Commercial Undertakings vs Contracts of Guarantee: Deciphering the Enforceability of Promoter Support in Corporate Debt Financing

Introduction : In the event of financial difficulty, there is a critical difference between a commitment to arrange or provide equity and a legally binding guarantee, and lenders will typically look to sponsors or promoters to provide risk-mitigation measures such as third-party guarantees, support agreements, letters of comfort, shortfall undertakings, and non-disposal covenants.

This article deals with conditions precedent of a contract of guarantee under the Indian Contract Act, 1872 and how such promises are treated under the Insolvency and Bankruptcy Code, 2016 (IBC), highlights relevant court decisions and provides some guidance for lenders on drafting such promises.

Legal Provisions

• Section 126 of the Indian Contract Act, 1872: defines a “contract of guarantee” as a contract between a principal debtor, creditor and surety, which stipulates that a third person is to be bound by the contract, or discharged from it, in the event of his default.

• Section 127 of the Indian Contract Act, 1872: It lays down the rules for consideration in guarantee contracts, which means that anything done or promised for the benefit of the principal debtor shall be sufficient consideration for the surety.

• Section 128 of the Indian Contract Act, 1872: Prescribes the co-extensive nature of surety liability with that of the principal debtor.

• Section 5(8)(h) & (i) of the Insolvency and Bankruptcy Code, 2016: Defines the term “financial debt” and guarantees liabilities in case of default.

• Section 7 of the Insolvency and Bankruptcy Code, 2016: Provides for the commencement of the Corporate Insolvency Resolution Process (CIRP) by the financial creditors against the corporate debtor and corporate guarantors.

Legal Analysis

The four legal factors which courts use to determine whether a contract is an enforceable guarantee or merely a commercial transaction are:

Intention and the Tripartite Contractual Nexus

The essence of the contract of guarantee under the Indian Contract Act, 1872 is that the surety will be liable for the debt of the principal debtor to the creditor if the principal debtor fails to pay the debt. By contrast, promoter support agreements or sponsor letters are usually between the lender and the promoter, or the borrower and the promoter, and are meant to help with capital or cash shortfalls. Absent clear intent and wording to take on secondary liability for the debtor’s obligations, a promise to arrange funds is not a contract of guarantee.

Definitive Wording vs Vague Commercial Assurances

Whether a contract is enforceable depends on the words used in the contract: Definitive Guarantee Clauses: include clear covenants like “unconditionally and irrevocably guarantees repayment,” “undertakes to discharge the liability upon first written demand,” and “acts as a primary obligor and not simply surety.”

Commercial support documents frequently include terms such as: “The promoter will provide funding to cover project cost overruns”, “The promoter will contribute required equity”, or “Comforts the borrower with respect to the functional viability”. These are assurances or best efforts promises made for commercial reasons, not promises to pay off the loan.

Distinct Consideration Requirements

Section 127 of the Indian Contract Act says that any benefit given to the principal debtor counts as valid consideration for a surety’s guarantee. If a promise is merely a commercial equity infusion or a letter of comfort, however, it must be separately and adequately considered in general contract law to be enforceable. Without this, the promise is just a non-binding assurance or moral comfort.

Under the IBC, the consequences of recovery and insolvency are as follows

How the instrument is classified directly affects what recovery options the lender has under the Insolvency and Bankruptcy Code, 2016:

• Remedies Under Guarantees: Under the IBC definition of "financial debt" under Section 5(8)(h)/(i), liabilities under invoked corporate guarantees fall under the definition. In case of a default by the borrower, the lender may continue the application under Section 7 of the IBC against the corporate guarantor without first taking any action against the principal debtor.

• Remedies under support promises: A promise to provide funds or arrange financing is not considered a "disbursement against consideration for the time value of money" or a secondary assumption of debt. Thus, if this promise is violated, it is not considered financial debt under Section 5(8) of the IBC. This implies that lenders may only seek civil remedies, such as damages and/or specific performance, and not seek to invoke the Corporate Insolvency Resolution Process (CIRP).

Case Laws

V Asset Reconstruction Company Ltd. v. Electrosteel Castings Ltd. 

The Supreme Court considered whether a promoter’s promise to arrange funds counts as a statutory guarantee under Section 126 of the Indian Contract Act, 1872. The Court held that a promoter’s (ECL) promise to provide funds to the borrower (ESL) to meet financial requirements is not a contract of guarantee. A promise to pay the creditor if the debtor fails to do so is a guarantee, not a mere promise to maintain financial discipline or liquidity.

Lucent Tech Inc. v. ICICI Bank Ltd. & Ors

The Delhi High Court considered the question of the enforceability of letters of comfort in the context of structured financing, and held that they are not binding guarantees unless they contain a clear legal obligation to pay another party's debt.

Edelweiss Asset Reconstruction Co. Ltd. v. GTL Infrastructure Ltd.

They examined Sponsor Support Agreements and non-disposal undertakings and debt-restructuring cash flow tools under the IBC and confirmed that promises in Sponsor Support Agreements to fund these gaps or to provide direct operational proceeds are not necessarily a corporate guarantee or a financial debt under Section 5(8) of the IBC unless the language is clear and unambiguous.

Practical Consequences

The difference between promoter promises and enforceable guarantees has important effects on the lending market:

• Limits apply to risk profile of institutional lenders who rely on shortfall undertakings or comfort letters as back-up security. In the absence of an enforceable guarantee, they are unable to avail of the speedy insolvency proceedings under the IBC, if there is a default.

• Balance sheet exposure for promoters and sponsors: Promoters who use letters of comfort or equity commitment agreements may not have to show contingent liabilities on their financial statements, as long as these promises aren't considered assurances under Section 126.

