Security Vs Guarantee

Introduction:

The terms "guarantee" and "suretyship" have been used interchangeably and a sharp distinction between them does not seem to be possible. But, what is the difference between security and a guarantee?

What is Security?

Although the term security has not been categorically defined, however, SARFAESI[1] does try to outline the pre-requisites of security by defining “secured debt”, “security interest” and “secured asset” the excerpts of the relevant sections are reiterated hereunder:

Section 2 (zc): “secured asset” means the property on which security interest is created;

Section 2 (ze): “secured debt” means a debt which is secured by any security interest;

Section 2 (zf) : “security interest” means right, title or interest of any kind, other than those specified in section 31, upon property created in favor of any secured creditor and includes— (i) any mortgage, charge, hypothecation, assignment or any right, title or interest of any kind, on tangible asset, retained by the secured creditor as an owner of the property, given on hire or financial lease or conditional sale or under any other contract which secures the obligation to pay any unpaid portion of the purchase price of the asset or an obligation incurred or credit provided to enable the borrower to acquire the tangible asset; or

(ii) such right, title or interest in any intangible asset or assignment or license of such intangible asset which secures the obligation to pay any unpaid portion of the purchase price of the intangible asset or the obligation incurred or any credit provided to enable the borrower to acquire the intangible asset or license of intangible asset;

After a close reading of the above-mentioned sections, it could be said that security is an interest vested in a person (creditor) in certain property owned by another (debtor), whereby certain rights are made available to the creditor over such property in order to satisfy an obligation personally owed or recognized as being owed to the creditor by the debtor or some other person. In other words, it is not a transaction, but an interest which arises from such transactions.

What is guarantee?

Section 126 of Indian Contract Act defines Guarantee , the relevant excerpts of the section is being reiterated hereunder :

Section 126. 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.

The said clause indicates that there are three sets of contractual relationships to qualify as a contract of guarantee:

·       Between the creditor and the principal debtor

·       between the creditor and the surety

·       between the principal debtor and the surety.

It is under the purview of the third contractual relationship whereby the principal debtor requests a third person expressly or by necessary implication to act as surety. In other words ‘perform the promise' or ‘discharge the liability' of the Borrower in case of an event of default[2].

Does having a secured interest qualify as guarantee?

Security document or a facility agreement with all intent and purport tries to create a covenant to pay, made by a third-party security provider in the security document. The question here arises is whether such third-party security be construed as guarantee? The question to this answer would be in negative.

The Hon’ble Supreme Court of India in PHOENIX ARC PVT. LTD Vs KETULBHAI RAMUBHAI PATEL[3] opined that:

“23. As clear from the definition 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 present is not a case where the corporate debtor has entered into a contract to perform the promise, or discharge the liability of borrower in case of his default. The Pledge Agreement is limited to pledge 40,160 shares as security. The corporate debtor has never promised to discharge the liability of borrower. The Facility Agreement under which the borrower was bound by the terms and conditions and containing his obligation to repay the loan security for performance are all contained in the Facility Agreement. A contract of guarantee contains a guarantee “to perform the promise or discharge the liability of third person in case of his default”. Thus, key words in Section 126 are contract “to perform the promise”, or “discharge the liability”, of a third person. Both the expressions “perform the promise” or “discharge the liability” relate to “a third person”. The Pledge Agreement dated 10.01.2012 does not contain any contract that the promise which was made by the borrower in the Facility Agreement dated 12.05.2011 to discharge the liability of debt of Rs.40 crores is undertaken by the corporate debtor. It was the borrower who had promised to repay the loan of Rs.40 crores in Facility Agreement dated 12.05.2011 and it was borrower who had undertaken to discharge the liability towards lender. The Pledge Agreement dated 10.01.2012 does not contain any contract that corporate debtor has contracted to perform the promise or discharge the liability of the third person. The Pledge Agreement is limited to pledge of 40,160 shares of GEL only. We have noticed above that in the Facility Agreement there is a Security Creation by way of Schedule IV in which 100% equity shares of GEL were pledged by the borrower and second pari-passu charge on all current assets of the GEL was also created as security for loan. It transpires that since some shares of GEL were also with the corporate debtor who is subsidiary Company of Doshion Ltd. the same was also pledged with the lender as additional security by a subsequent agreement dated 10.01.2012.

