The TJSB Sahakari Bank Ltd. v. Amritlal P. Shah

15. He submits that in the Dispute Application itself, the petitioner stated that the borrowers had disposed of the hypothecated goods. The petitioner was aware of this disposal. In spite of such knowledge, the petitioner sanctioned another loan of Rs 89 lakhs. The petitioner still took no steps against the borrowers regarding the unlawful sale of the goods.

16. He submits that under the Hypothecation Agreement a) the borrower could not remove the goods till the dues were cleared; b) the borrower had to indemnify the petitioner for any loss due to damage or destruction; c) the petitioner could enter the premises at any time for inspection d) the petitioner’s name was to be clearly marked on the goods; e) the petitioner could take possession of the goods till the dues were paid; f) if the borrower failed to pay the installments, the petitioner had the right to sell the goods and apply the proceeds to the loan dues

17. He submits that these terms show that the petitioner had wide powers. Though possession remained with the borrower, the borrower held the goods in trust for the petitioner and acted as petitioner’s agent. The petitioner had the power and duty to ensure that the goods remained available when security had to be enforced. The petitioner was required to supervise and control the hypothecated goods. Because the petitioner failed to exercise its powers, the goods were lost. He relies on Indian Bank v. M Ambika, 2000 SCC OnLine Kar 228, and Suresh Bhailal Mehta v. Union Bank of India, 1996 SCC OnLine Guj 100, where courts held that negligence or inaction of the creditor in respect of hypothecated goods results in discharge of surety.

18. Respondent No.1 also relies on M R Chakrapani Iyengar v. Canara Bank, 1996 SCC OnLine Kar 533. The Karnataka High Court held that in cases of hypothecated goods, the bank must exercise higher vigilance. The Court held that if the security disappears, the bank must take adequate steps including lodging a police complaint. The Court held that when the surety gives information about the security, but the bank still does not act, the surety stands discharged under Section 139.

19. On the basis of these judgments, respondent No.1 submits that the petitioner’s negligence and failure to act resulted in loss of hypothecated goods. Hence, respondent No.1 stands discharged as surety.

20. Mr. Sharad Bansal submits that the petitioner now argues that the promissory notes were executed by respondent No.1 as borrower and not as surety. He submits that this argument has been raised for the first time in oral submissions. It contradicts the petitioner’s own pleadings and evidence. a) In the writ petition, the petitioner stated that respondent No.1 executed the promissory notes as security or as guarantor. The writ petition originally had no pleading that respondent No.1 was liable as borrower. b) In the Dispute Application, the petitioner did not allege that respondent No.1 was liable as borrower. The entire claim was based on guarantee. c) The affidavit of petitioner’s witness before the Cooperative Court states that the promissory notes were executed as security. d) The acknowledgment of debt dated 31 March 1998 also refers to respondent No.1 as guarantor.

21. Hence, the promissory notes were executed in the capacity of surety and not as borrower. Once respondent No.1 stands discharged under Section 139, no liability survives under the promissory notes. He relies on (a) S Chattanatha Karayaiar v. Central Bank of India, 1965 SCC OnLine SC 67; (b) State Bank of Saurashtra v. Chitranjan Rangnath Raja, (1980) 4 SCC 516; and

(c) Bank of India Ltd. v. Fustom Fakirji Cowasjee, 1954 SCC

22. He submits that the petitioner relies on documents dated 31 March 1998 to show liability of respondent No.1. However, in an Arbitral Award dated 2 May 2024 between the petitioner and respondent No.1, the Arbitrator held that the signatures of respondent No.1 were obtained by coercion and misrepresentation. Hence, the documents are not binding. The petition challenging the award is pending. There is no stay on the award.

23. Respondent No.1 submits that this finding binds the parties and operates as res judicata. He relies on Ferrodous Estates Pvt Ltd v. P Goparathnam, 2020 SCC OnLine SC 825; and Mathura Prasad v. Bossibai N B Jeejeebhoy, (1970) 1 SCC 613.

