• May
  • 04
  • 2011

Director’s Personal Guarantee – A Void Agreement

Posted In Corporate Law | | 10 Comments » Print Friendly and PDF

Narendra Sharma, Consultant (Legal)

1. Evolution of concept of legal entity

A division bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd (2006 134 Comp cas 106 Del. decided on 3.3.2006) observed that “the concept that a company is a distinct legal entity apart from its shareholders, vide Salomon vs. Salomon & Co. (1897 AC 22 HL) had a historical purpose. Its main purpose was to encourage entrepreneurs to start new business ventures and, thus, help in the process of industrialisation.” This background is so important that it merits consideration in detail as follows.

1.1 Delhi High Court further observed that “In every business there is a risk that the business may fail due to recession, competition, etc. Hence,  businessmen were reluctant to set up new industrial ventures out of fear that if it failed, recovery would be issued in respect of the loans they had taken and thereupon even their household and personal effects may be sold in connection with the recovery. Hence, businessmen were reluctant to take risks and start new industrial ventures. To get over this hurdle and to encourage industrialisation the legal principle was created that if a company is incorporated under the Act, the liability of the shareholders becomes limited because the shareholders, directors, etc., are legally treated as being different from the company. A company was held to be a distinct legal entity separate from its shareholders and directors. This legal principle gave protection to businessmen who were otherwise reluctant to start new industrial ventures due to the risk involved. Thus, this legal principle was of great help to industrialisation in Eurpoe (where industrialisation first began during the Industrial Revolution) and there after all over the world. “

2. Effect of Incorporation : Company as separate legal person

As per Section 34 of the Companies Act, 1956 one of the characteristics of  a company is that it is an incorporated body of persons. It is constituted into a distinct and independent person in law and is endowed with special rights and privileges.   Hon’ble Supreme Court in TELCO Vs. State of Bihar (1964) 34 Com Cases 458 : AIR 1965 SC 40  observed as follows :-

“ …..The Corporation in law is equal to a natural person and has a legal entity of its own.  The entity of the corporation is entirely separate from that of its share holders;  it bears its own name and has a seal of its own; its assets are separate and distinct from those of its members;  it can sue and be sued exclusively for its own purpose; its creditors cannot obtain satisfaction from the assets of its members;  the liability of the members or shareholders is limited to the capital invested by them; similarly the creditors or the members  have no right to the assets of the corporation. This position is well established ever since the decision in case of Salomon V. Salomon & Co. 1897 AC 22 was pronounced in 1897 and indeed, it has always been the well recognized principle of common law.  ..”

3. Limited Liability

Section 13 (2) of the Companies Act, 1956 provides that “The memorandum of a company limited by shares or by guarantee shall also state that the liability of its members is limited.” This means that no member can be called upon to pay anything more than the nominal value of the shares held by him, or so much thereof as remains unpaid; and if his shares be fully paid up his liability is nil.

3.1 “ The privilege of limited liability for business debts is one of the principal advantages of doing business under the corporate form of organization {Cadman, THE CORPORATION IN NEW JERSEY , 327 (1949)}. ” The company, being a separate person, is the owner of its assets and bound by its liabilities. Members, even as a whole, are neither the owners of the company’s undertaking, nor liable for its debts. Where the subscribers exercise the choice of registering the company with limited liability, the members’ liability becomes limited or restricted to the nominal values of the shares taken by them or the amount guaranteed by them. No member is bound to contribute anything more than the nominal value of the shares held by him {J.H. Rayner (Mincing Lane) Ltd V. Deptt. of Trade and Industry, (1989) 3 WLR 969 HL}. In a partnership, on the other hand, the liability of the partners for the debts of the business is unlimited. They are bound to meet, without any limit, all the business obligations of the firm. The whole fortune of a partner is at stake, as the creditors can levy execution even on his private property. Speaking of the advantage of trading with limited liability, BUCKLEY J observed {London & Globe Finance Corpn, Re (1903) 1 Ch 728, 731}:

“The statutes relating to limited liability have probably done more than any legislation of the last fifty years to further the commercial prosperity of the country. They have, to the advantage of the investor as well as of the public, allowed and encouraged aggregation of small sums into large capitals which have been employed in undertakings of great public utility largely increasing the wealth of the country.”

4. General Powers of Board

Sub Section (1) of Section 291 of the Companies Act, 1956 provides as follows:-

“Subject to the provisions of this Act, the Board of Directors of a Company shall be entitled to exercise all such powers, and to do all such acts and things, as the Company is authorized to exercise and do ….”

5. Borrowing

Section 292 (1) (c) of the Companies Act, 1956 provides that “(1) The Board of directors of a company shall exercise the following powers on behalf of the company,  and it shall do so only by means of resolutions passed at meetings of the Board :-

(a)……………………… ……………………
(aa) …………………….

(b)……………………….
(c) the power to borrow moneys otherwise than on debentures;

A company cannot borrow money unless it is so authorized by its memorandum. In the case of a trading company, it is not, however, necessary that the objects clause of         its memorandum should expressly authorise it to borrow. As borrowing is incidental to trading, such a company has implied power to borrow. Other companies must have a borrowing power clearly specified in the memorandum.

6. Finances

The company  is the only medium of organising business which is given the privilege of raising capital by public subscriptions either by way of shares or debentures. Further, public financial institutions lend their resources more willingly to companies than to other forms of business organisation. The facility of borrowing and giving security by way of a floating charge is also an exclusive privilege of companies. In New Horizons Ltd. v Union of India, (1997) 89 Comp Cas 785 at 802 (Delhi) the hon’ble Delhi high court has observed that “Capital in many cases is the life-blood of a concern, and it is always a great misfortune where the development of a business is arrested or restricted by want of capital.”

7. Directors as agents

It was clearly recognized as early as 1866 in Ferguson v Wilson (1866) LR 2 Ch LR 77: 36 LJ Ch 67 : 15 LT 230. that directors are in the eyes of law, agents of the company. The Court said:

“The company has no person; it can act only through directors and the case is, as regards those directors, merely the ordinary case of principal and agent.”

The general principles of agency, therefore, govern the relations of directors with the company and of persons dealing with the company through its directors. Where the directors contract in the name, and on behalf of the company, it is the company which is liable on it and not the directors.

8. Share Qualification

Section 270 (1) of the Companies Act, 1956 provides as follows

“ Without prejudice to the restrictions imposed by section 266, it shall be the duty of every director who is required by the articles of the company to hold a specified share qualification and who is not already qualified in that respect, to obtain his qualification within two months after his appointment as director.”

By necessary implication it follows that a director may not hold any share qualification at all, if he is not required by the articles of the company to hold a specified share qualification.

9. Directors, etc., with unlimited liability in limited company

Section 322 (1) of the Companies Act, 1956 provides as follows

“In a limited company, the liability of the directors or of any director or manager may, if so provided by the memorandum, be unlimited. “

By necessary implication it follows that a director’s liability is limited. As aforesaid, in para no. 3 above, section 13 (2) the Companies Act, 1956 provides that “The memorandum of a company limited by shares or by guarantee shall also state that the liability of its members is limited.” Further, section 270 (1) of the Companies Act, 1956 provides that if not required by the articles a director may not hold any share qualification. Therefore, a director may not have at all even a limited liability for the debts of the company, as a member as provided in section 13 (2) the Companies Act, 1956. This view has already been upheld by Delhi high court in Indian Overseas Bank v. R. M. Marketing and Services Pvt Ltd (2001) 107 Comp Cas 606. The court observed, inter alia, that “ ……. simply because they were directors of defendant No. 1 they could not be fastened with the liability as defendant No. 1 which is a company incorporated under the Companies Act is a separate legal entity.”

10. Registration of charges

Section 125 of the Companies Act, 1956 (hereinafter referred to as ‘the Act’) is reproduced below for ready reference:

125. Certain charges to be void against liquidator or creditors unless registered : (1) Subject to the provisions of this part, every charge created on or after the 1st day of April, 1914, by a company and being a charge to which this section applies shall, so far as any security on the company’s property or undertaking is conferred thereby, be void against the liquidator and any creditor of the company, unless the prescribed particulars of the charge, together with the instrument, if any, by which the charge is created or evidenced, or a copy thereof verified in the prescribed manner, are filed with the Registrar for registration in the manner required by this Act within thirty days after the date of its creation.

