This article is written by Vaishanvi Anand, Amity Law School, Amity University Patna, 3rd Year BBA LL.B(Hons) student during an internship at LeDroit India.
Keywords
1. Contract of Guarantee
2. Surety ship
3. Guarantee Agreement
4. Contract Law
5. Security Agreement
1. INTRODUCTION
Black laws dictionary defines the term guarantee as the assurance that a legal contract will be duly enforced. A contract of guarantee is governed by the Indian Contract Act, 1872 and includes 3 parties in which one of the parties acts as the surety in case the defaulting party falls to fulfill his obligations. Contracts of guarantee are mostly required in cases when a party requires a loan, goods or employment. The guarantor in such contracts assures the creditor that the person in need may be trusted and in case of any default, he shall undertake the responsibility to pay. Thus we can say contract of guarantee is invisible security given to the creditor and shall be discussed further. reform the words.
- What is Contract of Guarantee?
Section 126 of The Indian Contract Act, 1872 defines a guarantee as a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor‘.
What this means is that a guarantee is a contract wherein the case that the principal debtor, who is the first source of liability fails to pay the debt to the creditor, the third person known as the surety who is the next source of liability will discharge the liability.
Illustration
A takes a loan of Rs. 1,00,000 from a Union bank of India. Here B, promises to bank that if A some how fails to return the amount, then I will make payment on his behalf.
Here, A is principal debtor, Union bank of India is creditor and lastly B will act as surety.
Sudha advances a loan of INR 70000 to Subhas. Srishti who is the boss of Subhas promises that in case Subhas fails to repay the loan, then she will repay the same. In this case of a contract of guarantee, Sudha is the Creditor, Shubhas the principal debtor and Srishti is the Surety.
A contract of guarantee may either be oral or written. It may be express or implied from the conduct of parties.
In P.J. Rajappan v Associated Industries(1983) the guarantor, having not signed the contract of guarantee, wanted to wiggle out of the situation. He said that he did not stand as a surety for the performance of the contract. Evidence showed the involvement of the guarantor in the deal and had promised to sign the contract later. The Kerala High Court held that a contract of guarantee is a tripartite agreement, involving the principal debtor, surety and the creditor. In a case where there is evidence of the involvement of the guarantor, the mere failure on his part in not signing the agreement is not sufficient to demolish otherwise acceptable evidence of his involvement in the transaction leading to the conclusion that he guaranteed the due performance of the contract by the principal debtor.
When a court has to decide whether a person has actually guaranteed the due performance of the contract by the principal debtor all the circumstances concerning the transactions will have to be necessarily considered.
1.2 Who can perfom the contract?
According to Section 126 of The Indian Contract Act, 1872 defines a guarantee as a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’.
- Any person who is legally competent to enter into a contract (i.e., above the age of majority and of sound mind) can act as a guarantor in a contract of guarantee.
- The guarantor does not have to have a direct interest in the transaction between the creditor and the principal debtor.
- Both individuals and corporate entities can act as guarantors, provided they are authorized to do so.
1.2 Time and Place for Performance
The time for the performance of a contract of guarantee is fully dependent upon the default of the principal debtor. The guarantor’s obligation to perform arises when the debtor fails to fulfill their obligation, and the creditor makes a demand for performance from the guarantor.
If the contract specifies a time for the guarantor’s performance, it must be adhered to. In the absence of a specified time, the guarantor is expected to fulfill their obligation immediately upon the creditor’s demand after the debtor’s default.
The place of performance is determined by the terms of the contract. If a particular location is mentioned, the guarantor is required to perform at that specified place.
In cases where the contract does not specify a place of performance, the obligation is generally fulfilled at the creditor’s place of business or where the principal obligation was originally intended to be performed.
- Essentials of Contract of Guarantee under Indian Contract Act 1872
1.Must be made with the agreement of all the three parties.
