Personal Guarantee-A Void Agreement

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Since long the public sector banks and financial institutions (hereinafter collectively referred to as ‘the Bank’ or ‘the Banks’) have unilaterally and arbitrarily developed a practice to execute personal guarantee agreements with the guarantors to secure the debts of a company. This view is supported by the judgement of hon’ble Supreme Court in Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. {2008 AIR 1797, 2008 (5) SCC 176, 2008 (4) JT 183; Date of Judgment: 13/03/2008}, wherein the court has observed as follows (in para 18):

“18. Banking practice may enable a financial corporation to ask for a collateral security. Such security, we would assume, may be furnished by the Directors of a Company but furnishing of such security or guarantee is not confined to the Directors or employees or their close relatives. They may be outsiders also. The rights and liabilities of a surety and the principal borrower are different and distinct.” (Emphasis supplied)

2. Definition of “the State”

Article 12 of the Constitution of India, 1949 has defined the term “the State” as follows:

‘Definition.- In this part, unless the context otherwise requires, “the State” includes the Government and Parliament of India and the Government and the Legislature of each of the States and all local or other authorities within the territory of India or under the control of the Government of India.’

2.1. Hon’ble Supreme Court in Ajay Hasia Etc. Vs. Khalid Mujib Sehravardi & Ors. Etc. {1981 AIR 487; 1981 SCR (2) 79; 1981 SCC (1) 722; Date of Judgment 13/11/1980} with a view to analyse whether a corporation is an instrumentality or agency of Government, therefore is “the State”, observed as follows: “The relevant tests gathered from the decision in the International Airport Authority’s case {Ramana Dayaram Shetty v. International Airport Authority of India, (1979) 3 SCC 489: (AIR 1979 SC 1628 at pp. 1637-38)} may be summarised as:

(i) ‘One thing is clear that if the entire share capital of the corporation is held by Government it would go a long way towards indicating that the Corporation is an instrumentality or agency of Government.

(ii) ‘Where the financial assistance of the State is so much as to meet almost entire expenditure of the corporation, it would afford some indication of the corporation being impregnated with governmental character.’

(iii) ‘It may also be a relevant factor whether the corporation enjoys monopoly status which is the State conferred or State protected.’

(iv) ‘Existence of deep and pervasive State control may afford an indication that the Corporation is a State agency or instrumentality.’

(v) ‘If the functions of the corporation of public importance and closely related to governmental functions, it would be a relevant factor in classifying the corporation an instrumentality or agency of Government.’

(vi) ‘Specifically, if a department of Government is transferred to a corporation, it would be a strong factor supportive of this inference of the corporation being an instrumentality or agency of Government.”

2.2. A public sector bank is “the State” under Article 12 of the Constitution

All the public sector banks / financial institutions are a body corporate, constituted either under the provisions of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, or under other allied laws respectively. The Central Government acting through RBI (in short for ‘Reserve Bank of India’) is the major shareholder and hence controller of the Bank. In view of the existence of deep and pervasive control of the Central Government over these banks / financial institutions, they are an instrumentality of the Central Government controlled through the RBI [C.V. Raman, Etc. Vs. Management Of State Bank Of India and Another, Etc. {1988 AIR 1369; 1988 SCC (3) 105;JT 1988 (2)167 1988 SCALE (1) 800; Date of Judgment 21/04/1988} See also Biharilal Dobray Vs. Roshan Lal Dobray {1984 AIR 385;1984 SCR (1) 877;1984 SCC (1) 551;1983 SCALE (2)761; Date of Judgment 23/11/1983}]. Therefore, the bank is “the State” as per Article 12 of the Constitution of India, consequent to which it has to act reasonably and in the interest of the country, economy, its borrowers as well as safeguarding interest of its depositors. It has to act in rational manner and can not act in arbitrary manner.