24. He submits that respondent No.1 is also discharged due to change in the constitution of the borrower. (a) The original borrower was a sole proprietorship. (b) The petitioner claims that it became a partnership firm on 8 January 1998.

(c) The petitioner’s witness says respondent No.1 signed a letter dated 31 March 1998 consenting to this transfer.

(d) The award records that petitioner’s witness admitted in cross-examination that intimation of change into partnership was received only in the year 2000. Therefore, the document dated 31 March 1998 could not have been signed in the manner claimed. Therefore, respondent No.1 as surety stood discharged under Section 133 of the Contract Act.

25. I have heard the learned counsel for the parties. I have examined the documents placed on record. Each argument raised by the parties must be examined in the light of the law and the evidence placed before the court. The task of the court is not to accept assertions at face value. The court must verify whether the submissions are supported by the documents and whether they stand the test of settled legal principles. Every contention must be tested on three points. First, whether the argument has a foundation in the contract or in the law. Second, whether the facts on record support what is being claimed. Third, whether the argument leads to a result that is fair and consistent with the rights and duties of the parties. The court cannot adopt an approach of general suspicion or assumption. A party who asserts that the surety stands discharged must prove the elements required under law. The creditor cannot be penalized when the contract does not impose the duty that the surety alleges. In the same way, the surety cannot be held liable if the creditor has acted in a manner that destroys the security. Therefore, each submission must be considered independently, and the conclusion must be based on the evidence and the legal principles already discussed. The decision on the discharge of a surety is not based on sympathy or broad notions of equity. It is based on precise statutory requirements. Only those submissions that satisfy these requirements can succeed.

26. To decide the issues involved in this case, it is necessary to examine the scope and effect of Sections 139 and 141 of the Indian Contract Act, 1872. Section 139 reads as under:- “139. Discharge of surety by creditors act or omission impairing surety’s eventual remedy. - If the creditor does any act which is inconsistent with the right of the surety, or omits to do any act which his duty to the surety requires him to do, and the eventual remedy of the surety himself against the principal debtor is thereby impaired, the surety is discharged.”

27. Section 139 casts a clear duty on the creditor. The creditor must not do anything, nor fail to do anything, which harms the right of the surety to recover the amount from the principal debtor. When the creditor takes an action, or fails to take necessary action, and because of that the surety loses the ability to proceed against the principal debtor, the law says that the surety stands discharged. The logic is rooted in fairness. A surety agrees to stand guarantee only with the expectation that, if he is forced to pay, he will be able to recover that amount from the principal debtor. If the creditor’s conduct makes that recovery difficult or impossible, the creditor cannot insist on the surety making payment. The law will not allow the creditor to take advantage of his own wrong. Section 141 reads as under:- “S.141. Surety’s right to benefit of creditors securities: A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not; and, if the creditor loses, or, without the consent of the surety, parts, with such security, the surety is discharged to the extent of the value of the security.”

28. Section 141 further strengthens this protection. When the creditor holds any security from the debtor at the time when the surety gives his guarantee, that security is treated as being held not only for the creditor’s benefit but also for the surety’s benefit. If the creditor releases that security or loses it by careless conduct, the surety is discharged to the extent of the value of the security. The law expects the creditor to act responsibly. The surety should not suffer because the creditor allowed the security to be wasted or lost. If the creditor does not safeguard the security, he cannot hold the surety liable for the same amount as if the security still existed.

29. Both these provisions show a clear legislative intent. A surety is not an easy target for recovery. His liability is secondary and conditional. The creditor cannot expand the surety’s liability by his own neglect or by giving up the rights or securities that existed at the time of the contract. The balance of rights between creditor, debtor, and surety must be preserved. The law protects the surety against any conduct of the creditor which weakens the surety’s legal position.

