B.A. LLB (Hons.)
The author is a lawyer practising in Mumbai and can be reached at manrajdsingh@gmail.com
The Guarantee Conundrum
It’s fairly common for lenders in India to obtain guarantees as part of the security package at the time of making available loans to corporate borrowers whether by way of facilities or subscribing to non-convertible debentures issued by such borrowers. These guarantees provide credit support to the financing transactions and are typically issued by individual promoters or by group companies of the borrowers, in favor of lenders directly or in favor of trustees appointed by lenders.
Section 128 of the Indian Contract Act, 1872 (“Contract Act”) states that liability of the guarantor, being the surety, is co-extensive with that of the principal debtor. i.e. the borrower, unless otherwise provided by the terms of the deed of guarantee. The creditor is not bound to exhaust its remedies against the borrower before invoking the guarantee or suing the guarantor for payment of outstanding amounts, unless otherwise agreed to in the guarantee deed. A suit may be maintained against the guarantor for payment of outstanding amounts in connection with the loan made available to the borrower even if the borrower itself has not been sued by the lender. This independent access to the guarantor provides additional comfort to the lenders and they typically prefer invoking the guarantee directly for recovering the monies due instead of enforcing the movable or immovable properties made available by or caused to be made by the borrower as security, in case of non-payment of loan amounts by the borrower on the due date. The lenders’ access to guarantees issued by the promoter or holding company becomes even more important when the borrower entity is a recently incorporated special purpose vehicle.
The enactment of The Insolvency and Bankruptcy Code, 2016 and the rules and regulations passed in connection thereto (“Bankruptcy Code”) has had a major impact on the insolvency resolution and debt recovery framework of India. Since the provisions of Bankruptcy Code inter alia govern the manner in which creditors of a corporate debtor shall be treated and the way in which assets of the corporate debtor shall be dealt with, once the corporate insolvency resolution process (“CIRP”) is initiated against such corporate debtor, there has been a profound change in the approach of lenders when it comes to structuring the security package in connection with loans, framing their rights under the financing documents and steps taken to recover their monies.
Set out hereinbelow is analysis of certain fundamental issues that have emanated from interplay between provisions of Bankruptcy Code and Contract Act in respect of guarantee issued to secure the debt obligations of a corporate debtor undergoing CIRP.
Whether moratorium under Section 14 of the Bankruptcy Code is applicable to assets of the guarantor?
While determining the scope of Section 14 of Bankruptcy Code in the matter of Schweitzer Systemtek India Private Limited v. Phoenix ARC Private Limited[1], the tribunals observed that the moratorium has no application on the properties beyond the ownership of the corporate debtor against whom the application has been filed. This was further clarified by the Supreme Court in State Bank Of India v. V. Ramakrishnan & anr.[2] (“Ramakrishnan Case”), wherein it held that the moratorium under Section 14 of the Bankruptcy Code will be limited to assets of corporate debtor only and shall not extend to assets of the guarantor. The Section 14 of Bankruptcy Code was amended in 2018 and a clarification was brought in to state that the provisions of Section 14 would not apply to a surety to the corporate debtor, in a contract of guarantee.
Whether a creditor can simultaneously claim the amounts due from the principal debtor as well as guarantor? Further, if a creditor can invoke third party guarantees during CIRP of the principal debtor?
As per Section 128 of the Contract Act, the liability of the guarantor is co-extensive with that of the principal debtor, unless otherwise specified in the guarantee deed. Therefore, unless the deed of guarantee stipulates any condition to the contrary, the creditor can demand payment from the guarantor and principal debtor at the same time and both persons are liable to pay the outstanding debt on a joint and several basis.
