An Analysis of the Legal Requirement of a Clear and Enforceable Undertaking: Key Ruling of the Supreme Court in UV Asset Reconstruction Co. Ltd. v. Electrosteel Castings Ltd.

Unlike ordinary contracts, consideration in a guarantee may flow to the principal debtor rather than the surety. However, the most crucial element remains the unequivocal undertaking.

A contract of guarantee is an indispensable instrument in modern commercial law, ensuring credit flow and financial stability. Defined under Section 126, Contract Act, 1872 (the Act), it involves three parties: the creditor, the principal debtor, and the surety. The essence of such a contract lies in the promise to perform or discharge the liability of a third person in case of default.

While the statutory definition appears straightforward, complexities arise in determining what constitutes a valid and enforceable “promise” or “undertaking”. These complexities are magnified under the Insolvency and Bankruptcy Code, 2016 (IBC), where creditors increasingly invoke guarantees to initiate insolvency proceedings against personal guarantors.

This paper seeks to answer:

1. What are the doctrinal essentials of a valid contract of guarantee?

2. How is the requirement of “promise to pay” judicially interpreted?

This paper undertakes a doctrinal analysis of the essential elements of a valid contract of guarantee under the Contract Act, with special emphasis on the requirement of a clear promise or undertaking.

Doctrinal foundations of contract of guarantee

Under Section 126, Contract Act, a contract of guarantee requires:

1. Existence of a principal debt

2. Consideration

3. A clear undertaking by the surety

Unlike ordinary contracts, consideration in a guarantee may flow to the principal debtor rather than the surety. However, the most crucial element remains the unequivocal undertaking. A guarantee must not be vague or contingent upon uncertain conditions. The courts have consistently held that intention to guarantee must be clearly expressed or necessarily implied.

Further, the distinction between guarantee and indemnity is critical. While indemnity involves primary liability, a guarantee involves secondary liability contingent upon default.

Interpreting the terms and content of a guarantee deed: A judicial approach to determining scope and liability

Supreme Court

UV Asset Reconstruction Co. Ltd. v. Electrosteel Castings Ltd.¹

Issue which arose: Whether the deed of undertaking executed by the promoters could be construed as a contract of guarantee so as to render a promoter a “corporate guarantor” under the IBC? The controversy lies in determining whether an undertaking clause constitutes a contract of guarantee within the meaning of Section 126, Contract Act thereby rendering the promoter as a guarantor to the creditor in respect of financial facilities availed by the borrower from the creditor?

Brief of the case

Electrosteel Steels Limited (ESL), the principal borrower, availed financial assistance of Rs 500 crores from SREI Infrastructure Finance Limited (SREI) pursuant to a sanction letter dated 26 July 2011. The sanction letter specifically identified the security package for the facility, which consisted of a demand promissory note and post-dated cheques. Notably, the sanction letter did not stipulate any requirement for a personal or corporate guarantee from Electrosteel Castings Limited (ECL), the promoter of ESL.

However, considering that ECL was the promoter entity, SREI required ECL to furnish an undertaking to arrange for the infusion of funds into ESL, so as to ensure compliance with stipulated financial covenants. In furtherance thereof, ECL executed a deed of undertaking, warranty and indemnity. Clause 2.2 of this deed obligated ECL to arrange infusion of funds into ESL in the event ESL was unable to comply with its financial covenants.

Subsequently, ESL, ECL and SREI entered into supplementary agreements modifying certain aspects of the facility and security structure. Importantly, none of these documents expressly recorded that ECL had undertaken to discharge ESL’s debt in the event of default.

Analysis of the Supreme Court

The Supreme Court held that Clause 2.2 of the deed of undertaking does not constitute a contract of guarantee and that ECL cannot be treated as a guarantor for the financial facilities availed by ESL.

The essential ingredients of a guarantee, therefore, are: 1) existence of principal debt, 2) default by the principal debtor, and 3) a promise by the surety to discharge the liability of the principal debtor upon such default. Thus, a guarantee is a promise to answer for the payment of some debt, or the performance of some duty, in case of failure of another party, who is in the first instance, liable to such payment or performance. A guarantee is a security in the form of right of action against a third party.

For an obligation to be construed as a guarantee under Section 126 of the Act, there must be a direct and unambiguous obligation of the surety to discharge the obligation of the principal debtor to the creditor. The clause neither records an undertaking to discharge the debt owed to the creditor nor does it contemplate payment to the lender in the event of the default.

The clause contains a promise, not to the creditor to pay the debt upon default, but to the borrower to facilitate compliance with financial covenants. An undertaking to infuse funds into a borrower so that it may meet its obligations cannot, by itself, be equated with the promise to discharge the borrower’s liability to the creditor. A mere covenant to ensure financial discipline or infusion of funds does not satisfy the statutory requirements of Section 126 of the Act.