30. For a surety to be discharged under Sections 139 and 141, three conditions must be clearly proved.

31. First, there must be an act or omission by the creditor. The court must clearly identify what exactly the creditor did or failed to do. The conduct of the creditor must be specific and not based on assumptions or general allegations. If the creditor takes a step that he was not authorised to take under the contract, that becomes a positive act. If the creditor fails to take necessary steps which the contract requires, that becomes an omission. The court must examine the contract and the evidence to see whether the creditor was expected to act in a particular manner. Only if the contract casts a duty on the creditor, can failure to perform that duty be treated as an omission. If the contract does not impose any such duty, the law does not hold the creditor responsible for not taking such action. The existence of the duty must be shown from the contract or from legal obligations. Therefore, the first requirement is to identify from the record the exact action or inaction of the creditor. Without proof of such act or omission, the question of discharge of the surety does not arise.

32. Second. The act or omission of the creditor must violate the legal rights of the surety. The creditor must have acted in a manner that the contract did not allow, or must have ignored a duty that the contract clearly placed on him. The surety gives a guarantee on the understanding that the creditor will preserve the security. The surety’s liability depends on the continued existence of that security. If the creditor takes a decision that reduces the value of the security, or allows the security to be lost, the surety’s position becomes worse without his consent. The law does not allow the creditor to act in such a manner. The creditor must respect the terms of the guarantee and the surety’s rights flowing from it. The surety is entitled to expect that the security will remain available at the time of enforcement. If the creditor, by his conduct, weakens or destroys that security, the creditor cannot hold the surety liable. The law treats such conduct as inconsistent with the surety’s rights.

33. Third. The act or omission of the creditor must cause loss to the surety. Misconduct or inaction by itself does not discharge the surety. The court must see whether the creditor’s conduct resulted in the security being lost or reduced in value. The court must also see whether the surety’s liability has increased because of that conduct. There must be a clear connection between what the creditor did or failed to do and the loss that the surety now faces. If the loss would have occurred even without the creditor’s conduct, the surety cannot claim discharge. The law requires proof that the creditor’s conduct directly caused the loss. If no loss is shown, the surety continues to remain liable under the contract.

34. Unless all three conditions are satisfied, the surety continues to remain liable. The court must therefore check each condition carefully. If any one of these conditions is not proved, the surety remains bound by the guarantee. This ensures that the discharge of the surety is not granted lightly. It is granted only when the creditor’s conduct has, in fact, prejudiced the surety.

35. The bank’s case rests on four points. First, the security was hypothecated. The Hypothecation Agreement expressly contemplates that possession of book debts and stock-in-trade will remain with the borrower. Clause (iv) so provides. Hypothecation differs from pledge. Under this agreement control and custody remained with the borrower. Second, the Hypothecation Agreement conferred only a right of inspection on the bank under clauses (ix) and (xi). It did not cast on the bank a contractual duty to protect or look after the goods. The contract placed that duty on the borrower. Third, the guarantor waived protections under Sections 139 and 141 by express clauses in the Agreement. Clauses (xxiii), (xxix) and (xxx) operate to that effect. Fourth, the Demand Promissory Note is an independent primary liability. The bank produced and proved that note before the Cooperative Court. Even if the hypothecation were attacked, the note gives the bank a separate cause of action against respondent No.1.

36. These submissions find support from the documents placed before the court. The Hypothecation Agreement is the starting point. The agreement clearly states that the custody of the hypothecated goods remains with the borrower. The bank only retains the right to inspect the goods and, if required, to enforce the security. There is nothing in the agreement that makes the bank a trustee of the goods. There is no clause that requires the bank to take physical control or to guard the goods. Such an arrangement is common in commercial transactions. The borrower keeps the goods and uses them in business. The bank is given only a security interest. The bank is expected to monitor and inspect. It is not required to station guards or to take physical possession unless the contract gives such power or imposes such duty. When default occurred, the bank issued a demand notice in February

2001. The borrower did not comply. The bank then took the next legal step and filed a civil suit for recovery. This shows that the bank acted without delay. It used the remedy that the law provides. On the record, there is no material to show that the bank remained silent for an unreasonable period. There is no evidence of gross neglect. The conduct shown in the documents indicates that the bank acted in accordance with the agreement. The bank enforced its legal rights through proper procedure. In these circumstances, the bank cannot be blamed and cannot be denied the benefit of the contract.