The aforesaid was affirmed in ICICI Bank v. CA Ritu Rastogi[3] (“Ritu Rastogi Case”), wherein CIRP was going on against the principal debtor and the guarantor simultaneously. Edu Comp Solutions Limited (“ECSL”) had availed a loan from ICICI Bank Limited (“ICICI”) and Edu Smart Service Private Limited (“ESSPL”) had issued a corporate guarantee for the benefit of ICICI for securing such loan. While DBS Bank, a financial creditor of ESSPL, had filed application under Section 7 of the Bankruptcy Code for CIRP of ESSPL, ECSL had initiated CIRP on its own under Section 10 of Bankruptcy Code. When ICICI filed its claim with the resolution professional of ESSPL, the resolution professional initially responded by stating that since ECSL was already under CIRP and ICICI was also on the committee of creditors of ECSL, the amount recoverable by ICICI in the CIRP of ESSPL would be the balance amount remaining after recovery from ECSL. After additional discussions, the resolution professional provisionally took on record the claim of ICICI and provided ICICI membership to the committee of creditors of ESSPL but did not offer any voting rights. The main argument of resolution professional was that ICICI could not claim against the principal borrower and guarantor, which were under their respective CIRP, for the same amount because it would create anomalies and would result in unjust enrichment. The National Company Law Tribunal (“NCLT”) at Delhi relied on provisions of Section 128 of the Contract Act and allowed the simultaneous claim of ICICI to be admitted as it fell within the definition of ‘financial debt’ under the Bankruptcy Code.
Similar question arose before the National Company Law Appellate Tribunal, Delhi (“NCLAT”) recently in the case of Dr. Vishnu Kumar Agarwal v. M/s. Piramal Enterprises Limited[4] (“Piramal Case”). The NCLAT in Piramal Case explicitly acknowledged that there is no bar under the Bankruptcy Code on filing applications under Section 7 against the principal debtor and corporate guarantor, or against two corporate guarantors, simultaneously. However, NCLAT in the said order has gone ahead to state that once for a specific claim and default an application under Section 7 of Bankruptcy Code filed by a particular financial creditor has been admitted against one of the entities (borrower or corporate guarantor), the second application by the same financial creditor for the same set of claim and default cannot be admitted against the other entity (borrower or corporate guarantor, as the case may be). An appeal has been filed against NCLAT’s decision in Piramal Case and the view of Supreme Court on the said issue is awaited.
At this juncture, it would be worthwhile to note that in the case of Export Import Bank of India v CHL Limited[5], the NCLAT held that where the reconciliation of the claim amount is pending between the principal debtor and the creditor, the creditor cannot proceed against guarantor. In this case the principal debtor had filed a suit before Economic Court at Dushanbe seeking revisions of terms and conditions of loan agreements and suspension of operations in relation to loan agreements. The court, by way of multiple orders, suspended the loan documents and the obligations arising therefrom until consideration of claim on its merits. While proceedings were pending before the court, a demand was served on the guarantor by creditor in connection with the loan repayment. The NCLAT observed that the creditor can invoke corporate guarantee only in the event the principal debtor fails to pay the recalculated interest and since the accounts had not been reconciled between the principal debtor and the creditor till date, there was no debt which was due and payable and on which the principal debtor had defaulted.
The Central Government and Insolvency and Bankruptcy Board of India have recently notified the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Regulations, 2019 and the Insolvency and Bankruptcy Board of India (Bankruptcy Process for Personal Guarantors to Corporate Debtors) Regulations, 2019 (“Personal Guarantor Regulations”). The Personal Guarantor Regulations inter alia lay down framework for insolvency process vis-à-vis individuals in their capacity as guarantors to corporate debtors.
Since the Personal Guarantor Regulations read with other provisions of Bankruptcy Code enable creditors to initiate proceedings against the personal guarantor and principal borrower simultaneously, we are yet to see how the entire process will play out and what mechanism will the resolution professionals of personal guarantor and corporate debtor resort to while dealing with parallel claims. More importantly, as things stand, the principles laid down in Piramal Case with regard to parallel claims have the potential to render the remedies of a financial creditor under Personal Guarantor Regulations futile. Therefore, the judgement of Supreme Court with respect to the appeal filed in connection with Piramal Case would be critical and to lay to rest the complications surrounding parallel claims.
Whether a creditor in whose favor an entity has provided a corporate guarantee file a claim with resolution professional, if the creditor has not invoked the corporate guarantee prior to commencement of CIRP of corporate guarantor?