A Case Study– Dena Bank (Letter of Guarantee)

3. Extracts of Paragraph nos. 1, 3, 4, 5, 6, 10 and 15 of Letter of Guarantee of Dena Bank are reproduced below for ready reference –

Paragraph no. 1

“In consideration of Dena Bank (hereinafter called ‘the Bank’) giving/having given credit accommodation or granting/having following credit facilities viz : ……….to ‘M/s. P’ ………………by making, opening, continuing a loan/overdraft/cash credit account or the discounting put on ……….and/or negotiating bills with or without security and/or in consideration of Bank opening and giving the credit and/or Trust receipt in favour of ________ on terms and conditions that may be settled between you and the said _______ at any time and from time to time with reference to me ‘Mr. K’ residing at _______________ jointly and severally and irrevocably hereby agree with and guarantee to you the due payment and discharge (within) two days after demand and writing, without demur or protest of all amounts due and payable to you by ‘M/s. P’ (hereinafter called ‘the Principal’) at any time …………..”

3.1. Paragraph no. 3

“………… The Guarantee shall continue in force notwithstanding the discharge of the Principal by operation of law or my death or the death of any of us and shall cease only on payment of the amount guaranteed hereunder either by me or any of us.”

3.2. Paragraph no. 4

“ …………. I/We also agree that I/We shall not be discharged from my/our liability by your releasing the Principal or by any act or omission of yours the legal consequence of which may be to discharge the Principal or by any act of yours which would but for this present provision be inconsistent with my/our rights as surety or by your omission to do any act, which, but for this present provision your duty to me/us would have required you to do. I/We hereby consent to each and every of the acts mentioned above as you may think fit. Moreover though as between the borrower and me/us, I am/We are sureties only, I/We agree that as between yourselves and me/us I am/We are borrowers jointly with him accordingly I/We shall not be entitled to any of the rights conferred on sureties by Section 133, 134, 135, 139 and 141 of the Indian Contract Act. ……… And for all the purposes of this claim thePrincipal is empowered to give consent on my/our behalf and any consent given by the Principal shall be deemed to have been given by me/us in all respects as if the same had been expressly given by me/us in writing.”

3.3. Paragraph no. 5

“The Bank may recover against me/us to the extent herein before mentioned notwithstanding that the Principal or his agents, partners, directors or officers may have exceeded his or their powers or that the arrangements with the Bank may have been ultra vires and without being bound to enforce its claim against the borrower or any other person or other security held by the Bank. The Bank shall not be bound to inquire into powers of the Principal or his agents or partners, directors or officers purporting to act on behalf of the borrowers and all moneys dues or liabilities incurred shall be deemed to form part of the present guarantee notwithstanding that the Principal or his agents, partners, directors and officers may have exceeded his or their powers or the arrangement with the Bank may have been ultra vires.

3.4. Paragraph no. 6

“I/We waive in the Bank’s favour all or any of my/our rights against the Bank or the Principal as may be necessary to give effect to any of the provisions of this guarantee.”

3.5. Paragraph no. 10

“…………. if the Principal shall become insolvent or go into liquidation or compound with his creditors, theBank shall be at liberty without discharging my/our liability to make or assent to any compromises, compositions or arrangements or prove and to rank as creditor in respect of the amount claimable by the Bank or any items thereof ………………….. to the entire exclusion andsurrender of my/our rights as sureties in competition with the Bank (and) any rule of law or equity to the contrary notwithstanding. And I/We shall not be paying off the sum guaranteed or any part thereof or upon any other ground prove or claim to prove in respect of the sum guaranteed or any part thereof or take advantage of any securities held by the Bank until the whole of your claim against the Principal has been satisfied.”

3.6. Meaning of the term ‘Right’

As per P Ramanatha Aiyar’s the Law Lexicon, 2^nd Edition 1997(Reprint 2007) the term “Right” means an interest which is recognised and protected by law. As it is recognised by law a man is entitled to have it. As it can be protected by law the possessor can enforce it by an appropriate action in a court. (Raj Rajendra Sardar Maloji Narsig Rao Vs. Shankar Saran, AIR 1958 All 775, 787).

3.7. Further, section 28 of the Contract Act provides that Agreements in restraint of legal proceedings void –Every agreement –

(a) by which any party thereto is restricted absolutely from enforcing his rights under or in respect of any contract, by the usual legal proceedings in the ordinary tribunals, or which limits the time within which he may thus enforce is rights;

is void to that extent.

