Unfair balance: Guarantees and the insolvency code

By Satish Anand Sharma and Devashree Limaye, SNG & Partners
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The uncertainty on whether guarantees would attract moratorium under section 14 of the Insolvency and Bankruptcy Code, 2016 (code), has ended with the promulgation of the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2018 (ordinance).

Satish Anand SharmaSenior associateSNG & Partners
Satish Anand Sharma
Senior associate
SNG & Partners

This ordinance, based on recommendations of the Insolvency Reforms Committee (committee), held that contractual principles of guarantee are to be respected even during the moratorium and creditors need not exhaust their remedies against the principal debtor before proceeding against the guarantor.

The fate of guarantors has been hanging in the balance since enactment of the code. The court in Sanjeev Shriya v State Bank of India, decided that the moratorium would apply to sureties since liability of guarantors in such cases had not yet been crystallized; however, in other cases such as Schweitzer Systemtek India Private Limited v Phoenix ARC Private Limited and Alpha and Omega Diagnostics (India) Ltd v Asset Reconstruction Company of India, courts held that guarantees would not fall under the moratorium.

It is pertinent to list several rights of surety (guarantor) under the Contract Act, 1872 (act), which are in conflict with the provisions of the code. Under section 141 surety is entitled to the benefit of every security that the creditor has against the debtor, and is discharged from his obligations if the creditor parts with or loses such security without his consent. Also, a surety is discharged under section 133 upon any variance in terms of the contract between the debtor and creditor or under section 135 if the creditor makes a composition with, or gives time to the debtor, if the same is done without his consent.

Devashree LimayeAssociateSNG & Partners
Devashree Limaye
Associate
SNG & Partners

Further, under section 140, once the guarantor has made payments to creditors in respect of the liabilities of the debtor, the principle of subrogation takes effect, and he steps into the shoes of the creditor. Lastly, section 145 of the act states that a contract of guarantee contains an implied promise of the principal debtor to indemnify the surety in respect of rightful payments made by him on behalf of the principle debtor.

However, these rights of guarantors have been seriously prejudiced since the code was enacted. Once a guarantor has made payments to a creditor, he should take the place of the creditor in committee of creditors to the extent of the payment made by him. However, the code contains no provision to this effect.

Further, under the code, a resolution plan may provide for sale or transfer of all or part of the assets of a corporate debtor, for a reduction of the amount payable to the creditors, either by fixed sums or by proportion, for extension of a maturity date, or for a change in interest rate or other terms of a debt due from the corporate debtor. If the adjudicating authority approves such resolution plan it becomes binding on all the stakeholders, including the guarantors, by virtue of section31(1) of the code.

Thus, on one hand the code has been amended to give effect to the rights of creditors under the act; on the other hand, the reciprocal rights and remedies of guarantors are curtailed. Further, it is common practice for guarantors to waive the above rights when entering into a contract of guarantee.

This leaves them with no remedy against the principal debtors. The resolution plans approved under the code with a provision whereby the resolution applicant asks for all liabilities of corporate debtors, including contingent liabilities, to be discharged will lead to guarantors being unable to recover anything from the corporate debtors.

The preamble of the code places importance, among other things, on balancing the interests of all stakeholders. However, the recent amendments to the code have tilted the balance in the favour of creditors. They have been permitted to claim their rights under a contract of guarantee, while guarantors who are usually the directors or promoters of the corporate debtor in question face stringent restrictions on enforcing their rights under the act.

These provisions in the code are likely to lead to greater recourse to litigation, as the guarantors would not want to give away their rights under the act. We may also see a change in the way such contracts are negotiated, as guarantors would attempt to retain their rights under the act.

SNG & Partners has offices in Delhi, Mumbai and Singapore. Satish Anand Sharma is a senior associate and a qualified insolvency professional, and Devashree Limaye is an associate.

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