10.1 As per Section 125 of the Act the power to borrow includes the power to mortgage the company’s assets or to create a charge upon them. The reason is that lenders always insist on some security and the only security that a company can give is to charge its assets. Any charge or mortgage created on certain specified assets of a company must be registered with the Registrar of Companies under Section 125 of the Act.

10.2 Section 139 of the Act is reproduced below for ready reference:

139. Power of Registrar to make entries of satisfaction and release in absence of intimation from company. The Registrar (i.e. the Registrar of Companies) may, on evidence being given to his satisfaction with respect to any registered charge, -

(a) that the debt for which the charge was given has been paid or satisfied in whole or in part; or

(b) that part of the property or undertaking charged has been released from the charge or has ceased to form part of the company’s property or undertaking;

enter in the register of charges a memorandum of satisfaction in whole or in part, or of the fact that part of the property or undertaking has been released from the charge or has ceased to form part of the company’s property or undertaking, as the case may be, notwithstanding the fact that no intimation has been received by him from the company.

By necessary implication it follows that any charge / mortgage created by the Banks on the  Director’s personal property / property of a third party, even if unconsciously registered by ROC, is illegal being without the authority of the Act, and therefore unenforceable at law.

11. Director’s personal guarantee

Since long the banks and public financial institutions (hereinafter collectively referred to as ‘the Banks’) have unilaterally and arbitrarily developed a practice, without the authority of law, to execute personal guarantee agreements with the directors of a company to secure the debts of the company. This view is supported by the following latest judgment of the Supreme Court.

Recently, the Supreme Court in the case of Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (2008 AIOL 348 Civil Appeal No. 610-612 of 2004 Decided on 13/03/2008) has observed as follows (in para 18):

“18. Banking practice may enable a financial corporation to ask for a collateral security. Such security, we would assume, may be furnished by the Directors of a Company but furnishing of such security or guarantee is not confined to the Directors or employees or their close relatives. They may be outsiders also. The rights and liabilities of a surety and the principal borrower are different and distinct.” (emphasis supplied)

Therefore, it stands concluded, without any doubt, that the banks have developed the practice to execute personal guarantee agreements with the directors of a company to secure the debts of the company without the authority of law. This practice is against the principle of limited liability of the shareholders as well as directors of the company as provided in the Companies Act, 1956. Accordingly, it is clearly against the letter and spirit of the Companies Act and therefore unlawful.

12. What agreements are contracts

Section 10 of the Indian Contract Act, 1872 provides that – An agreement between two or more parties becomes a contract when the following conditions are satisfied:

(1) ……………………….

(2) ……………………….

(3) The parties’ consent is free.

(4) The parties’ object is lawful.

12.1 “Free consent” defined

Consent is said to be free when it is not caused by:

(1) ……………………

(2) undue influence, as defined in Section 16, or

(3) ……………………

(4) ……………………

(5) ……………………

Consent is said to be so caused when it would not have been given but for the existence of such coercion, undue influence, fraud, misrepresentation or mistake.”

12.2 Object is lawful

In P Ramanatha Aiyar’s The Law Lexicon 2nd Edition 2007 the term “Object” is defined “As a noun, the end aimed at; the thing sought to be accomplished (as) object aimed at; the aim or purpose (as) object not authorized by law; the thing sought to be attained (as) object of the law.”

The Hon’ble  Supreme Court in the case of Gurmukh Singh v. Amar Singh (1991) 3 SCC  79  has held that the word “object” would mean the purpose and design which is the object of the contract. If it is opposed to public policy which tends to defeat any provision of law or purpose of law, it becomes unlawful and thereby it is void under Section  23 of the Contract Act.

Further, in P Ramanatha Aiyar’s The Law Lexicon 2nd Edition 2007 the term “lawful”  is defined  as “By lawful, it means not contrary to law, public policy or void ab-initio, or unlawful. (Order 23, Rule 3 C.P.C. S.G. Thimmappa v. T. Anantha, AIR 1986 Kant 1, 4)

13. “Undue Influence”

Section 16 of the Contract Act provides that-

“(1) A contract is said to be induced by “undue influence” where the relations subsisting between the parties are such that one of the parties is in a position to dominate the will of the other and uses that position to obtain an unfair advantage over the other.

(2) …………………………….

(3) Where a person who is in a position to dominate the will of another, enters into a contract with him, and the transaction appears, on the face of it or on evidence adduced, to be unconscionable, the burden of proving that such contract was not induced by undue influence shall lie upon the person in a position to dominate the will of other.” (Italics supplied)

13.1 Position of dominance necessary for presumption to arise

The Privy Council in Raghunath Prasad v Sarju Prasad AIR 1924 PC 60 pointed out the conditions for presumption to arise. Referring to sub-section (3) of Section 16, which provides for presumption of undue influence, Lord SHAW observed as follows:

“By this sub-section three matters are dealt with. In the first place, the relations between the parities to each other must be such that one is in a position to dominate the will of the other. Once that position is substantiated the second stage has been reached, viz., the issue whether the contract has been induced by undue influence. Upon the determination of this issue a third point emerges, which is that of onus probandi. The burden of proving that the contract was not induced by the undue influence is to lie upon the person who was in a position to dominate the will of the other.

Error is almost sure to arise if the order of these propositions be changed. The unconscionableness of the bargain is not the first thing to be considered. The first thing to be considered  is the relations of these parties. Were they such as to put one in a position to dominate the will of the other?” (Italics supplied)

13.2 Inequality of bargaining power

The presumption of undue influence may also arise from the fact that there is such an inequality of bargaining power between the parties that one can cause economic duress to the other. The decision of the Court of Appeal in Lloyds Bank v. Bundy (1975) 1 QB 326. is a remarkable illustration of the concept of inequality of bargaining power.

A  contractor borrowed a sum of money from a bank. He could not pay back in time. The banker pressed for payment or for security. He suggested that his father might mortgage the family’s only residential house. The bank officer visited the father and obtained his signatures upon readymade papers. The contractor still could not pay and the banker sought to enforce the mortgage which might have meant throwing out of the family from its only residence. Accordingly, Mr Bundy relied upon the unfair character of the mortgage. He was allowed to set aside the mortgage.

13.3 Judicial intervention for rescuing parties from unreasonable terms

In Central Inland Water Transport Corpn vs. Brojo Nath Ganguly ( 1986 3 SCC 156, 206 )  the Supreme Court has noted that the word “unconscionable” means something as shows no regard for conscience and which is irreconcilable with what is right or reasonable. The matter before the court was a service contract. A clause in the contract empowered the employer (a Govt. undertaking) to remove an employee by three months’ notice or pay in lieu. The employee, who contested the validity of this clause, was removed by handing him over a three months’ pay packet. The Supreme Court regarded the clause to be constitutionally as well as contractually void. The court added that any term which is so unfair and unreasonable as to shock the conscience of the court would be opposed to public policy therefore also void under section 23 of the Contract Act. The contract was not based upon a real consent. It was rather an imposition upon a needy person. The term was unconstitutional because it was so absolute that any officer could be made a target irrespective of his conduct, good or bad.  (Italics supplied)

13.4 Commenting upon this expanding power of the court to relieve a party from the consequences of his own contract, a learned writer J H Baker says that “freedom of contract turns out to be a misleading guide when so many contracts are not free in the economic sense. The notion of contract as private legislation appears less attractive when legislation is always drawn up one-sidedly. Judges are empowered to read in terms which are not there, or read out terms which are there. They are to impose reasonableness. Whatever is not reasonable is not law. If the parties have agreed to something unreasonable, they should be treated as if they have not agreed at all and released”. (Emphasis supplied) (J. H. Baker, From Sanctity of Contract to Reasonable Expectation, Current Legal Problems 1979).

