Is Invocation Of A Guarantee A Mandatory Precondition For Insolvency Proceedings Against A Personal Guarantor?

A. Introduction 

Indian corporate lending is dominated by personal guarantees particularly in cases where promoters and directors are obligated to guarantee the debts of corporate borrowers. This has changed the enforcement landscape with the introduction of personal guarantors to corporate debtors into the Part III of the Insolvency and Bankruptcy Code, 2016 (“IBC”) on 15 November 2019. In this backdrop, an important question has come to occupy the attention of the Ld. National Company Law Tribunal (“NCLT”)/ Hon’ble National Company Law Appellate Tribunal (“NCLAT"): does a creditor have a burden to enforce a contractual demand on a personal guarantor under Section 95 of the IBC? 

This article discusses that above mentioned question by providing a summary of the applicable statutory framework, authoritative rulings of the Hon’ble Supreme Court and the way in which default occurs in personal guarantees. It also brings forth the practical implications on creditors as well as guarantors. The discussion, which has been very succinctly summed up in the conclusions, shows that, by settled principles and judicial adjudication, it is ordinarily essential to invoke the guarantee in terms and in accordance with the terms of the guarantee, to obtain a finding of default on the part of the guarantor, unless the guarantee actually dispenses with the condition of demand. 

B. Legal Framework: Guarantees and “Default” Under the IBC 

Sections 126 to 128 of the Indian Contract Act, 1872 acknowledge a contract of guarantee as giving rise to a secondary and collateral obligation, and the liability of the surety is co extensive with the principal debtor except where there is an intention to the contrary expressed in the contract. In Bank of Bihar Ltd. v. Damodar Prasad, AIR 1969 SC 297 the Supreme Court has clarified that a creditor may directly proceed against the guarantor without necessarily trying to recover against the principal debtor. But that principle, although resolving the question of the liability of the guarantor, does not, in itself, fix the timeline at which the liability of the guarantor is due and payable; such a question is made up by the terms of the particular guarantee. 

Under the concept of guarantees, the liability would otherwise mature on demand in which case the guarantee would be issued as an on-demand instrument. On the contrary, in those cases in which the guarantee clearly states that it does not require demand or that it will automatically accelerate on default of the principal debtor, the terms of the deed will determine the time when the obligation of a guarantor crystallises.  

The Supreme Court in Lalit Kumar Jain v. Union of India, (2021) 9 SCC 321, upheld the 15.11.2019 notification bringing personal guarantors to corporate debtors within the NCLT’s jurisdiction and recognised personal guarantors as a distinct IBC category. Nothing in Lalit Kumar Jain (supra) alters the requirement that a guarantor’s debt must have matured in terms of the contract to constitute a “default.” 

C. Invocation as the Trigger for “Default” 

As a general rule, the time when a personal guarantor becomes liable and payable is at the time of invocation of the guarantee. In the case where a guarantee is in the form of a demand obligation, the creditor must issue a clear and contractually binding demand to the guarantor; only when the guarantor fails to comply with the demand can a default be said to occur under Section 95 of the IBC. The financial default of the corporate debtor and the contractual default of the guarantor create two separate legal situations which the differences between them demonstrate. The evidence requirement for an existing enforceable obligation must be fulfilled according to IBC admission standards and Section 126 to 128 Indian Contract Act 1872 principles. 

The Insolvency and Bankruptcy (Application to Adjudging Authority for Insolvency Resolution Process to personal guarantor of corporate debtors) Rules, 2019 (“2019 Rules”) further require the issuance of a demand notice under Rule 7(1) before an application is filed. Such a requirement is procedural, though. The 2019 Rules do not replace the necessity of invoking the contract unless the conditions of the guarantee specifically waive the demand. Creditors are advised to treat them, as a prudent measure, as separate steps: first, a substantive invocation of the guarantee by the terms of the guarantee, and second, by complying with the statutory demand requirement in Rule 7(1) of the 2019 Rules.  

D. Cohesion with Supreme Court Jurisprudence on Guarantor Liability  

In Laxmi Pat Surana v. Union Bank of India, Civil Appeal No. 2734 of 2020, the Supreme Court accepted and acknowledged that a creditor has a right to take action against a guarantor due to his or her own default, and that the liability of a guarantor, though co extensive, is still independent in nature. Taken in conjunction with Bank of Bihar judgement (Supra), this establishes that enforcement against the guarantor does not have to await enforcement against the principal debtor. The more subtle question is when the default of the guarantor can be determined to have occurred? That is a question which depends squarely on the terms provided in the guarantee itself: where the deed reflects on a liability becoming demanded, invocation is a pre-requisite to the obligation becoming due and where the demand is expressly waived or the liability accelerated by the express wording of a contract, an independent invocation may not be necessary. The precedents of Lalit Kumar Jain (Supra) or State Bank of India v. V. Ramakrishnan, [(2018)17SCC394] further strengthens the ‘nothing to take away of this contract’ centered approach to answering the question of when the debt of the guarantor will mature. 

 E. Practical Implications for Creditors and Guarantors 

To creditors, it is important to be able to sequence carefully and have proper documentation maintained. An application under Section 95 of the IBC should be based on a substantive contractual claim to the guarantee, which satisfies the terms of the deed, post which the Rule 7(1) notice of the 2019 Rules can be issued. As a sound practice, the invocation must expressly state the obligation guaranteed, refer to the clauses of the contract which created the liability, specify the amount of the claim, expressly make a claim upon the guarantor, and specify a time which is reasonable to pay. Correct service of the invocation on the guarantor, and in some cases, a notice to the corporate debtor, help to prove default and reduce the risk of objections to the admission phase. 

In the eyes of personal guarantors, the moment of crystallization of liability is invocation, unless the guarantee deed specifically waives any demand. It also implicates limitation and affords the guarantor a chance to make objections as to the quantum, scope, impairment or discharge of liability. Since filing an application pursuant to Section 95 will draw an interim moratorium pursuant to Section 96 of the IBC, it is critical to ensure that a good and contractually matured default exists when filing an application under the Section.  

F. Doctrinal Coherence and Policy Rationale 

Considering invocation as a precondition facilitates consistency of the contract law with the IBC. It helps to avoid insolvency as a substitute of demand, upholds the autonomy of parties in the determination of when obligations of the guarantor become due and discourages untimely filings that are costly and time consuming. It also makes sure that the interim moratorium of Section 96 does not occur when there is not a payment default by the guarantor.  

Commercial drafting varies. Some guarantees contain explicit waivers of demand or automatic‑trigger language. In cases where such clauses are clear and unambiguous, liability might arise instantly and once the principal debtor has become bankrupt, a separate demand might be unnecessary. The creditor still has to prove on the text of the deed that the debt owed by the guarantor had been matured and not paid. Practically, the majority of the guarantees are prepared on-demand basis and the creditors must demonstrate invocation in order to establish default.  

G. Conclusion  

1. An invocation in compliance with the guarantee is typically necessary to prove default by a personal guarantor under Section 95 of the IBC while liability under an on-demand guarantee crystallizes on demand and non-payment.
2. Rule 7(1) of 2019 Rules mandates that notice is a procedural pre-condition and is not in place of contractual invocation, unless the notice expressly dispenses with demand under the guarantee.
3. Creditors ought to proceed in stages in the following way by invoking first under the deed; second issue the Rule 7(1) notice; and lastly place under Section 95 with evidence of a matured and unpaid guarantor obligation.
4. Personal guarantors should test maintainability by scrutinizing whether the guarantee was validly invoked and whether the claimed sum was due and unpaid at the time of filing. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.