The use of the words “………………….. to the entire exclusion and surrender of my/our rights as sureties in competition with the Bank (and) any rule of law or equity to the contrary notwithstanding” in para 10 violates section 28 of the Contract Act, hence Para 10 of the Letter of Guarantee is void.

3.8. Paragraph no. 15

“The guarantee hereby given is independent and distinct from any security that the Bank has taken or may take in any manner whatsoever whether it be by way of hypothecation/pledge and/or mortgage and/or any other charge over goods, movables, ……………………………… and I/We (and) the Guarantor will not claim to be discharged to any extent because of the Bank’s failure to take any of other such security or in requiring or obtaining any or other such security or losing for any reason whatsoever,including reasons attributable to its default and negligence, benefit of any or other security or any of rights to any or other such security that have been or could have been taken.”

3.9. It is pertinent to note here that all the banks and/or financial institutions have incorporated in their Personal Guarantee Agreements almost identical clauses as quoted above.

4. Mandatory waiver of the rights conferred on a guarantor by sections 133, 134, 135, 139 and 141 of the Contract Act ?

An extract of paragraph no. 4 of Letter of Guarantee of Dena Bank is reproduced below for ready reference:

“ …………. I/We also agree that I/We shall not be discharged from my/our liability by your releasing the Principal or by any act or omission of yours the legal consequence of which may be to discharge the Principal or by any act of yours which would but for this present provision be inconsistent with my/our rights as surety or by your omission to do any act, which, but for this present provision your duty to me/us would have required you to do. I/We hereby consent to each and every of the acts mentioned above as you may think fit. Moreover though as between the borrower and me/us, I am/We are sureties only, I/We agree that as between yourselves and me/us I am/We are borrowers jointly with him accordingly I/We shall not be entitled to any of the rights conferred on sureties by Section 133, 134, 135, 139 and 141 of the Indian Contract Act. ……… And for all the purposes of this claim thePrincipal is empowered to give consent on my/our behalf and any consent given by the Principal shall be deemed to have been given by me/us in all respects as if the same had been expressly given by me/us in writing.”

4.1. Guarantor is entitled to invoke the provisions of section 141 of the Indian Contract Act

A 3 judge bench of hon’ble Supreme Court in State Bank Of Saurashtra Vs. Chitranjan Rangnath Raja And Anr. {1980 AIR 1528; 1980 SCR (3) 915; 1980 SCC (4) 516, Date of Judgment 30/04/1980} held as follows:

“It is difficult to entertain a contention that s. 141 would not be attracted and the surety would not be discharged even if it is found that a creditor has taken more than one security on the basis of which advance was made and the surety gave personal guarantee on the good faith of other security being offered by the principal debtor which itself may be a consideration for the surety offering his personal guarantee and the creditor by its own negligence lost one of the securities.Acceptance of such a contention would tantamount to putting a premium on the negligence of the creditor to the detriment of the surety who is usually described as a preferred debtor.Should a Court by its construction of such letter of guarantee enable the creditor to act negligently and yet be not in any manner accountable ?” (Italics supplied)

5. There could be no waiver of the fundamental right founded on Article 14 of the Constitution

Now, therefore, in this context let us examine the earlier case laws as to whether there could be a waiver of the provisions of the Indian Contract Act, 1872 (hereinafter referred to as ‘the Act’), keeping in view the fundamental right of equal protection of laws enshrined in Article 14 of the Constitution of India. It is pertinent to note here the maxim Nemo potest renunciare juri publico means ‘No one can renounce a public right’.

5.1. Article 14 provides as follows

“The State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India.”

5.2. A 7 judge Constitution Bench of hon’ble Supreme Court in Maneka Gandhi Vs. Union Of India {1978 AIR 597; 1978 SCR (2) 621; 1978 SCC (1) 248; Date of Judgment 25/01/1978} held as follows.