13.5    Serious terms of a contract must be specifically brought to the notice of the parties

The Bombay High Court in Road Transport Corpn Vs. Kirloskar Bros Ltd ( AIR 1981 Bom 299 ) said that it is for the carrier to plead and prove that the print on the receipt was brought to the notice of the consignor and that he had agreed to and accepted the same. The Court held that it is necessary that serious terms of a contract must be specifically brought to the notice of the parties whose rights are sought to be curtailed. In Oriental Fire and General Ins Co Vs. New Suraj Transport Co (AIR 1985 All 136) the consignment note was not even signed by the booking party or his agent, the Allahabad High Court held that the consignor was not bound by a printed term about the exclusive jurisdiction. The Court said that something more must be done than merely printing the terms on consignment documents. (Italics supplied)

13.6 In Road Transport Organisation of India vs. Barunai Powerloom Weaver’s Coop Society Ltd ( 1994 84 Cal LT 174 ) the Calcutta High Court held that the law requires that before making a person bound by any such term ( a clause in a consignment note as to exclusive jurisdiction ) it must be proved that the same was brought to the knowledge of the consignor in such a way that it should seem to be the result of a mutual assent. In Grandhi Pitchaiah Venkatraju & Co vs. Palukuri Jagannadham & Co ( AIR 1975 AP 32 ) where a consignment way bill contained the words “subject to Calcutta jurisdiction”,  the Andhra Pradesh High Court ignored it since it was not one to which the plaintiff assented.  Following these principles in East India Transport Agency vs. National Insurance Co ( AIR 1991 AP 53 FB ) the Andhra Pradesh High Court came to the conclusion that a term as to the place of suit was not binding on the insurer who had paid out the consignee and who was  then suing the carrier for the negligent loss of the goods unless it could be proved that the insurer too was made or was otherwise aware of the terms.

13.7 The law plays in this respect the role of a parent. It has been opined by the learned author Anthony T Kronman, in Paternalism and the Law of Contracts, (1988) 32 Yale Law Journal 763 “A person who would give away too much of his own liberty must be protected from himself, no matter how rational his decision or compelling the circumstances.” Therefore, it is expected that the DRT / Courts shall take suo motu cognizance of the legal gimmick being played by the Banks in drafting their documents regarding Director’s personal guarantee agreement and if the borrower / director has agreed to something unreasonable, he should be treated as if he has not agreed at all and released (J. H. Baker, From Sanctity of Contract to Reasonable Expectation, Current Legal Problems 1979).

14. What considerations and objects are lawful, and what not

Section 23 of Contract Act provides as follows-

“The consideration or object of an agreement is lawful, unless-

it is forbidden by law; or

is of such a nature that, if permitted, it would defeat the provisions of any law; or

……………………………………….”

14.1 Defeat any Law

Sometimes the object of, or the consideration for, an agreement is such that though not directly forbidden by law, it would, if permitted, defeat the provisions of any law. Such an agreement is also void.

14.2 Undercutting of Statutory Privileges

A term in a contract of carriage requiring that notice of loss must be given within 30 days of the arrival of the goods has been held by the Supreme Court to be contrary to and defeating Section 10 of the Carriers Act, 1865, which prescribes a period of six months for the purpose. {(M. G. Bras v Prasad Textiles, (1983) 3 SCC 61.}

In V. Raghunadha Rao v State of A. P., (1988) 1 Andh. LT 461. It was held that – the clauses in question were an attempt to relieve the State of its liability and the court said that a State is not free to impose arbitrary or unjust clauses in a public contract. (Italics supplied)

Conclusion

In view of above discussion the following inferences may be drawn.

(1) The Companies Act provides that the directors of a company are not liable for the debts of the company. This view has been upheld by Delhi High Court in Indian Overseas Bank v. R. M. Marketing and Services Pvt Ltd (2001 107 Comp Cas 606) and subsequently by a Division Bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd (2006 134 Comp cas 106 Del. decided on 3.3.2006).

(2) It stands concluded that the agreement of personal guarantee of a director being executed by the banks as a prerequisite, amounts to making the liability of a director unlimited towards the debts of a company, which is absolutely prohibited by the provisions of Companies Act, 1956.

(3) Further, the consent of a director is not free being obtained by the banks by undue influence, because the company is in need of funds for its working capital requirements and the banks have made the execution of agreement of personal guarantee by a director a prerequisite for obtaining the working capital limits from the banks.

(4) Section 23 of the Contract Act provides that every agreement of which the object or consideration is unlawful, is void. Therefore, the agreement of personal guarantee executed by a director is a void agreement, because its object is unlawful as it defeats the provisions of the Companies Act, 1956. (END)

(5) Public servant disobeying law, with intent to cause injury to any person : Section 166 of Indian Penal Code, 1860 provides as follows-

“Whoever, being a public servant, knowingly disobeys any direction of the law as to the way in which he is to conduct himself as such public servant, intending to cause, or knowing it to be likely that he will, by such disobedience, cause injury to any person, shall be punished with simple imprisonment for a term which may extend to one year, or with fine, or with both.” The insistence of the banks for execution of personal guarantee by a director amounts to disobeying the provisions of Companies Act, 1956, and therefore, the officers of the banks have committed an offence punishable under section 166 of IPC.

Now let us examine some provisions of the DRT Act, 1993 and Securitisation Act, 2002

15. Recovery Of Debts Due To Banks And Financial Institutions Act, 1993 (hereinafter referred to as ‘the DRT Act’ )

Act to have overriding effect.

Section 34. (1) Save as provided under sub-section (2), the provisions of this Act shall have effect notwithstanding anything inconsistent therewith contained in any other law for the time being in force or in any instrument having effect by virtue of any law other than this Act.

(2) The provisions of this Act or the rules made thereunder shall be in addition to, and not in derogation of, the Industrial Finance Corporation Act, 1948 (15 of 1948), the State Financial Corporations Act, 1951 (63 of 1951), the Unit Trust of India Act, 1963 (52 of 1963), the Industrial Reconstruction Bank of India Act, 1984 (62 of 1984) , the Sick Industrial Companies (Special Provisions) Act, 1985 (1 of 1986) and the Small Industries Development Bank of India Act, 1989 (39 of 1989)].

15.1 Section  2 (g) of the DRT Act provides as follows: “debt” means any liability (inclusive of interest) which is claimed as due from any person by a bank or a financial institution or by a consortium of banks or financial institutions during the course of any business activity undertaken by the bank or the financial institution or the consortium under any law for the time being in force, in cash or otherwise, whether secured or unsecured, or assigned, or whether payable under a decree or order of any civil court or any arbitration award or otherwise or under a mortgage and subsisting on, and legally recoverable on, the date of the application;

Admittedly, by the letter and spirit of the DRT Act, 1993 it means ‘a debt’ is due from a company and not from its director or promoter.

15.2 When does the overriding effect operate:

As per the rules of interpretation the provisions of an Act are to be interpreted keeping in view the object of enactment of that Act. The important aspect to notice is that the overriding effect of the provisions of the Act, scheme or rules made thereunder  would be that  only when there is anything inconsistent  in the said Act or rules or scheme vis-a-vis the other laws or provisions. If the rules or schemes made under the Act are silent on any particular subject matter and the other law requires any particular action being taken in respect there of, such a law would have to be complied with. As held by Hon’ble Supreme Court in the important decisions rendered in   Karunanidhi vs. UOI (1979) 3 SCC 431; Hoechst Pharmaceuticals Ltd vs. State of Bihar AIR (1983) SC 1019 and other cases, the material test of inconsistency is that both the provisions under consideration should not be able to stand together  i.e., if one is followed, the other, in the result,  would be violated. This may arise by reason of direct conflict or indirectly by the later law occupying the same field, as the earlier one. It is in this context that in several schemes of the BIFR where fresh issue of share capital in case of merger or other cases is envisaged, the approval of the Controller of  Capital Issues earlier required under the Capital Issues (Control) Act, 1947  has been specifically put out of the way.

15.3 Hon’ble Supreme Court in Maharashtra Tubes Ltd. Vs SICOM (1993) 78 Comp Cas 803 (SC), held that the special legislation SICA, 1985 was to prevail over the provisions of the earlier special legislation State Financial Corporations Act, 1950. Therefore, it would be a case of misdirecting oneself, if he assumes that DRT Act,1993 shall override each and every law for the time being in force in India.

15.4 For example the mandate of Section 22 (1) of SICA,1985 had always  an overriding  effect on the initiation or continuance of  proceedings before DRT under the  DRT Act ,1993, whereas the DRT Act,1993 is a later special Act than SICA,1985 and also has a non-obstante clause in section 34 of DRT Act, 1993. It is pertinent to note that subsequently SICA, 1985 has been included in section 34 (2) of DRT Act, 1993 by the Amendment Act, 2000 with effect from 17-01-2000.

