Contract of Guarantee

Introduction

It is common knowledge that there is risk associated with entering into a debtor-creditor relationship. This is especially true for the creditor who has to bear the risk of bad debt accruing to it due to default in payment of the loaned amount by the debtor. A contract of guarantee can prove gainful in remedying this situation by protecting the interest of the creditor. A contract of guarantee is essentially a secondary contract whose existence is predicated on the existence of primary contract betwixt the principal creditor and debtor.

Under the Indian Contracts Act, 1872

The Contract of guarantee is governed pursuant to Chapter VIII of the Indian Contracts Act, 1872 (hereinafter referred to as “Act”). The principal purpose of a contract of guarantee being to act as a sentinel with a view to safeguard the interest of the creditor against default of payment by the principal debtor.

Section 126 of the Act lays down the essentials of a contract of guarantee –

“‘Contract of guarantee’, ‘surety’, ‘principal debtor’ and ‘creditor’—A ‘contract of guarantee’ is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’. A guarantee may be either oral or written. — A ‘contract of guarantee’ is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’. A guarantee may be either oral or written.”

Thereby, in the absence of four essentials –

  1. The existence of the Contract itself;
  2. A Suretyship/Guarantorship;
  3. A Principal Debtor;
  4. A Creditor.

The contract would be termed as a simple contract.

The contract of guarantee under IBC in comparison to the Act

The Insolvency & Bankruptcy Code, 2016 (hereinafter “the Code”) is an enactment that governs both corporations as well as natural persons. The Code prescribes a resolution process that is time barred. Pursuant to the Code on occurrence of a default in repayment on part of the debtor, the assets of the debtor are controlled by the creditors and a decision has to settle the insolvency has to be made by them within a one-hundred-and-eighty-day time limit.      

Furthermore, debtors are afforded safeguard against resolution claims by creditors within the aforementioned time limit under this Code. This safeguard has been provided under the Code in order to ensure that the resolution process is not hindered by interruptions and is executed smoothly.  Another major feature of the present Code is that it has consolidated provisions under the prevalent legal framework so as to set up a common forum to tackle insolvency amongst all categories of debtors and creditors. Section 128 of the Act states that –

“Surety’s liability.—The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract. —The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract.”   

Thereby, from the above provision of the Act it can be concluded that, provided it is explicitly mentioned otherwise, liability that is accrued to the ‘surety’ or ‘guarantor’ is co-extensive with that of the principal debtor.

In the case of Alpha & Omega Diagnostics (India) Ltd. v. Asset Reconstruction Company of India Ltd. & Ors, the High Court of Bombay putting emphasis on the issue of whether the creditor shall be entitled to sell off the assets of the personal guarantor.  The Court while assessing the implication of the word “it” under Section 14 of the Code, 2016, the Court held that the moratorium is not available to the personal guarantors of the concerned debtors.

Section 14 sub-section (1) clause (c) of the Code categorically prescribes that –

“(1) Subject to provisions of sub-sections (2) and (3), on the insolvency commencement date, the Adjudicating Authority shall by order declare moratorium for prohibiting all of the following, namely […] (c) any action to foreclose, recover or enforce any security interest created by the corporate debtor in respect of its property including any action under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (54 of 2002); […]”

In accordance with Section 126 of the Act, liability accrues to the guarantor only in the event of a default on the part of the principal debtor in repayment of the loaned sum. The Code provides for a very similar relief pursuant to its provisions. Thereunder, the creditor is obligated to establish that there was a default in repayment. Once established that the creditor has not received payment from the debtor, the National Company Law Tribunal (hereinafter NCLT) has been authorized under Section 7 of the Code to initiate Corporate Insolvency Resolution Process (hereinafter CIRP) against the debtor –

“(1) A financial creditor either by itself or jointly with 1[other financial creditors, or any other person on behalf of the financial creditor, as may be notified by the Central Government,] may file an application for initiating corporate insolvency resolution process against a corporate debtor before the Adjudicating Authority when a default has occurred […]”

An important point of difference betwixt the provisions of the Act and the provisions of the Code is that under the former, emphasis is placed on the breaking of a promise, while the latter places emphasis on the existence of a default.  

Furthermore, the Code also provides the creditor with the avenue pursuant to Section 60 sub-section (2) of the Code, while CIRP is pending before the NCLT, an insolvency claim can be initiated by the creditor against the concerned personal guarantor before the NCLT –

“(2) Without prejudice to sub-section (1) and notwithstanding anything to the contrary contained in this Code, where a corporate insolvency resolution process or liquidation proceeding of a corporate debtor is pending before a National Company Law Tribunal, an application relating to the insolvency resolution or [liquidation or bankruptcy of a corporate guarantor or personal guarantor, as the case may be, of such corporate debtor] shall be filed before such National Company Law Tribunal.”

In Sanjeev Shreya v. LML Industries, the Court held that when CIRP is pending against the corporate debtor before the NCLT, an insolvency or bankruptcy claim can further be initiated against the personal guarantor of the said corporate debtor.  

Conclusion

While the contract of guarantee is principally governed by the Indian Contract Act, 1872, the Insolvency and Bankruptcy Code, 2016, has brought about a revolutionary change in this domain. The present article has covered how each act governs the contracts of guarantee and protects the interests of all parties to a contract of guarantee. Further, this article also covered the judicial treatment of contract of guarantee in light of both enactments.

Sources:

  1. The Indian Contract Act, 1872, No. 09, Acts of Imperial Legislative Council, 1872.
  2. The Insolvency and Bankruptcy Code, 2016, No. 31, Acts of Indian Parliament, 2016.  
  3. Alpha & Omega Diagnostics (India) Ltd. v. Asset Reconstruction Company of India Ltd. & Ors, Company Appeal (AT) (Insol.) No. 116 of 2017.
  4. Sanjeev Shreya v. LML Industries, Writ – C No. – 30285 of 2017
  5. Sankeit Taneja, Contract guarantee under IBC, IPleaders (Mar. 11, 2022, 3:34 PM), https://blog.ipleaders.in/contract-guarantee-ibc/#Contract_guarantee_under_Indian_Contract_Act_1872
  6. Abhay, Law of Guarantee and its scope under I.B.C, Manupatra (Apr. 19, 2021), https://articles.manupatra.com/article-details/Law-of-Guarantee-and-its-scope-under-IBC

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