Surety’s Right of Subrogation Under the Insolvency and Bankruptcy Code

Speaking on the nature of ‘right of subrogation’, Lord Justice Sir Samuel Romilly in an elegant and beautiful passage said “a surety be entitled to every remedy, which the creditor has against the principal debtor; to enforce every security and all means of payment; to stand in the place of the creditor; not only through the medium of contract but even by means of securities, entered into without the knowledge of the surety, having a right to have those transferred to him; though there was no stipulation for that, and to avail himself of all those securities of the debtor. This right of a surety also stands not upon the contract but upon a principle of natural justice; the same principle, upon which one surety is entitled to contribution from another.”[1]

The Author wishes to start this essay with above passage ‘Principle of law of subrogation of Section 140 of the Contract Act, 1872’[2] with reference to insolvency law as found in Insolvency and Bankruptcy Code (Code).

Starting with Ramakrishnan[3], Respondent No. 1, as personal guarantor to the corporate debtor, came to the Supreme Court (SC) that ‘moratorium imposed under Section 14 of the Code on allowing insolvency process (known as ‘IP’) against Respondent No. 2, the corporate debtor (known as CD)[4] shall also apply to him leading to stay of insolvency proceedings against him and his property.’

It is interesting to observe that both Tribunals[5] came to opinion that “…………resolution plan approved and confirmed would bind the personal guarantor as well, ………………since ‘the guarantor stands in the shoes of the creditor (may claim on right to subrogation) therefore, ‘the benefit of moratorium also applied to guarantors.”[6]

Declaring that ‘reliance on Section 31 of the Code[7] by the Respondents wasirrelevant, Lord Justices R. F. Nariman and Indu Malhotra said “this Sec. only states that once a Resolution Plan, as approved by the Committee of Creditors, takes effect, it shall be binding on the corporate debtor as well as the guarantor, otherwise, under Section 133 of the Indian Contract Act, 1872[8] (the Act), any change made to the debt owed by the corporate debtor, without the surety’s consent, would relieve the guarantor from payment. Section 31(1), in fact, makes it clear that the guarantor cannot escape payment as the Resolution Plan, which has been approved, may well include provisions as to payments to be made by such guarantor. Section 31 in fact does not help the Respondents because personal guarantor having to pay for debts due without any moratorium applying to save him.”

While setting aside Tribunals orders, Justices R.F. Nariman and Indu Malhotra did not find any necessity to further examine “the right to subrogation of surety’ when it was declared that ‘moratorium gives shelter to the corporate debtor until insolvency process results in success but has nothing to do with surety liability.”

As happened in Ramakrishna[9], Lalit Kumar Jain[10] too argued that “when the corporate debtor is discharged of liability, the guarantor too was discharge, on principle of co extensiveness”[11] therefore, allowing IP against them under Part III of the Code, through impugned notification[12], deprives their valuable substantive rights like, ‘right to subrogation’.

Following Ramakrishna and Another[13], Justices L. Nageswara Rao and S. Ravindra Bhat 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” after examining precedents.[14]

Justices L. Nageswara Rao and S. Ravindra Bhat declared that “exercise of power in issuing the impugned notification under Section 1(3) is therefore, not ultra vires, the notification is valid.”

Coming to the latest appeal, Gujarat Hydrocarbon and Power SEZ Limited, subsidiary of ACIL, was ‘corporate debtor,’ that received loan of Rs. 100 crores from SREI Infrastructure Finance Ltd., [15] Respondent No.1 and ‘financial creditor’.

M/s. Assam Company India Limited (ACIL), became ‘corporate guarantor’ for the full amount of the loan without any limitation.

First round of insolvency proceedings against ACIL came to end, when Appellant, BRS Ventures Investments Ltd., successful Resolution Applicant, paid Rs.38.87 crores to Respondent No. 1 in full and final settlement of the entire loan when admitted claim was Rs. 241.27 crores inclusive of Rs.100 crores loan.

Second round insolvency proceedings initiated by Respondent No. 1 against corporate debtor to recover the balance amount of loan, were challenged before the Supreme Court on reason on reason ‘nothing remains outstanding when full settlement of loan was completed in first round.’

In the above scenario,[16] that ‘on stepping into the shoes of ACIL,’ Appellant, not guarantor, claimed that ‘even a partial payment, though not full amount, paid to Respondent No. 1 was sufficient to trigger the principle of subrogation’ relying on Shib Charan Das[17] case.

Dealing with a situation ‘where a resolution plan for the principal borrower was approved in CIRP, and the principal borrower was discharged from the debt by operation of law through an involuntary process,’ Justices in most important observation held that ‘the contract between the creditor and the surety is independent, therefore, the approval of the resolution plan of the principal borrower will not amount to the discharge of the surety. The same principles will apply when the resolution plan is approved in CIRP of the surety, then in such a case, the surety gets a discharge from his liability under the guarantee by operation of law or by involuntary process. It will not amount to the discharge of the principal borrower.’

