India: Treatment Of Contract Of Guarantee Under Ibc: Unrest Amongst Creditors

The present article is based on the analysis of the judgment of the Hon'ble National Company Law Appellate Tribunal ["NCLAT"] in the matter of Dr. Vishnu Kumar Agarwal v. M/s Piramal Enterprises Limited¹ ["Piramal judgment"] in view of the underlying principle of Contract of Guarantee and its treatment under the provisions of the Insolvency and Bankruptcy Code, 2016 ["Code, 2016"]. In the present article, we will first deal with the concept of Contract of Guarantee under the provisions of the Indian Contract Act, 1872, in brief and subsequently deal with the treatment of the Contract of Guarantee under the provisions of the Code, 2016 in view of the Piramal judgment of the Hon'ble NCLAT and its implication.

CONTRACT OF GUARANTEE UNDER THE PROVISIONS OF INDIAN CONTRACT ACT, 1872

In India, banking sector has been through a long journey and has faced many challenges with respect to recovery of dues. Despite there being various provisions under law, inter alia, safeguarding the interest of the creditors, banking sector is still not able to realize its debts. One of such challenge is with respect to realization of debts in terms of the Contract of Guarantee.

A Contract of Guaranteeis a contract by way of which a 'surety' affirms to safeguard the interest of creditors/ lenders towards the repayment obligation of the principal borrower qua the loan amount, in case of a default. In a commercial transaction, suretyship forms a secondary obligation to the principal contract to guarantee its performance or to furnish means to indemnify the creditor in case of performance.² In Halsbury's Laws of England, it has been stated that "A guarantee is an accessory contract whereby the promisor undertakes to be answerable to the promise for the debt, default or miscarriage of another person, whose primary liability to the promise, must exist or be contemplated".³

Contract of Guarantee in India is governed by the provisions of Chapter VIII of the Indian Contract Act, 1872. The underlying object of a Contract of Guarantee is to secure the interest of the creditor, which presupposes a principal debtor and a debt/ obligation for which the principal debtor is primarily liable. In terms of the provisions of Section 128 of the Indian Contract Act, 1872, the liability of the surety is co-extensive with that of the principal debtor, unless provided otherwise by the contract. In other words, it is not necessary for a creditor/ lender to exhaust its remedy against the principal borrower before exercising its right to remedy against the surety. Also, there is no bar in law for a creditor/ lender to initiate simultaneous proceedings, both against the principal borrower as well as the guarantor, as they are liable at the same time to the creditors.⁴

Hon'ble Supreme Court of India in the matter of Bank of Bihar Limited v. Damodar Prasad & Anr.⁵, recognising the immediate liability of the surety to the creditor, observed the following:

"The very object of the guarantee is defeated if the creditor is asked to postpone his remedies against the surety. In the present case the creditor is a banking company. A guarantee is a collateral security usually taken by a banker. The security will become useless if his rights against the surety can be so easily cut down."

[Emphasis supplied]

Since, the liability of the surety is co-extensive with that of the principal borrower; the surety plays a significant role in facilitating the commercial transactions. Despite there being a well-established principle on the Contract of Guarantee, the question of simultaneous initiation of Corporate Insolvency Resolution Process under the Code, 2016, against the principal borrower as well as the guarantee, has been subject to debate since the enactment of the Code, 2016.

CONTRACT OF GUARANTEE UNDER THE PROVISIONS OF INSOLVENCY AND BANKRUPTCY CODE, 2016

Since the enactment of the Code, 2016, the legislation has witnessed numerous amendments and clarifications, by the legislature as well as the judiciary, respectively, to address the various issues that have cropped up during its implementation. It is worthy to mention herein that the enactment of the Code, 2016 is a paradigm shift to a creditor-centric regime⁶, as the availability of the credit in the credit market was one of the prime objectives for enacting the Code, 2016. This is further evident from the following recommendation of the Bankruptcy Law Reforms Committee in its Report dated 04.11.2015:

"India is in the process of laying the foundations of a mature market economy. This involves well drafted modern laws, that replace the laws of the preceding 100 years, and high performance organisations which enforce these new laws. The Committee has endeavoured to provide one critical building block of this process, with a modern insolvency and bankruptcy code, and the design of associated institutional infrastructure which reduces delays and transaction costs. We hope that the implementation of this report will increase GDP growth in India by fostering the emergence of a modern credit market, and particularly the corporate bond market. GDP growth will accelerate when more credit is available to new firms including firms which lack tangible capital."⁷

The Hon'ble Supreme Court of India in the matter of Chitra Sharma & Ors. v. Union of India & Ors.⁸, while acknowledging the aforesaid recommendation and the need for enactment of the Code, 2016, has observed as follows:

"The IBC is intended to consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner to achieve a maximisation of the value of the assets of such persons and to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders. The enactment of the IBC has created a paradigm shift in the regulatory framework and processes governing corporate insolvency. The IBC reflects a fundamental change in the basic premise of a "debtor in possession" to a "creditor in possession". The resolution process is market driven."