In the event an entity has issued corporate guarantee in favor of a creditor in connection with loan availed by a borrower and CIRP has commenced in respect of such corporate guarantor, the creditor who is beneficiary of a corporate guarantee has the right to file its claim with the interim resolution professional pursuant to public announcement made under Section 13(1)(b) read with Section 15(1)(c) of the Bankruptcy Code. The NCLAT in the case of Axis Bank Limited v. Edu Smart Service Private Limited[6] was faced with such a situation and has, in its order, stated that for the creditor to lodge its claim with the interim resolution professional, its not necessary that the creditor shall have invoked the corporate guarantee prior to initiation of CIRP of corporate guarantor. The NCLAT further rejected the arguments that for such claim to be admitted, the creditor is required to serve a demand notice on the corporate guarantor or the creditor’s debt has to be due and payable. The NCLAT held that the claim of the creditor should be as on the date of initiation of the CIRP (date of order of admission and moratorium) and any person who has right to claim payment, as defined under Section 3(6) of the Bankruptcy Code, is supposed to file the claim whether matured or unmatured. The question as to whether there is a default or not is not to be seen.
Can a financial creditor file an insolvency application against a company which has issued corporate guarantee in connection with the loan made available by the financial creditor to an individual or sole proprietorship?
A financial creditor can file an application under Section 7 of the Bankruptcy Code against a company who is a corporate guarantor to an individual or sole proprietorship firm.[7]
Whether a third party can be treated as ‘financial creditor’ of the principal debtor when it makes repayment of the loan that had been advanced by a financial creditor to the principal debtor?
Taking into consideration the orders of NCLAT and various NCLTs on this subject matter till date, it would be safe to say that the status of the third party vis-à-vis the principal borrower really depends upon the nature of transactions carried out amongst the third party, the principal debtor and financial creditor and the contractual obligations entered into amongst them.
The NCLAT in the case of Neeraj Bhatia v. Davinder Ahluwalia & 2 others[8] (“Neeraj Bhatia Case”) held that the guarantor cannot claim to be a ‘Financial Creditor’ as defined under Section 5(7) read with Section 5(8) of the Bankruptcy Code, till it is shown that the payment made by a guarantor to the financial creditor pursuant to contract of guarantee towards loans availed by the principal debtor from the financial creditor, is a debt that has been disbursed against the consideration for time value of money.
In the case of P. B. Radhakrishnan & Ors. V. M/s Deleo Construction Private Limited[9] (“Deleo Case”), Mr. P. B. Radhakrishnan was a director of the principal debtor and in consideration of the loan made available by Kotak Mahindra Bank Limited (“Kotak”) to the principal debtor, he had issued a guarantee in favour of Kotak and provided additional security by way of equitable mortgage in favour of Kotak, thereby securing the obligations of the principal debtor in connection with the loan. The principal debtor defaulted on the loan repayments and Mr. P. B. Radhakrishnan on various occasions deposited amounts from his personal account on behalf of principal borrower towards repayment of the loan, on the request of managing director of principal debtor, who promised to return the amount at the earliest. The NCLT held Mr. P. B. Radhakrishnan as a ‘financial creditor’ of the principal debtor. In the appeal filed before NCLAT, the status of Mr. P. B. Radhakrishnan as a ‘financial creditor’ of the principal borrower was challenged again but NCLAT upheld the order of the NLCT and stated that since Mr. P. B. Radhakrishnan paid the amount from his personal account on behalf of the principal borrower, he is a ‘financial creditor’ of the principal borrower.
