Extinguishment of a Personal Guarantor’s Right of Subrogation: A Critique

[Vijay Rohan Krishna is pursuing his LLM (Corporate and Commercial Laws) at NUJS, Kolkata, and Sambhawi Sanghamitra is a 3rd year B.A. LL.B. (Hons.) student at CNLU, Patna]

Ever since personal guarantors were made liable under the Insolvency and Bankruptcy Code, 2016 (IBC) by way of the notification dated 15 November 2019, their rights and liabilities under the IBC have been extensively debated in various legal fora. This is primarily due to the disparity between the treatment of corporate guarantors under the scheme of the IBC and the well-established principles relating to contracts of guarantee under the Indian Contract Act, 1872 (ICA).

The right of subrogation is an essential facet of a contract of guarantee, and is founded upon the most basic principles of natural justice and equity, and is deeply rooted in common law. However, this right is sacrificed to further the object of the IBC, which is the revival and rehabilitation of the corporate debtor, and not the recovery of debt by the personal guarantor. The present post seeks to critically analyse the rationale behind the extinguishment of the personal guarantor’s right of subrogation.

Extinguishment of Right of Subrogation

In Lalit Mishra v. Sharon Bio Medicine, the National Company Law Appellate Tribunal (NCLAT) held that the corporate insolvency resolution process (CIRP) under the IBC is centred on the revival of the corporate debtor and the maximization of the value its assets, and that recovery of debt by personal guarantors is antithetical to that object. Under the scheme of the IBC, the personal guarantor’s right to subrogate is not an absolute right and is not granted primacy by the legislation, as it would render the insolvency resolution pointless by further encumbering the assets of the corporate debtor.

Additionally, it is also pointed out that personal guarantors are generally promoters of the corporate debtor who have profited from the debtor and may have contributed to its insolvent state through mismanagement, and the Code seeks to prevent them from rewarding themselves or benefitting from the CIRP at the expense of the creditors.

That being said, a personal guarantor is not entirely deprived of the right of subrogation. If the debt is satisfied prior to the approval of the resolution plan, then the personal guarantors can exercise their right of subrogation by having their claim included in the plan. Further, if the debt is satisfied after the approval of the plan, then the resolution applicants may exercise their discretion to provide for claims relating to subrogation. However, in the Essar Steel case, the Supreme Court held that failure to provide for such claims would not invalidate the plan, as it is binding on all stakeholders under section 31(1) of the IBC.

Critical Analysis

Since its inception, the IBC has been a debtor-centric legislation, with the primary object saving companies from insolvency. However, it could be argued that the legislation has a very myopic approach when it comes to personal guarantors. In the crusade to ‘to maximise the value and assets of the corporate debtor’, it seems that the courts have forgotten that the CIRP must also ‘balance the interests of all stakeholders’.

A guarantor’s right of subrogation is founded upon the theory of unjust enrichment, which states that no one should profit at the expense of another. The corporate debtor is unjustly enriched due to the denial of this right, which is justified by the fact that further encumbering the assets of the debtor would defeat the objectives of the IBC.

This disparity between the guarantor’s contractual rights and their liabilities under IBC is defended by the overriding effect of section 238 of the IBC, which states that the provisions of the IBC shall prevail over anything inconsistent contained in any other law in force. Further, in the event of an inconsistency between two special legislations, the latter enacted legislation shall prevail. An approved resolution plan would prevail over the contractual rights of a guarantor. This leads to the inescapable conclusion that the right of subrogation must be sacrificed at the altar of the IBC.

Furthermore, allowing the personal guarantors to exercise their right will initiate a never-ending vicious circle as can be seen from Davinder Ahluwalia v. Sumit Aviation, wherein the personal guarantor was placed into the shoes of the creditor. The corporate debtor defaulted again which compelled the guarantor to file a section 7 application to initiate CIRP against the corporate debtor.

