This is part two of a three-part series on Contracts of Guarantee.
Interpretation of Section 133 of the Indian Contract Act
Section 133 of the Indian Contract Act provides that any alteration or change in the terms of the contract among the Borrower, Creditor, or Guarantor without the guarantor’s consent will discharge the guarantor from the liability of providing guarantee. The purpose is to protect the rights of the Guarantor. The Guarantor should not be compelled to do something which he hasn’t consented to do. The essential ingredients of section 133 are as follows:
- There must be variance or change in the contract
- The variance must be between the Creditor and Borrower.
- It must be without the consent of the Guarantor.
For example, Shyam borrowed ₹50,000 from HDFICI Bank, to be repaid within six months. Shyam’s friend, Bharat, guarantees the loan. Subsequently, HDFICI Bank and Shyam renegotiated the loan agreement to increase the repayment period from six months to 10 months. Bharat was not aware of the renegotiation. Therefore, Bharat will stand discharged from his liability to repay the loan on behalf of Shyam, if Shyam fails to do so.
Discharge of the Guarantor by Variance Without Consent
This right of the Guarantor to be discharged from his liability has been considered by various courts. The Bombay High Court considered a case (Keshavlal Harilal Setalvad v Pratapsing Moholalbhai Seth, AIR 1932 Bom 168) in which the Creditor and the Borrower negotiated between themselves to reduce the mortgage amount, without the consent of the Guarantor. The Bombay High Court discharged the Guarantor and declared the renegotiated contract to be voidable. The Bombay High Court noted that in such cases, the Guarantor has the sole right to decide whether he wants to continue to guarantee the loan or not.
In another peculiar case (Union Bank of India v Chairperson, Debts Recovery Appellate Tribunal Writ Petition No. 29076 & 29083 of 2011), one Asha Edible Oils Pvt Ltd was granted credit facilities by a bank, guaranteed by one Mr. Handa. Asha Edible Oils later defaulted in repayment. An application was filed by the bank before the Debts Recovery Tribunal for recovery of ₹12,38,91,472. Another case was filed under the Companies Act, in which the High Court ordered Asha Edible Oils to be wound up and an Official Liquidator (“OL”)was appointed. The Official Liquidator took charge of the management and assets of the company under law. All other proceedings against the company were stayed.
The bank entered into a settlement with the OL for ₹78,16,428.42, without the consent of Mr Handa. The Court held that Mr Handa’s liability terminated when the bank and the company (represented by the OL) settled the debt, thereby varying the terms of the agreement, without his consent. The Court further held that since the liabilities of a Guarantor is coextensive with the liabilities of a Borrower, once the bank accepted a full and final settlement from the OL (on behalf of the Borrower), the liability of the Guarantor was also discharged.
Thus, a Guarantor is liable to repay a renegotiated loan on behalf of a Borrower, only when the Guarantor has also been a party to the renegotiations. This is because, in such cases, the Guarantor has consented to the variation in the terms of the contract.
Does the Variance Have to be Substantial?
The Supreme Court of India has incorrectly added an additional criterion to section 133. In a particular case (MS Anirudhan v Thomco’s Ltd, AIR 1963 SC 746), the amount of debt was reduced to ₹20,000 from the original ₹25,000 by the Creditor and the Borrower. The Guarantor did not consent to the reduction. The Supreme Court, in this case, considered whether the variance affects the position of the Guarantor or not. The Court here held that the variance to the amount of debt was “unsubstantial” and ultimately benefitted the Guarantor. However, it is our considered opinion that the decision of the Supreme Court was incorrect. Section 133 itself does not require the variance to be “substantial variance” or “unsubstantial variance”. As long as there is a variance to which the Guarantor has not consented, whether or not it is to the benefit of the Guarantor, the liability of the Guarantor stands discharged.
One Time Settlement between a Bank and Borrower: Where Does the Guarantor Stand?
A “one-time settlement” (“OTS”) is an alternative crafted by the Reserve Bank of India (“RBI”) to allow banks to recover the maximum possible extent of defaulted loans. An OTS involves compromise between a bank and its borrowers; a bank is allowed to settle a loan declared as a “non-performing asset” with the Borrower. OTS usually helps the Borrower reduce the amount to be repaid to the bank to a mutually decided, smaller figure, subject to compliance with RBI guidelines. Although OTS has existed for some time, it has come into vogue in the backdrop of the SARS-Cov2 pandemic.
It is our considered opinion that when Banks and Borrowers enter into an OTS agreement, they vary the terms of the original loan agreement. The variance occurs when the Bank and Borrower mutually agree to reduce the amount to be repaid by the Borrower, typically without involving the Guarantor. In such cases, section 133 of the Indian Contract Act squarely applies. A Guarantor is no longer liable to repay the loan on behalf of the Borrower, when the Bank and Borrower have entered into an OTS agreement.
Much emphasis is placed by banks on credit scores published by licensed credit information companies in recent times. In cases where a bank and Borrower enter into an OTS agreement, the bank may cause a credit information company to publish negative remarks in the Guarantor’s credit report as well. Such publication is incorrect, and Guarantors may be entitled to relief by having such negative remarks removed and claiming compensation for tortious defamation.
You can read Part 1 of this series here
The next part will cover how a Guarantor can improve his credit score after a variance to the contract between the Bank and Borrower