laws dealing with insolvency and bankruptcy into a single comprehensive piece of legislation, culminating in the Code superseding the Indian Contract Act’s provisions.

Section III

After deliberating upon the first two issues in the previous sections, the author shall, in this section, delve into the realm of remedies available to debtors under the IBC and the Indian Contract Act. The author concluded in Section II of this paper that the legislative intent and the court’s direction is to view the IBC as an all-encompassing legislation that shall prevail over any other existing legislation in case of a general contradiction. Having said that, it can also be concluded that the debtor shall hold the rights to enjoy special remedies available under the IBC in conjunction with the general remedies pertaining to breach of a contract that are available under the Indian Contract Act.

Under the Act, a suit for breach of contract may lie if the surety refuses to make good the amount guaranteed by him, or if the creditor refuses to accept the requisite sum from the surety, or if there has been any unjust enrichment by either the surety or the creditor etc. Under these circumstances, the remedy that shall firstly be available to the debtor is rescission of contract u/s 75 of the Act.[24] If the debtor legitimately and equitably rescinds a contract, he shall be rightfully entitled to claim compensation for any damage or loss that has been caused to him by such rescission owing to non-performance of the contract.[25] Secondly, the debtor can file a suit for damages u/s 73 of the Act.[26] According to this section, the party that has been aggrieved by the non-performance of the contract because the other party did not fulfill his part of the promise can sue him for damages suffered by the aggrieved party in the normal course of business.[27] Thus, if the creditor fails to lend the requisite money or the surety refuses to pay the guarantee amount to the creditor, the debtor suffers a harm that was likely to result from such breach, then he can sue the parties u/s 73 of the Act.

Having looked at the general remedies available to the debtor under the Indian Contract Act, I shall now shift my focus to the specific remedies that are available to the debtors under the IBC 2016. Under Part III of the IBC, the debtor primarily has two main methods to resolve insolvency of personal debtors. These are, firstly, The Fresh Start Process and secondly, The Insolvency Resolution Process.

Fresh-Start Process

The IBC, under Chapter II of Part III establishes a fresh-start process focused largely at providing small-time individual debtors with a once-in-a-lifetime opportunity to re-start their lives free of debt.[28] Debtors who are unable to repay their creditors are given the option of paying off their debts in a progressive and timed way or obtaining a moratorium if they meet specific criteria. A debtor with assets less than Rs.20,000, gross annual income of less than Rs.60,000, no home-ownership and qualifying debts of less than Rs.35,000 will be eligible to get a complete waiver of debts.[29] These conditions have been elaborately laid down in Section 80 of the IBC.[30] This provision has significantly bolstered the rights of debtors, who at least in theory, may find a tool to enjoy a complete waiver of their debts under the IBC, or to thwart creditor enforcement and bring the creditor to the negotiating table.

Insolvency Resolution Process (IRP)

The Insolvency Resolution Process (IRP) is a procedure in which the creditors and the debtor come to an agreement on a repayment plan.[31] Either of the parties, i.e., the creditor or the debtor can initiate the IRP at the relevant Debt Resolution Tribunal (DRT). Once the formalities of the IRP application are complete, the debtor proposes a repayment plan to the creditor under the supervision of a Resolution Professional (RP), which should be more than three-fourth in value and should meet the approval of majority of creditors.[32] The creditor and the debtor become bound by the plan once it has been authorized by the adjudicating authority and approved by the creditors. By way of this provision, “the IBC thus balances the propensity in India of the law and regulations to micro-manage every process with the welfare of the debtor.”[33]

Another provision that strengthens the rights of debtors lies in S. 87 of IBC[34] which lays down a mechanism for the debtor who may be aggrieved by any direction of the Resolution Professional (RP) to complain to the DRT or relevant Adjudicating Authority.

Conclusion

In this paper, the author looked at the question of whether the Indian Contract Act effectively safeguards the rights of debtors and considering the arguments advanced in Section I of this paper, came to the conclusion that the debtor’s rights are not adequately protected under a contract of guarantee u/s 126 and the sections that follow. This is to say that there is a noteworthy lack of jurisprudence around this matter and thus the rights of debtors remain largely unexplored under the Act.