Having dealt with the objective of the Code, 2016, let us now deal with the confusion with respect to applicability of moratorium in terms of Section 14 of the Code, 2016, which has been subject to debate before the Adjudicating Authority as well as the Appellate Authority. The Hon'ble NCLAT in the matter of State Bank of India v. V. Ramakrishnan & Anr.⁹, while deviating from its earlier rulings in the matters of Alpha & Omega Diagnostics (India) Ltd. v. Asset Reconstruction Company of India Ltd. & Ors.¹⁰ and Schweitzer Systemtek India Pvt. Ltd v. Phoenix ARC Pvt. Ltd. & Ors.¹¹, held that moratorium under Section 14 of the Code, 2016 will also be applicable to the assets of the guarantor.

Thus, in order to put an end to the aforesaid confusion, the Insolvency Law Committee, Ministry of Corporate Affairs ["Committee"] following the aforesaid object of the Code, 2016, proposed one of the most significant amendments to the Code, 2016 with respect to the treatment of assets of guarantors of the corporate debtor vis-à-vis the moratorium on the assets of the corporate debtor. In this regard, the Committee in its Insolvency Law Committee Report dated 26.03.2018 ["ILC Report"] recommended to keep all assets of the guarantors to the corporate debtor outside the scope of moratorium imposed under the Code.

Pursuant to the aforesaid recommendation of the Committee, clause (b) was inserted to sub-section (3) of Section 14 of the Code, 2016 by way of the Insolvency and Bankruptcy Code (Second Amendment Act), 2018 ["2018 Amendment"], which came into effect from 6th June, 2018, inter alia, clarifying the inapplicability of moratorium to the Guarantor of a Corporate Debtor. Following the said insertion, sub-section (3) of Section 14 of the Code, 2016 read as follows:

"(3) The provisions of sub-section (1) shall not apply to –

(a) such transaction as may be notified by the Central Government in consultation with any financial regulator;

(b)a surety in a contract of guarantee to a corporate debtor."

At this juncture, it is also pertinent to mention the judgment passed by the Hon'ble Supreme Court of India in the matter of State Bank of India v. V. Ramakrishnan & Anr.¹², in an Appeal against the Order of the Hon'ble NCLAT, wherein it was observed as follows:

"The object of the Code is not to allow such guarantors to escape from an independent and co-extensive liability to pay off the entire outstanding debt, which is why Section 14 is not applied to them."

Keeping in mind the object of the Code, 2016 as well as the aforesaid judgments, let us examine the Piramal judgment of the Hon'ble NCLAT, which goes against the settled position of law laid down by the Hon'ble Supreme Court of India. It is also pertinent to mention that the Piramal judgment is not only against the settled position of law but also hampers the interest of the creditors/ lenders, thereby hampering the augmentation of the credit market.

PIRAMAL JUDGMENTS AND ITS IMPLICATION

The following issues were raised before the Hon'ble NCLAT in the matter of Dr. Vishnu Kumar Agarwal v. M/s Piramal Enterprises Limited¹³:

1. Whether the 'Corporate Insolvency Resolution Process' can be initiated against a 'Corporate Guarantor', if the 'Principal Borrower' is not a 'Corporate Debtor' or 'Corporate Person'? and;
2. Whether the 'Corporate Insolvency Resolution Process' can be initiated against two 'Corporate Guarantors' simultaneously for the same set of debt and default?

The Hon'ble NCLAT while applying the principles laid down by the Hon'ble Supreme Court of India in the matter of Bank of Bihar Limited v. Damodar Prasad¹⁴, has answered the first issue in affirmative. However, the Hon'ble NCLAT while dealing with the second issue has held that a second Application under Section 7 of Code, 2016 based on the same set of claim and default is not maintainable against the other Corporate Debtor (principal borrower or corporate guarantor), if earlier application under Section 7 of the Code, 2016 for the same set of claim and default has been admitted against one of the Corporate Debtor (principal borrower or corporate guarantor).

The aforesaid ratio of the Hon'ble NCLAT goes against the settled position of law with respect to law of Guarantee, as it gives an escape route to the guarantor, which may be jointly and severally liable for the debt. Though the Hon'ble NCLAT has in its Piramal judgment, accredited the principle of the co-extensive liability of the surety with that of the principal borrower, it has failed to read the said principle in consonance with the Code, 2016.