37. It is argued by respondent no. 1 that the bank did admit that the borrowers sold the hypothecated goods. That fact is on record and cannot be ignored. Yet admission of disposal alone does not decide the case. The law looks beyond the fact of sale. It asks why and how the sale happened.

38. The key question is causation. Who caused the disposal? Did the bank do or omit something that allowed or encouraged the sale? The answer matters because Sections 139 and 141 require proof of the creditor’s wrongful act or omission that prejudiced the surety. A mere sale by the borrower, without proof that the bank’s conduct contributed to that sale, will not free the surety. The Appellate Court treated the bank’s own averment of disposal as an automatic reason to discharge the surety. That was a short cut. The Court did not enquire whether the bank had any contractual duty to take physical control or to guard the goods. The Court did not ask whether the bank knew of the sale and then stood idle for a long time. The Court did not examine whether any act or omission of the bank was inconsistent with the surety’s rights under the Hypothecation Agreement. Finally, the Appellate Court made no finding of bank negligence. Discharge under Sections 139 and 141 follows only when the creditor’s conduct causes loss to the surety. Without a finding on negligence or causation, the conclusion of discharge rests on an incomplete factual and legal foundation. The omission to test these elements makes the Appellate Court’s reasoning legally unsound.

39. The respondent no. 1 argues that by granting a further loan, the bank acted in bad faith. He claims that this proves negligence and shows that the bank helped the borrower instead of protecting the surety. This submission is not supported by the record. A bank may decide to extend further credit to a borrower for commercial reasons. Such decisions are based on business assessment and financial evaluation. Granting a loan does not automatically mean that the bank acted against the surety’s interest. The law does not presume mala fide intent only because credit was extended. To prove mala fide or negligence, the respondents must show that the bank granted the loan with an improper purpose. They must show that the bank knowingly put the surety at risk or ignored duties that the contract imposed. There is no such proof. The documents show that the bank continued its business relationship with the borrower. There is no material to show that the bank tried to protect the borrower or hide the sale of goods. There is also no material to show that the bank acted with the intention of harming the surety. The Appellate Court did not make any finding of mala fides. It did not hold that the bank acted with an improper motive. It did not state that the sanctioning of the further loan led to the loss of security. In the absence of such findings, a commercial decision cannot be treated as a breach of duty. A business decision by itself does not discharge the surety. Only when the bank’s conduct is inconsistent with the surety’s rights and causes loss can the surety seek discharge. No such link has been established. The surety therefore cannot escape liability on this ground.

40. The respondent no.1 argues that the bank did not use its powers under the Hypothecation Agreement. They say that since the bank had the right to inspect, mark and even sell the goods, the bank should have taken steps to secure the goods and prevent their disposal. This argument does not hold. The Agreement gives the bank these powers, but it does not make it mandatory for the bank to take physical custody of the goods. The contract clearly places the goods in the custody of the borrower. The bank may inspect or enforce if needed. The contract does not say that the bank must supervise the day-to-day movement of the goods or stand as a watchman. The bank exercised its legal right by issuing a demand notice and filing a suit when payment was not made. That shows prompt action. The law requires proof of neglect or breach of duty before a surety is discharged. Mere existence of powers in the contract is not enough. The respondents must show that the bank was passive for an unreasonable time and allowed the loss to occur. There is no such evidence. The record shows that after default, the bank acted in accordance with the contract. It used the legal remedy available to it and filed a civil suit. The Appellate Court did not record any finding that the bank neglected its duties. It did not point to any act or omission that violated the surety’s rights. Without such a finding, the Court cannot assume negligence only because the goods later went out of the borrower’s control. The law does not discharge a surety on assumptions. It requires clear proof that the creditor’s conduct caused the loss. Here, no such proof exists.

