Liability Of Personal Guarantors After Assignment Of Debt Under IBC: The Unsettled Fate

Liability Of Personal Guarantors After Assignment Of Debt Under IBC: The Unsettled Fate

INTRODUCTION

The enactment of the Insolvency and Bankruptcy Code, 2016 (IBC) has fundamentally transformed India’s insolvency framework by establishing a comprehensive mechanism for the resolution of corporate insolvencies. In conjunction with this, the IBC introduced notable amendments concerning the liability of personal guarantors in 2019¹. A personal guarantor is an individual who guarantees the obligations of a borrower, typically a corporate entity, to a lender. In instances where the corporate debtor defaults on its obligations, the personal guarantor assumes responsibility for repaying the debts owed by the corporate debtor.

While the legal principle asserts that a personal guarantor’s liability is not extinguished solely upon the approval of a Resolution Plan, an essential question arises regarding the status of personal guarantees following the execution of a resolution plan, particularly in cases involving assignment of debt. This article intends to center on the assignment of debt vis-à-vis Resolution Plan, by critically examining the changing jurisprudence regarding the co-extensive liability of debtors, the disparity between the IBC and the principle of subrogation, and the paradoxical challenges that warrants the Supreme Court's attention.

CONTEXT OF THE JURISPRUDENCE LAID DOWN IN LALIT KUMAR JAIN

Supreme Court in the case of Lalit Kumar Jain vs. Union of India² and others had adjudicated the question that whether sanctioning of Resolution Plan relieve the Personal Guarantor’s liability and decided the constitutional validity of the MCA’s notification dated 15.11.2019. The Apex Court upheld the validity of the notification and relied on the judgement of SBI v. V. Ramakrishnan³, holding that:

“122. It is therefore, clear that the sanction of a resolution plan an finality imparted to it by Section 31 does not per se operate as a discharge of the guarantor’s liability. As to the nature and extent of the liability, much would depend on the terms of the guarantee itself. …

125. In view of the above discussion, it is held that approval of a resolution plan does not ipso facto discharge a personal guarantor (of a corporate debtor) of her or his liabilities under the contract of guarantee. As held by this Court, the release or discharge of a principal borrower from the debt owed by it to its creditor, by an involuntary process i.e. by operation of law, or due to liquidation or insolvency proceeding, does not absolve the surety/guarantor of his or her liability, which arises out of an independent contract.”

Additionally, the Court made observation regarding the principle of subrogation under Indian Contract Act and opined that the same would be antithetical to the ‘clean slate theory’ envisaged under the Code.

It is pertinent to note here that the specific issue before the Court was regarding the constitutionality of the Notification and whether the approval of a resolution, leading to a discharge of a Corporate Debtor can, in and itself, i.e. automatically lead to a discharge of the personal guarantor; hence the use of the phrase “does not ipso facto discharge”. The judgement does not discuss the impact on guarantors’ liability specifically when the Resolution Plan provides for (a) full and final settlement of debt; and (b) subsequent assignment of debt by the Creditor to Resolution Applicant. Therefore, even though the Lalit Kumar Jain judgment lays down the basic principle to be followed, the impact on guarantor’s liability is required to be analyzed through the lens of factual backdrop while harmoniously interpreting the IBC and principles governing guarantee.

WHAT HAPPENS IN THE CASE OF ASSIGNMENT OF DEBT IN LIEU OF THE RESOLUTION PLAN?

The assignment of financial debt is a common transaction in financial markets, involving the transfer of debt from a creditor (assignor) to a third party (assignee). Upon assignment, the third-party assignee assumes the creditor's position and acquires all the rights the creditor holds against the debtor. Creditors may choose to assign debt for various reasons, such as exiting a particular exposure, monetizing debt, or managing risk and balance sheets.