It is also pertinent to mention that Hon'ble NCLAT in the Piramal judgment has also observed that the moment an Application initiating CIRP against one of the Corporate Debtor (principal borrower or guarantor) is admitted for a debt, it is open for the other Corporate Debtor (principal borrower or guarantor) to raise an issue stating that the debt in question is not payable in law, as for the same debt, a CIRP has already been admitted. The said observation of the Hon'ble NCLAT further provides an escape route to the guarantor, as the guarantor might take an objection with respect to admission of claim against principal borrower would constitute elimination of the right against the guarantor, which shall defeat the fundamental principle of law of guarantee.

It is further pertinent to mention the definition of financial debt enshrined under sub-section (8) of Section 5 of the Code, 2016, which includes money borrowed against the payment of interest¹⁵ as well as any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution¹⁶. On perusal of the aforesaid, it cannot be denied that both the principal borrower and guarantor has been included in the definition of the financial debt qua the same debt, a fact which has also not been denied by the Hon'ble NCLAT in its Piramal judgment. However, the Hon'ble NCLAT having recognised the aforesaid position of law went on to hold that a creditor cannot file an Application under Section 7 of the Code, 2016 against the principal borrower and the guarantor for the same debt.

In this regard, it is trite to reiterate that the liability of the guarantor is co-extensive with that of the principal borrower and is immediate, qua the same debt. It is further trite to reiterate that the Hon'ble Supreme Court of India in the matter of Damodar Prasad¹⁷ has observed that the security will become useless if his rights against the surety can be so easily cut down. Thus, the Piramal judgment restricts the right of the creditors against the Guarantors under a Contract of Guarantee and further defeats the purpose of securing the interest of the creditors towards the repayment obligation of the principal borrower qua the loan amount. The creditors/ lenders seeking remedies under the Code, 2016 will now have to choose between principal borrower and guarantor to initiate CIRP, as the underlying principle of initiation of simultaneous proceedings against the principal borrower and the guarantor under the Contract of Guarantee is now subject to limitation/ restriction under the Code, 2016.

Following the Piramal judgment of the Hon'ble NCLAT, various Adjudicating Authorities in the matters of M/s. SEW Infrastructure Ltd v. M/s. Mahendra Investment Advisors Pvt. Ltd.¹⁸, IFCI Ltd. Vs. M/s ACCIL Hospitality Ltd.¹⁹ and ICICI Bank v. Era Infrastructure (India) Limited²⁰ have passed similar orders and the same having been subsequently upheld by the Hon'ble NCLAT, has created a sense of unrest amongst the creditors/ lenders, as it denies the rightful entitlement of share of claim to the creditors/ lenders.

The aforesaid judgments as well as the Piramal judgment, without any iota of doubt, are based on the principle of duplicity of claim; however, the Adjudicating Authorities as well as the Appellate Authority have failed to consider the issue with respect to a claim of debt against two separate legal entities. Therefore, in this context, it is pertinent to examine the rule against double proof, which is a long-established principle of insolvency law and is also implicit in the UK Insolvency Act, 1986.

The rule against double proof has been discussed in the case of Kaupthing Singer and Friedlander Limited²¹, wherein the Supreme Court of United Kingdom, at para 11 of the judgment, had observed the following:

"11. The function of the rule is not to prevent a double proof of the same debt against two separate estates (that is what insolvency practitioners call "double dip"). The rule prevents a double proof of what is in substance the same debt being made against the same estate, leading to the payment of a double dividend out of one estate. It is for that reason sometimes called the rule against double dividend. In the simplest case of suretyship (where the surety has neither given nor been provided with security, and has an unlimited liability) there is a triangle of rights and liabilities between the principal debtor (PD), the surety (S) and the creditor (C). PD has the primary obligation to C and a secondary obligation to indemnify S if and so far as S discharges PD's liability, but if PD is insolvent S may not enforce that right in competition with C. S has an obligation to C to answer for PD's liability, and the secondary right of obtaining an indemnity from PD. C can (after due notice) proceed against either or both of PD and S. If both PD and S are in insolvent liquidation, C can prove against each for 100p in the pound but may not recover more than 100p in the pound in all."

[Emphasis supplied]

Following the aforesaid principle of rule against double proof, it can be derived that there is no bar under the Insolvency law for a creditor to sue the surety as well as the principal borrower for the same debt, however, the creditor/ lender shall not recover more that what is due to him.

CONCLUSION

The fundamental rationale of the Contract of Guarantee is to secure the interest of the creditors/ lenders, thereby creating a secondary obligation, though immediate, on the surety to repay the debt. In view of the same, the Insolvency Law Committee has concluded that "Section 14 does not intend to bar actions against assets of guarantors to the debts of the corporate debtor and recommended that an explanation to clarify this may be inserted in Section 14 of the Code. The scope of the moratorium may be restricted to the assets of the corporate debtor only". Following the said recommendation of the Committee, the legislature has amended Section 14(3) of the Code, 2016, inter alia, restricting the applicability of moratorium to the assets of the Corporate Debtor.

