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 several times in various decisions of the Courts, but none of them had given the precise decision until the recent order of the National Company Law Tribunal, Kolkata Bench. The decision, however, conflicts with the order of the NCLAT, denying the right of subrogation to the guarantors if such right is extinguished by the resolution plan.¹

Introduction

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 the three parties involving the ‘Debtor’, the ‘Creditor’ and the ‘Guarantor’. The guarantor acts as a surety to pay off the debt in the situation of debtor failing to discharge his liabilities towards the creditors. But what if no agreement is signed by the parties? Kerala High Court in the case of P. Rajappan v. State of Kerala², 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 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?

Right of subrogation

The contract of guarantee give 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 and make good to the creditors, he further steps in 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 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.

Insolvency Proceedings by the Guarantor against the Principal Debtor

It has been decided by the Supreme Court of India in Lalit Kumar Jain v. Union of India³, that a guarantor is not absolved of his liabilities because of the initiation of Corporate Insolvency Resolution Process against the corporate debtor, or formulation of a resolution plan. The decision also affirmed the 2018 amendment of IB Code (as amended vide the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018, effective from 6 June 2018), which created three distinct categories, personal guarantors to corporate debtors being one of them. The judgement 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 could be initiated against the personal guarantors, who are jointly and severally liable to pay off the debts of the creditor. The move seeks to protect the creditors, leaving the personal guarantors remediless as their right to subrogation would be extinguished if the resolution plan provides for the same.

The decision of NCLT, Kolkata Bench in the case of Orbit Towers Pvt. Ltd. v. Sampurna Suppliers Pvt. Ltd.⁴ has given contrasting opinion in this regard as the decision gives consideration to Section 140 of the Indian Contract Act, 1872, i.e., the right of subrogation. The decision states that law is very clear on this point that if the surety discharge the obligations of the corporate debtor when he fails to do the same, the surety would step in 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.

Since, the NCLAT has settled the position in Lalit Mishra Judgement, that resolution plan is binding on the guarantors. IBC is a special law and bears overriding effect under Section 238 of the Code. It shall override the provisions of the Indian Contract Act, 1872.⁵ Thus, the right of subrogation shall stand extinguished. The guarantor’s liability is not an alternative, rather co-extensive with the principal debtor.

Conclusion

In view of the above, it is concluded that 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 CIRP against the debtor which further diminishes the value of the assets of the debtor, hampering the very objective of I&B Code. It is accepted that CIRP under I&B Code is not a recovery suit, rather 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. A clarity is required in this regard in the interests of justice.

1. Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors., SCC OnLine NCLAT 669.
2. (1986) ACC 2.
3. 2021 SCC OnLine SC 396.
4. C.P (IB) No. 2046 /KB/2019.
5. Pr. Commissioner of Income Tax vs Monnet Ispat and Energy Ltd., 2017 SCC OnLine Del 12759.