Validity of Recovery Actions against Guarantor Post Assignment of Debt

[By Arjun Makuny]

The author is an Insolvency and restructuring lawyer.

Introduction                 

The rights of creditors have been severely weakened due to a recent order of the Debts Recovery Tribunal at Ahmedabad (DRT) in State Bank of India v. Prashant Ruia.[i] The DRT ruled that a creditor cannot sue the guarantor if the principal debt is assigned by the creditor for consideration. Further, it was also held that a creditor cannot choose to reserve its rights against the guarantor during the assignment of the principal debt.

In this background, the author argues on the validity of creditors’ recovery actions vis-à-vis guarantors notwithstanding any waiver of rights as against the principal borrower. The author believes that any hindrance to such a course of action of creditors has the potential to cause huge ramifications in contemporary business transactions.

Facts in brief 

  • The consortium of lenders led by the State Bank of India had filed an Original Application under Section 19 of the Recovery of Debts and Bankruptcy Act, 1993 before the DRT against Mr. Prashant S. Ruia and other guarantors for recovery of sums due to the consortium.
  • During the pendency of the Original Application, the principal borrower (Essar Steel India Limited) was admitted into Corporate Insolvency Resolution Process under the Insolvency and Bankruptcy Code, 2016. Subsequently, the resolution plan proposed by ArcelorMittal India Private Limited (ArcelorMittal) was approved by the National Company Law Tribunal, Ahmedabad, and thereafter by the Supreme Court. Accordingly, the principal borrower was acquired by ArcelorMittal.
  • The resolution plan provided that all debts payable by the principal borrower shall be assigned to a third-party assignee and the creditors would receive consideration for such assignment of debt. However, the resolution plan explicitly provided that the guarantees that have been created in respect of the debt would not be assigned and would continue to be retained by the creditors.
  • Prashant S. Ruia filed an Interim Application to dismiss the Original Application as against him on the ground that no debt as defined under Section 2(g) of the Recovery of Debts and Bankruptcy Act, 1993 exists in law due to the assignment of debt.                                                                                                           

Decision

Upon examining the terms of the resolution plan and the assignment deed, the DRT observed that the assignment of debt had discharged the principal debtor of its repayment obligations and the net result of such an assignment is that the debt is totally extinguished leaving nothing to be recovered from the guarantors. The DRT proceeded on the line of thought that if the creditors have nothing to recover from the principal borrower, the guarantors stand discharged of their obligations despite the clause in the Assignment Deed that specifically provides that the guarantees have been retained and not assigned.

The DRT also placed emphasis on the clause in the resolution plan which stated that the payments made to the creditors as consideration for the assignment of debt will be a full and final settlement of the entire outstanding dues. In view thereof, the DRT proceeded to conclude that the debt due from the principal borrower stood discharged.

The DRT held that a subsisting underlying “debt” due from the principal borrower is a precondition for creditors to proceed against the guarantors and since in the present facts and circumstances, there is no subsisting underlying debt due from the principal borrower, the creditors are precluded to invoke the guarantees in respect of the assigned debt.

The need for reconsideration

Pollock & Mulla’s book has recognized the right of a creditor to proceed against the guarantor, even in situations where the principal debtor stood discharged, if the creditor has reserved its rights to proceed against the guarantor in such situations:

Sometimes agreements described as guarantee may contain clauses which preserve the liability of the guarantor, even where the principal debtor has either never been liable (viz. contract is ultra vires the company as the principal debtor is a minor), or has ceased to be liable to the creditor.”[ii]

The question of enforcing remedies against the guarantor notwithstanding a waiver of rights as against the principal borrower is not something that has come up for judicial consideration for the first time. Indian Courts have previously recognized that, if the creditor, while giving up its claim against the principal debtor, expressly reserves his remedies against the surety, or generally his securities and remedies against the persons other than the principal debtor, the surety is not discharged, irrespective of whether the creditor has done so with or without his consent or knowledge.[iii]

Pertinently, Indian Courts have also recognized the legal validity of an agreement that provides for the release of a principal debtor, while simultaneously reserving the creditor’s rights of recourse against the surety:

Where the principal has entered into a deed of arrangement containing a release, subject to the reservation of the creditor’s rights of recourse against the surety, the latter has no right to raise objection.”[iv]