In the matter of Mrs. Anita Kumaran v. KGS Developers[10], Mrs. Anita Kumaran (“Applicant”) had created mortgage over certain properties owned by her in favour of ICICI Bank (“ICICI”) as security for credit facilities sanctioned by ICICI to the principal debtor. Since the principal debtor failed to repay the loan to ICICI, the Applicant, upon receiving notice from ICICI in this regard, stepped in and caused the required payment to be made to ICICI. The NCLT distinguished the facts of the present case from the facts of Neeraj Bhatia Case and Sharon Bio Case (identified hereinafter) for the reason that the collateral security (by way of mortgage) has been given by the Applicant in favour of ICICI on the basis of which the principal debtor had availed loan from ICICI. That the loan taken by principal debtor carried the element of time value of money and payment thereto by Applicant is also against the time value of money of the loan taken by the principal borrower. The NCLT stated that in the event it is interpreted that the money paid by the Applicant does not have an element of time value of money, the effect of definitions of ‘financial creditor’ and ‘financial debt’ under Section 5(7) and Section 5(8) of the Bankruptcy Code respectively, would be taken away. The NCLT observed that the settled principle of interpretation is that an interpretation must give effect to the provisions of statutes and not render them otiose. This view is based on the maxim ‘ut res magisvaleat quam pereat’, which means that it is better for a thing to have effect than to be void. The NCLT observed that it could not be the intention of legislature to exclude shareholder and directors / promoters from the purview of definition of ‘financial creditor’ or ‘financial debt’, who might have given loan to principal borrower or repaid the loan of principal borrower. The NCLT also referred to principles laid down in Deleo Case to back its view. The NCLT further contended that the Applicant has given collateral security by way of mortgage to ICICI, and the same falls within the purview of the term “any other instrument” under Section 5(8)(h) of the Bankruptcy Code.
Whether a resolution plan can deny a promoter-personal guarantor the right of subrogation enshrined under Section 140 of the Contract Act?
In the case of Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors.[11] (“Sharon Bio Case”), the resolution plan explicitly provided that the personal guarantee issued by the existing promoters of the principal debtor would not result in any liability towards the principal debtor i.e. the resolution plan did not provide for their dues, as personal guarantors, to be paid off. The same was alleged to be in violation of Section 133 and Section 140 of the Contract Act. This argument was rejected by NCLAT on the ground that on approval of resolution plan, the claims of all stakeholders stood cleared and the personal guarantors thereafter could not claim that they were discriminated against and lost their right to exercise subrogation. The NCLAT observed that the Bankruptcy Code prohibits the promoters from gaining control of the principal borrower or benefiting from the CIRP or its outcome, and further seeks to protect creditors of the principal debtor by preventing promoters from rewarding themselves at the expense of creditors and undermining the insolvency processes. It further acknowledged that it in many cases, it were the promoters of the principal debtors who contributed to the insolvency of the principal debtors. After taking into consideration the aforesaid, the NCLAT observed that it was open to the resolution applicant to waive the liability of the principal debtor towards the promoter-personal guarantor by providing for the same in the resolution plan.
The NCLAT in its order added that the process under Bankruptcy Code was not a recovery suit and the intention of the Bankruptcy Code was not to benefit the personal guarantors by denying the creditors access to legal remedies available under law for recovering their dues by enforcing guarantees, which were independent contracts. The restructuring of principal borrower’s debt under the resolution plan approved by NCLT does not always provide for a complete discharge of the liability of personal guarantors to principal debtors.
The view of NCLAT in Sharon Bio Case is also in consonance of NCLT, Allahabad’s decision in the case of J.R. Agro Industries Private Limited v. Swadisht Oils Private Limited[12] wherein the NCLT referred to the UNCITRAL Legislative Guide on Insolvency Law which states that intragroup transactions should be treated differently from similar transactions conducted between unrelated parties i.e. debt will be treated as an equity contribution rather than intragroup loan, with the consequence that the intragroup obligation will rank lower in priority than the same obligation between unrelated parties. NCLT further observed that Promoter loan to the company is like equity participation. Mostly their debt remains without time value of money and is without any agreement to pay the interest and without any time limit to repay the debt. The NCLT directed that unsecured debt of related party which is intragroup debt will be treated as equity contribution rather than as intragroup loan, with the consequence that intragroup obligation will rank lower in priority than the same obligation between unrelated parties
In addition to the observations of tribunals set out above, it must be noted that Section 31 of the Bankruptcy Code provides that an approved resolution plan shall be binding on the principal debtor and its employees, members, creditors, governmental authorities, guarantors and other stakeholders involved such resolution plan. This effectively means that once the resolution plan is approved by NCLT, no claims can be raised on the principal debtor by any of these persons, including the guarantor. On the other hand, Section 140 and Section 145 of the Contract Act entitle the guarantor to file claims against the principal debtor to recover monies it has paid to the creditor on behalf of the principle borrower. This conflict can be overcome by resorting to Section 238 of the Bankruptcy Code, which explicitly states that in case of inconsistency between the provisions of Bankruptcy Code and any other law for the time being in force, the provisions of Bankruptcy Code will prevail.
