Analyzing the enforceability of ‘letter of comfort’ under IBC

Introduction

In the case of Shapoorji Pallonji and Company Pvt. Ltd. v. ASF Insignia SEZ Pvt. Ltd., the Hon’ble National Company Law Tribunal, New Delhi (“NCLT”) recently ruled that “an entity who has given a ‘Letter of Comfort’ (LoC) cannot be viewed as a corporate debtor or a corporate guarantor within the framework of law.” The adjudicating authority was of the view that a letter of comfort could not be equated with a contract of guarantee as given under Section 126 of the Indian Contract Act, 1872.

A ‘Letter of Comfort’ (LoC), also known as a ‘Letter of Intent’ or ‘Letter of Support’, is a banking and financial document issued by a parent company assuring the lenders that the financial obligations of its subsidiary company would be met. It is generally understood to be non-binding in nature and is treated as a mere moral obligation with regard to the performance of financial duties. They are widely used in commercial transactions as a means to provide some sort of comfort to the lenders while at the same time securing lending facilities for the borrower.

In this case, Shapoorji Pallonji and Company Pvt. Ltd. (“SPC”) and Black Canyon SEZ Private Limited (“Black Canyon”) entered into a contract under which SPC agreed to provide Black Canyon with duly certified works in exchange for a consideration or payment that Black Canyon would bear. ASF Insignia SEZ Pvt. Ltd. (“AIS”) had provided a letter of comfort in which AIS agreed that if Black Canyon failed to pay for the works performed by SPC, AIS would intervene and secure prompt payment of such dues.

As a result of Black Canyon’s failure to meet its payment commitments to SPC, SPC submitted a demand notice to AIS under Section 8 of the Insolvency and Bankruptcy Code, 2016 (“IBC”), to which AIS reacted by asserting that AIS did not assume any repayment responsibilities to SPC, even as a guarantee under the comfort letter.

They further claimed that the contents of the LoC cannot be seen as imposing a duty of guarantee on them because they did not assume any repayment obligations; rather, the letter simply stated that they would step in and make sure Black Canyon complied with its payment commitment in the event of default.

After that, SPC submitted an application under Section 9 of the IBC to begin the corporate insolvency resolution procedure against AIS. After evaluating the relevant facts and circumstances, the NCLT dismissed SPC’s Section 9 application as being unmaintainable and determined that AIS cannot be viewed as a “corporate guarantor” under Section 5(5A) of the IBC and that the extant obligation cannot be regarded as an operational debt under Section 5(21) of the IBC.

In the light of this case, it becomes pertinent to discuss the enforceability of LoC and the liability that such issuers of letters might face under the framework of law.

Letter of comfort & letter of guarantee distinguished

Quite often, letters of comfort are misunderstood to be similar to “Contracts of Guarantee” though a significant difference persists between the two with respect to their nature, enforceability and the liabilities arising out of them.

A Contract of Guarantee (CoG) has been defined under Section 126 of Indian Contract Act and it requires presence of three parties i.e., principal debtor, surety and the creditor. A CoG is an independent contract in itself, wherein the surety voluntarily agrees to bind himself to the repayment obligations.

A CoG is legally enforceable, and in the event of surety default, a claim can be made against him; however, the same cannot be said of LoC.  Unlike CoG which are specifically defined under Section 126 of the Indian Contract Act, 1872 and governed by Section 372A, 295, etc. of the Companies Act, 2013, LoCs do not have any such statutory or legal framework.

Their applicability and enforceability heavily depend on the words used and the intention of the parties, as has been held in a catena of cases across jurisdictions, including India.

LoC in foreign jurisdictions

An attempt to answer the question whether LoC are enforceable in nature was first dealt by the English Court of Appeal in Kleinwort Benson Ltd. v. Malaysia Mining Corp. Bhd. [(1989) 5 BCC 337 (CA)]. In this case, the plaintiff bank issued a £5m credit line to the subsidiary of the defendant in lieu of a LoC from the defendant, which stated, “it is our policy to ensure that the business of the subsidiary is at all times in a position to meet its liabilities to you under the above arrangements.”