The principle in English law that discharge of principal debtor will not affect the right of suit against sureties where there is a reservation to proceed against them, is applicable in India, and it is consistent with the terms of the scheme of the Indian Contract Act, 1872.[v] The rationale behind this principle is that a nominal release of the debtor, subject to a reservation of securities, is not a release destroying the debt, but operates only as a covenant not to sue the principal-debtor, who remains, however, liable to indemnify the surety. The surety’s right to indemnity against the principal debtor is a necessary result of such a reservation.[vi]

It has to be understood that if a creditor agrees to discharge a principal debtor, it would be a breach of the agreement that is entered with the surety because the surety’s right to enforce his remedy against the principal debtor is extinguished. However, if the agreement to discharge the principal debtor contains a reservation of rights against the surety, the surety’s rights against the principal debtor are not extinguished. This is because the principal debtor has notice that the surety’s remedies against him are not extinguished.[vii]

If a condition is placed in an agreement of release that the rights of a creditor to sue or receive money from the surety are reserved, the principal debtor is aware that only the creditor is legally precluded from raising a claim as against him and he is still exposed to a claim at the instance of the surety.[viii]

The DRT’s Order has clearly overlooked the above legal principle to conclude that it is impermissible for a creditor to proceed against the guarantor. This deviation from the above-discussed legal position is not in line with the practicalities of the contemporary business world.

The DRT failed to consider that a contract of guarantee, in all practical aspects, brings into existence two debts, one being the liability of the principal borrower and the other being the liability of the guarantor when the principal debtor defaults. It cannot be made a blanket rule that a surety can never be liable when the principal debtor is not liable, since a contract of guarantee is not a collateral, but a principal contract.[ix]

Conclusion

From the above discussion, the only logical conclusion that can be deduced is that the DRT’s Order is per incuriam. The DRT ought not to have taken a narrow interpretation of contract law to summarily dismiss the legitimate rights of a secured creditor, which has the potential to cause far-reaching financial implications.

More importantly, the DRT’s Order can significantly increase the haircuts on the claims of financial creditors, which is a problem that has long been plaguing the Insolvency & Bankruptcy Code, 2016. The existence of an independent right against the guarantor, while assigning the principal debt against a consideration, would significantly reduce the haircuts faced by financial creditors.  Therefore, it is legally imperative that the DRT’s order is reversed by the appellate courts.

[i] IA No. 92 of 2022 in OA No. 650 of 2018, Debts Recovery Tribunal at Ahmedabad.

[ii] Pollock & Mulla on Indian Contract and Specific Relief Acts, thirteenth edn., at 1766

[iii] Jawala Singh v. Raj Kaur, AIR 1930 Lah812; Mahant Singh v. U Ba Yi, (1939) 66 IA 198; P Murugappa  Mudaliar v. Munuswami Mudali, AIR 1920 Mad 216 (1919) 38 Mad LJ 131, 54 IC 758; Annadana Jadaya Goundar v. Konammal (1933) 56 Mad 625, AIR 1933 Mad 309, 141 IC 852

[iv] P Murugappa Mudaliar v. Munuswami Mudali, AIR 1920 Mad 216 (1919) 38 Mad LJ 131, 54 IC 758

[v] P Murugappa Mudaliar v. Munuswami Mudali, AIR 1920 Mad 216 (1919) 38 Mad LJ 131, 54 IC 758

[vi] P Murugappa Mudaliar v. Munuswami Mudali, AIR 1920 Mad 216 (1919) 38 Mad LJ 131, 54 IC 758; Bateson v. Gosling, (1871) LR 7 CP 9; Green v. Wynn, (1869) LR 4 Ch 204; Webb v. Hewitt, (1857) 3 K&J 438 at 442; Cole v. Lynn, [1942] 1 KB 142, [1941] 3 All ER 502 (CA); United Bank of India v. Modern Stores (India) Ltd., AIR 1988 Cal 18, at 24

[vii] Rowlatt on Principal and Surety, second edn., at 260.

[viii] Annadana Jadaya Goundar v. Konammal (1933) 56 Mad 625, AIR 1933 Mad 309, 141 IC 852

[ix] Edavan Kavingal Kelappan Nambiar vs Moolakal Kunhi Raman And Anr., AIR 1957 Mad 164

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