However, the purpose of the said amendment has seen to be defeated, following the judgment of Hon'ble NCLAT in the matter of Piramal Enterprises Limited, as the right to initiate Corporate Insolvency Resolution Process simultaneously against the principal borrower and the surety has been curtailed. Also, the said judgment has been passed without any foundation in the Code, 2016, as there is no provision in the Code, 2016 which restricts a creditor to trigger Corporate Insolvency Resolution Process against the principal borrower and the guarantor, simultaneously. Moreover, the Code, 2016 does not restrict simultaneous filing of claim in the Corporate Insolvency Resolution Process initiated against the principal borrower and the guarantor.

Considering the law on Contract of Guarantee and rights of the surety arising thereof, it is also worth mentioning that the right of the surety in terms of the indemnity provided to the surety by the principal borrower has also been curtailed in view of the recent decision of the Hon'ble Supreme Court of India in the matter of Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta & Ors.²². The Hon'ble Supreme Court has given wide powers in the hands of the Resolution Applicant in the name of clean and fresh slate, and has held that "A successful resolution applicant cannot suddenly be faced with 'undecided' claims after the resolution plan submitted by him has been accepted as this would amount to a hydra head popping up which would throw into uncertainty amounts payable by a prospective resolution applicant who successfully take over the business of the Corporate debtor." This being the case, the Guarantors might not be able to exercise their right of subrogation under the provisions of Sections 140 and 141 of the Indian Contract Act, 1872, as the case may be.

There is still a possibility that the aforesaid issues might be addressed by the Hon'ble Supreme Court of India in an Appeal pending against the judgment of Piramal Enterprises Limited. If the Piramal judgment of the Hon'ble NCLAT is upheld by the Hon'ble Supreme Court of India, the same shall create an escape route to the Guarantors before others fora as well, as the guarantors might argue that the debt is not payable in law. Therefore, it is interesting to see how the Hon'ble Supreme Court of India deals with the present issue and safeguard the interest of the creditors/ lenders and the credit market qua the economy.

It is also the need of the hour, wherein legislature should step in and safeguard the interest of the creditors/ lenders qua the recovery of debt by making provisions for initiating consolidated proceedings under the Code, 2016 against the principal borrower and the surety.

Footnotes

1 Company Appeal (AT) (Insolvency) No. 346 and 347 of 2018

2 Vathsala Mani, "The India Law of Guaranties and Securities", available at http://14.139.60.114:8080/jspui/bitstream/123456789/718/17/The%20Indian%20Law%20of%20Guaranties%20and%20Securities%20i.pdf

3 Vinti Agrawal, "Corporate Guarantee: Computation of Guarantee Fees at Arm's Length Price", Christ University Law Journal, 5, 1 (2016), 19-34, ISSN: 2278-4322

4 Jagannath Ganeshram Agarwala v. Shivnarayan Bhagirath, (1940) 42 BOMLR

5 1969 AIR 297

6 Insolvency and Bankruptcy Board of India, "Insolvency and Bankruptcy Code-A Miscellany of Perspectives", Part III-The Ecosystem, Pg. 143, available at https://ibbi.gov.in/uploads/publication/2019-10-11-191135-wv5q0-2456194a119394217a926e595b537437.pdf

7 Executive Summary, The Report of the Bankruptcy Law Reforms Committee, November, 2015, Volume I: Rationale and Design, available at https://ibbi.gov.in/uploads/resources/BLRCReportVol1_04112015.pdf

8 Writ Petition (Civil) No. 744 of 2017

9 Company Appeal (AT) (Insolvency) No. 213 of 2017

10 Company Appeal (AT) (Insolvency) No. 116 of 2017

11 Company Appeal (AT) (Insolvency) No. 129 of 2017

12 Civil Appeal No. 3595 of 2018

13 Supra note 1.

14 Supra note 5.

15 See clause (a) of sub-section (8) of Section 5 of the Insolvency & Bankruptcy Code, 2016.

16 See clause (h) of sub-section (8) of Section 5 of the Insolvency & Bankruptcy Code, 2016.

17 Supra note 5.

18 Company Appeal (AT) (Insolvency) No. 1500 of 2019

19 C.P. (IB) No. 1167(PB)/2019

20 C.P. (IB) No. 1151(PB)/2018

21 [2011] UKSC 48, Judgment dated 19 October 2011

22 Civil Appeal No. 8766-67 OF 2019, Judgment dated 15 November, 2019

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