[The Viewpoint] Right of subrogation to the rescue of the guarantor? Stepping in the shoes of the creditor

A ‘guarantor’ or a ‘surety’ comes to the rescue of the corporate debtor during the insolvency proceedings, but who is there to rescue the guarantor? The plight of the guarantor has been discussed in various decisions of the courts, but none of them delivered a the precise decision, until the recent order of the National Company Law Tribunal, Kolkata Bench.

The decision, however, is in conflict with another order of the National Company Law Appellate Tribunal (NCLAT), denying the right of subrogation to the guarantors if such right is extinguished by the resolution plan.

Before discussing the recent decision, we shall discuss the contract of guarantee. A contract of guarantee as defined under Section 126 of the Indian Contract Act, 1872 arises out of the relationship of three parties -the debtor, the creditor and the guarantor. The guarantor acts as a surety to pay off the debt when the debtor fails to discharge his liabilities towards the creditors.

But what if no agreement is signed by the parties? The Kerala High Court in the case of P Rajappan v. State of Kerala answered this query and stated that a guarantor cannot wiggle out of the situation on the basis of hyper technicalities. If a person has promised to act as a guarantor, he has to discharge the liability in the event the principal debtor fails to do so. The contract of guarantee could be either oral or written. Now, what happens once the guarantor has duly performed his duties?

The contract of guarantee gives rise to the right of subrogation. The right of subrogation, as provided under Section 140 of the Indian Contract Act, 1872, states that once the guarantor has paid off the debt of the principal debtor, he steps into the shoes of the creditor and is possessed of all the rights that a creditor has against the principal debtor.

Recognizing the right of subrogation in this situation, could we say that the guarantor has the right to step into the shoes of the creditor and initiate the Corporate Insolvency Resolution Process (CIRP) against the corporate debtor as per Section 7 of the Insolvency and Bankruptcy Code, 2016? Moreover, what is the situation if there is no contract of guarantee between the principal debtor and the borrower? It is a question of law that does not have a settled position yet.

It has been decided by the Supreme Court of India in Lalit Kumar Jain v. Union of India that a guarantor is not absolved of his liabilities because of the initiation of the CIRP against the corporate debtor, or formulation of a resolution plan. The decision also affirmed the 2018 amendment of the IBC [as amended vide the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018, effective from June 6, 2018], which created three distinct categories, personal guarantors to corporate debtors being one of them. The judgment also upheld the Insolvency and Bankruptcy (Application to Adjudicating Authority for Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Rules, 2019, which provides that separate recovery proceedings can be initiated against personal guarantors who are jointly and severally liable to pay off the debts of the creditor. The move seeks to protect creditors, leaving personal guarantors remediless, as their right to subrogation would be extinguished if the resolution plan provides for the same.

The decision of the NCLT Kolkata Bench in the case of Orbit Towers Pvt Ltd v. Sampurna Suppliers Pvt Ltd has given a contrasting opinion in this regard. It gives consideration to Section 140 of the Indian Contract Act, 1872, i.e., the right of subrogation. The decision states that the law is very clear on this point that if the surety discharges the obligations of the corporate debtor when he fails to do the same, the surety would step into the shoes of the creditors and will have the same rights as the creditors. In this case, even if the contract of guarantee is absent, the guarantor will have the same right to proceed against the corporate debtor and initiate recovery proceedings.

The NCLAT has settled the position in the Lalit Mishra judgment, that the resolution plan is binding on the guarantors. IBC is a special law and has an overriding effect under Section 238 of the Code. It shall override the provisions of the Indian Contract Act, 1872.Thus, the right of subrogation shall stand extinguished. The guarantor’s liability is not an alternative, rather co-extensive with the principal debtor.

In view of the above, it is concluded that the right to subrogation is not an absolute right of the personal guarantor against the debtor under CIRP, and therefore, he must not be allowed to initiate the CIRP against the debtor. This further diminishes the value of the assets of the debtor, hampering the very objective of Code. It is accepted that the CIRP under I&B Code is not a recovery suit, rather it seeks to restructure the assets and provide security to the creditors. Initiation of CIRP by the guarantor against the debtor would lead to creation of a vicious circle, a never-ending hustle for the parties, thereby maximizing litigation. Clarity on this aspect is required in the interests of justice.

Madhu Gadodia is Deputy Managing Partner and Shashank Trivedi is Manager at Naik Naik & Co.