Essar Steel’s Insolvency: Distribution To Operational Creditors Isn’t The Lenders’ Only Worry
Photographer: Dhiraj Singh/Bloomberg

Essar Steel’s Insolvency: Distribution To Operational Creditors Isn’t The Lenders’ Only Worry

The fight of Essar Steel’s financial creditors isn’t just limited to the issue of distribution to operational creditors. The National Company Law Appellate Tribunal’s view on guarantees and indemnities given by Prashant Ruia, Essar Steel’s promoter, also has the creditors worried.

In its July order, the NCLAT had held that Ruia’s right of subrogation has become ineffective since Essar Steel’s debt has been cleared under the resolution plan. This right stems from the Contract Act, that allows the guarantor—in this case Ruia—to step into the shoes of the lenders to recover from the corporate borrower—Essar Steel—the amount it has paid to clear the debt. Essentially, once the guarantor settles the principal borrower’s dues, the rights of the creditors against this entity vest with the guarantor. Such a guarantor also has the right to be indemnified or compensated for any amount it has spent to discharge the guarantee.

Both the guarantee and indemnity, the NCLAT had said, become ineffective once the financial creditors are paid under the resolution plan.

Once the debt payable by the ‘Corporate Debtor’ stands cleared in view of the approval of the plan by making payment in favour of the lenders (‘Financial Creditors’), the effect of ‘Deed of Guarantee’ comes to an end as the debt stands paid.
NCLAT, Essar Steel Order

This conclusion has implications not just for Ruia but lenders as well. If the guarantee deed becomes ineffective, it means lenders cannot go after Ruia for the remaining amount of their debt, Sudipta Routh, partner at IndusLaw, said. If the outstanding debt is Rs 100 and the financial creditors are receiving Rs 90 under the resolution plan, can they go after the guarantor for the remaining Rs 10? The NCLAT has said you can’t, Routh added, and rightly so.

If the principal debtor’s debt has been considered discharged by any process, then there’s no question of going after the guarantor. Indemnity, on the other hand, is a contingent contract i.e. it kicks in on the happening or non-happening of an event. If that event results in a loss, fundamentally, the right to be indemnified should be sustained.
Sudipta Routh, Partner, IndusLaw

But practically if lenders are allowed to invoke indemnities, it would make no sense—they would settle for less under resolution plan and then go after the guarantor for the remaining amount, he explained. IBC isn’t a recovery tool, and once a debt is restructured and the company is in the hands of a new promoter, it would be unfair to say that the liability of the erstwhile promoter on account of indemnities should continue, Routh added.

Lenders to Essar Steel, however, are arguing otherwise before the Supreme Court. A lawyer involved in the case explained the key arguments of the creditors requesting anonymity:

  • Guarantors don’t stand absolved when the resolution plan for the principal borrower is approved unless the plan gives full payment to financial creditors.
  • Liability of guarantor is co-extensive with principal borrower. Hence, till the entire debt is paid off, guarantor is jointly and severally liable to pay.
  • Section 31 of IBC makes an approved plan binding on all, including guarantors. And so, variance of terms of guarantee on account of principal borrower doesn’t absolve guarantor from his liability to pay.
  • The liability of a guarantor continues when principal borrower is discharged by operation of law like a court-approved bankruptcy.

The Supreme Court has held that guarantors have an independent and coextensive liability to pay off the entire outstanding debt, and so the NCLAT view ought to be reversed, this lawyer said.

The apex court had said so in SBI vs Ramakrishnan case while deciding on the question as to whether the moratorium under IBC will extend to guarantors. Answering this in the negative, the apex court said that personal guarantor has to pay debts due without any moratorium applying to save him.

Most resolution plans say that banks would continue to have the right to go after the guarantor for the remaining amount of debt, but the guarantor won’t have the right of subrogation. And that’s what was challenged by Essar’s promoters in this case, Pooja Mahajan, managing partner at Chandiok and Mahajan, pointed out. The question before NCLAT was whether subrogation rights go away or not but instead the appellate tribunal held this question doesn’t arise since the guarantee itself goes away when the debt is settled, Mahajan said.

It is a problematic interpretation. In Ramakrishnan’s case, the Supreme Court had said that the resolution plan may well include provisions as to payments to be made by a guarantor. A lot of people are drawing comfort from this that perhaps guarantees can continue.
Pooja Mahajan, Managing Partner, Chandiok and Mahajan

The general rule on guarantees for lenders is that you want to rely on the credit of someone else besides the principal borrower. In a situation where the borrower hasn’t paid and you’re forced to go through a statutory process to recover as much as you can, it’ll be unfair if the lenders’ credit call is frustrated to say that you can only recover so much, Nilang Desai, partner at AZB, said. “It belies the logic of guarantees. It’s fair to say that the guarantor’s right of subrogation should go under IBC but why should the lender not be allowed to recover his full dues. And indemnities are on an even firmer ground,” Desai said.

Lenders to Essar Steel have already invoked the guarantees given by Ruias before the Debt Recovery Tribunal in Ahmedabad. But the DRT hasn’t passed an order since the case is pending before the apex court. And so, whether creditors can still go after guarantors once their debt has been restructured and discharged in part via a resolution plan, is a question that the Essar Steel case will settle.

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