The court undertook a detailed examination of the essential ingredients of a guarantee and reiterated that:

1. there must be an existing principal debt,

2. there must be a default by the principal debtor, and

3. there must be a promise by the surety to discharge the liability of the principal debtor upon such default.

The Supreme Court in Canara Bank Overseas Branch v. Archean Industries (P) Ltd.² has reiterated the fact that to constitute a valid guarantee, the requirement is an undertaking or promise to make a payment to the creditor upon the default of the principal debtor for a benefit received by the principal debtor.

NCLAT

In Subrata Sardar v. Central Bank of India³, the National Company Law Appellate Tribunal (NCLAT) held that merely because the appellant has chosen to describe its coextensive liability arising under the deed of guarantee as a contingent liability in its balance sheets may not have any legal consequence of a coextensive liability into a contingent liability.

In Mavjibhai Nagarbhai Patel v. SBI⁴, it was held that if a guarantee is in the nature of an on-demand guarantee, the default is to arise only when a demand notice is issued as contemplated in the deed of guarantee.

Further, in S. Elangovan Promoter and Erstwhile Managing Director of Kaveri Gas Power (P) Ltd. v. ASREC (India) Ltd.⁵, the NCLAT held that the term guarantee is a continuous one and therefore, the “right to sue accrues” when the guarantee agreement was invoked and the date when the corporate debtor had failed to discharge its obligation, in terms of guarantee.

In Rajkumar Nandlal Dhoot v. SBI⁶, NCLAT held that where the deed of guarantee provides for payment by the guarantor on demand, the cause of action against the guarantor arises when the demand notice is issued and the guarantee is invoked. Reliance was placed on the Supreme Court judgment in Syndicate Bank v. Channaveerappa Beleri⁷ reiterate the same propositions:

24. The scheme of I&B Code clearly indicate that both the principal borrower and the guarantor become liable to pay the amount when the default is committed by the principal borrower the amount becomes due not only against the principal Borrower but also against the corporate guarantor, which is the scheme of the I&B Code. When we read with as is delineated by Section 3(11) of the Code, debt becomes due both on principal borrower and the guarantor, as noted above. The definition of default under Section 3(12) in addition to expression “due” occurring in Section 3(11) uses two additional expressions, i.e. “payable” and “is not paid by the debtor or corporate debtor”. The expression “is not paid by the debtor” has to be given some meaning. As laid down by the Supreme Court in “Syndicate Bank v. Channaveerappa Beleri”, a guarantor’s liability depends on terms of his contract. There can be default by the principal Borrower and the Guarantor on the same date or date of default for both may be different depending on the terms of contract of guarantee. It is well-settled that the loan agreement with the principal borrower and the Bank as well as deed of guarantee between the Bank and the guarantor are two different transactions and the guarantor’s liability has to be read from the deed of guarantee.

NCLT-Hyderabad

In Bank of Baroda v. Katmula Srinivasa Reddy⁸, the judgment unequivocally clarifies that although the liability of a personal guarantor is coextensive with that of the principal borrower, such coextensiveness operates subject to the terms of the contract of guarantee. The guarantor’s liability is not automatic in all circumstances, rather, it is governed strictly by the stipulations contained in the deed of guarantee.

Where the deed expressly provides that the liability of the guarantor shall arise “on demand”, such a clause constitutes a condition precedent to the enforcement of the guarantee. The contract further prescribing the specific mode and manner in which such demand is to be issued and served makes compliance with those requirements mandatory. The guarantor’s liability crystallises only upon issuance and service of a valid demand strictly in accordance with the contractual terms.

The judgment further clarifies that mere issuance of a notice under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act) to the principal borrower, with a copy merely marked to the personal guarantor, does not amount to valid invocation of the personal guarantee. Such an act does not satisfy the contractual pre-conditions stipulated in the deed of guarantee.

Proper invocation necessarily entails a distinct and specific demand addressed to the guarantor, served in the manner contemplated under the deed. In the absence of such proper invocation, the liability of the personal guarantor cannot be said to have arisen in law.

Author’s view

Mere furnishing of a personal or corporate guarantee for the purpose of availing a loan does not, by itself, render the guarantor immediately liable upon default by the principal borrower. Though according to Section 128, Contract Act, 1872, liability of surety is coextensive is that of principal borrower, liability does not arise automatically upon default. The enforcement of a guarantee is contingent upon its proper invocation in accordance with the specific terms and conditions stipulated in the “deed of guarantee”.

As the Supreme court in its landmark judgment UV Asset Reconstruction Co. Ltd.⁹ has clarified that for an obligation to be construed as a guarantee under Section 126 of the Act, there must be a direct and unambiguous obligation of the surety to discharge the obligation of the principal debtor to the creditor. There must be a promise by the surety to discharge the liability of the principal debtor upon such default.