However, multiple irregularities present themselves when the legal position is considered from a natural law perspective. A surety’s obligation is to discharge the debt of the principal borrower in the event of a default. Once the surety has fulfilled their liability, they obtain a corresponding right, i.e., to step into the shoes of the creditor and recover the debt. In the authors’ opinion, the argument that the surety cannot recover the amount from the debtor, without doing anything egregious or defaulting on their payments, is wholly unsustainable.

Subrogation is an equitable right which cannot be strictly enforced by overlooking analogous legal and equitable rights of other parties. However, that does not mean that it should be treated as being entirely expendable. To incorporate the right into the IBC, far-reaching changes would have to be made, as any solution that attempts to indemnify personal guarantors would have the potential to restart the CIRP all over again, as it did in Davinder Ahluwalia.

Unlike the IBC, the United States Bankruptcy Code has devised a more pragmatic approach towards the insider guarantor’s rights of reimbursement or subrogation. Under section 547(b) of the Bankruptcy Code, an insider guarantor who has fulfilled their obligation and indemnified the insolvent corporation is treated like a creditor of the corporate debtor, and can exercise their right of subrogation and recovery their assets.

This approach to insider guarantee reduces the cost of financial agency, as the guarantors are personally liable to the creditors, and they are incentivized to prevent the debtor from spiralling into insolvency by making efficient management and investment decisions. Further, even after the creditors move against the insider guarantors and the guarantor has to indemnify the company, the presence of subrogation rights would mean that the guarantor’s incentives remain aligned with the corporation, as any increase in the borrowers assets would also increase the amount the guarantor can recover from the corporate debtor.

In contrast, the scheme of the IBC provides no such incentives to personal guarantors. Personal guarantors are made coextensively liable while simultaneously being deprived of their subrogation rights. Once insolvency is imminent, they realise that they would be at the mercy of the creditors and have no advantage in acting in the interests of the corporate debtor. In such a situation, they are more likely to prioritize their own perverse incentives to the detriment of the CIRP.

Alternatively, the US law also contemplates a waiver of the right of subrogation or reimbursement through clauses in the contract of guarantee, also known as ‘Deprizio waivers’. Such clauses protect creditors from the reduction in the potential liability of the guarantor to discharge the debt by nullifying the validity of pre-petition payments, which are preferential transactions made by the debtor for the benefit of the guarantor. Such transactions are protected by virtue of the fact that the guarantor retains his subrogation rights and consequently, its status as a ‘creditor’ under section 547(b). However, if the subrogation rights are waived, the guarantor can no longer be classified as a ‘creditor’. 

Even in common law countries like the United Kingdom and Australia, the insolvency resolution procedure does not contemplate a statutory extinguishment of the guarantor’s right of subrogation. However, like the US, this right may be expressly or impliedly waived through contract clauses, or the conduct and intention of the parties of the parties.

In doing so, these legal systems incorporate the personal guarantor’s right of subrogation into the insolvency procedure without resorting to unjust enrichment of the corporate debtor or violating the principles of equity or natural justice, while devising mechanisms to allow creditors to protect themselves. This is something the IBC has not been able to do.

Conclusion

In all, the extinguishment of the personal guarantor’s right of subrogation not an unavoidable and unassailable fact, but a corollary of a flawed insolvency resolution structure that has become too myopic and debtor-centric. One of the primary objects of the IBC is to provide greater ‘ease of doing business’ to all stakeholders, bring about a more transparent corporate structure and foster better corporate governance. India currently ranks 63rd on the World Bank’s Ease of Doing Business 2020 report.

The fact that the IBC actively and unashamedly undermines a core aspect of commercial transactions, i.e. contracts of guarantee, goes directly against that object. Contracts entered into by personal guarantors are essential for the smooth injection of capital into the market as they put the creditors at ease. Undermining such contracts shall have a detrimental effect on the economy, as it would impair the willingness of both creditors and guarantors to enter into such contracts. However, considering the direction that jurisprudence under IBC is taking with regard to the rights and liabilities of personal guarantors, any mechanism that encumbers the assets of the corporate debtor after the CIRP process, especially for the benefit of the personal guarantors, may be anathema to the IBC scheme.

Vijay Rohan Krishna & Sambhawi Sanghamitra

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