When the subsidiary defaulted, the bank sued the defendant for compensation under this LoC. The court rejecting this plaint held that a LoC, which is merely a representation of fact or present practice of a parent company, would not amount to a contractual promise as to its future conduct.

However, this judgement was criticized as the court placed heavy reliance on the usage of words in the LoC rather than on the intention of the parties. Critiquing the above interpretation as unnecessarily technical and commercially unrealistic, the Supreme Court of New South Wales in Banque Brussels Lambert SA v. Australian National Industries Ltd. [(1989) 21 NSWLR 502], treated the LoC in question to be a guarantee as the requisite intention of the parties to involve in contractual liabilities and language of the instrument were sufficient to create a binding obligation on the author of instrument.

The court also laid down certain principles to decide whether an LoC gives rise to contractual obligations. The Court first said that the ordinary rules of construction and interpretation relating to contracts would apply. Secondly, it said that the intention of the parties, deducible from documents and events surrounding its inception seen in the context of existing practices in the industry, would be the overriding factor.

Lastly, the Court stated that the prima facie presumption would always be in favour of the intention of the parties and it would be the burden of the party claiming no legal effect to disprove the presumption. These are popularly known as the Banque Brussels Principles.

Similarly, courts in Malaysia and Singapore held that the enforceability of LoC depends less on the terms used and more on the intention of the parties in each case along with the surrounding circumstances. In China, the courts have held that a LoC which assures mere commitment to performance of financial obligation is not enforceable in nature. The LoC must include an assumption of guaranteed obligation.

Indian jurisdiction on LoC

When the Karnataka High Court was encountered with the case of United Breweries (Holdings) Ltd. v. Karnataka Industrial Investment and Development Corporation Ltd. [AIR 2002 Kar 65], it said that “where a person has not stood as a guarantor or surety, he cannot be treated as a guarantor or surety without there being a specific undertaking by him that he would discharge the liability of the third person in the case of his default.” The court held that the LoC given by the appellant was not a guarantee as it merely stated the ‘normal practice’ of the company and was more in the nature of a recommendatory letter.

Similarly, in Lucent Technologies Inc. v. ICICI Bank Limited & Ors., the court was confronted with the issue of construction and legal impact of LoC. Applying, the principles laid down in the Banque Brussels case, the court concluded that the LoC issued by Lucent Technologies did not create any legal relations and thus could not be deemed to be a guarantee. Therefore, the issuer was declared free from any financial obligation under the agreement between the borrower and the bank.

The Bombay High Court in Yes Bank Ltd. v. Zee Entertainment Enterprises Ltd. while holding that the enforceability of an LoC in India depends upon the actual terms of the LoC and the intent of the parties and that there is no “one size fits all” approach to an LoC necessitating the need to be interpret each LoC independently, carved the following guidelines:

1. Not every LoC can be considered a guarantee. The nomenclature is important.
2. An LoC should be read as a whole in the context of the transaction and the associated documents.
3. An LoC can be a guarantee only if it conforms to the provisions of Section 126 of the Contract Act, 1872.
4. The guarantor cannot be made liable for anything more than the terms stated in the document.
5. The role and conduct of each party to a commercial contract have to be taken into consideration while interpreting the contract.

Therefore, it can be stated that the wording used and the intentions of the party are critical in determining whether an LoC is enforceable in India.

Conclusion

In commercial transactions based on credit financing, the classification of liabilities originating under an LoC and its execution as a guarantee has consistently remained a difficult subject. Since LoCs typically do not follow a standard format, it is necessary to examine the wording, language, and context to determine the parties’ intentions. Thus, it becomes critical that the language of the LoC aligns with the intention of the parties.

Thus, from the above discussion, it is quite clear that where the LoC can be reasonably interpreted as a CoG, the issuer of the LoC will be treated as a corporate guarantor under Section 5(5A) and claims shall lie against him. This is most likely to happen where the issuer explicitly undertook or guaranteed a financial payment or where the words and the terms of the LoC imply that the parties had the intention to enter into a legal relationship. Therefore, parties should exercise due care and attention while wording the LoC to avoid any future possible dispute.

This article has been authored by Yashila Bansal and Shubham Sharma, students at Chanakya National Law University, Patna.