41. The respondent argues that in hypothecation matters, the bank must maintain a higher level of vigilance and care. It is argued that when a contract treats hypothecated goods as being held by the borrower in trust or as an agent of the creditor, the creditor is treated as having constructive possession. In such situations, the creditor may have a higher duty to preserve the security. The contract before this Court is different. Clause iv, read with the other clauses, makes it clear that the goods remained in the possession of the borrower. The contract does not say that the borrower would hold the goods as a trustee or as an agent of the bank. The contract only gives the bank the right to inspect or enforce the security if needed. It does not give the bank control over the goods. It does not cast a duty upon the bank to take physical custody of the goods. Since the contract keeps possession with the borrower and not with the bank, the principle of constructive possession does not apply.

42. The respondent no.1 relies on the Arbitral Award dated 2 May 2024. In that Award the Arbitrator has held that the signatures of respondent No.1 on certain documents were obtained by coercion and misrepresentation. The bank has already challenged that Award before this Court. The petition to set aside the Award is pending. There is no stay on the Award. In law an arbitral award continues to operate between the parties until it is set aside. However, while deciding this writ petition, I cannot reopen every finding of the Arbitrator. There is already a statutory remedy available to the parties. The correctness of the Award will be examined in those proceedings. The question in the present writ petition is different. Here the issue is whether the Appellate Court was justified in discharging the surety under Sections 139 and 141 of the Contract Act. The Appellate Court did not rely on the Arbitral Award as it was passed after delivery of the judgment. The Appellate Court did not hold that the promissory note is invalid because of the Award. Instead, the Appellate Court discharged the surety on the ground that the hypothecated goods were sold by the borrowers. That approach is incorrect. The Appellate Court should have examined whether there was any act or omission of the bank that violated the rights of the surety.

43. The existence of the Award does not cure the legal errors committed by the Appellate Court. The Award introduces disputed facts that must be tested in the proper proceeding. It does not justify the discharge of the surety in writ jurisdiction. The proper forum to test the validity of the Award is the petition filed under the Arbitration Act. The present writ petition concerns the incorrect application of Sections 139 and 141 of the Contract Act. Therefore, the Award cannot be used to sustain the Appellate Court’s conclusion. The Award may have its own consequences in the pending arbitration challenge. It does not support or validate the reasoning adopted by the Appellate Court to discharge the surety.

44. The respondent argues that the borrower changed from a sole proprietorship to a partnership firm and that such change automatically discharged him as surety. According to the respondent, if the business structure changed without his consent, his guarantee cannot continue. This contention does not stand on the record. The petitioner’s witness has clearly stated that respondent No.1 signed a letter dated 31 March 1998 consenting to the transfer of the loan from the sole proprietorship to the partnership firm. This means that, on the bank’s evidence, respondent No.1 himself agreed to continue as surety even after the change of constitution. The respondent relies on the crossexamination of the same witness, where it was stated that the bank came to know in the year 2000 that A.S. Construction became a partnership. On this basis, the respondent argues that there was no question of respondent No.1 signing the letter in March 1998. This reasoning is not acceptable. The fact that the bank formally received intimation in the year 2000 does not prove that respondent No.1 did not sign the letter dated 31 March 1998. The timing of intimation to the bank and the timing of execution of the document are two different aspects. The respondent must explain why, if he never signed the letter, his signature appears on that document. Mere assertion is not proof. He has not shown any material explaining the circumstances or denying the execution. He has not led evidence showing that the letter was forged or obtained improperly.

45. Once the petitioner has placed a signed document on record showing respondent No.1’s consent, the burden shifts to respondent No.1 to prove that he never signed it or that the document is not valid. He has not discharged that burden.

46. The law on discharge of surety in cases of change of constitution is clear. Discharge occurs only when the constitution changes, the surety has not consented, and the change prejudices the surety.

47. Here, the record shows a written consent. The respondent has not proved lack of consent. In absence of such proof, the surety cannot be discharged on this ground.