16. The Securitisation And Reconstruction Of Financial Assets and Enforcement Of Security Interest Act, 2002 (hereinafter referred to as ‘the Securitisation Act, 2002’ )

Section 2(f).borrower” means any person who has been granted financial assistance  by any bank or financial institution or who has given  any guarantee or  created  any  mortgage or pledge as  security for the financial  assistance granted by any bank or financial institution and includes a person who becomes borrower of a securitisation company or reconstruction company consequent upon acquisition by it of any rights or  interest of any bank or financial institution in relation to such financial assistance;

16.1. Section 17. Right to Appeal.

(1) Any person (including borrower), aggrieved by any of the measures referred to in sub-section (4) of section 13 taken by the secured creditor or his authorised officer under this Chapter, may  make an application, along with such fee, as may be prescribed, to the Debts Recovery Tribunal  having jurisdiction  in  the matter within forty-five days from the  date  on which such measure had been taken.

Sub-section (2) to (6)…………………………………………………………….

(7) Save as otherwise provided in this Act (i.e. ‘the Securitisation Act, 2002 ’), the Debts Recovery Tribunal shall, as far as may be, dispose of the application in accordance with the provisions of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (51 of 1993) and the rules made thereunder.”.

16.2.        Section 37. Application of other laws not barred

The provisions of this Act or the rules made thereunder shall be in addition to, and not in derogation of, the Companies Act, 1956 (1 of 1956), the Securities Exchange Board of India Act, 1992 (15 of 1992), the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (51 of 1993) or any other law for the time being in force.

17.   Conclusion and Recommendations

From a combined reading of paras 15 and 16 above  the following inferences may be drawn.

(1) The DRT, while hearing appeals under section 17 of the Securitisation Act, 2002, can not override provisions contained in any other law for the time being in force, as the DRT has to act in accordance with Section 17(7) of the Securitisation Act, 2002, which provides  “Save as otherwise provided in this Act ”. And Section 37 of the Securitisation Act, 2002 provides “Application of other laws not barred”.

(2) The director should immediately file a declaratory suit in a Civil Court to get cancelled the director’s personal guarantee, because Section 2(f) of the Securitisation Act, 2002 provides that  “borrower” means any person who has been granted financial assistance  by any bank or financial institution or who has given  any guarantee.

(3) Similarly, the director should immediately file an application before the Registrar of Companies to get cancelled the charge created on the  personal property of director / any third party, because Section 2(f) of the Securitisation Act, 2002 provides that  “borrower” means any person who has been granted financial assistance  by any bank or financial institution or who has given  any guarantee or  created  any  mortgage or pledge as  security for the financial  assistance granted by any bank or financial institution. And as per Section 139 of the Companies Act, 1956 the  Registrar has power to enter in the register of charges a memorandum of satisfaction in whole or in part, or of the fact that part of the property or undertaking has been released from the charge or has ceased to form part of the company’s property.

(4) However, some grounds of defence may also be raised by the guarantors as per the latest judgment of the Supreme Court in the case of Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (2008 AIOL 348 Civil Appeal No. 610-612 of 2004 Decided on 13/03/2008) in which the Court  has observed as follows (in para 18):

“……….. Apart from the defences available to a principal borrower under the provisions of the Indian Contract Act, a surety or a guarantor is entitled to take additional defence. Such additional defence may be taken by the guarantor not only against the corporation but also against the principal debtor. He, in a given situation, would be entitled to show that the contract of guarantee has come to a not. Ordinarily, therefore, when a guarantee is sought to be enforced, the same must be done through a court having appropriate jurisdiction. In the absence of any express provision in the statute, a person being in lawful possession cannot be deprived thereof by reason of default on the part of a principal borrower.

(5) The Supreme Court in the latest judgment in the case of Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (2008 AIOL 348 Civil Appeal No. 610-612 of 2004 Decided on 13/03/2008) has further observed as follows (in para 30 and 31):

“30. Right of property, although no longer a fundamental right, is still a constitutional right (Article 300A). It is also human right. In absence of any provision either expressly or by necessary implication, depriving a person therefrom, the court shall not construe a provision leaning in favour of such deprivation.”

“31. A surety may be a Director of the Company. He also may not be. Even if he is a close relative of the Director or the Managing Director of the Company, the same is not relevant. A Director of the Company is not an industrial concern. He in his capacity as a surety would certainly not be. A juristic person is a separate legal entity. Its veil can be lifted or pierced only in certain situations. [See Salomon v. Salomon and Co. [1897 AC 22], Dal Chand and Others v. Commissioner of Income Tax, Punjab (1944) 12 ITR 458, Juggilal Kamlapat v. Commissioner of Income Tax, U.P. (1969) 1 SCR 988 = 1969 (73) ITR 702 and Kapila Hingorani v. State of Bihar (2003) 6 SCC 1]”

(6) Law declared by Supreme Court to be binding on all courts- Article 141 of the Constitution of India provides that “the law declared by the Supreme Court shall be binding on all courts within the territory of India.” Therefore, the ratio of the judgment of Supreme Court in Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (2008 AIOL 348 Civil Appeal No. 610-612 of 2004 Decided on 13/03/2008) given above, in para 4 and 5, is binding on the Debts Recovery Tribunals and other authorities under the DRT Act, 1993 and the Securitisation Act, 2002 respectively. (END)

DENA BANK – A CASE STUDY

(Letter of Guarantee)

(01). An extract of paragraph no. 1 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“In consideration of Dena Bank (hereinafter called ‘the Bank’) giving/having given credit accommodation or granting/having following credit facilities viz : ……….to ‘M/s. P’ ………………by making, opening, continuing a loan/overdraft/cash credit account or the discounting put on ……….and/or negotiating bills with or without security and/or in consideration of Bank opening and giving the credit and/or Trust receipt in favour of ________ on terms and conditions that may be settled between you and the said _______ at any time and from time to time with reference to me ‘Mr. K’ residing at _______________ jointly and severally and irrevocably hereby agree with and guarantee to you the due payment and discharge (within) two days after demand and writing, without demur or protest of all amounts due and payable to you by ‘M/s. P’ (hereinafter called ‘the Principal’) at any time …………..”

(02). An extract of paragraph no. 3 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“………… The Guarantee shall continue in force notwithstanding the discharge of the Principal by operation of law or my death or the death of any of us and shall cease only on payment of the amount guaranteed hereunder either by me or any of us.”

COMMENTS:

1. What considerations and objects are lawful, and what not-

Section 23 of Indian Contract Act, 1872 provides as follows-

“The consideration or object of an agreement is lawful, unless-

it is forbidden by law; or

is of such a nature that, if permitted, it would defeat the provisions of any law; or ……………………………………….”

1.1 Defeat any Law

Sometimes the object of, or the consideration for, an agreement is such that though not directly forbidden by law, it would, if permitted, defeat the provisions of any law. Such an agreement is also void.

The object of para 3 of the Letter of Guarantee is unlawful, because it seeks to make the guarantor liable for payment of the amount guaranteed even if the Principal is discharged by operation of law i.e. by operation of the Companies Act, 1956 and any other applicable law. Therefore para 3 is void as per section 23 of Contract Act, because if permitted it would defeat the provisions of the Companies Act, 1956.

(03). An extract of paragraph no. 4 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“ …………. I/We also agree that I/We shall not be discharged from my/our liability by your releasing the Principal or by any act or omission of yours the legal consequence of which may be to discharge the Principal or by any act of yours which would but for this present provision be inconsistent with my/our rights as surety or by your omission to do any act, which, but for this present provision your duty to me/us would have required you to do. I/We hereby consent to each and every of the acts mentioned above as you may think fit. Moreover though as between the borrower and me/us, I am/We are sureties only, I/We agree that as between yourselves and me/us I am/We are borrowers jointly with him accordingly I/We shall not be entitled to any of the rights conferred on sureties by Section 133, 134, 135, 139 and 141 of the Indian Contract Act.

COMMENTS:

1. Surrender of Rights

The consent of the Guarantor is obtained by undue influence by the Bank therefore, Para 4 of the Letter of Guarantee is voidable.