“All the three parties to the contract i.e. the principal debtor, the creditor, and the surety must agree to make such a contract with the agreement of each other. It is important to note that the surety takes his responsibility to be liable for the debt of the principal debtor only on the request of the principal debtor. Hence communication either express or implied by the principal debtor to the surety is necessary. The communication of the surety with the creditor to enter into a contract of guarantee without the knowledge of the principal debtor will not constitute a contract of guarantee.”
Illustration
Ram lends money to Shiva. Ram is the creditor and Shiva is the principal debtor. Ram approaches Raghav to act as the surety without any information to Shiva. Raghav agrees. This is not valid.
2) Consideration
According to section 127 of the act, anything done or any promise made for the benefit of the principal debtor is sufficient consideration to the surety for giving the guarantee. The consideration must be a fresh consideration given by the creditor and not a past consideration. It is not necessary that the guarantor must receive any consideration and sometimes even tolerance on the part of the creditor in case of default is also enough consideration.
In State Bank of India v. Premco Saw Mill (1983), the State Bank gave notice to the debtor-defendant and also threatened legal action against her, but her husband agreed to become surety and undertook to pay the liability and also executed a promissory note in favor of the State Bank and the Bank refrained from threatened action. It was held that such patience and acceptance on the bank’s part constituted good consideration for the surety.
3) Liability
In a contract of guarantee, the liability of a surety is secondary. This means that since the primary contract was between the creditor and principal debtor, the liability to fulfill the terms of the contract lies primarily with the principal debtor. It is only on the default of the principal debtor that the surety is liable to repay.
4) Presupposes the existence of a Debt
The main function of a contract of guarantee is to secure the payment of the debt taken by the principal debtor. If no such debt exists then there is nothing left for the surety to secure. Hence in cases when the debt is time-barred or void, no liability of the surety arises. The House of Lords in the Scottish case of Swan vs. Bank of Scotland (1836) held that if there is no principal debt, no valid guarantee can exist.
5) Must contain all the essentials of a valid contract
Since a contract of guarantee is a type of contract, all the essentials of a valid contract will apply in contracts of guarantee as well. Thus, all the essential requirements of a valid contract such as free consent, valid consideration offer, and acceptance, intention to create a legal relationship etc are required to be fulfilled.
6) No Concealment of Facts
The creditor should disclose to the surety the facts that are likely to affect the surety’s liability. The guarantee obtained by the concealment of such facts is invalid. Thus, the guarantee is invalid if the creditor obtains it by the concealment of material facts.
7) No Misrepresentation
The guarantee should not be obtained by misrepresenting the facts to the surety. Though the contract of guarantee is not a contract of Uberrima fides i.e., of absolute good faith, and thus, does not require complete disclosure of all the material facts by the principal debtor or creditor to the surety before he enters into a contract. But the facts, that are likely to affect the extent of surety’s responsibility, must be truly represented.
2.2The Extent of the Surety’s Liability
Section 128 speaks about one of the cardinal principles relating to the contract of guarantee. It states that the liability of the surety is co-extensive with that of the principal debtor. The surety may, however, by an agreement place a limit upon his liability.
Section 128- The liability of the surety is co-extensive with that of the principal debtor unless it is otherwise provided by the contract.
Illustration- A guarantees to B the payment of a bill of exchange by C, the acceptor. The bill is dishonoured by C. A is liable not only for the amount of the bill but also for any interest and charges which may have become due on it.
1. Co-extensive:
The first principle governing surety’s liability is that it is co-extensive or common with that of the principal debtor. He is liable for the whole amount for which the principal debtor is liable and he is liable for no more. Where the principal debtor acknowledges liability and this has the effect of extending the period of limitation against him the surety also becomes affected by it.
2. Condition precedent:
Where there is a condition precedent to the surety’s liability, he will not be liable unless that condition is first fulfilled. Section 144 to an extent is based on this principle: Where a person gives a guarantee upon a contract that creditor shall not act upon it until another person has joined it as co-surety, the guarantee is not valid if that other person does not join.
An illustration in point is National Provincial Bank of England v Brackenbury: The defendant signed a guarantee which was intended to be a joint and several guarantees of three other persons with him. One of them did not sign. There is no agreement between the bank and the co-guarantors to dispense with his signature, the defendant was held not liable.
