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Financial Bank Guarantees And Moratorium Under IBC,2016

Manu Ayilyath
16 Aug 2020 8:03 AM GMT
Financial Bank Guarantees And Moratorium Under IBC,2016

The legal framework for rehabilitation of the sick industries and the corporate insolvency mechanism has witnessed enormous reformations with the advent of the Insolvency and Bankruptcy Code in 2016. The Code brought in a much more robust mechanism with strict time frames into the resolution process giving a much needed transparency and efficiency to the system. Unlike the SICA regime...

The legal framework for rehabilitation of the sick industries and the corporate insolvency mechanism has witnessed enormous reformations with the advent of the Insolvency and Bankruptcy Code in 2016. The Code brought in a much more robust mechanism with strict time frames into the resolution process giving a much needed transparency and efficiency to the system. Unlike the SICA regime the IBC mechanism completely removed the controlling powers of the Companies under the resolution process from its Board of Directors and transferred the same to a Resolution Professional to ensure a sincere transition and revival process. Unlike the never ending moratorium under the earlier regime, the Code also brought in a much more realistic framework with a definite time frame.

Similar to the Section 22 of the SICA, the Section 14 of the IBC restrains the creditors of a Company under the Corporate Insolvency Resolution Process (CIRP) from initiating any steps for recovery of a security interest created by the Corporate Debtor while the moratorium is in force. The scope of this Moratorium has been a debatable issue from its inception. Some of these debates had germinated from the actions of the Financial Creditors in their attempt to set off the monies of the Corporate Debtor already lying with them as deposits and some had arisen from the attempts to enforce the bank guarantees issued on behalf of the corporate debtor. The question as to whether it is permissible for the lenders to proceed against the assets of the sureties to the debts of the corporate debtor has been put to rest with the incorporation of Sub Section 3(b) to Section 14 under the 2018 Amendment Act. However questions continue to arise before the courts as to the enforceability of the Bank Guarantees when the moratorium is in force.

Before exploring the judicial pronouncements in this regard, it is necessary to understand the language of Section 14 of the Code. By virtue of Sub Section 1(c) of the Section 14, the Code prohibits 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. For a better understanding it is necessary to look into the fact as to how the Code has proceeded to define the term "security interest". Section 3(31) of the Code defines Security Interest as follows:

"security interest" means right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person:

Provided that security interest shall not include a performance guarantee;

Rather than the main clause of the definition, it is the proviso to this Section which is more relevant to our queries. A conjoint reading of this proviso along with the Section 14, carves out an exception for the performance guarantees from the general prohibition imposed under the moratorium. The NCLAT has, in its decision in GAIL (India) Ltd v Rajeev Mannadiar & Ors[1], held that the prohibition under Section 14 (1) (c) shall not include the enforcement of a Performance Bank Guarantee.

The Ahmedabad Bench of NCLT had earlier proceeded to differentiate between the "Performance Bank Guarantees" and "the Bank Guarantees which are of the nature other than that of a Performance Bank Guarantees" while addressing the question of applicability of moratorium on enforcement of Bank Guarantees. In the matter of Nitin H Parikh v Madhya Gujarat Vij Company Ltd[2] it had held that even though the moratorium passed by an Adjudicating Authority is not applicable for the Performance Bank Guarantees, the same shall be applicable to the Bank Guarantees other than those which shall come within the meaning of performance bank guarantees.

Since the Code does not provide any definition for Performance Guarantee or performance bank Guarantee for that matter, we may have to resort to external sources to provide a clarity as to the difference between a Performance Bank Guarantee and non performance Bank Guarantee. In general banking parlance the Bank Guarantees can be broadly classified into Performance Bank Guarantees and Financial Bank Guarantees. RBI has in one of its Circulars[3] differentiated between these two categories of Guarantees. In terms of this Circular, Financial Guarantees are direct credit substitutes wherein a Bank irrevocably undertakes to guarantee the repayment of a contractual obligation. Performance guarantees have been described as essentially transaction-related contingencies that involve an irrevocable undertaking to pay a third party in the event the counterparty fails to fulfil or perform a contractual non-financial obligation.

However it may be an injustice to interpret the Code solely based on a classification made for a financial understanding. Both Performance Bank Guarantees and Financial Bank Guarantees, irrespective of the underlying differences related to their end use or purpose, are essentially contracts of guarantee. The Indian Contract Act defines a 'contract of guarantee' as a contract to perform the promise or discharge the liability, of a third person in case of his default. Taking cue from this definition a financial guarantee is involving an agreement by the Surety to perform his promise to make good the financial loss incurred by the beneficiary from the default of the principal debtor to honour his financial obligations towards the beneficiary and hence is also a performance guarantee.