• In insolvency proceedings, creditors holding only commercial comfort letters are not allowed to become secured financial creditors against the sponsor in the context of a restructuring or debt recovery. This has a significant influence on the amount of debt that they can recover.

Guidance for Lenders on Documentation & Drafting of Support Letters

Lenders and lawyers can help prevent such confusion by using clear and precise drafting techniques in the following structural components:

Operative Clause : Enforceable Guarantee Approach: Explicit Covenant to pay the underlying loan amount if defaulted. Non-Binding Commercial Support Approach: Express covenant to introduce equity or arrange subordinated debt or provide “best efforts”.

Identity of Obligor :Enforceable Guarantee Approach: Specified as the "Guarantor" or "Surety" as a primary obligor. Non-Binding Commercial Support Approach: Any person who is a "Sponsor," "Promoter," or "Supporting Shareholder.

Remedies on Default : Enforceable Guarantee Approach: Acceleration of debt as financial liability and recovery of the debt immediately under IBC (Insolvency and Bankruptcy Code). Non-Binding Commercial Support Approach: Damages for breach of contract or an action for specific performance under civil law.

Indemnity & Waiver : Enforceable Guarantee Approach: Contains specific waiver of Sections 133–141 of the ICA (surety liability is not waived as a result of restructuring). Non-Binding Commercial Support Approach: Excludes statutory surety waivers, emphasises equity lock-in and share retention requirements.

Specific Drafting Safeguards for Institutional Lenders

Remove any conflicting hybrid clauses: There should be no best-effort equity infusion clauses and conditional guarantee clauses in documents. The deed must be well worded and structured from the outset as an "Unconditional and Irrevocable Deed of Guarantee".

Include terms for first demand repayment obligations: In the case of sponsor shortfall undertakings as credit enhancements, include clear terms that the sponsor will be directly liable to the lender for the shortfall if the lender makes a written demand.

Indicate consideration recitals in Section 127: Make it clear that giving the loan to the borrower is direct and adequate consideration for the obligations of the parties. Whether a commercial commitment to make funds available is equivalent to an enforceable commitment to provide a secondary debt is dependent on the legal intent, the language of the contract, and the language of the commitment to provide a second debt obligation. A promise to provide funds or sponsor support without a clear obligation to pay in case of a default by the borrower cannot be enforced as a guarantee under Section 126 of the Indian Contract Act or as financial debt under the IBC. Financial institutions, promoters and lawyers should draft financing papers carefully, so that legal enforceability matches the parties' commercial intent.

Conclusion

The difference between a non-binding commercial comfort and an enforceable contract of guarantee is narrowly drawn and hinges on the intent and on the specific language of the contract. In both Indian Contract Act, 1872 and Insolvency and Bankruptcy Code, 2016, the courts have held that such "generous" representations of arranging funds or keeping a liquidity position do not impose a secondary obligation to repay, nor do they constitute “financial debt” for corporate insolvency to arise.

As institutional lenders and legal practitioners, they need to eliminate ambiguity in documentation between commercial expectations and legal reality. If the goal is to reduce credit risk through third-party recourse, the instrument should clearly state existing unconditional first-demand repayment covenants and the appropriate statutory waivers. Lastly, a sponsor's support can only be ensured to become binding on the sponsoring party if the terms are drafted with precision, in case they are defaulted.

Author: Shreya Mukherjee in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney

References

1. See Promoter’s Undertaking to Infuse Funds Does Not Amount to a Contract of Guarantee Under Section 126 of the Indian Contract Act: A Critical Analysis of the Supreme Court’s Ruling, Bhatt & Joshi Associates (Oct. 22, 2023), https://bhattandjoshiassociates.com/promoters-undertaking-to-infuse-funds-does-not-amount-to-a-contract-of-guarantee-under-section-126-of-the-indian-contract-act-a-critical-analysis-of-the-supreme-courts-ruling/.

2. See Undertaking to Infuse Funds Not a Guarantee, Asialaw (Sept. 8, 2023), https://www.asialaw.com/NewsAndAnalysis/undertaking-to-infuse-funds-not-a-guarantee/Index/2509.

3. The Indian Contract Act, 1872, § 126, No. 9, Acts of Parliament, 1872 (India).

4. Id. § 127.

5.  Id. § 128.

6. The Insolvency and Bankruptcy Code, 2016, § 5(8)(h)–(i), No. 31, Acts of Parliament, 2016 (India).

7. Id. § 7.

8. Promoter’s Undertaking to Infuse Funds Does Not Amount to a Contract of Guarantee Under Section 126 of the Indian Contract Act, supra note 1.

   ⁹ See Guarantee or Mere Commercial Assurance: Impact on Recovery Process, Indian Rev. Corp. & Com. L. (IRCCL) (Nov. 14, 2023), https://www.irccl.in/post/guarantee-or-mere-commercial-assurance-impact-on-recovery-process.

9. The Insolvency and Bankruptcy Code, 2016, § 7; see also Guarantee or Mere Commercial Assurance: Impact on Recovery Process, supra note 9.

10. Promoter’s Undertaking to Infuse Funds Does Not Amount to a Contract of Guarantee Under Section 126 of the Indian Contract Act, supra note 1.

11. UV Asset Reconstruction Co. Ltd. v. Electrosteel Castings Ltd., 2024 SCC OnLine SC 123.

12. Lucent Techs. Inc. v. ICICI Bank Ltd., (2009) 165 DLT 412 (Del).

13. Edelweiss Asset Reconstruction Co. Ltd. v. GTL Infrastructure Ltd., 2020 SCC OnLine Del 1478; see also Guarantee or Mere Commercial Assurance: Impact on Recovery Process, supra note 9.

14. UV Asset Reconstruction Co. Ltd. v. Electrosteel Castings Ltd., 2024 SCC OnLine SC 123, supra note 13.