S.126 Indian Contract Act | Promoter's Undertaking To Infuse Funds Won't Amount To 'Guarantee' : Supreme Court

The Supreme Court has held that a contractual clause obligating a promoter to arrange infusion of funds into a borrower to meet financial covenants does not amount to a contract of guarantee under Section 126 of the Indian Contract Act, 1872. At the same time, the Court clarified that approval of a resolution plan under the Insolvency and Bankruptcy Code, 2016 does not automatically extinguish unsustainable debt against third-party security providers unless the plan expressly provides so.Interpreting Section 126 of the Indian Contract Act, the Court held that for an obligation to be construed as a guarantee, there must be a direct and unambiguous obligation of the surety to discharge the obligation of the principal debtor to the creditor.“A 'See to it' guarantee in English Common Law refers to an obligation upon the guarantor to ensure that principal debtor itself, performs its own obligation and the guarantor, therefore, is in breach as soon as principal debtor fails to perform. However, a 'See to it' guarantee does not include an obligation to enable the principal debtor to perform its own obligation. Such an arrangement would not be a guarantee under Section 126 of the Act”, a bench of Justices Sanjay Kumar and Alok Aradhe observed. Factual background Electrosteel Limited (ESL) availed financial assistance of Rs. 500 crores from SREI Infrastructure Finance Limited (SREI), vide sanction letter dated 26.07.2011. Electrosteel Castings Limited (ECL), being its promoter, was required to furnish an undertaking to arrange for the infusion of funds to enable ESL to comply with financial covenants. When SREI and ESL executed a Loan Agreement, there was a clause therein to that effect. ECL also executed a Deed of Undertaking dated 27.07.2011, undertaking a limited obligation to arrange for infusion of funds into ESL.In 2017-18, ESL underwent corporate insolvency resolution process. A resolution plan was approved and implemented. SREI issued an unconditional 'no due certificate' to ESL. However, it subsequently claimed that it had been allotted reduced amount of equity shares upon conversion of balance debt. Later, it assigned its rights on the alleged residual debt in favour of UV Asset Reconstruction Company Limited (appellant).Proceedings before NCLT and NCLATClaiming residual debt, the appellant then approached NCLT, Cuttack with a petition under Section 7 of IBC. The same was dismissed on two grounds: (i) ECL was not a guarantor in respect of financial facilities availed by ESL and, therefore no financial debt was owed by ECL, and (ii) the conversion of ESL's debt into equity under resolution plan resulted in extinguishment of any liability of ECL. In appeal, the NCLAT held that ECL was not a guarantor for financial facilities availed by ECL. However, it also said that approval of the resolution plan extinguished debts only qua ESL, and not third-parties, unless it was specifically provided. The appeal was dismissed on the ground that ECL was not ESL's guarantor. Aggrieved by the findings, both parties approached the Supreme Court.Issues(i) Whether ECL was a guarantor for financial facilities availed by ESL and, therefore, financial debt was owed by ECL? (ii) Whether conversion of ESL's debt into equity under Resolution Plan resulted in extinguishment of any liability of ECL?Court ObservationsFrom the subject Clause in the Deed of Undertaking, the Supreme Court inferred that ECL was obligated to arrange for infusion of funds into ESL, so as to enable ESL to comply with the stipulated Financial Covenants. However, it was not obligated to “discharge" any debt owed by ESL. “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”, the Court said. It further added, “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 referred to other documents as well, including the sanction letter, to note that there was no “guarantee” furnished by ECL. Ultimately, it concurred with the findings of NCLT and NCLAT that Clause 2.2 of the Deed of Undertaking did not constitute a contract of guarantee and that ECL could not be treated as guarantor for the financial facilities availed by ESL.Accordingly, the appeal was dismissed. In a connected appeal filed by ECL, the Court observed that the Resolution Plan did not provide the financial creditors, including SREI, with the full value of unsustainable debt of ESL. It further held that the approval of the Resolution Plan of ESL did not result in...

S.126 Indian Contract Act | Promoter's Undertaking To Infuse Funds Won't Amount To 'Guarantee' : Supreme Court

Debby Jain

To be construed as a guarantee, there must be a clear and direct obligation to discharge the debts of the original debtor.

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