We will leave this point open at this juncture and shall proceed further on the two exceptions carved out for the prohibition imposed during the moratorium. As discussed earlier the Section 3 (31) creates an exception for the performance guarantees saving it from the prohibitions under the moratorium. The second exception for the moratorium is carved out under Sub Section 3(b) to Section 14 of the Code. This Sub Section provides that the prohibitions under Section 14 (1) shall not apply to a surety in a contract of guarantee to a corporate debtor. Now the question that arises in relation to our broader discussion here is that whether this exception also includes the Bank Guarantees under its ambit. The Principal Bench of NCLT in the matter of M/s Levcon Valves (P) Ltd v Energo Engineering Projects Ltd[4] had extended this exception to the Bank Guarantees also. However, with all the due respect towards the Tribunal, such an interpretation seems to be erroneous and is moving away from the intention of the legislature. Even though the earlier BLRC Reports were silent as to its intention to carve out an exception for performance guarantees under Section 3(31), the Report of the Insolvency Law Committee dated March 26, 2018[5] discusses in detail as to its intention to carve out the exception for proceedings against sureties during moratorium.

The Report proceeds to state as follows:

"the assets of the surety are separate from those of the corporate debtor, and proceedings against the corporate debtor may not be seriously impacted by the actions against assets of third parties like sureties……… since many guarantees for loans of corporates are given by its promoters in the form of personal guarantees, if there is a stay on actions against their assets during a CIRP, such promoters (who are also corporate applicants) may file frivolous applications to merely take advantage of the stay and guard their assets"

On a plain reading of the above extract from the Report, it is explicit that the intention of the Legislature was to include only the personal or corporate guarantees, provided either by the promoters or Group Companies of the Corporate debtor, as a security comfort to the lenders for the debts extended to the Corporate Debtor under the ambit of exception under Section 14(3)(b) and not the Bank Guarantees issued by the Lenders on behalf of the Corporate Debtor.

Reverting to the issue as to the scope of exception under Section 3(31), we may have to examine the same in light of the implications of bringing the enforcement of financial bank guarantees under the said exception. Under the above referred RBI Circular dated 02.04.2013, the Regulator has provided an indicative list of financial guarantees. As per this indicative list a financial guarantee may be extended by a Lender to another Lender as guarantee for extending fresh credit facilities or enhancement of the existing credit facilities to a borrower.

For instance on the request of a corporate Debtor 'X', Bank 'A' issues a financial guarantee to Bank 'B', against which Bank 'B' extends a credit facility to 'X'. In such a scenario both Bank 'A' and Bank 'B' shall be essentially the financial creditors of the Corporate Debtor 'X'. If it is presumed that the financial guarantees shall fall under the exception carved out by proviso to Section 3(31) then Bank 'B' will be able to enforce the financial guarantee issued by Bank 'A' and recover its loan extended to 'X' and thereby bypass the restriction otherwise imposed on it for recovery under Section 14.

It is thus evident that such an inclusive interpretation shall indeed dilute the intention of the Legislature under the Code to place the creditors of the same class under a uniform footing. If the exception under Section 3(31) is extended to the Financial Bank Guarantees, a creditor holding a financial guarantee as a security of its loan will be allowed to enjoy a differential treatment and take an undue advantage in comparison to other financial creditors as to the recovery of its due. Hence it is safe to conclude that the decision of Ahmedabad Bench of the NCLT in the matter of Nitin H Parikh[6], is completely in consonance with the legislative intention when it had differentiated between the performance Bank Guarantees and Non Performance Bank guarantees while determining the enforceability of the Bank Guarantees during the moratorium period.

Views are personal only.

[1] CA(AT) Insolvency No 319/2018

[2] IA 340/2017 in C.P. (I.B) No. 28/10/NCLT/AHM/2017 dated 09.02.2018

[3] See RBI Circular on New Capital Adequacy Framework- Non-market related Off Balance Sheet Items- Bank Guarantees (RBI/2012-13/467vDBOD.No.BP.BC. dated 02.04.2013) <>

[4] CA No 453(PB)/2017 in CP No (IB)-160(ND)/2017

[5] <>

[6] Supra Note 2

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