The right of subrogation is an equitable and natural right of the guarantor against the principal borrower on whose behalf he has paid the money.
Section 128 of the Indian Contract Act 1872 provides that the liability of the guarantor is co-extensive with the principal debtor. It means the guarantor of a loan is liable if the debtor fails to clear it. There is no such rule that the creditor should have first exhausted his remedy against the borrower before demanding money from the Guarantor to clear the dues of the borrower unless otherwise provided in the contract of guarantee. In the other words, the guarantor’s liability is not reduced or waived off simply because the creditor has not sued the principal debtor for recovering his dues. Further, the guarantor cannot escape paying the amount under the guarantee even if the liability of the borrower is discharged due to some statutory or legal provisions under which the creditor is not able to initiate legal action to recover the dues from the borrower.
RBI also vide its circular dated September 9, 2014, on Wilful defaulter clarified that when a payment default is made by the principal debtor, the bank is entitled to proceed against the guarantor/surety even without exhausting the remedies against the principal debtor. In case the said guarantor refuses to comply with the demand made by the creditor/bank, despite having sufficient means to make payment of the dues, such guarantor would also be treated as a ‘wilful defaulter’.
Guarantor’s right of subrogation:
The guarantor’s right to be placed in the creditor’s position on the discharge of the principal debtor’s obligation, to the extent that the guarantor’s property, has been used to satisfy the creditor’s claim and to effect such discharge, is called the guarantor’s “Right of Subrogation”. Section 140 and section 141 of the Indian Contracts Act, 1872 states the right of subrogation. It is the substitution of another person in place of the creditor so that the person substituted will succeed to all the rights of the creditor with reference to the debt.
Section 140 ICA provides that “Rights of surety on payment or performance, where a guaranteed debt has become due, or default of the principal debtor to perform a guaranteed duty has taken place, 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”. The creditor had the right to sue the principal debtor in the rights of the creditor. In the other words, Guarantor is entitled to stand in the shoes of the creditor and to enjoy all the rights that the creditor has against the principal debtor.
Section 141 of the Indian Contract Act, 1872 reads as under:
“A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not; and if the creditor loses, or, without the consent of the surety, parts with such security, the surety is discharged to the extent of the value of the security”.
Denial of the right of subrogation under IBC
The NCLAT discussed the issue of subrogation in the case of Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors, when the promoters, who were also the personal guarantors, sought to claim the right of subrogation under section 133 and 140 of the Contract Act. The NCLAT held that the resolution under IBC is not a recovery suit, and it was not the intention of the legislature to benefit the ‘Personal Guarantors’ by excluding the exercise of legal remedies available in law by the creditors, to recover legitimate dues by enforcing the personal guarantees, which are independent contracts.
From the above decision of the NCLT, we may observe that the guarantor is entitled to step into the shoes of the creditor and recover the amount, when the personal guarantors discharge their liability towards the creditor before the initiation of the Corporate Insolvency Resolution Process (“CIRP”) under Sections 7 and 9 of the IBC or 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, 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.
Although, the guarantor’s liability is co-extensive, in the following cases the guarantor stands discharged from his liabilities to the creditor.
- There have been subsequent variations to the contract of guarantee to which the guarantor was not privy to or had no knowledge of, the creditor, discharges surety as to transactions subsequent to the variance in original contract (section 133 of Contract act).
- The guarantor shall stand discharged from its liabilities under a contract of guarantee in case of any agreement arrived at between the creditor and the principal debtor, by which the principal debtor is released. (Section 134 of contract act).
- If without the consent of the surety, the creditor and debtor enter into a contract, whereby the creditor agrees to make composition/compromise with or gives time to or agrees not to sue the surety, in such a case, guarantor being the surety stands discharged by law to fulfill his obligations under the contract of guarantee unless the surety assents such contract.(section 135)
Guarantee obtained by concealment:
- Where the creditor either does something, which is inconsistent with the rights of the surety or omits to do his duty towards the surety(Guarantor) and because of this, the eventual remedy of the surety that he had against the principal debtor is impaired, the surety/guarantor is discharged from his liability towards the creditor.( Section 139 of the contract act).[ In the case of Jose Inacio Lourence vs Syndicate Bank and Another [1989 65 Comp Cas 698 Bom], the Hon’ble Bombay High Court held that “failure in not registering the charge is also an act which is inconsistent with the rights of surety within the meaning of Section 139, ICA and the eventual remedy which the surety may have against the principal debtor is impaired resulting in discharge of the surety.”]
- Where the guarantee was obtained by concealment is an invalid guarantee. Further, in case where a guarantee has been obtained by means of misrepresentation made by the creditor, or with his knowledge and consent, concerning a material part of the transaction, such a guarantee is invalid (Section 142 of contract Act)