Does reduction of debt payable to the creditors pursuant to the sanctioned resolution plan always result in the guarantor getting relieved for the remainder debt?
The Supreme Court in its judgement in Ramakrishnan Case held that guarantors cannot take benefit of Section 133 of the Contract Act and the scaling down of the debt of the principal debtor in terms of the sanctioned resolution plan would not always relieve the guarantor for the remainder debt as the guarantor is bound by the terms of the resolution plan as per Section 31 (1) of the Bankruptcy Code and the resolution plan may very well provide for payments that can be recovered by the guarantor.
The High Court at Calcutta in the case of Gouri Shankar Jain v. Punjab National Bank[13] (“Gouri Shankar Case”) was faced with the question as to whether the liability of a guarantor of a debt of a principal debtor / corporate debtor stands reduced / extinguished upon an insolvency resolution plan in respect of the principal borrower being approved by NCLT under Bankruptcy Code. Here, the sanctioned resolution plan in connection with the principal debtor did not deal with the guarantee issued by the guarantor in respect of the loan availed by the principal debtor from the financial creditor. Under the sanctioned resolution plan, the financial creditor received a haircut in respect of its claim against the principal debtor and thus, had to record money to be received as the full and final payment towards its claim against the principal debtor. The Court took into consideration Section 128, 133, 134, 135, 139 and 145 of the Contract Act to determine the status of the guarantee vis-à-vis sanctioned resolution plan.
Section 128 of the Contract Act stipulates that the liability of guarantor is co-extensive with the principal debtor unless it is otherwise provided by the contract. In the present case, the guarantor failed to establish that the contract of guarantee contained any stipulation contrary to the liability of the guarantor being co-extensive with that of the principal borrower.
Section 133 of the Contract Act stipulates that any variation made without the surety’s consent in the terms of the contract between the principal debtor and the creditor discharges the surety as to the transaction subsequent to the variance. The High Court referred to the decision of Supreme Court in the case of Maharashtra State Electricity Board v. Official Liquidator[14] (“Maharashtra Electricity Board Case”) wherein it was held that a discharge which the principal debtor may secure by operation of law in bankruptcy or in liquidation proceedings does not absolve the surety of his liability. The High Court stated that consent of the surety is immaterial when the creditor is dealing with the principal debtor under the Bankruptcy Code. When NCLT sanctions a resolution plan in respect of the principal debtor under CIRP, the action taken by the creditor in a proceeding under Section 7 of the of Bankruptcy Code is involuntary. The principal debtor in a proceeding under Section 7 of the of Bankruptcy Code may stand discharged of its liability to its creditors. However, such discharge being in a proceeding for bankruptcy and insolvency, does not absolve the surety of the liability as has been held in Maharashtra Electricity Board Case. Further, the sanctioned resolution plan cannot be construed to be a variation of the terms of the contract between the principal debtor and the creditor, without the consent of the surety, thereby discharging the surety as to transaction subsequent to the variants or at all
Section 134 of the Contract Act lays down that the surety is discharged by any contract between the creditor and the principal debtor by which the principal debtor is released, or by any act or omission of the creditor the legal consequence of which is the discharge of the principal debtor.
Section 135 of the Contract Act states that a contract between the creditor and the principal debtor by which the creditor makes a composition with, or promises to give time to, or not to sue, the principal debtor, discharges the surety, unless the surety assents to such contract.