“Now, the question immediately arises as to what is the requirement of Article 14; what is the content and reach of the great equalising principle enunciated in this article ? There can be no doubt that it is a founding faith of the Constitution. It is indeed the pillar on which rests securely the foundation of our democratic republic. And, therefore, it must not be subjected to a narrow, pedantic or lexicographic approach. No attempt should be made to truncate its all embracing scope and meaning, for, to do so would be to violate its activist magnitude. Equality is a dynamic concept with many aspects and dimensions and it cannot be imprisoned within traditional and doctrinaire limits. We must reiterate here what was pointed out by the majority in E. P. Royappa v. State of Tamil Nadu & Another (1975) 2 S.C.R. 832, namely, that “from a positivistic point of view, equality is antithetic to arbitrariness. In fact equality and arbitrariness are sworn enemies; one belongs to the rule of law in a republic, while the other, to the whim and caprice of an absolute monarch. Where an act is arbitrary, it is implicit in it that it is unequal both according to political logic and constitutional law and is therefore violative of Article 14″.

6. Laws inconsistent with or in derogation of the fundamental rights shall be void as per Article 13 of the Constitution

Article 13.-Laws inconsistent with or in derogation of the fundamental rights

(1) All laws in force in the territory of India immediately before the commencement of this Constitution, in so far as they are inconsistent with the provisions of this Part, shall, to the extent of such inconsistency, be void.

(2) The State shall not make any law which takes away or abridges the rights conferred by this Part and any law made in contravention of this clause shall, to the extent of the contravention, be void.

(3) In this article, unless the context otherwise requires

(a) ”law” includes any Ordinance, order, bye law, rule, regulation, notification, custom or usages having in the territory of India the force of law;

(b) “laws in force” includes laws passed or made by Legislature or other competent authority in the territory of India before the commencement of this Constitution and not previously repealed, notwithstanding that any such law or any part thereof may not be then in operation either at all or in particular areas.

(4) Nothing in this article shall apply to any amendment of this Constitution made under Article 368.

6.1. A 7 Judge Constitution Bench of Supreme Court in The State Of West Bengal Vs. Anwar All Sarkarhabib Mohamed,The State Of Hyderabad, and Ors. (1952 AIR 75; 1952 SCR 284; Date of Judgment: 11/01/1952) held as follows:

“………Article 14 secures all persons within the territories of India against arbitrary laws as well as arbitrary application of laws. This is further made clear by defining “law” in article 13 (which renders void any law which takes away or abridges the rights conferred by Part III) as including, among other things, any “order” or “notification”, so that even executive orders or notifications must not infringe article 14. This trilogy of articles thus ensures non-discrimination in State action both in the legislative and the administrative spheres in the democratic republic of India…………”

6.2. Meaning of the term ‘Custom’

As per P Ramanatha Aiyar’s the Law Lexicon, 2^nd Edition 1997(Reprint 2007) at page 455 the term “Custom” in the legal sense means a long established practice considered as unwritten law and resting for authority on long consent, for instance the custom of free grazing in the village waste.

6.3. Execution of personal guarantee agreement is a ‘Custom’, being a long established Banking practice

As aforesaid, since long the public sector banks and financial institutions have unilaterally and arbitrarily developed a practice to execute personal guarantee agreements with the guarantors to secure the debts of a company. This view is supported by the latest judgment of the Supreme Court in Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (supra) (in para 18):

“18. Banking practice may enable a financial corporation to ask for a collateral security. Such security, we would assume, may be furnished by the Directors of a Company but furnishing of such security or guarantee is not confined to the Directors or employees or their close relatives. They may be outsiders also. The rights and liabilities of a surety and the principal borrower are different and distinct.” (italics supplied)

In view of above, the Banking practice of execution of personal guarantee agreements established by the banks is a ‘custom’, having in the territory of India the force of law, therefore is a ‘law’ as defined in Article 13(3) of the Constitution. As majority of the clauses of Personal Guarantee Agreement, quoted above, have denied to the guarantors the equal protection of the laws enjoined by Article 14 of the Constitution, particularly the Indian Contract Act, 1872, this Banking practice is unconstitutional and void under Article 13(2) of the Constitution as detailed below.

