Explained: Recovery of debt from guarantors

The world economy enters an unprecedented economic crisis caused by the COVID-19 pandemic. The Policymakers in Washington and other global capitals are on their toes and giving various fiscal stimulus to arrest the economic slide down. With countries facing complete shutdown and industries being closed the world, the economy is facing a stark reality—a recession or even a depression. We may see more unemployment, lockdowns, insolvencies etc. We are soon going to see many businesses getting busted or being declared insolvent. This is going to have far-reaching effects. Most of the business houses have taken loans for running their business.

Taking a loan comes with Personal Guarantees and sureties and other collateral. All these were given with the assumption that the business will do good and everyone will stand benefited. COVID-19 has completely taken everyone by storm and now business houses, Guarantors and Sureties face a stark reality—the demand for repayment of the loan. But now we are going to see more and more lawsuits for the collection of money either be it from the principal debtor or from the guarantors.

It is an undertaking to pay back another's liability when required by the lender to do so. It is a collateral undertaking to pay the debt of another in case the primary borrower fails to pay the debt. In India, the Contract of Guarantee is explained in Section 126 of the Indian Contract Act, 1872. A "Contract of Guarantee" is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the "Surety", the person in respect of whose default the guarantee is given is called the "Principal Debtor", and the person to whom the guarantee is given is called the "Creditor". A guarantee may be either oral or written.

Guarantee–Easiest security: A guarantee is the simplest and easiest form of banking security. However, it is the most difficult to realise too. A guarantee is usually treated as intangible security. A guarantee at times may not be adequate to realise the value of the debt. The real value of any guarantee depends on entirely financial and solvency of the guarantor to meet the liability promptly when demanded. The banker should however ensure that the debt value is much lower than what the real worth of the guarantor is. Sometimes, due to the fluctuation of fortunes and business woes, the value of the guarantor falls. But if the value falls below the actual debt then realisation will practically be impossible. It not only depends on the valuation of the guarantor but also on his ability and intention to pay. There could be scenarios where the guarantor has the ability to pay but has no intention to pay. In such scenarios, it becomes a very long drawn-out legal battle to extract the money from the guarantor.

Contract of Guarantee: The contract of guarantee has to be well drafted. An intelligent lawyer ensures that he has all the wherewithal in the legal armor to extract money from the guarantor. The practicality and the ease of extracting money through the courts may be different. But the lawyer ensures that the documents are watertight and have no gaping potholes through which the guarantor could slide out. The lawyer ensures that the contract of guarantee does not relieve the guarantor even when the principal debtor is released under any legal circumstances. Part-payment by the principal debtor does not relieve or lessen the burden of the guarantor. Usually, the bank has the clause inserted in the contract of guarantee whereby the bank can approach the guarantor at any time to claim the amount from the guarantor. The default by the principal debtor may or may not even be notified to the guarantor. So, an intelligent lawyer ensures that the sword of debt always hangs above the guarantor. It should be borne in mind that no guarantor ever expects to have to pay and when called upon to do so will inevitably be pained or surprised. He will try everything legally possible to avoid paying the debt to the creditor or the lender.

Guarantor–the Darling of Creditor: Bankers always insist on getting the contract of guarantee signed by the guarantor with absolutely no negotiation. These contracts of the guarantee are prepopulated printed forms and the guarantor has literally no teeth to negotiate. Usually, the Bankers ensure that the guarantors are well of and easy to go after if the principal debtors are insolvent or unable to pay. The bankers always prefer to go after the guarantors as it is easy to realize the money from the guarantors as they are already "certified" to be capable to pay the debt. It may be an altogether different story as to how to realise the money if the guarantor is unwilling to pay.

Principle of Co-Extensive: Section 128 of the Indian Contract Act, 1872 provides that the liability of the guarantor is co-extensive with that of the principal debtor. The guarantor's liability is not reduced or waived off simply because the creditor has not sued the principal debtor. The creditor is not required to exhaust his remedy against the principal debtor before approaching the guarantor. However, where the liability only arises after the happening of a contingency, the guarantor will not be liable until that contingency has taken place. The liability of the guarantor to pay the amount under the guarantee is not automatically suspended when the liability of the principal debtor is suspended under some legal or statutory provision. Hence, the liability of the guarantor is co-extensive with that of the principal debtor.

Creditors Act inconsistent with the rights of the Guarantor: Section 139 of the Indian Contract Act, 1872 provides that if the creditor does any act which is inconsistent with the rights of the guarantor or omits to do any act which is his duty to the guarantor and thus the eventual remedy of the guarantor himself against the principal debtor is impaired then the guarantor is discharged. Thus, the negligence of the banker or the creditor in handling the security will discharge the guarantor's liability to the extent of the impairment of such security. If the creditor holds some securities belonging to the principal debtor, he should not return them to the principal debtor as it will prejudice the interests of the guarantor.

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. 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". The guarantor who has performed the obligations of the principal debtor which are the subject of his guarantee 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 140 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 guarantor steps into the shoes of the creditor. The creditor had the right to sue the principal debtor. The guarantor may, therefore, sue the principal debtor in the rights of the creditor.

Contribution among Co-guarantors: Where there are multiple guarantors and one pays more than his properly allocable contributive share of the common debt, then he can have a right of contribution against the other co-guarantors. A co-guarantor with rights of contribution is entitled to payment by the relevant co-guarantor upon payment of more than his contributive share of the common obligation.

When there are multiple co-guarantors for the same underlying obligation, it is necessary to determine whether the guarantors are co-guarantors of sub-guarantors. If they are co-guarantors, they can be liable for contribution among themselves such that each of them is required to bear its contributive share of the aggregate amounts paid by the co-guarantors on the common obligation. If, on the other hand, one guarantor is a sub-guarantor and another guarantor is the principal guarantor, then between the two, the principal guarantor has primary liability for the common obligation and the sub guarantor has secondary liability for it.

The co guarantor's contributive share is the aggregate liability of the co-guarantor to the obligee divided by the number of co-guarantors. Each co-guarantor is allocated an equal share of the guaranteed debt unless the guarantors have expressly or impliedly agreed otherwise.