In view of above scenario, the Appellant, not the guarantor,submitted that ‘on stepping into the shoes of creditor, the right of subrogation can be claimed under sec. 140 of the Indian Contract Act, 1872 against the corporate debtor.’

Justices Abhay S. Oka and Pankaj Mithal observed that ‘if the surety pays only a part of the amount payable to the creditor, the equitable right the surety gets under Sec. 140 will be confined to the debt he cleared’ on examining the words in Sec. 140 ‘upon payment or performance of all that he is liable for, " specifically 'all that he is liable' on universally accepted principle that ‘the principal borrower must continuously indemnify the surety’ as the foundation for right of subrogation. However, If the surety pays the entire amount under guarantee to the creditor, then he gets the rights of the creditor to recover from the principal debtor the amount which was paid as per the guarantee.’[18]

But in the present case, Justices clearly said that ‘even if Section 140 is attracted, it will confer on ‘the guarantor or the appellant’ the right to recover the amount mentioned above from the corporate debtor. Notwithstanding the subrogation to the extent of the amount paid on behalf of the corporate guarantor by the resolution applicant ……..’

Justices B. N. Kirpal, D. P. Mohapatra and  Ruma Pal in an interesting opinion said in Punjab National Bank, Appellant-Creditor that ‘the right of the appellant to recover money from Respondents Nos. 1, 2 and 3 who stood guarantors arises out of the terms of the deeds of guarantee’ which are not in any way superseded or brought to a naught merely because ‘the Appellant may not be able to recover money from Res No.4, textiles company and principal-borrower,’ where ‘the liability of the principal-borrower does not come to an end. It is only the mode of recovery which is referred to in the said Act. Taken over by UP Govt. under UP Ind. (Dev. & Reg.) Act. Even as a result of the then the liability of the principal-borrower does not come to an end. It is only the mode of recovery which is referred to in the said Act.’[19]

Former Justices Ashok Bhushan, M. Satyanarayana Murthy and Mr. Barun Mitra[20] comprising the Principal Bench of the NCLAT,firmly held in the case of K.V. Jayaprakash [21] in important ruling that ‘the appellant being a Personal Guarantor entitled to recover the amount under Section 140 ofthe Indian Contract Act, as if he is a creditor, on discharge of part of the loan payable by the Corporate Debtor but not a 'Secured Creditor' under Section 3(30) of the Code since ‘no security interest was created in favour of the creditor.’[22]

Comments of the Author

Author finds it very difficult to come to opinion ‘whether BRS[23] settled the surety’s right to claim subrogation’ not settled in Ramakrishna[24] nor in Lalit Kumar[25] or was it to be said that it was merely ‘obiter’ since the issue was not canvassed, nor insisted upon in the appeal.’[26]

On the other hand, the Supreme Court appears to have settled the issue on reading all relevant paragraphs.

Coming to practical scenario in BRS[27], since nothing was recovered from corporate guarantor, being insolvent, right to subrogation was ruled out.[28]

‘No payment, no right to subrogation’ was settled principle of law of guarantees.

The Author was of opinion that Punjab National Bank and Others appeals show that ‘right of subrogation was not completely ruled out’ since the guarantors gave unconditional guarantees for the loans.

Guarantor, after payment, can prove his claim as ordinary creditor in subsequent insolvency process initiated against corporate debtor appears to as pragmatic solution in view of K.V. Prakash[29].

The corporate guarantor, in alternative, ‘can restrict his liability to avoid coextensive principle,’ but banks and other financial institutions may not come forward to provide huge loans to corporate debtors in practical circumstances.

Notwithstanding anything in the existing law, the corporate debtor shall indemnify the guarantor as part of law of guarantees. |||

References:

[1]. Craythorne v. Swinburne, (1807) 14 Ves 160.

[2]. ‘Rights of surety on payment or performance’.

[3]. State Bank of India v. V. Ramakrishnan, REEDLAW 2018 SC 08560 : (2018) 9 SCALE 597 : AIR 2018 SC 3876.

[4]. CD itself filed the application under Sec. 10 of Code.

[5]. Known as NCLT and NCLAT.

[6]. The Appellate Tribunal in addition relied upon Sec. 60(2) and (3) of the Code.

[7]. Approval of resolution plan.

[8]. ‘Discharge of surety by variance in terms of contract’.

[9]. State Bank of India v. Ramakrishnan and Another, REEDLAW 2018 SC 08560.

[10]. Lalit Kumar Jain v. Union of India and Others, REEDLAW 2021 SC 05510 : AIR ONLINE 2021 SC 402, provided ‘personal guarantees’ for banks and other financial institutions for the loans given to the corporate debtors, in their status as ‘directors, promoters or chairman or managing directors of companies’, they are now hauled up in IP the guarantees.