1.1 In  Muniammal v Raja, AIR 1978 Mad 103 hon’ble Madras High Court held that a wife who is entitled to maintenance can give up her right in consideration of a lump sum payment, but the surrender of the right to claim revision of the amount in the context of rising prices would be opposed to public policy and therefore, would be void under section 23 of the Contract Act.

1.2 In Bhaskar Tanhaji Dhokrat v Parwatbai, (1996) 1 Bom CR 311, hon’ble Bombay High Court held that a custom to the effect that legal right to maintenance would become surrendered would be contrary to law if it is destructive of those rights without alternative security.

1.3 Ordinarily, an agreement to give up one’s legal right is not hit by Section 23 of the Contract Act. The hon’ble Supreme Court in the case of BOI Finance Ltd v Custodian, (1997) 10 SCC 488: AIR 1997 SC 1952: (1997) 89 Comp Cas 74: (1997) 25 CLA 115, held that what makes an otherwise legal agreement to be void is that its performance is impossible except by disobedience of law. It is submitted that, in author’s view, performance of para 4 of Letter of Guarantee is not possible except by disobedience of the provisions of the Companies Act, 1956; further the performance of para 4 of Letter of Guarantee is not possible except by disobedience of the provisions of the Contract Act, because it coerces the Guarantor to act in dual legal capacity, firstly as  surety, and, secondly as borrower jointly with the Principal, simultaneously.

1.4 Hon’ble Karnataka High Court in the case of City Municipal Council v C. Ramu, ILR 1989 Kant 2138 and Suresh Mahajan v Myveneers, ILR 1990 Kant 2910 held that in order to attract section 23 of the Contract Act, it is not necessary that the contract should be tainted with illegality. It would be enough if it contains terms which are so unfair and unreasonable that they shock the conscience of the court.

1.5 However, in a subsequent judgment the Karnataka High Court in the case of T. Raju Shetty v Bank of Baroda, AIR 1992 Kant 108, held that this general observation is not applicable where a guarantor agrees not to claim the benefit of Sections 133, 134, 135, 139 and 141 of the Contract Act which give to the guarantor certain protective rights. Such rights being variable with the consent of the surety, there is no violation of the Contract Act if he agrees not to claim any of those rights. (It is respectfully submitted that this judgment is distinguishable and not applicable in the context of the case in hand, because the initial consent of the guarantor is obtained by undue influence and therefore, his rights as surety being variable only with his free consent, however subsequent consent is also obtained by undue influence and therefore, such terms of the Letter of Guarantee are voidable under section 10 of the Contract Act.)

1.6 The conduct of the Bank in inserting such onerous terms, which are contradictory to each other, in the same para 4 of Letter of Guarantee amounts to approbate and reprobate at the same time, which is unlawful and therefore such terms of the Letter of Guarantee are void under section 23 of the Contract Act. It contains terms which are so unfair and unreasonable that they would certainly shock the conscience of the court.

(04). An extract of later part of paragraph no. 4 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“ ……… And for all the purposes of this claim the Principal is empowered to give consent on my/our behalf and any consent given by the Principal shall be deemed to have been given by me/us in all respects as if the same had been expressly given by me/us in writing.”

COMMENTS:

Surrender of Rights

It is evident as the Day Light that the Principal is empowered to give consent on behalf of surety, which appears quite illogical, the inescapable conclusion is that the consent of the Guarantor is obtained by undue influence by the Bank therefore, Para 4 of the Letter of Guarantee is voidable. It contains terms which are so unfair and unreasonable that they would certainly shock the conscience of the court.

(05). An extract of paragraph no. 5 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“The Bank may recover against me/us to the extent herein before mentioned notwithstanding that the Principal or his agents, partners, directors or officers may have exceeded his or their powers or that the arrangements with the Bank may have been ultra vires and without being bound to enforce its claim against the borrower or any other person or other security held by the Bank. The Bank shall not be bound to inquire into powers of the Principal or his agents or partners, directors or officers purporting to act on behalf of the borrowers and all moneys dues or liabilities incurred shall be deemed to form part of the present guarantee notwithstanding that the Principal or his agents, partners, directors and officers may have exceeded his or their powers or the arrangement with the Bank may have been ultra vires.

COMMENTS:

Surrender of Rights

The consent of the Guarantor is obtained by undue influence by the Bank therefore, Para 5 of the Letter of Guarantee is voidable. Further, it is clearly against the principles contained in section 13 (1) of the Companies Act, 1956, as for ultra vires acts of his agents, directors and officers the Principal itself is not liable. It contains terms which are so unfair and unreasonable that they would certainly shock the conscience of the court.

(06). An extract of paragraph no. 6 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“I/We waive in the Bank’s favour all or any of my/our rights against the Bank or the Principal as may be necessary to give effect to any of the provisions of this guarantee.”

COMMENTS:

Surrender of Rights

The consent of the Guarantor is obtained by undue influence by the Bank therefore, Para 6 (and also para 7) of the Letter of Guarantee is voidable. It contains terms which are so unfair and unreasonable that they would certainly shock the conscience of the court.

(07). An extract of paragraph no. 10 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“…………. if the Principal shall become insolvent or go into liquidation or compound with his creditors, the Bank shall be at liberty without discharging my/our liability to make or assent to any compromises, compositions or arrangements or prove and to rank as creditor in respect of the amount claimable by the Bank or any items thereof ………………….. to the entire exclusion and surrender of my/our rights as sureties in competition with the Bank (and) any rule of law or equity to the contrary notwithstanding. And I/We shall not be paying off the sum guaranteed or any part thereof or upon any other ground prove or claim to prove in respect of the sum guaranteed or any part thereof or take advantage of any securities held by the Bank until the whole of your claim against the Principal has been satisfied.”

COMMENTS:

1. Surrender of Rights

The consent of the Guarantor is obtained by undue influence by the Bank therefore, Para 10 (and also para 11) of the Letter of Guarantee is voidable. It contains terms which are so unfair and unreasonable that they would certainly shock the conscience of the court.

1.1 Further, section 28 of the Contract Act provides that Agreements in restraint of legal proceedings void –Every agreement –

a)     by which any party thereto is restricted absolutely from enforcing his  rights  under or in respect of any contract, by the  usual  legal proceedings in the ordinary tribunals, or which limits the time within which he may thus enforce is rights;

The use of the words “………………….. to the entire exclusion and surrender of my/our rights as sureties in competition with the Bank (and) any rule of law or equity to the contrary notwithstanding” in para 10 violates section 28 of the Contract Act, hence Para 10 of the Letter of Guarantee is void.

(08). An extract of paragraph no. 15 of Letter of Guarantee of Dena Bank is reproduced below for ready reference –

“The guarantee hereby given is independent and distinct from any security that the Bank has taken or may take in any manner whatsoever whether it be by way of hypothecation/pledge and/or mortgage and/or any other charge over goods, movables, ……………………………… and I/We (and) the Guarantor will not claim to be discharged to any extent because of the Bank’s failure to take any of other such security or in requiring or obtaining any or other such security or losing for any reason whatsoever, including reasons attributable to its default and negligence, benefit of any or other security or any of rights to any or other such security that have been or could have been taken.”

COMMENTS:

1.  Surrender of Rights

The consent of the Guarantor is obtained by undue influence by the Bank therefore, Para 15 of the Letter of Guarantee is voidable. It contains terms which are so unfair and unreasonable that they would certainly shock the conscience of the court.

1.1 Public Policy

An agreement is unlawful if the court regards it as opposed to public policy. The term “public policy” in its broadest sense means that sometimes the courts will, on considerations of public interest, refuse to enforce a contract (Thomson- CSF v National Airport Authority of India, AIR 1993 Del 252). The normal function of the courts is to enforce contracts; but considerations of public interest may require the courts to depart from their primary function and to refuse to enforce a contract (See Lord Wright in Fender v St John Mildmay, (1938) AC 1, at p. 38).

1.2 Explaining the scope of the expression “public policy” and the role of the judge, C. Reddy J of the Andhra Pradesh High Court observed in Ratanchand Hirachand v Askar Nawaz Jung, AIR 1976 AP 112:

“The twin touchstones of public policy are advancement of the public good and prevention of public mischief and these questions have to be decided by judges not as men of legal learning but as experienced and enlightened members of the community representing the highest common factor of public sentiment and intelligence.”