24. The Pledge Agreement and undertaking given, entered between Assignor and corporate debtor cannot be termed as contract of guarantee within the meaning of Section 126.”

The Hon’ble Supreme Court of India tries to draw the inference on the lines of Jaypee Infratech Limited vs. Axis Bank Limited[4] with respect to issue as to whether “credit facility which was extended to the borrower is referable to Section 5(8) (b) and the corporate debtor pledged his share to give indemnity for credit facility and which is in a sense of guarantee.”

The Hon’ble Supreme Court of India while referring to Jaypee Infratech Limited[5] observed as follows:

“46. Applying the aforementioned fundamental principles to the definition occurring in Section 5(8) of the Code, we have not an iota of doubt that for a debt to become 'financial debt' for the purpose of Part II of the Code, the basic elements are that it ought to be a disbursal against the consideration for time value of money. It may include any of the methods for raising money or incurring liability by the modes prescribed in Subclauses (a) to (f) of Section 5(8); it may also include any derivative transaction or counter-indemnity obligation as per Subclauses (g) and (h) of Section 5(8); and it may also be the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in Subclauses (a) to (h). The requirement of existence of a debt, which is disbursed against the consideration for the time value of money, in our view, remains an essential part even in respect of any of the transactions/dealings stated in Sub-clauses (a) to (i) of Section 5(8), even if it is not necessarily stated therein. In any case, the definition, by its very frame, cannot be read so expansive, rather infinitely wide, that the root requirements of 'disbursement' against 'the consideration for the time value of money' could be forsaken in the manner that any transaction could stand alone to become a financial debt. In other words, any of the transactions stated in the said Sub-clauses (a) to (i) of Section 5(8) would be falling within the ambit of 'financial debt' only if it carries the essential elements stated in the principal Clause or at least has the features which could be traced to such essential elements in the principal clause. In yet other words, the essential element of disbursal, and that too against the consideration for time value of money, needs to be found in the genesis of any debt before it may be treated as 'financial debt' within the meaning of Section 5(8) of the Code. This debt may be of any nature but a part of it is always required to be carrying, or corresponding to, or at least having some traces of disbursal against consideration for the time value of money.

47. As noticed, the root requirement for a creditor to become financial creditor for the purpose of Part II of the Code, there must be a financial debt which is owed to that person. He may be the principal creditor to whom the financial debt is owed or he may be an assignee in terms of extended meaning of this definition but, and nevertheless, the requirement of existence of a debt being owed is not forsaken.

49.1. The use of the expression "means and includes" in these clauses, on the very same principles of interpretation as indicated above, makes it clear that for a person to become a creditor, there has to be a debt i.e., a liability or obligation in respect of a claim which may be due from any person. A "secured creditor" in terms of Section 3(30) means a creditor in whose favour a security interest is created; and "security interest", in terms of Section 3(31), means a right, title or interest or claim of property created in favour of or provided for a secured creditor by a transaction which secures payment for the purpose of an obligation and it includes, amongst others, a mortgage. Thus, any mortgage created in favour of a creditor leads to a security interest being created and thereby, the creditor becomes a secured creditor. However, when all the defining clauses are read together and harmoniously, it is clear that the legislature has maintained a distinction amongst the expressions 'financial creditor', 'operational creditor', 'secured creditor' and 'unsecured creditor'. Every secured creditor would be a creditor; and every financial creditor would also be a creditor but every secured creditor may not be a financial creditor. As noticed, the expressions "financial debt" and "financial creditor", having their specific and distinct connotations and roles in insolvency and liquidation process of corporate persons, have only been defined in Part II whereas the expressions "secured creditor" and "security interest" are defined in Part I.