The High Court referred to its judgement in the case of United Bank of India v. Modern Stores (India) Limited[15] and observed that the first part of Section 134 of Contract Act is not applicable since there has not been any contract between the creditor and principal debtor whereby the principal debtor is released. With respect to the second part of Section 134, the High Court observes that it is settled law that the discharge of principal debtor by operation of law does not operate as discharge of surety and a discharge could only take place if the creditor voluntary discharges the principal debtor. In an insolvency proceeding initiated by a financial creditor under Section 7 of Bankruptcy Code, the financial creditor is not granting any release to the principal debtor and merely is exercising a statutory right to recover its debts. The outcome of the proceedings under Section 7 of Bankruptcy Code is a product of statute. The financial creditor cannot be said to have voluntarily discharged the principal debtor in the event the resolution plan sanctioned by NCLT under the Bankruptcy Code ultimately results in the financial creditor not receiving any part or portion of its claim. On the same analogy, an application under Section 7 of the Bankruptcy Code cannot be construed to be a discharge of the surety under Section 135 of the Contract Act.
Section 139 of the Contract Act recognizes that if the creditor does any act which is inconsistent with the rights of the surety, or omits to do any act which his duty to the surety requires him to do, and the eventual remedy of the surety against the principal debtor is thereby impaired, the surety is discharged. The High Court held that an application under Section 7 of the Bankruptcy Code and the consequential orders that may be passed under the Bankruptcy Code cannot also be construed to be a discharge of the surety in terms of Section 139 of the Contract Act.
Section 145 of the Contract Act states that 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. The High Court held that the implied promise recognized under Section 145 of the Contract Act is not impaired by any order that may be passed under the Bankruptcy Code. As noted above when, a financial creditor approaches the NCLT under the provisions of the Bankruptcy Code, it does so, in exercise of statutory rights. Contractual obligations between the financial creditor and the surety are not obliterated or modified or suspended by the eventual outcome of such proceeding.
In addition to the above, the High Court also took an opportunity to reflect on the applicability of Section 141 of the Contract Act. Section 141 of the Contract Act states that a surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not; and if the creditor loses, or, without the consent of the surety, parts with such security, the surety is discharged to the extent of the value of the security. The High Court resorted to the judgement in the case of Industrial Finance Corporation of India v. Canonnore Spinning and Weaving Mills Limited[16], wherein the Supreme Court has considered discharge of liability of a guarantee under the provisions of section 141 of the Contract Act. 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 Contract Act. Further, 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.
Conclusion
Since lenders rely heavily on the guarantees for recovering the loans advanced by them, it is imperative that the complexities surrounding it are resolved at the earliest. While judgements and orders of courts and tribunals in India have time and again provided guidance on the status of guarantee issued by companies undergoing CIRP or issued to secure the debt obligations of companies undergoing CIRP, an amendment to the Bankruptcy Code clarifying the exact position would be very useful.
Reference
[1] Company Appeal (AT) (Insolvency) No. 129 of 2017
[2] Civil Appeal No. 3595 of 2018
[3] CA 366(PB)/ 2017 connected with (IB)-102(PB)/2017
[4] Company Appeal (AT) (Insolvency) No. 346 of 2018
[5] Company Appeal (AT) (Insolvency) No. 51 of 2018
[6] Company Appeal (AT) (Insolvency) No. 302 of 2017
[7] Laxmi Pat Surana v. Union Bank of India (Company Appeal (AT) (Ins) No. 77 of 2020)
[8] Company Appeal (AT) (Insolvency) No. 142 of 2017
[9] CP/18/(IB)/CB/2018 and Company Appeal (AT) (Insolvency) No. 387 of 2018
[10] CP/678/IB/2018
[11] Company Appeal (AT) (Insolvency) No. 164 of 2018
[12] Company Application No. 59 of 2018 in Company Petition No. (IB) 13/ALD/2017
[13] W.P. No. 10147 (W) of 2019
[14] 1982 AIR 1497, 1983 SCR (1) 561
[15] AIR 1988 Cal 18, 1990 69 CompCas 697 Cal, 91 CWN 1186
[16] AIR 2002 SC 1814
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