Indemnity of Surety Under IBC?

Contracts of Guarantee[1] are required in cases when a party requires a loan, goods or employment. There are three parties in this form of contract, namely, Principal Debtor, Creditor and Guarantor/Surety. The person in respect of whom the surety is given is called the Principal Debtor, and the person to whom the guarantee is given is called the Creditor. The guarantor/surety in such contracts assures the creditor that the person in need may be trusted and in case of any default, he shall be liable to pay. Thus, we can say contract of guarantee is an additional shield protecting the interests of the creditor. As per the provisions of the Indian Contract Act, 1872 (“ICA”), the surety shall be vested with the right of subrogation[2] to recover the debt payed to the creditor on behalf of the principal debtor.

The authors aim to interpret the provisions of ICA vis-à-vis Insolvency and Bankruptcy Code, 2016 (“IBC”) with a view to highlight the neglected rights of the surety in this process of revival of the corporate debtor.

In the recent judgment of Lalit Mishra & Ors. Vs. Sharon Bio Medicine Ltd.[3] & Ors. followed by Standard Chartered Bank v. Satish Kumar Gupta, R.P. of Essar Steel Limited & Ors,[4] National Company Law Appellate Tribunal (“NCLAT”) ruled against the basic principles of the Contract Act and denied the right of subrogation to the promoter personal guarantors. These decisions of the NCLAT can be viewed as an inequitable and prejudicial treatment against the guarantors by denying the right of subrogation to them. However, interestingly, granting the same would imply that the debt remains as it is, thereby defeating the objective of resolution.

As per Section 128[5] of ICA, the liability of the Surety is co-extensive with that of the Principal Debtor, unless otherwise provided in the contract. The expression “co-extensive with that of the Principal Debtor” establishes the maximum extent of the Surety’s liability. The surety is not only liable for the principal amount but also for the interest and charges incurred in enforcing the liability[6].

The Hon’ble Supreme Court in the matter of Bank of Bihar Vs. Damodar Prasad[7] held that the creditor can proceed against Surety even before proceeding against the Principal Debtor and hypothecated property. The Court said, “The very objective of the guarantee is defeated if the creditor is asked to postpone his remedies against the surety”. The same rational was upheld by the Allahabad High Court in the matter of U.P. Financial Corporation Vs. Garlon Polyfeb Industries and Others[8]

The most desirable interpretation of Section 128 of the Act would be that a statutory reduction or extinguishment of principle debtor’s liability by the creditor will operate as pro tanto reduction or extinguishment of surety’s debt.

As per Section 134[9] of ICA, the Surety is discharged by any contract between the creditor and the Principal Debtor, by which the Principal Debtor is released, or by any act or omission of the Creditor, the legal consequences of which is the discharge of the Principal Debtor.

The supra section provides for the following two kinds of discharge of surety from the liability:

1. When the creditor and principal debtor enter into a contract by which principal debtor is released.

It would be pertinent to point that the discharge of the principal debtor is not bought by the voluntary act of the creditor, but by the operation of law[10] or where the creditor while discharging the principal debtor, reserve the rights against the surety[11] or where the principal debtor is discharged by the reasons of insolvency or winding-up, the same does not absolve the surety from his liability[12].

Therefore, it can be established that the discharge of Corporate Debtor by virtue of approval of resolution plan under the IBC does not discharge the surety from its liability, but the question which still remains is whether the Surety will be liable for entire amount or the reduced amount.

The Full Bench of the Madras High Court while applying the provisions of the Madras Agriculturist Debt Relief Act, 1938 held that “the surety is liable only for the reduced amount”[13]. This was also supported by the Kerala High Court in Ayunni Mani Vs. Devassy Kochouseph[14]

In one of the matters the full bench of Madras High Court held that “if the creditor is to choose to enforce his remedy against the surety, the debt must exist and should not have been extinguished as under Madras Agriculturists Relief Act. The exception noticed relates to the release of principal debtor’s liability under the law of Limitation and Bankruptcy Laws etc. which merely bars the remedy and not to the extinction of the principal debtor’s liability as under Madras Agriculturists Relief Act.”

2. By any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor.

If the liability of the surety is coextensive with that of the principal debtor, his right is not less coextensive with that of the creditor after he satisfies the creditor’s debt[15]. The surety may, therefore, sue the principal debtor in the rights of the creditor.

Considering the supra provisions of ICA, the authors have taken the liberty to distinguish the situation for recovering the debt from surety under IBC in three (3) phases. The three phases are as follows:

a. Before CIRP[16]

Where a surety has discharged the liability of the principal debtor towards the creditor before the initiation of CIRP against the principal debtor, the surety shall be entitled to every remedy which the creditor had against the principal debtor. By virtue of right of subrogation, the surety shall enter the shoes of the creditor and may recover the amount from the principal creditor i.e. the surety will be treated as the creditor of the principal debtor.

b. During CIRP

Where the creditor after initiation of CIRP against the principal debtor (i.e. the Corporate Debtor) but before approval of resolution plan or passing of liquidation order under IBC, recover the debt from the surety, the surety shall be entitled to stand in the place of the creditor and file the claim as required under the IBC. The Hon’ble Supreme court has held that the right of surety not merely stands upon contract but also upon natural justice[17]. However, the surety will not be able to sue the principal debtor (i.e. Corporate Debtor) due to applicability of moratorium under Section 14[18] of IBC.

c. After CIRP

Where the resolution plan of the resolution applicant has been approved by the committee of creditors as well as the adjudicating authority under the IBC and the creditor of the principal debtor (i.e. Corporate Debtor) proceed against the surety for the recovery of the unrecovered amount (commonly known as “Haircut/Waived-off Debt”). The Hon’ble NCLAT[19] observed that a guarantee becomes ineffective in view of the payment of underlying debt in resolution. Typically, lenders preserve their rights with respect to a third-party security and the resolution applicant protects itself from claims through extinguishment of rights of the guarantor. In the Sharon Bio[20] matter, NCLAT had upheld the extinguishment of subrogation right under a resolution plan.