An assignment is fundamentally a contractual arrangement whereby one party's rights and obligations are transferred to another. The assignee, by stepping into the assignor’s position, agrees to be bound by the terms of the original agreement and is entitled to enforce those rights. For an assignment to be legally valid, it must meet the requirements of the Indian Contract Act, 1872. Under Section 23 of the Act, an assignment agreement may be declared void if its objective (a) contravenes the law, (b) is fraudulent, (c) involves harm to a person or property, or (d) is deemed immoral or against public policy by the court.

In cases where an Assignment Deed is executed in favor of a Resolution Applicant as part of a Resolution Plan, the issue arises that such deeds are not scrutinized by the Adjudicating Authority (NCLT) during the Corporate Insolvency Resolution Process (CIRP). A multitude of judgments have held that proceedings under the Insolvency and Bankruptcy Code (IBC) cannot address the validity of an assignment, as such legal questions fall under civil jurisdiction rather than IBC proceedings. The Hon’ble NCLAT, in T. Johnson v. Phoenix ARC (P) Ltd.⁴, clarified this issue, stating that:

“In cases involving assignment of debts, another issue arises. Often, the corporate debtor, whilst not challenging the locus of the assignee, may challenge the very assignment before the NCLT. In such cases, the process adopted for such assignment, the consideration paid for such assignment, etc, may be challenged. The NCLT, being a tribunal of summary jurisdiction, does not have any jurisdiction to deal with such challenges. The consideration for assignment of debt is of no relevance in so far as the liability and obligation on the part of Corporate Debtor is concerned. The assignment only changes the hands of the creditor clothing the assignee with authority to enforce the claim. The liability in regard to claim as regards the Corporate Debtor remains intact and does not get diluted in any manner whatsoever.”

Due to the lack of clear guidelines in the IBC regarding the scrutiny of Debt Assignment Deeds, the timing, circumstances, and legal validity of such assignments in relation to the Approved Resolution Plan become key factors in determining their enforceability.

JUDICIAL PRECEDENTS DISCUSSING EFFECT OF ASSIGNMENT OF DEBT ON PERSONAL GUARANTORS’ LIABILITY

While the law is settled on principle that approval of Resolution Plan does not ipso facto absolve Personal Guarantor’s liability, the ambiguity remains with respect to the status of Personal Guarantees when the Resolution Plan provides for Assignment of Debt and subsequent full and final settlement accepted by the Creditors.

There are two judgements of Gujarat High Court and Delhi High Court when the said question was brought before the writ court. The issue before both the Courts was whether after assignment of debt to the Resolution Applicant in consideration of full and final settlement, the Creditor can invoke the personal guarantees. Even though both the writ courts dismissed the petitions and remanded it back to the respective Tribunals, it delved into the questions regarding the legal effect of assignment of debt on the liability of personal guarantors.

A. Prashant Shashi Ruia v. SBI [Gujarat High Court, 2021]

Factual Matrix:

In 2017, CIRP process was initiated against ESIL by the creditors. As per the terms of the RP presented by ArcelorMittal, out of the claims of INR 45,559.24 Crores, it agreed to accept an amount of INR 45,000 Crores After a round of litigious pursuits⁵, the Resolution Plan (“RP”) was finally approved, and the acquisition was finalized on December 16, 2019. Resultantly, the debt owed by ESIL was assigned to ArcelorMittal by virtue of the process. As per the Resolution Plan, ESIL assigned/sold the Loan Asset worth 45,000 crores to ArcelorMittal along with all underlying securities, excluding the Personal Guarantees by Guarantors. Thereafter, the Banks preferred an application under Section 19 of Recovery of Debts and Bankruptcy Act, 1993 (the RDB Act, 1993) against the Personal Guarantors. The writ applicants sought a writ of prohibition from the High Court against DRT proceedings initiated by the Banks. They argued that the DRT lacks jurisdiction over them as guarantors since the Bank's entire debt was assigned to ArcelorMittal, rendering their personal guarantees unenforceable. Thus, they contended that, with no debt on the Bank's books, the guarantees cannot be invoked.