[11]. Can discharge of corporate debtor from liability on the loan, through operation of law, like insolvency proceedings’ also discharges guarantors was the issue.

[12]. The legislature competency in bringing some legislative changes to the Code in 2018 was mainly challenged.

[13]. State Bank of India v. Ramakrishnan and Another, REEDLAW 2018 SC 08560.

[14]. Maharashtra State Electricity Board v. Official Liquidator, High Court, 1982 AIR 1497, 1983 SCR (1) 561; Punjab National Bank Limited. v. Bikram Cotton Mills & Another, AIR 1970 SC 1973; Punjab National Bank v. State of U.P. and Others, (2002) 112 COMPCAS 150 (SC) : (2002) 5 SCC 80 : AIRONLINE 2001 SC 238, discharge of debtors thorough operation of law in multiple contexts was the issue in these appeals.

[15]. BRS Ventures Investments Limited v. SREI Infrastructure Finance Limited and Another, REEDLAW 2024 SC 07589.

[16]. Whether single or separate proceedings can be allowed under the Code happened to be the second issue.

[17]. In Shib Charan Das v. Muqaddam, 1936 Allahabad 62, it was declared that ‘all that is necessary to confer the right of subrogation was that mortgage should have been redeemed in full’ but ‘it was not necessary that the entire amount due on the basis of the mortgage should be paid if the mortgagee agrees to let the mortgage be redeemed on payment of a smaller amount.’ Justice also observed that mortgagor accepted the decree amount without any dissent’ an important factor unlike in BRS where creditor did not consent, but was bound by law.’ This appeal Dismissed. In contrary decision in Darbari Lal and Another v. Mahbub Ali Mian and Others, AIR 1927 All 538A, it was conceded that‘Rani Barkatunnissa, surety, did not pay the whole of the indebtedness that existed between the creditor and the principal debtor, but a part only,’ therefore, ‘she was nothing more than a creditor having a claim upon the principal debtor without benefit of Section 140 of Act. She acquired none of the rights of either Lalta Prasad or Darbari Lal, the plaintiff's-creditors and mortgagees, under any of the documents in question. Therefore, the plaintiff's rights acquired by them under the mortgage of the 26th of January 1913, took, in our opinion, priority over the claims of Rani Barkatunnissa.’ The appeal succeeds.

[18]. In Amit Lal Goverdhan v. State Bank of Travancore & Ors, (AIR 1968 SC 1432)  quoting Sir Samuel Romilly, Justices V. Ramaswami & J. C. Shah said that the words ‘is invested with all the rights which the creditor had against the principal debtor’ in Sec. 140 of the Indian Contract Act, 1872 makes it plain that ‘even without the necessity of a transfer, the law vests those rights in the surety,’ where, to quote again from Sec. 140, ‘the surety, upon payment or performance of all that he is liable for is invested with all the rights which the creditor had against the principal debtor.’

[19]. ‘Unconditional guarantees, where the surety has absolute liability’ were involved in Punjab National Bank and Others appeals, it was also observed that the Act deals ‘………………………………., with no provision which in any way affects the liability of a guarantor who is bound by the deed of guarantee executed by it.’

[20]. Former Justices of SC, of AP HC and Member.

[21]. K.V. Jayaprakash v. State Bank of India and Another, REEDLAW 2022 NCLAT Del 09663.

[22]. In reply to the questions (4) Whether the provisions of IBC override the provisions of Indian Contract Act, more particularly, Sec 140 of Contract Act? ‘Yes’ the answer. If not, whether the appellant is entitled to include himself as secured creditor in the list of creditors prepared under Sec. 36 of IBC by respondent No.2 so as to recover the amount, he paid to the corporate debtor due to non-payment of debt due to respondent No.1 by the corporate debtor? ‘No’ the Answer.

[23]. BRS Ventures Investments Limited v. SREI Infrastructure Finance Limited and Another, REEDLAW 2024 SC 07589.

[24]. State Bank of India V. Ramakrishnan, REEDLAW 2018 SC 08560.

[25]. Lalit Kumar Jain v. Union of India and Others, REEDLAW 2021 SC 05510.

[26]. Can we have any contrary opinion? But abandoned the argument, on recognizing, perhaps, that if surety was given the right, the assets of corporate debtor, against whom recovery can be taken up later, may be depleted to the detriment of Appellant interests.

[27]. BRS Ventures Investments Limited v. SREI Infrastructure Finance Limited and Another, REEDLAW 2024 SC 07589.

[28]. Under the Scheme of Code, under all circumstances, the successful applicant taking over corporate debtors has nothing to do with debts on clean slate basis.

[29]. K.V. Jayaprakash v. State Bank of India and Another, REEDLAW 2022 NCLAT Del 09663.