7. There could be no waiver, not only of the fundamental right enshrined in Article 14 but also of any other fundamental right guaranteed by Part III of the Constitution

A 5 Judge Constitution Bench of hon’ble Supreme Court in Basheshar Nath vs. The Commissioner of Income-tax, Delhi & Rajasthan & another {1959 AIR 149; 1959 SCR Supl. (1) 528, date of judgment 19/11/1958} held as follows (Per Curiam):

“Per Das, C. J., and Kapur J.-There could be no waiver of the fundamental right founded on Article 14 of the Constitution and it was not correct to contend that the appellant had by entering into the settlement under s. 8A of the Act, waived his fundamental right under that Article. Article 14 was founded on a sound public policy recognised and valued all over the civilised world, its language was the language of command and it imposed an obligation on the State of which no person could, by his act or conduct, relieve it…………. “(Italics supplied)

Hon’ble Court further observed: “Per Bhagwati and Subba Rao, JJ.-There could be no waiver, not only of the fundamental right enshrined in Art. 14 but also of any other fundamental right guaranteed by Part III of the Constitution. The Constitution made no distinction between fundamental rights enacted for the benefit of the individual and those enacted in the public interest or on grounds of the public policy. There could, therefore, be no justification for importing American notions or authority of decided cases to whittle down the transcendental character of those rights, conceived in public interest and subject only to such limitations as the Constitution had itself thought fit to impose.” “(Italics supplied)

8. The fundamental rights, enshrined in Part III of the Constitution, are inherent and cannot be extinguished by any Constitutional or Statutory provision

8(a). Recently in State of West Bengal & Ors. v. The Committee for Protection of Democratic Rights, West Bengal & Ors. {(2010) 3 SCC 571; Date of Judgment 17.02.2010} a 5 Judge Constitution Bench of Supreme Court having examined the rival contentions in the context of the Constitutional Scheme, concluded as follows: (SCC pp. 600, para 68)

“68(i).The fundamental rights, enshrined in Part III of the Constitution, are inherent and cannot be extinguished by any Constitutional or Statutory provision. Any law that abrogates or abridges such rights would be violative of the basic structure doctrine. The actual effect and impact of the law on the rights guaranteed under Part III has to be taken into account in determining whether or not it destroys the basic structure.”

8(b). Supreme Court further observed as under: (SCC pp. 602, para 69)

“69…….Being the protectors of civil liberties of the citizens, this Court and the High Courts have not only the power and jurisdiction but also an obligation to protect the fundamental rights, guaranteed by Part III in general and under Article 21 of the Constitution in particular, zealously and vigilantly.”

9. Law declared by Supreme Court to be binding on all Courts

Article 141 of the Constitution provides that “the law declared by the Supreme Court shall be binding on all Courts within the territory of India.” Now let us examine the concept in detail as held by the Supreme Court in its various decisions.

All courts in India are bound to follow the decision of the Supreme Court even though they are contrary to the decisions of the House of Lords or of the Privy Council.

‘Law declared’ – In case of conflict between decisions of the Supreme Court itself, it is the latest pronouncement which will be binding upon the inferior courts; unless the earlier was of a larger bench. If the later decision is that of a larger bench the previous decision will be deemed to have been overruled and completely wiped out. This rule is followed by the Supreme Court itself. (Source: The Book ‘Shorter Constitution of India’ by D.D.Basu, 11^th edition 1994 Pp 475-479)

10. Conclusion

It stands concluded that a public sector bank or financial institution is “the State” as per Article 12 of the Constitution of India, consequent to which it has to act reasonably and in the interest of the country, economy, its borrowers as well as safeguarding interest of its depositors. It has to act in rational manner and can not act in arbitrary manner. The Banking practice of execution of personal guarantee agreements established by the banks is a ‘custom’, having in the territory of India the force of law, therefore is a ‘law’ as defined in Article 13(3) of the Constitution. As majority of the clauses of Personal Guarantee Agreement, quoted above, have denied to the guarantors the equal protection of the laws enjoined by Article 14 of the Constitution, particularly the Indian Contract Act, 1872, this Banking practice is unconstitutional and void under Article 13(2) of the Constitution. Consequently, the personal guarantee taken by the Bank is a void agreement, being in violation of Article 14 of the Constitution. (END)