Decision of the Court:

• The writ petition seeking writ of prohibition was dismissed as there existed an equally efficacious remedy with the writ applicants before the DRT.
• The High Court delved into the facts of the case and submissions by both the parties for prima facie inspection and remanded the matter to DRT to adjudicate and decide whether with the assignment of debt by the secured creditor (State Bank of India) to the Resolution Applicant, all other liabilities and obligations of the Guarantors stood discharged.

Reasoning:

Provisions of Contract Act regarding Guarantee:

• Section 134 of the Contract Act has two components: (i) if a contract between the creditor and principal debtor releases the debtor, the surety is also discharged, and (ii) the surety is discharged by any act of the creditor that results in the debtor’s discharge.
• In this case, there is no contract between the Bank (the creditor) and ESIL (the principal debtor) that releases ESIL. Thus, the writ applicants cannot be discharged from their obligations to the Bank.
• It can be said that the assignment of debt may exonerate the principal debtor (ESIL) by operation of law, but this does not necessarily discharge the sureties.
• The Lalit Kumar Jain judgement indicates that the involuntary release of a principal borrower does not automatically absolve the guarantor of liability under an independent contract. However, it’s important to note that the Supreme Court has not yet addressed the implications of debt assignment.

Scheme of IBC and its implication on Guarantors’ liability

• Under the IBC, once the Committee of Creditors (CoC) accepts a resolution plan and it is approved by the Adjudicating Authority, the Corporate Insolvency Resolution Process (CIRP) concludes. The approved plan settles the debt owed by the Corporate Debtor, preventing any further proceedings related to that debt. This resolution plan is binding on the Corporate Debtor, its employees, creditors, guarantors, and other stakeholders, effectively ending the Corporate Debtor's liabilities. However, creditors retain the right to pursue claims against the guarantors.
• According to Section 134, a guarantor is discharged from liability if the creditor voluntarily releases the Principal Debtor. This discharge must result from the creditor's actions, not merely by operation of law. In the context of the IBC, the Corporate Debtor's discharge occurs through the legal approval of the resolution plan, not at the creditor's discretion, regardless of individual creditor opinions.
• Thus, whether guarantors are discharged from liability when the Principal Debtor is released under the IBC will need to be determined by the Tribunal, considering this case involves debt assignment.

Liability of Guarantors

• For a surety to be discharged under Section 139 of the Indian Contract Act, two conditions must be met: (1) the creditor must act in a way that conflicts with the surety's rights or fail to fulfill a duty owed to the surety; and (2) this action or inaction must impair the surety's remedy against the principal debtor.
• The Tribunal will need to closely examine whether these conditions are met, considering the terms of the Resolution Plan, the guarantee, and the legal implications of the debt assignment on the guarantors’ liability, referencing the Hutchens v. Deauville Investments Pty Ltd decision from the High Court of Australia.

B. Vineet Saraf v. REC [Delhi High Court, 2023]

Factual Matrix:

The Petitioner herein, Vineet Saraf acted as a personal guarantor for a Rs. 517.90 crore loan taken by FACOR Power Ltd. (FPL) from REC Ltd. The loan was also secured by a corporate guarantee from Ferro Alloys Corporation Ltd. (FACOR). Following FPL's default, REC initiated CIRP against FACOR in May 2017, leading to a Resolution Plan approved by NCLT on January 30, 2020, and a subsequent Assignment Agreement transferring the debt to Sterlite Power Transmission Limited (SPTL). On 09.12.2022, REC issued a Demand Notice under Rule 7(1) of the Insolvency and Bankruptcy (Application to Adjudicating Authority for Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Rules, 2019, invoking petitioner’s personal guarantees for the outstanding debt. The writ petition seeks to quash this notice, arguing that, following the assignment, REC is no longer a creditor of FPL, and thus no debt is owed.