Indorsing this view, the Supreme Court in Ratanchand Hirachand v Askar Nawaz Jung, (1991) 3 SCC 67 added that going by prevailing social values, an agreement having tendency to injure public interest or public welfare is opposed to public policy.

1.3 Unfair or Unreasonable Dealings

Where the parties are not economically on equal footing and there is a wide gap in the bargaining power of the parties, where one of them is in a position to exploit and the other is vulnerable and the contract made with that other is apparently unfair, it can in circumstances be also regarded as opposed to public policy. For example, the Supreme Court laid down in Central Inland Water Transport Corpn vs. Brojo Nath Ganguly ( 1986 3 SCC 156, 206 ) that a Government corporation imposing upon a needy employee a term that he can be removed just by three month’s notice or pay in lieu of notice and without any ground is an exploitation and every ruthless exploitation is against public policy.

In reference to the conduct of public financial institutions holding shares in companies, it has been held by the Supreme Court in the case of N. Parhasarthi v Controller of Capital Issues, (1991) 3 SCC 153, arising out of the L & T mega issue, that a surreptitious transfer of a bulk shares in one company without caring to see whether it would result in the creation of a monopoly adverse to public interest, if it is done with a mala fide intention, the deal would be illegal.

1.4 The officers of the bank have committed an offence punishable under sections 166 and 167 of IPC.

(i) Section 166 of Indian Penal Code, 1860 provides - Public servant disobeying law, with intent to cause injury to any person

“Whoever, being a public servant, knowingly disobeys any direction of the law as to the way in which he is to conduct himself as such public servant, intending to cause, or knowing it to be likely that he will, by such disobedience, cause injury to any person, shall be punished with simple imprisonment for a term which may extend to one year, or with fine, or with both.”

(ii) Further, Section 167 of Indian Penal Code, 1860 (hereinafter called ‘IPC’) provides - Public servant forming an incorrect document with intent to cause injury – “Whoever, being a public servant, and being, as such public servant, charged with the preparation or translation of any document or electronic record, frames, prepares or translates that document or electronic record in a manner which he knows or believes to be incorrect, intending thereby to cause or knowing it to be likely that he may thereby cause injury to any person, shall be punished with imprisonment of either description for a term which may extend to three years, or with fine, or with both.”

1.5 Firstly, the preparation of illegal document by the bank for execution of personal guarantee by a director amounts to disobeying the provisions of the Contract Act, 1872 and therefore, the officers of the bank have committed an offence punishable under section 167 of IPC. Secondly, the insistence of the bank for execution of personal guarantee by a director amounts to disobeying the provisions of Companies Act, 1956, and therefore, the officers of the bank have committed an offence punishable under section 166 of IPC.

Bank is “the State” under Article 12 of the Constitution of India

(09). The Bank is a body corporate under the provisions of the Banking Companies (Acquisition and Transfer of Undertakings) Act 1970. The Central Government acting through RBI (in short for Reserve Bank of India) is the major shareholder and hence owner of the  Bank. It is, therefore, an instrumentality of the Central Government acting through the RBI. Therefore, the bank is “State” under Article 12 of the Constitution of India, consequent to which it has to act reasonably and in the interest of the country, economy, its borrowers as well as safeguarding interest of its depositors.  It has to act in rational manner and can not act in arbitrary manner depending on the fancy and whims of it’s officers.

In this regard some case laws of Supreme Court merit consideration

(i) AIR 1996 SC 3538 – Common Cause, A Registered Society v. Union of India. This Court referred Ramana Dayaram Shetty v. International Airport Authority of India, (1979) 3 SCC 489: (AIR 1979 SC 1628 at pp. 1637-38).

“‘It must, therefore, be taken to be the law that where the Government is dealing with the public, whether by way of giving jobs or entering into contracts or issuing quotas or licences or granting other forms of largesse, the Government, cannot act arbitrarily at its sweet will and, like a private individual, deal with any person it pleases, but its action must be in conformity with standard or norms which is not arbitrary, irrational or irrelevant. The power or discretion of the Government in the matter of grant of largesse including award of jobs, contracts, quotas, licences, etc. must be confined and structured by rational, relevant and non-discriminatory standard or norm and if the Government departs from such standard or norm in any particular case or cases, the action of the Government would be liable to be struck down.”

(ii) AIR 1997 SC 1886 – Common Cause, A Registered Society v. Union of India (It follows AIR 1979 SC 1628)

This Court has authoritatively laid down in Nilabati Behera (Smt.) alias Lalita Behera v. State of Orissa, (1993) 2 SCC 746: (1993 AIR SCW 2366) that damages can be awarded by this Court in proceedings under Article 32 of the Constitution of India. In the Privy Council judgement in Rookes v. Barnard, 1964 Appeal Cases 1129, Lord Devlin in his opinion has held that exem­plary damages can be awarded for “oppressive, arbitrary and unconstitutional action by the servants of the Government”.

(10). “The Government is a Government of Law and not of men. Activities of the Government have a public element and therefore there should be fairness and equality. State need not enter into any contract with anyone but if it does so, it must do so fairly without discrimination and without unfair procedure. Exclusion of a member of public from dealing with the State in a sales transaction has the effect of preventing him from doing a lawful trade. Reputation is a part of person’s character and personality. Blacklisting tarnishes that reputation. Blacklisting has the effect of preventing a person from the privilege and advantage of entering into lawful relationship with the Government for purpose of gains. This privilege arises because it is the Government which is trading with the public and a democratic form of government demands equality and absence of arbitrariness and discrimination in such transactions. The fact that disability is created by the order of blacklisting indicates that the relevant authority is to have an objective satisfaction. Fundamentals of fair play require that the person concerned should be given an opportunity to represent his case before he is to be on the black list” (AIR 1975 SC 266) (Eurasian Equipment and Chemicals v. Slate of West Bengal).

(11). SUMMING UP:

It is difficult to define and delineate definitely the parameters of the executive power and we will have to be content with a negative definition by saying that whatever function is not legislative or judicial can be said to be executive, subject to the law of land in general and provisions of the Constitution in particular. While the scope and content of the executive power is co-terminus with the scope and content of the legislative power of the Parliament, it is not confined to the laws already placed on the Statute Book but extends to the laws that can be made consistent with the Constitution. And, further, it embraces the implied powers as well. Government functions are a reflection of the activities of the State and must, therefore, necessarily be flexible. As the State takes on more functions, or enlarges the scope of existing functions, inevitably the impact is manifested in governmental activities. It is, therefore, that the executive functions cannot be listed with any degree of finality. As Government activity in the economic sphere increases, the contracting power enables the Government to control many hitherto unregulated activities of contracting parties through the imposition of conditions. The Government, unlike private individual, is limited in its ability to contract by the Constitution.

The State is devoid of power to impose unconstitutional conditions. Unless the objectives sought by terms and conditions of Government contracts requiring the surrender of rights are constitutionally authorised, the conditions must fail as ultra vires exercise of power. It must be shown that the conditions imposed are necessary to secure the legitimate objectives of the contract, ensure its effective use, or protect society from the potential harm which may result from the contractual relationship between the Government and the individual. As right to livelihood is right to life which is protected by the Constitution, right of the State to choose a person with whom to enter into a contract for supplies or services, is in ultimate analysis, the power to deny livelihood (life) to the rejected party and therefore, the exercise of that power has to be constitutionally correct. The Court can relieve the citizen from unconstitutional contractual obligations, unjust, unfair, op­pressive and unconscienable conditions as the citizen is unable to meet on equal terms with the State.

The power of the Court is traceable to the trinity of the Constitution 1) Preamble, 2) Fundamental Rights — Part III, 3) Directive Principles — Part IV. The Court, as a court of constitutional conscience is zealously to project and uphold new values in establishing the egalitarian and socialist order. The Court has to find whether the citizen, when entering into contracts was in distress, need or compelling circumstances to enter into contract on dotted lines or whether the citizen was in a position of either to “take it or leave it” and if it finds to be so, the Court would not shirk striking down the contract by appropriate declaration. Therefore, though certainty is an important value in normal commercial contract law, it is not an absolute and immutable one but is subject to change in the changing social conditions.