48. In the case relied upon by the respondent Chakrapani Iyengar, the facts were materially different. The surety in that case had not remained silent. He had acted with full honesty and cooperation. He informed the bank that the hypothecated property, an electric oven, had been sold by the borrower. He even provided the exact location of that oven. Despite being given these details, the bank did nothing. The Karnataka High Court noted that the bank neither seized the oven nor filed any police complaint, even though the surety had given precise information. The Court held that when the bank ignores such information and fails to use legal remedies, the surety cannot be forced to bear the burden. The Court treated the surety as discharged under Section 139 of the Contract Act. In the said case, the surety proved his bona fides. He showed that the security could have been recovered. The bank failed to act even when seizure of the oven could have cleared the dues. The High Court observed that the bank had remedies such as taking possession and lodging a complaint with police authorities to trace the property. Since the bank failed to use these remedies, the Court held that such inaction caused loss of security and, therefore, the surety stood discharged.

49. Those facts do not exist here. In the present case respondent No.1 never gave specific details of where the hypothecated stock was, he did not inform the bank about the sale with the precision that was seen in the Chakrapani Iyengar, there is no evidence that the bank ignored any specific information given by the surety, the contract itself placed custody and responsibility of the goods on the borrower, not on the bank. In the cited case, the discharge was granted only because there was clear proof of negligence by the bank. The bank ignored concrete information and failed to act. Here, no such proof exists. The record shows that the bank acted by issuing notice and filing legal proceedings without delay. Therefore, the principle applied in that judgment does not apply to the facts of this case. The discharge of surety depends on negligence and loss caused by the creditor. In that case, negligence was proved. Here, it is not.

50. The parties have cited several judgments, including Mahendra Kantilal Dave, Indian Bank v. M. Ambika, Suresh Bhailal Mehta and others. These judgments lay down guiding principles. They explain that in some cases of hypothecation, the creditor must show vigilance. They also explain that if the contract places the goods in constructive possession of the creditor, or if the creditor has a direct duty to safeguard the goods, then failure to act may discharge the surety. These judgments further clarify that when a creditor remains silent for a long period despite knowing that the security is being damaged or disposed of, the law may protect the surety.

51. At the same time it well settled that every case depends on its contract and its facts. The disappearance or sale of hypothecated goods is not enough. The surety is discharged only when the creditor had a duty under the contract to protect the goods and failed to do so. If the contract leaves physical possession with the borrower and gives the creditor only the right to inspect and enforce, then the creditor is not at fault merely because the borrower disposes of the goods. The court must see whether the creditor was required to take care of the goods and whether the creditor remained negligent.

52. When these decisions are applied to the present case, the outcome becomes clear. The Hypothecation Agreement leaves possession with the borrower. The bank only has inspection rights and right of enforcement. There is no clause which states that the bank must guard the goods or must take physical steps to prevent removal. The bank issued a demand notice within time and filed a proceeding for recovery. The bank did not sleep over its rights.

53. Therefore, when the principles from the cited judgments are applied to the facts on record, the facts do not support discharge of the surety. The evidence shows that the contractual duties did not require the bank to physically secure or guard the goods. The bank acted within its rights and used the remedies available to it. The disappearance of goods, without proof of a breach of duty by the bank, cannot release the surety.

54. For these reasons I allow the writ petition. I set aside the judgment and order dated 27 December 2021 of the Maharashtra State Cooperative Appellate Court which discharged respondent No.1 as surety. I restore the award of the Cooperative Court dated 25 October 2017 to the extent it is against respondent No.1.

55. Parties will bear their own costs in this petition.

56. I record my sincere appreciation of the valuable assistance rendered by learned counsel Mr. Shadab Jain, appearing for the petitioner, and learned counsel Mr. Sharad Bansal, appearing for respondent No.1. Both have rendered thorough and wellresearched submissions which greatly aided the Court in arriving at a just conclusion.

57. At this stage, learned Advocate for respondent No.1 requested to stay the operation of this judgment. However, considering the reasons assigned, the request for stay is rejected. (AMIT BORKAR, J.)