Decision of the Court:

• The Court stated that having an alternate remedy does not prevent the court from issuing a writ of prohibition. However, in these situations, the petitioner must demonstrate to the Court not only that the proceedings or actions in question lack jurisdiction, but also provide reasons why the alternate forum should not be allowed to determine its own jurisdiction.
• Secondly, the Court observed that the petitioner argued that the respondent's decision to assign all debts to Ferro Alloys Corpn. Ltd., while excluding the personal guarantees as per the Resolution Plan and Assignment Agreement, meant that the respondent could no longer rely on the guarantee provided by the petitioner. While the Court left the issue for the NCLT to resolve on its merits, it established key principles for the NCLT's consideration including analysis of the Hutchen’s judgment.

HUTCHENS V. DEAUVILLE INVESTMENTS PTY LTD

Facts:

• The Kenbrite Corporation Pty. Ltd. (Kenbrite), where Hutchens was a director, borrowed money from General Credits Limited. To secure the loan, Kenbrite gave a first mortgage debenture, which included a floating charge over its assets. Hutchens also signed a guarantee to cover any money owed by Kenbrite to General Credits. About a year later, when General Credits lent more money, Hutchens provided additional security through a real property mortgage.
• By February 1982, Kenbrite was insolvent. General Credits appointed receivers for Kenbrite’s assets on March 5, 1982. At that time, Kenbrite had around $1.5 million in assets, about $430,000 owed to preferred creditors, and over $3 million in secured debts, primarily to General Credits and Helvetic Investment Corporation.
• If the assets had been used to pay creditors according to priority, General Credits would have been fully paid, and Hutchens would not have owed anything under his guarantee. Conversely, if General Credits had collected from Hutchens, he could have reclaimed his payment from Kenbrite’s assets.
• On March 12, 1982, Helvetic appointed its own receiver. General Credits then demanded payment from Hutchens without specifying an amount owed. On April 6, 1982, General Credits assigned its rights to Helvetic, including the mortgage related to Hutchens’ guarantee

Finding of the Court

While ascertaining the status of Hutchen’s liability, the Court opined the following:

“As we followed the argument, it was suggested that, by such a transaction, Hutchens’ liability as a guarantor could be transformed into an independent liability to a different creditor from the creditor to whom the guaranteed debt remained owing. That suggestion would seem to lie ill with the basic principle that the debt owed by a guarantor, upon default by the principal debtor, is and remains the same debt as that owing by the principal debtor. Put differently, it would seem to be simply impossible, as a matter of basic principle, to assign the benefit of a guarantee or the security for it (as distinct from the property secured) while retaining the benefit of the guaranteed debt and thereby to convert the one debt owing by both principal debtor and guarantor to the one creditor into two debts, one owing by the principal debtor to the creditor and the other owing by the guarantor to the assignee. If it were otherwise, the position would seem to be that, by assigning the benefit of a guarantee and the guarantor’s security and retaining the benefit of a principal debtor’s indebtedness and the principal debtor’s security, a creditor could effectively divorce the guarantor’s liability from that of the principal debtor and effectively deprive the guarantor of the rights which flowed from his position as such including (where available) his rights of subrogation.”

While adjudicating the principle of guarantor’s liability, the Australian High Court made reference to International Leasing Corp. Ltd v. Aiken [1967] 2 N.S.W.R. 427

“If the debt is assigned but the guarantee is not assigned then the right in the original creditor to recover under the guarantee must at least be suspended so long as the debt is assigned. There cannot be two persons entitled to recover the amount of the same debt, one from the principal debtor, and so long as the principal debtor was in default, another from the surety.

Let it be assumed otherwise and suppose that the original creditor, the assignor of the principal debt, could show that it was overdue and thereupon sued the surety. Let it be assumed that the surety paid. Then, the assignee sues the principal debtor. He must be entitled to succeed unless there are some special circumstances of estoppel in the particular case, a factor which I place to one side. The assignee under an absolute assignment could not be deprived of his right to recover from the debtor because the assignor had recovered from the surety.”

