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Status and Role of Guarantors under the Indian Contract Act, 1872 and Insolvency and Bankruptcy Code, 2016

Specifics related to the contract of guarantee is governed under the principles of Indian Contract Act, 1872 and is mentioned in chapter VIII of the Contract Act. For a layman to understand a contract of guarantee is a contract to discharge the liability of a third person in case he defaults. It is a tri-party contract between the principal debtor, creditor and the surety.

The Contract Act has very well specified the rights and liabilities of a guarantor in regards to a contract of guarantee. Here the main point of understanding is that the contract of guarantee is to safeguard the position of the creditor in case the principal debtor defaults. As per the Contract Act, the guarantor enjoys the right of subrogation wherein the guarantor gets to claim indemnity from the principal debtor in case  the guarantor when the principal debtor defaults.

In recent times this has posed as an issue when guarantee is being discussed in the cases coming under the Insolvency and Bankruptcy Code, 2016. Under the Insolvency and Bankruptcy Code,2016 the surety is denied the right to subrogation. In this article, we will see how the Insolvency and Bankruptcy Code stands as a contrast to the Indian Contract Act,1872 in terms of guarantee agreements.

Liability of Guarantors after approval of CIRP under the IBC, 2016

The question here is about the rights of the creditor against that of the guarantor after the conclusion of Corporate Insolvency Resolution Process (CIRP) of the concerned. The issue here has to be understood while throwing light on the objective of the Insolvency and Bankruptcy code, 2016. The object of the IBC is to maximize the value of the assets of the corporate debtor.

The resolution approved during CIRP is not for recovery. Once the resolution plan is approved by the adjudicating authority the obligations of the corporate borrower cease. However, the creditors retain the right to proceed against the guarantors of the corporate debtor concerned. Under IBC there is no bar on the creditor with regard to his right to claim its remaining debt from the guarantor. Here the due debt or the remaining debt is the part that has not been recovered from the debtor through CIRP.

As we know that the Indian Contract Act,1872 has made it clear that the liability of the guarantor is coextensive with that of the borrower the liability of the guarantor is dependent in itself as the contract of guarantee is an independent contract under section of the Contract Act.

Section 133, 134 and 140 of the Indian Contract Act gives certain rights to the guarantors. However, after the approval of the CIRP the guarantor cannot be discharged of his liability towards the creditor on the discharge of the principal debtor´┐Żs liability (S 134). This happens because the debtor is discharged by the operation of law hence the main ingredient of section 134 is missing here.

Placing strong reliance on section 31 of the IBC the guarantor cannot be released from making the payment by virtue of section 133 of the Indian Contract Act.

However, under section 140 of the Indian Contract Act the guarantors enjoy the right of subrogation, under this the guarantor has a right of subrogation of the debt amount paid on the behalf of the principal debtor but under IBC after the CIRP is concluded the guarantor cannot enjoy this right of subrogation for the payment made by him with respect to the debt for which the guarantee was provided.

Case law:

Lalit Mishra & Ors. vs. Sharon Bio Medicine Ltd. & Ors.

As seen in the case mentioned above the judgement held that the guarantor cannot exercise his right to subrogation under section 140 of the Indian Contract Act as the proceedings of the IBC are not recovery proceedings. Thus there is no such recovery that can be made by the guarantors. It is clear that the conclusion of CIRP does not bar the creditor from proceeding against the guarantors. The right of a creditor against that of the guarantor is independent.

Double dip under IBC

Guarantee contacts are governed by the provisions of the Indian Contract Act,1872, which clearly states that the guarantor's liability is coextensive with that of the principal debtor. In the context of guarantee the more debated issue under the IBC is that if a lender can make simultaneous claim against the principal debtor and the guarantor.

On seeing through the lens of the principals of the Contract Act the most significant characteristic of guarantee contract is coextensive liability of the principal debtor and the guarantor (Section 128). The implication of this section being that the liability of the guarantor is immediate and cannot be deferred until the creditor exhausts his remedies against the principal debtor.

For the judgement in the case of Bank Of Bihar v. Damodar Prasad & Anr held that the very objective of obtaining a guarantee under the Contract Act would be defeated if the creditor was asked to postpone his remedies against the guarantor.

In the case of Bank Of Bihar v. Damodar Prasad & Anr the judgement held that before payment the guarantor has no right it to command the terms to the creditor, as in asking the creditor to pursue his remedies against the debtor in the first instance. It is the business of the guarantor to see if the principal debtor pays and not that of the creditor. This case highlights the fact that the solvency of the principal is not a sufficient ground for restraining execution of the decree against the surety. It is the surety's liability to pay the debt.

