Liability of Personal Guarantors vis a vis their Rights under the IBC: A Legal Conundrum

[Pinak Parikh is an Associate at Singhi & Co, Ahmedabad, and is a B.A L.L.B (Corp Hons) graduate (2019) from the Institute of Law, Nirma University]

In December 2019, ArcelorMittal India Private Limited (“AMIPL”) paid over Rs. 42,000 crores to the State Bank of India to complete the acquisition of Essar Steel India Private Limited (“Essar Steel”), in what has been one of the biggest resolution of stressed assets under Insolvency and Bankruptcy Code, 2016 (“IBC”). However, it appears that the battle between erstwhile promoters, i.e., the Ruias, and the financial creditors of Essar Steel is far from over. The financial creditors have moved against the personal guarantors of Essar Steel to recover the remaining portion of their debt. It remains to be seen whether the financial creditors can pursue the personal guarantors after approval of the resolution plan under the IBC.

Section 31(1) of the IBC clears the smoke on the aforesaid issue to some extent. Lawyers for personal guarantors contend that, on a plain reading of section 31(1), the liability of personal guarantors stands extinguished upon approval of the resolution plan under IBC since the resolution plan is binding on the personal guarantors. However, the above view is untenable in law. The Supreme Court, in State Bank of India v. V. Ramakrishnan, observed that liability of the personal guarantors is not extinguished upon approval of the resolution plan. Further, the Supreme Court observed that section 31(1) of the IBC has made the resolution plan binding on the guarantors so as to be in consonance with the principles of discharge under section 133 of the Indian Contract Act, 1872 (“Contract Act”).

Essar Steel Case: Liability of personal guarantors upon approval of resolution plan

The Supreme Court in Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta had the occasion to deal with the issue of liability of the personal guarantors towards financial creditors following the approval of resolution plan under IBC. However, the Supreme Court, instead of giving a decisive decision on the aforesaid issue, observed: “So far as the present case is concerned, we hasten to add that we are saying nothing which may affect the pending litigation on account of invocation of these guarantees”.  In view of colossal amount of debt still unpaid, it appears that the Supreme Court has clearly failed to come to the rescue of either personal guarantors or financial creditors.

There is a clear procedure laid down under the IBC starting from admission of insolvency application to approval of a resolution plan for the corporate debtor. However, difficulty arises when the resolution plan is approved and the personal guarantors to the corporate debtor are asked to discharge the remaining portion of debt owed by corporate debtor to the financial creditors. The IBC is silent on the liability of personal guarantors to pay off the debts of corporate debtor following the approval of resolution plan. Such a situation is problematic because: (1) the resolution plan for the corporate debtor, which is a contract, discharges the principal debtor and, consequently, the guarantor (section 128 of the Contract Act); and (2) even though the guarantor is not discharged and is allowed to exercise the right of subrogation (section 140 of the Contract Act), it will bring the corporate debtor back to where it was prior to passing of a resolution plan, which was clearly not the intention of the legislature.

It is not clear why the Supreme Court was reluctant to decide the issue, when the resolution plan submitted by AMIPL conspicuously provided that liability of the personal guarantors does not stands extinguished upon approval of resolution plan. However, the said resolution plan requires some consideration. The first part of section XIII (1)(g) of the said resolution plan provided that claims of the guarantor on account of subrogation shall be deemed to have been abated, discharged and extinguished, and the second part of section XIII (1)(g) provided that rights of the financial creditors to enforce personal guarantees shall not be extinguished upon approval of resolution plan. In other words, the said resolution plan has created an anomaly, i.e. financial creditor can invoke guarantees against the personal guarantor, but the personal guarantor cannot recover the amount paid from the corporate debtor.

In my opinion, such a resolution plan should not have been given a green signal by the adjudicating authority. The said resolution plan proposes to take away the statutory right of subrogation of the personal guarantor provided under section 140 of the Contract Act. How can two parties take away the right of a third party, who is not even a party to the contract, by way of a contract? Therefore, the said plan is in contravention of section 30(2)(e) of the IBC. The balance has to be struck between the rights of a personal guarantor and interests of the corporate debtor. Just because, in a vast majority of cases, directors of the corporate debtor give personal guarantees, their right to recover the amount from corporate debtor cannot be taken away indifferently.  

Liability of guarantor under Indian Contract Act, 1872

The High Court of Calcutta in Gouri Shankar Jain v. Punjab National Bank was faced with the similar question, i.e., whether liability of the personal guarantor is extinguished upon approval of the resolution plan. The Calcutta High Court observed that liability of the personal guarantor is not extinguished upon approval of the resolution plan. While coming to the said conclusion, the Court analyzed various provisions of the Contract Act dealing with discharge of the surety and observed the following:

1. According to section 128 of the Contract Act, liability of the guarantor is co-extensive with that of the principle debtor. The word “co-extensive” relates to the quantum of the principal debt. The lawyers for personal guarantors contended that liability of the principal debtor is extinguished upon approval of resolution plan, i.e., principal debt becomes zero and, consequently, in light of section 128 of the Contract Act, liability of the guarantor also stands extinguished. However, the Supreme Court in Maharashtra State Electricity Board, Bombay v. Official Liquidator, High Court, Ernakulam observed that it is a well settled principle of law that a discharge which is secured by a principal debtor by operation of law (i.e., by bankruptcy or insolvency or liquidation proceedings) does not absolve surety of his liability. Therefore, the Court observed that in case of discharge by operation of law, the liability of the surety is not extinguished.

2. According to second part of section 134 of the Contract Act, a surety is discharged by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor. The question, which arises for consideration, is whether an application filed by financial creditor under section 7 of the IBC could amount to a “voluntary act” on part of the creditor. The Calcutta High Court observed that a financial creditor filing an application under section 7 of the IBC is exercising its statutory right and not contractual right. Therefore, the exercise of such statutory right, which is involuntary in nature, will not alter the contractual obligations of the parties. Consequently, the guarantor is not discharged upon discharge of debtor by way of an insolvency proceeding.

3. According to section 135 of the Contract Act, a surety is discharged if the creditor makes a composition with the principal debtor. The Court observed that it could not be said that the filing of an application under section 7 of the IBC amounts to a composition with the principal debtor. Further, the resolution plan may either provide for payment of the entire claim or only a portion of the claim as final settlement and in neither of the two situations can the creditor be said to have entered into voluntary compromise with the corporate debtor with regard to the quantum of debt.

4. According to section 139 of the Contract Act, a surety is discharged if the creditor does any act inconsistent with the rights of the surety and the eventual remedy of the surety against the principal debtor is thereby impaired. The Court observed that the filing of an application under section 7 of the IBC is a statutory right and does not affect the contractual obligations of the parties, who are bound by independent contracts between the creditor, principal debtor and guarantor. The question still remains whether a resolution plan that takes away the right of subrogation, thereby impairing the remedy of the surety, will be hit by section 139 of the Contract Act and consequently discharge the surety?

Conclusion

The above-referred judgments leave no manner of doubt that the liability of personal guarantors is not extinguished upon approval of the resolution plan. At the same time, the right of subrogation of the personal guarantors should not be taken away under the garb of superior interests of the corporate debtor. The time is ripe for the Supreme Court to conclusively determine liability of the personal guarantors as well as rights of the personal guarantors in respect of the corporate debtor following the approval of the resolution plan.  

– Pinak Parikh