In Section II of this paper, the author dealt with the classic dichotomy between a special law, in this case the IBC 2016 and a general law, in this case the Indian Contract Act 1872. Perusing the legislative intent and various judicial pronouncements, we can sufficiently conclude that the provisions of IBC override the provisions of the Indian Contract Act with respect to debt resolution and loan default mechanism in case of any dispute between the two legislations. The Legislature and the Judiciary have showcased the IBC as an all-encompassing and all-pervasive legislation that shall replace all existing legislations dealing with the subject matter that is now covered under the IBC.

Section III of this paper dealt with the debt resolution remedies available to the debtor under the Indian Contract Act and the IBC. Under this section, the author concludes that the IBC efficiently complements the Act for adequately safeguarding debtor rights. The rights available to debtors range from claiming compensation for breach of contract u/s 73 of the Act to initiating a fresh-start process and insolvency resolution process under the IBC 2016.

From the standpoint of debtors, the IBC gives a tool that is currently unavailable for dealing with debtor’s distress. The IBC gives debtors a legal option to stay enforcement operations by allowing them to petition for insolvency. It also gives a venue for debtors to re-negotiate their payment plan, which may be highly beneficial if the debtor has several creditors. The fresh start clauses, in particular, may be particularly beneficial to a debtor seeking a loan waiver.

 

    Reference 

[1] Indian Contract Act, 1872

[2] The Insolvency and Bankruptcy Code, 2016

[3] The Indian Contract Act defines a contract of guarantee as:

                “Contract of guarantee”, “surety”,principal debtor” and “creditor”. —A “contract of

guarantee” is a contract to perform the promise, or discharge the liability, of a third person in case of his

default. The person who gives the guarantee is called the “surety”, the person in respect of whose default

the guarantee is given is called the “principal debtor”, and the person to whom the guarantee is given is

called the “creditor”. A guarantee may be either oral or written.”

[4] Ananthanarayanan B and VS Ajaykrishna, ‘Contract of Guarantee’ (Social Science Research Network 2021) SSRN Scholarly Paper ID 3838030 <https://papers.ssrn.com/abstract=3838030&gt; accessed 30 March 2022.

[5] Section 140, of the Indian Contract Act, 1872 deals with the principle of subrogation with reference to rights of a surety/guarantor. It says: “140. Rights of surety on payment or performance: Where the guaranteed debt has become due, or default of the principal debtor to perform a guaranteed duty has taken place, the surety upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the principal debtor.”

[6] Nishi Bhandari, ‘Doctrine of Subrogation and Its Uses in Contract of Guarantee’ (2018) 3 International Journal for Advance Research and Development 29.

[7] ibid.

[8] Section 145 of Indian Contract Act says: Implied promise to indemnify surety. —In every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety, and the surety is entitled to recover from the principal debtor whatever sum he has rightfully paid under the guarantee, but, no sums which he has paid wrongfully.”

[9] Shri Bisiowakarma Furniture Workshop v Santanu Sarkar, (2006) 5 AIR Kant (NOC)

[10] Section 127 of the Indian Contract Act: Consideration for guarantee. —Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee.”

[11] Chokalinga Chettiar v. Dandayuthapani Chettiar 1928 SCC OnLine Mad 236

[12] Bank of Bihar Ltd. v. Damodar Prasad AIR 1969 SC 297

[13] Ankeeta Gupta, ‘Insolvency and Bankruptcy Code, 2016: A Paradigm Shift within Insolvency Laws in India’ (2018) 36 The Copenhagen Journal of Asian Studies 75.

[14] Indian Contract Act, 1872 s. 126

[15] Gujarat Urja Vikas Nigam Ltd vs. Yes Bank Limited and Anr 2020 SCC OnLine NCLAT 726

[16] Pallavi Arun Verma, ‘Can IBC Override Existing Contracts? Why Giving Primacy to Insolvency Law May Set a Wrong Precedent’ The Economic Times (18 January 2021) <https://economictimes.indiatimes.com/small-biz/legal/can-ibc-override-existing-contracts-why-giving-primacy-to-insolvency-law-may-set-a-wrong-precedent/articleshow/80322886.cms?from=mdr&gt; accessed 2 April 2022.

[17] ibid.

[18] Indian Contract Act, 1872 s. 2(h)

[19] Duncans Industries Ltd. v. AJ Agrochem, (2019) 9 SCC 725

[20] Insolvency and Bankruptcy Code, 2016 s. 238

[21] Innoventive Industries Ltd. Vs. ICICI Bank and Ors, (2018) 1 SCC 407

[22] Guest, ‘Understanding the Scope of Section 238: Overriding Nature of the IBC’ (IndiaCorpLaw, 19 October 2019) <https://indiacorplaw.in/2019/10/understanding-scope-section-238-overriding-nature-ibc.html&gt; accessed 3 April 2022.