Treatment of Guarantee under IBC

Under IBC it is made very clear that the moratorium would not extend to the guarantor of a corporate debtor and that the creditor can proceed against the guarantor while the CIRP of the principal borrower. The amendment in Section 60 of the IBC was in order to provide a link between the insolvency resolution of the debtor and the guarantor. By the amendment the intention of the legislature to allow a financial creditor to initiate simultaneous proceedings against the debtor and the guarantor is highlighted.

Here it is made clear that the IBC has permitted the creditor can file a proof of claim in the liquidation of both the debtor and the guarantor. However, the creditor in no way can recover more than the amount due in respect of the loan amount given.

Case law:

Dr. Vishnu Kumar Agarwal v. M/S Piramal Enterprise limited

The case mentioned above concerns a principal debtor having borrowed from a creditor which was guaranteed by two corporate guarantors.

The issues of the case are:
  1. CIRP could be initiated against the guarantor when the principal debtor was not a body corporate and
  2. if there could be simultaneous initiation of CIRP against the two guarantors at the same time.

The judgement of the court in regards to the first issue was affirmative. While deciding on the second issue the court held that there is no bar in the insolvency and bankruptcy code 2016 for filing simultaneously two applications under Section 7 against the principal debtor as well as the guarantor or against both the guarantors.

However, the court held that once for the same set of claim an application is filed under section 7 by the creditor and is admitted against one of the principal debtor or corporate guarantor(s) a second application by the same creditor for the same claim cannot be admitted against the other principal debtor or guarantor(s). Accordingly, if a creditor has recovered a portion of his claim from one debtor he would be barred from claiming the rest from the others.

The NCLAT seems to have arrived at the above mentioned conclusion on the basis that for a same set of debt the same financial creditor cannot file for two simultaneous CIRP's- this condition is essentially a double dip which is permissible under the Insolvency and Bankruptcy Code, 2016. Though in this case the reason for arriving to the above said judgement has not been discussed.

The Piramal judgement clearly weighs against the principles of Guarantee under the Indian Contract Act,1872.  The Contract Act entitles the creditor to proceed against either the debtor or one or more of the guarantors or against both in no specific order.

This fact has been catered to in the case of Chokalinga Chettiar v. Dandayunthapani Chattiar, AIR 1928 Mad 1262. Section 146 of the Contract Act,1872 states the liability of the surety is co-extensive with that of the debtor and the surety is jointly and severally liable. Co-guarantors are liable to contribute equally and for instances where there is more than one guarantor they have to share the liability equally unless the contract provides otherwise.
The hallmark of the contract of guarantee under the Indian Contract Act is the lender's remedy against the debtor and the guarantor without an obligation to exhaust the remedy against one of them before proceeding against the other. As we say that the section 14 of the Insolvency and Bankruptcy Code, 2016 has made it clear that the order of moratorium will not be applicable against the guarantor.

So saying that the creditor cannot have two simultaneous claims against the same that against the data and the guarantor render the aforesaid amendment redundant. There is no provision in the IBC which bars the creditor from initiating CIRP simultaneously against both the borrower and the guarantor.

Have the legislation intended to prevent a double dip in an insolvency it would have made it clear and Section 14 of the insolvency and bankruptcy code would have excluded any such proceedings. In this scene the decision of the supreme court in regards to the appeal filed in the Piramal Case is much waited for that will throw more light on the matter with regards to double dip under IBC.

By now we can see how the rights of the surety is at cost under the Insolvency and Bankruptcy Code, 2016 and if it continues this way it is very probable the guarantors will be unwilling to stand as a surety to transactions as their rights are in doubt here. Apart from this I am of the opinion that the insolvency and bankruptcy code 2016 needs some necessary amendments to address to the issues that might arise from simultaneous CIRPs against the principal debtor and the corporate guarantor.
  • The Indian Contract Act, 1872
  • The Insolvency and Bankruptcy Code, 2016
  • Lalit Mishra & Ors. v. Sharon BioMedicine Ltd. & Ors., Company Appeal (AT) (Insolvency) No. 164 of 2018.
  • Bank of Bihar Vs. Damodar Prasad, AIR 1969 SC 297: (1969) 1 SCR 620
  • Dr. Vishnu Kumar Agarwal v. M/S Piramal Enterprise limited
  • Chokalinga Chettiar v. Dandayunthapani Chattiar, AIR 1928 Mad 1262.

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