Invocation of Unmatured Corporate Guarantee during Moratorium under Bankruptcy Law

[Himanshu Handa is an Associate with UKCA and Partners, a Law Firm in New Delhi]

Introduction

In Axis Bank Limited v Edu Smart Services Private Limited, the National Company Law Tribunal (“NCLT”), Delhi had rejected a plea from the financial creditor i.e. “Axis Bank” against the corporate guarantor i.e. Edu Smart in respect of its claim pertaining to a corporate guarantee in the insolvency resolution process of Edu Smart Services Private Limited. The NCLT held that the corporate guarantee could not be treated as a debt since it had not been invoked before the commencement of corporate insolvency resolution process (“CIRP”) as Axis Bank had invoked its claim around two weeks after the initiation of the resolution process. This decision was challenged before the National Company Law Appellate Tribunal (“NCLAT”), which overturned the decision and the claim of Axis Bank was upheld.

Background

Educomp Solution, the principal borrower, had availed a loan from Axis Bank and its subsidiary company Edu Smart had furnished a corporate guarantee in its favour. Axis Bank submitted its claims before the interim resolution professional (“IRP”) in respect if its claim aggregating to Rs. 396,76,07,676. The aforesaid amount was claimed to be the amount guaranteed by the corporate debtor by way corporate guarantee furnished by it in favour of Educomp Solutions Ltd. The IRP rejected Axis Bank’s claim and thereafter Axis Bank filed an application before the NCLT under section 60(5) of the Insolvency and Bankruptcy Code, 2016 (“IBC”).

The resolution professional (“RP”) submitted before the NCLT that Axis Bank had already claimed the amount of debt from the principal borrower, i.e. Educomp, but it failed to disclose the same in its application. The RP took the stand that “the claim made by Axis Bank on the basis of corporate guarantee is a mala fide attempt to create hurdle in the corporate insolvency resolution process of the corporate debtor”.

In another case of V Ramakrishnan V. Veesons Energy Systems Private Ltd, the NCLT, Chennai Bench held that the financial creditor cannot not proceed against corporate guarantor as allowing invocation of the corporate guarantee would mean that the interest would be shifted to the guarantor which would violate section 14 (1) of the IBC.

The issue before the NCLT in Edu Smart Services was that whether a corporate guarantee must have been invoked prior to the initiation of CIRP for the guarantee holder to be granted the status of a ‘financial creditor’.

NCLT Judgment

After the plea of Axis Bank was rejected by the RP, Axis Bank had filed an application under section 60(5) of the IBC before the NCLT challenging the decision of the RP. The principal bench of the National Company Law Tribunal (NCLT) dismissed Axis Bank’s plea and held as follows:

(a) The ‘corporate guarantee’ had not been invoked prior to the initiation of the CIRP and hence the liability under the guarantee had not crystalized or matured as on the insolvency commencement date, i.e., date on which the application seeking initiation of the insolvency process had been admitted;

(b) Under the IBC, only those claims should be considered which are due and payable as on the insolvency commencement date;

(c) A right to claim any debt only arises when the creditor’s debt is due and payable; in case of a guarantee the debt becomes due only when a creditor invokes a guarantee; and

(d) After the order of admission, a moratorium is in effect which will bar any action to foreclose, recover or enforce any security interest created by the corporate debtor, which will bar invocation of a guarantee as well.

The NCLT also held that the provisions of regulations 12 and 13 of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 would not come to the rescue of the applicant bank as the corporate guarantee was invoked after the commencement of CIRP and it had become due and payable after the insolvency commencement date.

NCLAT Judgment

The NCLAT scrutinized the corporate guarantee and stated that, according to the provisions of the guarantee, in the event of any default on the part of the principal borrower, the guarantor shall, upon demand, pay without demur all the amounts payable by the ‘principal borrower’. The appellant Bank had submitted that the liability of the guarantor under section 128 of the Indian Contract Act, 1872 is joint and severable and therefore the Bank can invoke the guarantee against the principal borrower and/or against the corporate guarantor. To this, the RP had taken the stand that the amount cannot be claimed simultaneously against the principal borrower, i.e. Educomp Solutions and corporate guarantor, i.e. Edu Smart, under the corporate insolvency process.

According to clause 21 of the Terms of Guarantee, “the guarantee shall be a continuing one and shall remain in full force and effect till the time the principal borrower repays in full the loans together with all interest, liquidated damages, costs, charges and all other monies payable”. Therefore, the NCLAT observed that Axis Bank could be considered as a lender to the guarantor and that Axis Bank could treat the guarantor as the principal debtor.

The NCLAT also weighed the definitions of “debt”, “default” and “claim” to conclude as follows:

(a) That financial debt under section 5(8)(h) of the IBC includes any counter-indemnity obligation in respect of: (i) a guarantee, (ii) indemnity, (iii) bond, (iv) documentary letter of credit and (v) includes any other instrument issued by a bank or financial institution.

(b) That ‘counter-indemnity obligation’ in respect of a guarantee or indemnity or bond or documentary or letter of credit is not necessarily to be issued by a bank or ‘financial institution’, but can be issued by any person to whom ‘financial debt’ is owed.

(c) A claim is independent of an actual default of the debt and a right of payment whether secured or unsecured come within the meaning of claim under section 3(6) of the IBC; and a claim can be treated as a right to payment arising from a breach of contract irrespective of whether the same is matured, unmatured, disputed or undisputed.

The NCLAT also observed that according to section 25(2)(e) of the IBC, the RP is supposed to maintain an updated list of claims submitted by the creditors. This fact also suggests that maturity of a claim or default of debt are not the guiding factors to be noticed for admission of claims.

The NCLAT observed that on the declaration of moratorium the RP has to issue a public announcement under section 13 read with section 15 of the IBC, inviting all creditors to submit their claims. Thereafter, the RP under section 18 would collate all the claims received from the creditors. However, the only stipulation with respect to the ‘claims’ is that the same has to be computed as on the insolvency commencement date. The right of the creditor to file a claim would be as per the definition of claim which includes matured, unmatured, disputed and undisputed claims. The RP would not need to examine as to whether there has been a default in respect of the claim being made by the creditor. Thereafter, the NCLAT held that the term “claim”, which is independent of debt and default, would also include an “unmatured claim”.

Conclusion

The ability to initiate insolvency process is based on the existence of debt and default therein, because without the element of default a corporate entity cannot be treated as insolvent. However, if the process has been initiated then the creditors have no option but to participate in the same. At that juncture, to disallow a creditor to participate in the process on the basis of the maturity or invocation of its dues would be unfair and inequitable. The initiation of insolvency proceedings would be the action deeming maturity of a debt; however, due to the onset of moratorium, creditors are being disallowed from enforcing their contracts following the insolvency commencement date. The order of the NCLAT will help resolve these situations and aid creditors in realising their dues irrespective of whether the same have matured as on the insolvency commencement date.

One of the most significant features of the IBC is the grant of a moratorium under section 14, during which any action to foreclose, recover or enforce any security interest created by the corporate debtor is stayed. The moratorium does not come into force automatically but is granted by the NCLT. The recent judgments of the NCLT and NCLAT have created confusion in the financial sector regarding the working of corporate guarantees under the code. The invocation of corporate guarantee during moratorium still remains a big question before the judicial and quasi-judicial authorities. This may adversely affect the finance sector and therefore the Insolvency and Bankruptcy Board of India should come up with clarifications on this cardinal issue.

– Himanshu Handa