Personal Guarantee-A Void Agreement

1. Personal Guarantee Agreement

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 recent 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 suretiesby 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 and surrender 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 suretiesby 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 maximNemo 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 theterritory 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 ofIndia………...”

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)

By Narendra Sharma, Consultant (Legal)

E-mail: nkdewas@yahoo.co.in