50. A conjoint reading of the statutory provisions with the enunciation of this Court in Swiss Ribbons (supra), leaves nothing to doubt that in the scheme of the IBC, what is intended by the expression 'financial creditor' is a person who has direct engagement in the functioning of the corporate debtor; who is involved right from the beginning while assessing the viability of the corporate debtor; who would engage in restructuring of the loan as well as in reorganisation of the corporate debtor's business when there is financial stress. In other words, the financial creditor, by its own direct involvement in a functional existence of corporate debtor, acquires unique position, who could be entrusted with the task of ensuring the sustenance and growth of the corporate debtor, akin to that of a guardian. In the context of insolvency resolution process, this class of stakeholders namely, financial creditors, is entrusted by the legislature with such a role that it would look forward to ensure that the corporate debtor is rejuvenated and gets back to its wheels with reasonable capacity of repaying its debts and to attend on its other obligations. Protection of the rights of all other stakeholders, including other creditors, would obviously be concomitant of such resurgence of the corporate debtor.

50.1. Keeping the objectives of the Code in view, the position and role of a person having only security interest over the assets of the corporate debtor could easily be contrasted with the role of a financial creditor because the former shall have only the interest of realising the value of its security (there being no other stakes involved and least any stake in the corporate debtor's growth or equitable liquidation) while the latter would, apart from looking at safeguards of its own interests, would also and simultaneously be interested in rejuvenation, revival and growth of the corporate debtor. Thus understood, it is clear that if the former i.e., a person having only security interest over the assets of the corporate debtor is also included as a financial creditor and thereby allowed to have its say in the processes contemplated by Part II of the Code, the growth and revival of the corporate debtor may be the casualty. Such result would defeat the very objective and purpose of the Code, particularly of the provisions aimed at corporate insolvency resolution.

50.2. Therefore, we have no hesitation in saying that a person having only security interest over the assets of corporate debtor (like the instant third party securities), even if falling within the description of 'secured creditor' by virtue of collateral security extended by the corporate debtor, would nevertheless stand outside the sect of 'financial creditors' as per the definitions contained in Sub-sections (7) and (8) of Section 5 of the Code. Differently put, if a corporate debtor has given its property in mortgage to secure the debts of a third party, it may lead to a mortgage debt and, therefore, it may fall within the definition of 'debt' Under Section 3(10) of the Code. However, it would remain a debt alone and cannot partake the character of a 'financial debt' within the meaning of Section 5(8) of the Code.”

In other words, Section 126 of the Indian Contract Act provides that a “contract of guarantee” is a contract to perform the promise or discharge the liability of a third person in case of his default, and the person who gives the guarantee is called the “surety” and that here there was no personal obligation on the defendants to pay anything, they merely handed over their property as security, and that being so, there was no contract to perform the promise or discharge the liability of a third person.

[1] In the year 2001, RBI issued CREATION AND ENFORCEMENT OF SECURITY INTEREST BY BANKS AND FINANCIAL INSTITUTIONS BILL, 2001 to codify and consolidate law and practice relating to the creation of security interest, and enforcement thereof by banks and financial institutions without the intervention of Court and for matters connected therewith or incidental thereto[1]. Later succeed by THE SECURITISATION AND RECONSTRUCTION OF FINANCIAL ASSETS AND ENFORCEMENT OF SECURITY INTEREST ACT, 2002 (would be referred to as SARFAESI for brevity)

[2] https://www.mondaq.com/india/financial-services/1034574/third-party-security-pledgees-not-financial-creditors

[3] CIVIL APPEAL NO.5146 of 2019

[4] Civil Appeal Nos. 8512-8527 of 2019

[5] Supra