CONCLUDING REMARKS

A guarantee is a collateral obligation/contract (though independent⁶) by the guarantor to the creditor that if the debt owed to the creditor is not discharged/paid on time, the creditor shall be entitled to invoke the guarantee, as if the guarantor was the principal debtor. Principles of the guarantee are provided under Section 134, Indian Contract Act, 1872⁷. In accordance with the IBC, the CIRP concludes when the resolution plan is agreed upon by the Committee of Creditors and approved by the Adjudicating Authority. Once the CIRP is completed and the plan is accepted by the Authority in accordance with Section 31, IBC⁸, the Corporate Debtor’s debt is resolved. If the erstwhile creditor has already assigned his debt, the question of his status as a creditor does not arise and the debtor is no longer required to either discharge or make any payments of the debt to him as a creditor.⁹ In such circumstances, the erstwhile creditor who no longer holds the status of the creditor/lender, would have no right to demand any amount from the borrower or Corporate Debtor towards any debt due, as the debt (qua the Corporate Debtor) itself no longer exists on the books of the erstwhile creditor, they having assigned it.¹⁰ Furthermore, a Contract of Guarantee is a contingent contract¹¹ on:

• The existence of a debt, and
• The right to claim payment of such a debt on or behalf of the debtor being available to creditor.

In such scenario, the erstwhile creditor being no longer a creditor, cannot call upon a guarantor to make payments or discharge any liability in lieu of or as a principal debtor, for the reason that the debt itself has ceased to exist in relation to the guarantor and the erstwhile creditor. As noticed above, the law requires the presence of both a creditor and a debtor for the existence of a debt. Here, the erstwhile creditor no longer holds the status of a creditor, and therefore qua the erstwhile creditors there is no existence of a debt.

While determining the liability of a guarantor, the relevance of existence of the debt assumes great importance. Against the present factual backdrop, the creditor having assigned his debt to a third person no longer continues to be a creditor insofar as the debtor is concerned. Therefore, on meaningful reading of the Contract Act provisions relating to guarantee, the following can be culled out:

- A guarantee is a collateral or is contingent with the creditor's lending arrangement with the borrower/debtor.

- A creditor alone is entitled to invoke a guarantee on the guarantor on a default of the debtor to the creditor.

- The existence of a debt is necessary for a guarantee to be invoked and guarantee is contingent on existence of debt, unless the underlying contingency (i.e. existence of debt) is not satisfied, the guarantee cannot be invoked.

In additional to contingency, the principle of impossibility to perform also assumes importance while ascertaining the tenability of the invocation of guarantees. As affirmed by Supreme Court¹², the word “impossible” under Indian Contract Act¹³ is not merely literally impossible to attain, but also impractical and inconsistent with the intent and purpose of the parties. if the very substratum of the contract or foundation of the contract is materially affected by any event or change of circumstances beyond the reasonable control of the promisee or the promisor, then in such circumstances, the word “impossible” has been held not to be not just literally impossible but impracticable and not in consonance with the object and purpose that the parties had in view when they entered into their bargain.

The following legal fallacy that would ensue in case of an assignment of debt, if the guarantees are allowed to continue independently in the hands of the assignor:

- One debt would be converted to two debts. One in the hands of the assignee qua the Principal Debtor and other in the hands of the Assignee qua the guarantors.

- Nothing would prevent both the assignor and assignee from recovering the debt independent from each other. In such a case, it would lead to recovery of the same debt twice or from two people.

- This would also effectively lead to a divorce of the Guarantors rights from the Principal Debtor and unjust enrichment of Creditors.

In lieu of the aforementioned fallacy, the paradox needs to be addressed by the Code in a comprehensive manner to ensure that the creditor is not unjustly enriched. Furthermore, the loss of a guarantor’s right of subrogation under the Code is a significant issue that has yet to be addressed by the courts. Traditionally, guarantors have the right to recover amounts they pay on behalf of the principal debtor by stepping into the creditor's position. However, the Code denies this right, highlighting the “pro-creditor” focus of the insolvency system. This denial will discourage personal guarantors from offering guarantees, given the harsh treatment they receive under the Code.

Disclaimer: This article was first published in the S&A Law Offices - 'Indian Legal Impetus' newsletter in October 2024.