While on the one hand contract calls for certainty in commercial affairs, the need for striking down a contract or a clause in a contract because of inequality of bargaining power etc., calls for action in aid of doctrine of public policy. “The present attitude of the Courts represents a compromise between the flexibility inherent in the notion of public policy and the need for certainty in commercial affairs. ” (AIR 1991 SC 101 Page 193, Para 254. ) Wherever, therefore, there is arbitrariness in State action whether it be of legislature or of the executive or of an “authority” under Article 12, Art. 14 immediately springs into action and strikes down such State action. In fact, the concept of reasonableness and non-arbitrariness pervades the entire constitutional scheme and is a golden thread which runs through the whole of the fabric of the Constitution.

Note: the views expressed are my personal and a view point only.

Author:

Narendra Sharma, Consultant (Legal)

E-mail: nkdewas@yahoo.co.in


10 Responses to “Director’s Personal Guarantee – A Void Agreement”

  1. Narendra Sharma says:

    Dear Mr. Rajiv Gupta

    Sorry, I could not see your comment earlier (you should have sent it direct to my email: nkdewas@yahoo.co.in or Mobile. 9229574214).
    The Bank will succeed in recovering the dues against the company from your personal assets.However, I have developed some defence. Please refer my following Article.REGARDS
    Recovery Proceedings by DRT against Guarantors Are Without Jurisdiction – See more at: http://taxguru.in/corporate-law/recovery-proceedings-drt-guarantors-jurisdiction.html#sthash.H5Ce2tFo.dpuf

  2. Rajiv Gupta says:

    I am the director/promoter of a private limited company incorporated under the Companies Act, 1956. I & three other directors have furnished personal guarantees to a Nationalized Bank in respect of a loan raised by the company. The company has debts to the Bank even after the sale of all assets by the Bank under the SARFESI Act. Now the Bank is planning to file suit before the DRT against me & other directors who had furnished a personal guarantee to the Bank for the recovery of the outstandings against the company.
    What is the legal position ? Will the Bank succeed in recovering the dues against the company from my personal assets ?

    Please advise.

  3. Krishna Murthy says:

    Sharmaji,

    How do you expect all bank employees to understand the purpose of the Bank in social terms. Purpose of majority of bank employees (may be 95%) is only to spend their time and earn their salary.  The kind of employees with social perceptions are exceptions than rule. Here is my experience.

    There was a Bank employee who thought in social terms and made me attempt a big order and I succeeded.  He stood by me and got the sanction for 400 Lakhs within 1 week during August 2011.  The man proposed and the God disposed.  In my case through Osama Bin laden and my project crashed due to 9/11 WTC attack.  

    Subsequent employee of the same bank froze my account in March 2002 and permitted operations during June 2004 after I got the discharge of warranty period performance BG. But my business was practically destroyed by then.  

    Subsequent employees made my  business stay in ICU until August 2010.

    Subsequent employee decided to pull the oxygen and refused renewal of Cash Credit and waited for 3 months and invoked Personal Guarantee of collateral security during Nov 2010 by applying securities act.  

    I owed 35.8 Lakhs then.  The Bank accepted my request for 1 year period to repay the debt.  I paid off 29L by Dec 2011 and could not pay the balance by March end.

    They came and stuck possession notice on April 11, 2012 and advertised in news paper on April 17, 2012 for the balance of 6.8L and interest.  They have served sale notice on April 27, 2012 and I found today at the Bank that they have a OTS.  I have requested for OTS.  

    The bank employees did the last part of the act without divulging the OTS that is in force since March 27, 2012.  Were they not aware of it or is it their casual approach to just reach the Bank at 10:30AM and do some thing and get out by 5:30PM?  Who cares society?  Your assumption that the Bank employees are to work with social responsibility is height of expectation.  They are just there following some rule and not all rules.  

    Same thing applies to Personal Guarantees

    Is it easy to go through legal process against banks?  Better to to work harder and pay back their money.   It is easier to earn money than going through courts and wasting time along with money.  Courts/Governments support banks only and the bank employees think that borrowers are crooks/cheats even though the same borrower is essential for their livelihood. 

  4. N. Krishnaraj says:

    Great Efforts – Apt & Precise – Excellent!

  5. AC says:

    Refer point 2.10 of the following link

    rbi.org.in/Scripts/NotificationUser.aspx?Id=1786&Mode=0

    Personal Guarantees of Directors have been recognised.However, like u said it may become voidable at the option of the Director if he/she is able to prove undue influence or the likes.

    Regards

  6. AS Dhillon says:

    Sh. Sharma, what would be the status of a personal guarantee given by the Nepali Director of an Indian Company? The assets are also located in Nepal. Would the invocation of this guarantee through Indian Courts be hit by any additional legal/ procedural issues other than the legal issues discussed by you?

  7. Narendra Sharma says:

    Dear Mr. XYZ (?)

    Now, why are you keeping mum? It is explicit that you have nothing to say and ONLY BEATING ABOUT THE BUSH, which is highly intolerable.

    With respect, it is ONCE AGAIN submitted that I am very much hurt to note that you have leveled superfluous BASELESS ALLEGATIONS against me, for which you are not entitled at all.

    Regards-N.K.SHARMA

  8. Narendra Sharma says:

    In continuation of aforesaid discussion, it is further humbly submitted for the information of all concerned.

    (1) As aforesaid, the payment of interest and repayment of said ‘Industrial Loan’ is primarily, wholly and solely out of earnings of the said industry. In fact all the project reports and appraisal reports prepared by the banks/financial institutions show only this mode of repayment of industrial loan as well as interest. Further, consequent on passing the Bank Nationalization Act, 1970, in the context of PROJECT ORIENTED FINANCING, there is no reason and justification for taking of any personal guarantee and / or collateral or any such security by the Bank.

    (2) I am mainly engaged in drafting Counter Claims (i.e. Claim for loss and damages suffered due to wrongdoings of the Bank) under the Law of Torts against Banks/Financial Institutions on behalf of sick companies facing recovery actions under DRT Act, 1993 and/or Securitisation Act, 2002. Therefore, I have first hand knowledge that MAJORITY OF PROJECTS FAIL, firstly, due to inexcusable DELAY IN SANCTION OF LOAN and secondly, due to inexcusable DELAY IN DISBURSEMENT OF LOAN by the idle bureaucracy in the Bank.

    (3) For example, recently a very ambitious HOSPITAL project namely, Saumya Medical Care & Media Ltd, Vijayawada has failed due to corruption in HUDCO. The Hospital was being constructed by a NRI Doctor, who returned from USA to serve his country, however, he was not ready to pay bribe to the officers of HUDCO. The NRI Doctor had already incurred more than Rs. 20 crores from his pocket, but could not succeed. At present, the NRI Doctor is ‘hand to mouth’, hence he is running a college on rent in the Hospital building to any how earn his livelihood.

    (4) Section 125 of the Companies Act, 1956 (Certain charges to be void against liquidator or creditors unless registered) provides that “(1) Subject to the provisions of this part, every charge created on or after the 1st day of April, 1914, by a company and being a charge to which this section applies shall, so far as any security ON THE COMPANY’S PROPERTY OR UNDERTAKING is conferred thereby, be void against the liquidator and any creditor of the company, unless………..” Therefore, the bank is entitled to create charge ‘on the company’s property or undertaking’ and not ON THE Director’s / Guarantor’s PERSONAL PROPERTY at all.

    (5) SUMMARY: The gist of the discussion is as follows:

    (a) It is explicit that said statutory provision u/s 125 of Cos. Act is based on the reasoning that the BANK LOAN HAS BEEN INVESTED IN BUSINESS ASSETS of the Company and NOT IN PERSONAL ASSETS OF THE BORROWER. Needless to mention that the Bank keeps a close watch on the business assets of the Company by way of Monthly Stock Statements, as well as by periodical Physical Verification.

    (b) In view of the Bank Nationalization Act, 1970, in the context of PROJECT ORIENTED FINANCING, there is no reason and justification for taking of any personal guarantee and/ or collateral or any such security by the Bank.

    (c) The bank is entitled to create charge ONLY ‘on the company’s property’, which has been purchased out of the loan sanctioned by the Bank.