[23] Ministry of Corporate Affairs, ‘Report of The Insolvency Law Committee’ (2018) <https://prsindia.org/policy/report-summaries/insolvency-law-committee-report&gt; accessed 3 April 2022.

[24] Section 75 of the act reads thus:

                “Party rightfully rescinding contract, entitled to compensation. —A person who rightfully

rescinds a contract is entitled to compensation for any damage which he has sustained through the

non-fulfilment of the contract.”

[25] Chetan Yadav, ‘Types & Remedies of Breach of Contract with Specifically Analysing Anticipatory Breach of Contract’ (2021) 2 Jus Corpus Law Journal 269.

[26] Section 73 of the Act reads thus:

Compensation for loss or damage caused by breach of contract. —When a contract has been broken, the party who suffers by such breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it.”

[27] Yadav (n 25).

[28] Insolvency and Bankruptcy Code, 2016                                   

[29] Renuka Sane, ‘The Way Forward for Personal Insolvency in the Indian Insolvency and Bankruptcy Code’ (Social Science Research Network 2019) SSRN Scholarly Paper 3309470 <https://papers.ssrn.com/abstract=3309470&gt; accessed 5 April 2022.

[30] Insolvency and Bankruptcy Code, s. 80

[31] Chapter III, Part III of IBC 2016

[32] Sane (n 29).

[33] ibid.

[34] Insolvency and Bankruptcy Code, 2016 s. 87

 

Bibliography

Legislations

  • Indian Contract Act, 1872
  • The Insolvency and Bankruptcy Code, 2016

Journal Articles

  • B A and Ajaykrishna VS, ‘Contract of Guarantee’ (Social Science Research Network 2021) SSRN Scholarly Paper ID 3838030 <https://papers.ssrn.com/abstract=3838030&gt; accessed 30 March 2022
  • Bhandari N, ‘Doctrine of Subrogation and Its Uses in Contract of Gaurantee’ (2018) 3 International Journal for Advance Research and Development 29
  • Guest, ‘Understanding the Scope of Section 238: Overriding Nature of the IBC’ (IndiaCorpLaw, 19 October 2019) <https://indiacorplaw.in/2019/10/understanding-scope-section-238-overriding-nature-ibc.html&gt; accessed 3 April 2022
  • Gupta A, ‘Insolvency and Bankruptcy Code, 2016: A Paradigm Shift within Insolvency Laws in India’ (2018) 36 The Copenhagen Journal of Asian Studies 75
  • Sane R, ‘The Way Forward for Personal Insolvency in the Indian Insolvency and Bankruptcy Code’ (Social Science Research Network 2019) SSRN Scholarly Paper 3309470 <https://papers.ssrn.com/abstract=3309470&gt; accessed 5 April 2022
  • Yadav C, ‘Types & Remedies of Breach of Contract with Specifically Analysing Anticipatory Breach of Contract’ (2021) 2 Jus Corpus Law Journal 269

Case Laws

  • Bank of Bihar Ltd. v. Damodar Prasad AIR 1969 SC 297
  • Chokalinga Chettiar v. Dandayuthapani Chettiar 1928 SCC OnLine Mad 236
  • Duncans Industries Ltd. v. AJ Agrochem (2019) 9 SCC 725
  • Gujarat Urja Vikas Nigam Ltd vs. Yes Bank Limited and Anr 2020 SCC OnLine NCLAT 726
  • Innoventive Industries Ltd. Vs. ICICI Bank and Ors (2018) 1 SCC 407
  • Shri Bisiowakarma Furniture Workshop v Santanu Sarkar (2006) 5 AIR Kant (NOC)

Miscellaneous

 

Disclaimer: The Opinions expressed in this article are that of the author(s). The facts and opinions expressed here do not reflect the views of IBC Laws (http://www.ibclaw.in). The entire contents of this document have been prepared on the basis of the information existing at the time of the preparation. The author(s) and IBC Laws (http://www.ibclaw.in) do not take responsibility of the same. Postings on this blog are for informational purposes only. Nothing herein shall be deemed or construed to constitute legal or investment advice. Discussions on, or arising out of this, blog between contributors and other persons shall not create any attorney-client relationship.