Sampriti & Sugi Malati Murmu
Introduction and Background
With the decision of Lalit Kumar Jain v. Union of India, the Supreme Court has dealt a death blow to the personal guarantor’s right of subrogation arising after the approval of the resolution plan. The bench upheld the constitutional validity of the notification dated November 15, 2019, that brought into effect specific provisions of the Insolvency and Bankruptcy Code, 2016 (“IBC”) concerning personal guarantors of corporate debtors. In doing so, the Supreme Court reaffirmed the decision in SBI v. V. Ramakrishnan to hold that approval of a resolution plan in view of Section 31 of the IBC does not discharge the personal guarantor’s liability since the same was because of an involuntary act, i.e., by operation of law, liquidation or insolvency. However, since the issue was confined to the discharge of the liability, the Court did not directly look into the guarantor’s subrogation rights arising from Section 140 of the Indian Contract Act, 1972. In this article, the author shall aim to inspect the status of the subrogation rights of the personal guarantor through the help of judicial precedents and offer a comparative perspective from the U.S Bankruptcy Code.
Extinguishment of Subrogation Rights: A Comparative Analysis with the legal position in the United States
In Lalit Mishra and Others v. Sharon Bio Medicine Ltd., NCLAT had categorically held that “guarantors cannot exercise the right of subrogation conferred upon them in contract law, since proceedings under IBC are not recovery proceedings.” This was further confirmed by the Supreme Court in the case of Committee of Creditors of Essar Steel Ltd. vs Satish Kumar Gupta. Although the IBC does not entirely restrict personal guarantors from invoking their right of subrogation, the personal guarantor is left with no remedy once the resolution plan is approved. This article lays down three situations where personal guarantors have the right of subrogation, each to varying degrees.
Firstly, when the personal guarantor discharges its liability towards the creditor before the initiation of the Corporate Insolvency Resolution Process (“CIRP”) under Sections 7 and 9 of the IBC, in which case the guarantor is entitled to step into the shoes of the creditor and recover the amount. Similarly, in the second scenario, when the creditor recovers the amount from the personal guarantor after initiating CIRP but before the approval of the resolution plan, the right of subrogation continues to remain with the personal guarantor. However, in the final scenario, when the adjudicating authority approves the resolution plan under the IBC and the debt is yet to be discharged, the personal guarantor’s right of subrogation extinguishes.
In the case of Essar Steel Ltd., the Supreme Court, relying on Section 31 of the IBC, observed that the goal of the resolution process is to provide the resolution applicant with a fresh start, also known as the clean slate theory. Granting the personal guarantor the right to subrogation would be antithetical to this principle of a fresh start, as once the resolution plan is approved, subrogation will allow the guarantor to step into the shoes of the creditor and file his claims against the debtor as a creditor himself. The clean slate theory prohibits such a possibility as once the debts are discharged, the creditors cannot bring further claims against the debtor. It is also an unfathomable scenario to step in as it will leave the debtor back with debts, vitiating the whole purpose of the CIRP. Insertion of Section 32A in the IBC after the amendment in 2020 reemphasises the point of fencing the liabilities of the corporate debtor to what has been already approved once in the resolution plan, and thus cannot be liable for further claims.
However, the Bankruptcy Code of the United States makes no such distinction among pre and post-approval of the resolution plan, and rightly so. Such a distinction puts the guarantors in a no-win situation. Neither the liability of the guarantor is discharged post-approval of the resolution plan, nor does the right to recover the amount remain with the guarantor. Unlike Indian law, US Bankruptcy law explicitly provides for the subrogation right under Section 506 to Section 509. Further, in the case of In re Sensor Systems, Inc., the United States Bankruptcy Court dismissed the rationale behind such a distinction by observing that, “The only practical difference arising from a full prepetition payment,” the court noted, “is that the original secured creditor would no longer remain a creditor of the debtor at the time of filing.” Thus, the Court held, “Why this fact would or should be significant in determining subrogation rights of the co-obligor who makes the payment is totally unclear to us”. Further, it was also expressly stated in In re Bugos, by the Court of Appeals that “the equitable principle of subrogation applies to the satisfaction of debts by a co-debtor prior to bankruptcy as well as to the post-petition satisfaction of debts.” Where the only difference between co-debtor and guarantor is that the co-debtor is made liable every time a claim is raised, a guarantor is liable when the debtor defaults. There is no reason for not extending the principle of subrogation rights to the case of a personal guarantor where both the parties are ultimately discharging the liabilities of the corporate debtor.
Furthermore, Section 509 of the US Bankruptcy Code, is fairly mechanical in its application. The guarantor only has to establish that it is liable to the debtor on a claim made against the debtor by the creditor, and the guarantor has paid off that claim. Unlike the US, India does not have a statutory provision in the Code solely dedicated to the principle of subrogation. Rather, it is guided by Indian Contract Law. Section 238 of the IBC makes it abundantly clear that in cases of conflict between two laws that are in force, the provisions of the IBC would take precedence. However, this gives rise to many grey areas which the court is yet to clarify. If the guarantor discharges part of the debt prior to the approval of the resolution plan, can the creditor still have the right to invoke the guarantee for the rest of the debt post-approval of the plan?
Although the Court in the Lalit Kumar Jain judgement has rejected the argument of discharge of surety under Section 135 of the Indian Contract Act owing to composition between corporate debtor and creditor, it ignores the equitable principle of subrogation. On the question of whether the settlement of debts in the resolution plan between the corporate debtor and the creditor permits them to exterminate the rights of the personal guarantor, a third party who is not a party to the contract, the Court must not lose sight of the decision of the Supreme Court in Krishna Pillai Rajasekharan Nair (D) by Lrs. v. Padmanabha Pillai (D) by Lrs. and Ors., where the Supreme Court observed that:
“A subrogation rests upon the doctrine of equity and the principles of natural justice and not on the privity of contract. One of these principles is that a person, paying money which another is bound by law to pay, is entitled to be reimbursed by the other. This principle is enacted in Section 69 of the Contract Act, 1872. Another principle is found in equity: ‘he who seeks equity must do equity’.”
It is understandable why Indian Courts would hold the personal guarantors liable without granting him their right to subrogation, as it has been pointed out in the Lalit Mishra case that the object is to revive the company and focus on maximisation of value of its assets, and not to ensure that the credit is available to all stakeholders. However, while the rights of the creditors are important, they cannot come at the cost of the rights of personal guarantors. The Courts wrongly believe that in the vast majority of cases, the personal guarantees are given by the directors, who often promote the value of the company out of personal interest rather than in the interest of the companies. Thus, any attempt to avoid their liabilities must be negated.
Nevertheless, disregarding the rights of the personal guarantor will demotivate them to stand as guarantors in the future. This will eventually raise difficulties for companies to raise funds as it would dissuade potential creditors from lending loans, and thus, companies will exhibit slower monetary growth with lower capital injection. It is undeniably true that the growth of companies has a spiralling effect on the economy of the nation and the role of personal guarantors cannot be dismissed by placing the rights of the creditors on a higher pedestal.
Both Authors are students in their Second Year, pursuing their B.A. L.L.B (Hons.) at WBNUJS, Kolkata.