    (d) In view of para 5(a) above, the bank is NOT entitled TO ASK FOR and to create charge ‘on the Guarantor’s personal property’.

    (e) Before declaring NPAs, Bankers have numerous duties to perform including “Duty of Care”(a concept of law of torts) and “Rehabilitation” not only once but multiple times.

    (f) After all said and done, if unfortunately, the Co’s PROJECT fails, the Company will be wound-up as provided in the Companies Act, and its assets will be distributed proportionately to all creditors, including the Bank.

    (g)There is no reason as to why the bank can ask for mortgage of personal assets / personal guarantee to secure its debts in preference to other creditors, whereas there is no such provision in the Companies Act and/or the Bank Nationalization Act, 1970.

    (h)Therefore, the inescapable conclusion is that the Bank does ask for mortgage of Director’s personal assets and/or Director’s personal guarantee, which is not justified at all, ONLY BECAUSE IT ENJOYS ‘STATE CONFERRED’ MONOPOLY STATUS.

    Regards-N.K.SHARMA

  9. Narendra Sharma says:

    Dear Mr. XYZ (?)
    With respect, it is submitted that I am very much hurt to note that you have leveled superfluous BASELESS ALLEGATIONS against me, for which you are not entitled at all.

    I am not AT ALL trying to twist the things in my way, and state that I firmly believe in my perception, my inferences MAY BE WRONG but I have NOT twisted the things in my way. YOU ARE REQUESTED to kindly quote specific mistakes, to enable me to reply the same. I assure you that I will give befitting reply to each and every query raised by you. However, it appears that you have nothing specific to point out, although, YOU ARE UNABLE TO DIGEST THE NOVEL APPROACH discovered by me on the subject, which is a trite reaction, having been faced by every PIONEER IN HIS FIELD. Regarding your statement “It is a well known fact that justice delayed is justice denied. By such mis-interpretation of law u are simply suggesting a way which leads to delay in justice”, I am sorry to state that you do not even know the true meaning of “JUSTICE”.

    Any way, I humbly submit my reply for information of all concerned as follows.

    1(a)/ The ‘Industrial Loan’ is required for an industry which is a social activity generating employment for the masses (direct as well as indirect), generation of public revenue by way of taxation for meeting public expenses through the government, making available goods indigenously and thus saving valuable foreign exchange, creating possibilities for export and thus earning valuable foreign exchange, creating wealth to improve standard of living of the citizens etc. Thus the ‘Industrial Loan’ is an object and purpose oriented loan for creating an activity for the benefit of the public. In this context, the payment of interest and repayment of said ‘Industrial Loan’ is primarily, wholly and solely out of earnings of the said industry. In fact all the project reports and appraisal reports prepared by the banks/financial institutions show only this mode of repayment of industrial loan as well as interest. In a running unit, all the transactions ultimately leave only the net profit in the hands of the Applicant Company. Average net profit in this relevant business is 2% to 4% of the turnover. Out of this if the Applicant Company reserves half, the balance half i.e. 1% to 2% is only available which the Applicant Company can use the way it likes say for keeping reserves for business risks, security and safety of key persons etc. All these aspects of the ‘Industrial Loan’ are well known and well understood by the Bank.

    1(b)/ The ‘Working Capital’, one of the categories of ‘Industrial Loan’ is used for payment of salary and wages to the workers, purchase of raw materials, financing of stocks and bills etc. The ‘Interest on Industrial Loan’ and ‘Repayment of Industrial Loan’ is paid out of ‘Surplus Generation’ of the running of the industry. If the business generates ‘Loss’ i.e. it is ‘Sick’, neither interest can be paid nor the loan can be repaid. Considering these basic requirements of the business and industry, the RBI has laid down various statutory ‘RBI Guidelines’ since 1976. All these aspects are well known and well understood by the Bank and its officials. In Central Bank of India Vs Ravindra and Ors. {2001 AIR 3095, 2002(1) SCC 367, 2001(7) SCALE 351, 2001(9) JT 101; Date of Judgment: 18/10/2001} hon’ble Supreme Court of India has held that the instructions and guidelines issued by the RBI have STATUTORY FORCE, hence are of BINDING NATURE on the Banking Companies.

    1(c)/ The businesses have usual risk factors including some beyond control of the entrepreneur. In our country there is no insurance for business failure even for ‘no fault’ on the part of the entrepreneur or his enterprise. On the other hand, the institutions like the Bank have multiple safeguards like protection of the government, mortgage of assets of the borrowing Company, collateral security, personal guarantees, margins etc. Further, there is no third party account in the event of any disputes with the Bank. All these facts and circumstances are highly against equity, justice and good conscience. The serious impact is that in the event of willful defaults of the Bank, the damages like aggravated and exemplary operate and unfold with greater force. Further, consequent on passing the Bank Nationalization Act, 1970, in the context of project oriented financing, taking of any personal guarantee and or collateral or any such security is void ab-initio. Hence the alleged guarantee agreement executed by the alleged guarantor(s) is not maintainable.

    1(d)/ Therefore, in the event of defaults in repayment, if any, if the Bank has obtained any guarantees including personal guarantees, the said guarantors are automatically discharged. Hence the Bank and its officials have, at all time, to take care that there is not a slight variation in the level of duty of care, terms and conditions with those at the time of obtaining guarantees otherwise the guarantors are automatically discharged. Further the Bank and its officials have to be careful that they should not draft or frame security documents having one sided terms and conditions, otherwise such documents are held illegal ab initio and are not binding even if signed by the Applicant company and guarantors. Such facts, circumstances and consequences are well known and well understood by the Bank and its officials.

    1(e)/ Limited Liability: Section 13 (2) of the Companies Act, 1956 provides that “The memorandum of a company limited by shares or by guarantee shall also state that the liability of its members is limited.” This means that no member can be called upon to pay anything more than the nominal value of the shares held by him, or so much thereof as remains unpaid; and if his shares be fully paid up his liability is nil. CONSEQUENTLY, the bank IS BOUND TO FOLLOW THE LAW OF THE LAND, until and unless the Companies Act, 1956 shall be SCRAPPED BY THE SINCERE EFFORTS OF THE BANK.

    ARE THE BANKS / FINANCIAL INSTITUTIONS ABOVE LAW ?

    1(f)/ Why a Bank does not agree to any of the rights conferred on sureties by section 133, 134, 135, 139 and 141 of Contract Act, and any Rule of Law or Equity? Read more at http://taxguru.in/corporate-law/banks-financial-institutions-law.html

    FINAL COMMENTS:
    So, my dear Mr. XYZ (?), I humbly request you to kindly EITHER quote specific mistakes, to enable me to reply the same OR have courage, and tender your UNCONDITIONAL APOLOGY to me publicly on this great website. IT APPEARS THAT YOU ARE A BANKER and therefore, not disclosing your identity, however, I am not concerned in this regard.

    Regards-N.K.SHARMA

  10. XYZ says:

    Respected Shri Narendra Sharma Ji,

    I am a regular reader of your articles published uploaded by Tax Guru and have deep respect about the knowledge of law. I have however, observed that you are trying to twist the things in your way. In the same way, in the present case relating to personal guarantee of directors of the company for securing a loan taken by the company, U have tried to (MIS)interpret various rulings given by honorable High courts and honorable Supreme court of India. As you rightly understood that a company constituted under Indian Companies Act is a artificial person and is similar to a natural person. With a view to secure repayment, the Bank of any other lender may ask that person (either natural or artificial person created under any law)to furnish personal guarantee of any third person (including a Director of that company). This does not violate any law made under the Companies Act or any ruling given by the honorable courts.

    I think u are trying to attract attention of the readers / Banks / Government towards your unrecognized talent by this misleading inference derived of by u by mis-interpreting the Law. for God sake come in the right stream and devote your talent in constructive work rather than creating sensational misinterpretation of law. No doubt u have done an excellent job in quoting different rulings and provisions of law. And this is an evidence of your talent which, of course be given a positive turn. It is a well known fact that justice delayed is justice denied. By such mis-interpretation of law u are simply suggesting a way which leads to delay in justice.

    I hope u will take my words in right perspective and u will contribute your talent for simplification of the legal knowledge.

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