The Kerala High Court[21] held that “It appears to us, that to hold otherwise, would be altogether deny the benefits of the ameliorative provisions of the Act to the agriculturist debtor. On any other view it would be open to the creditor to recover the debt as scaled down from the agriculture debtor and the balance from the surety and the latter in his turn could seek reimbursement from the principle debtor. Such a construction would nullify the benefits of the ameliorative legislation to indebted agriculturist”

However, IBC being an Insolvency and Bankruptcy law does not amount to extinction of principle debtor’s liability, therefore, it is open to creditor to proceed against the surety for the waived-off amount. In that case, if the surety after paying the entire remaining debt to creditor, recovers the said amount from the principal debtor by the virtue of right of subrogation, it would be defeating the basic object of IBC i.e. reorganizing the principal debtor.

After due consideration of treatment of rights in both the scenarios, the authors have established a matter of concern, i.e. whether the right of subrogation will be provided to the surety against the insolvent principal debtor (Corporate Debtor), which has been resolved under the provisions of IBC, 2016or not?

Therefore, if the surety is not provided with right of subrogation, which is not only a statutory right under the ICA but also comes under the ambit of principles of natural justice, would be very unjust to the surety and would land him in unexpected and unmerited loss. However, if the same is provided to the surety, the basic objective of the IBC will be defeated and will act as an obstacle in reviving an insolvent corporate debtor.

This issue related to surety’s right of subrogation has been discussed in detail under the “Title-11-Bankruptcy” (“US Code”). Under Section 509[22] of the US Code “an entity that is liable with the debtor on, or that has secured, a claim of a creditor against the debtor, and that pays such claim, is subrogated to the rights of such creditor to the extent of such payment.” However, right of subrogation is not available to the surety in following cases: –

a. A claim of such entity for reimbursement or contribution on account of such payment of such creditor’s claim is allowed under Section 502[23] of this title; or

b. A claim of such entity for reimbursement or contribution on account of such payment of such creditor’s claim disallowed other than under Section 502(e)[24] of this title; or

c. A claim of such entity for reimbursement or contribution on account of such payment of such creditor’s claim subordinated under Section 510[25] of this title; or

d. If such surety has received the consideration for the claim held by such creditor.

Under US Code, a surety has two types of claims: [26]

“(1) a claim for reimbursement or contribution, and (2) a subrogation claim; and it is clear under the Code that it cannot have an allowed claim in both categories because that would permit it to effectuate a double recovery.” Therefore, the surety can choose whether to proceed under subrogation or reimbursement rights based on each creditor whose claim the surety has paid.

Based on the various provisions of ICA, IBC and comparing practices under US Code, as discussed above, the authors are of the view that the right of subrogation is an essential feature of contract of guarantee and the surety is entitled for discharging the liability of the principal debtor towards the creditor in event of insolvency of the principal Debtor.

Disclaimer: The opinion expressed in the article are those of authors. The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Note:

[1] Section 126 of the ICA

[2] Section 140 of the Act provides for “Right of Subrogation” i.e. the surety upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the principal debtor.

[3] CA (AT) No. 164 of 2018

[4] Company Appeal (AT) (Insol.) Nos. 242, 243, 257, 265, 266, 279, 290, 291, 292, 293, 300, 302-303, 304- 305, 332-333, 337, 338, 345, 349, 361, 374, 375, 376, 428, 429, 449, 454, 517, 518, 580, 181 & 551 of 2019

[5] Section 128 of ICA

[6] Indian Overseas Bank Vs. G. Ramulu (1999) 2 ALD 104

[7] Bank of Bihar Vs. Damodar Prasad, AIR 1969 SC 297: (1969) 1 SCR 620

[8] U.P. Financial Corporation Vs. Garlon Polyfeb Industries and Others, AIR 2001 All 286

[9] Section 134 of ICA

[10] Raja Thiagaranjan Vs. South Indian Bank Ltd, 1985 KLT 29 (SN)

[11] Bank of India Ltd. Vs. Rustom Fakirji Cowasjee AIR 1955 bom 419

[12] Maharashtra SEB Vs. Official Liquidator, (1982) 3 SCC 358

[13] Subramania Chettiar Vs. M.P. Narayanaswami Gounder, AIR 1951, MAD 48

[14] Ayunni Mani Vs. Devassy Kochouseph, AIR 1966 KER 203

[15] Babu Rao Ramchandra Rao Vs. Babu Manaklal Nehmal, AIR 1938 Nag 413

[16] Corporate Insolvency Resolution Process.

[17] Amritlal Goverdhan Lalan Vs. State Bank of Travancore, AIR 1968 SC 1432

[18] Section 14 of IBC

[19] Supra Note 4.

[20] Supra Note 3.

[21] Ayunni Mani Vs. Devassy Kochouseph, AIR 1966 KER 203

[22] Section 509 of Title-11 Bankruptcy, US.

[23] Section 502 of Title-11 Bankruptcy, US.

[24] Section 502(e) of Title-11 Bankruptcy, US.

[25] Section 510 of Title-11 Bankruptcy, US.

[26] Richardson, 193 B.R. at 380