3.1 Kinds of Guarantee
Contracts of guarantees may be classified into two types: Specific guarantee and continuing guarantee. When a guarantee is given in respect of a single debt or specific transaction and is to come to an end when the guaranteed debt is paid or the promise is duly performed, it is called a specific or simple guarantee. However, a guarantee which extends to a series of transactions is called a continuing guarantee (Section 129). The surety’s liability, in this case, would continue till all the transactions are completed or till the guarantor revokes the guarantee as to the future transactions.
3.1.1Continuing Guarentee
Continuing Guarantee– A guarantee which operates on a number of transactions within a particular period, is called a “Continuing Guarantee”.
This type of guarantee includes a number of transactions over a period of time. A creditor can hold the surety responsible for the default of the principal debtor for transactions that happen within a period of time.
Illustration–
A guarantees payment to B, a mobile dealer, to the amount of $100, for any mobile he may supply to C as required by C over a period of time. B supplies C with mobile above the value of $100, and C pays B for it. Afterwards B supplies C with mobile to the value of $200. C fails to pay. The guarantee given by A was a continuing guarantee, and he is accordingly liable to B to the extent of $100.
The essential feature of a continuing guarantee is that it doesn’t restrict to a specific number of transactions, but to any number of them and makes the surety liable for the unpaid balance at the end of the guarantee.
In Chorley & Tucker the distinction is explained: “A specific guarantee provides for securing of a specific advance or for advances up to a fixed sum, and ceases to be effective on the repayment thereof, while a continuing guarantee covers a fluctuating account such as ordinary current account at a bank, and secures the balance owing at any time within the limits of the guarantee.
Rights Of Surety
A surety has certain right against the principal debtor, creditor and co-surety.
Rights Against Principal Debtor
- Rights of Subrogation:
When the principal debtor fails to pay or perform to creditor, than surety steps in and perform on behalf of principal debtor. After which surety is equipped with all the rights which creditor has against the principal debtor. And, hereby surety can recover the amount or performance which he has done on the behalf of principal debtor, it is know as Right of Subrogation. This is mention under section 140 of Indian Contract Act, 1872.
- Right of Indemnity against the principal debtor:
This part discuss about Section 145 of Indian Contract Act, 1872. When the principal debtor makes any default, then the surety fulfil all the needs of creditor, which has to be completed by the principal debtor according to the contract. Now, there is implied promise involved in this contract that if the surety is performing on the behalf of principal debtor, then principal debtor is liable to pay back all the amount which surety had pay on his behalf to creditor lawfully. He is vested with all those rights which creditor had against the principal debtor.
Rights Against Creditor
- Securities received by the creditor at the time of contract guarantee: This point brings out Section 141 of Indian Contract Act, 1872 in the discussion, which says, Surety’s right to benefit of creditor’s 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.
Rights Against Co-Sureties
- Right of Contribution against the Co-sureties in equal sums: Section 146 of Indian Contract Act, 1872 discuss about the provision regarding distribution of liabilities of debt. Section 146 says, Where two or more persons are co-sureties for the same debt or duty, either jointly or severally, and whether under the same or different contracts, and whether with or without the knowledge of each other, the co-sureties, in the absence of any contract to the contrary, are liable, as between themselves, to pay each an equal share of the whole debt, or of that part of it which remains unpaid by the principal debtor. This section speak up about the equal contribution by surety. It is irrelevant that whether the sureties have undertaken the contract individual or in a group. Whether they are aware about the other sureties or not, they have to divide the amount of debt equally. This is all about this section.
- Right of Contribution against the Co-sureties in equal sums : In section 147, it says, Co-sureties who are bound in different sums are liable to pay equally as far as the limits of their respective obligations permit.” In many conditions, the co-sureties are free to make a contract in between themselves, about the different proportional of the liability. The principal debtor and the creditor can’t interfere in between them. There will be a different maximum limit for different sureties. There must be consent of all the other surety members, if any one member is not ready with the contract, then contract will be quashed.
- Right of Contribution: If due to any reason, one of the surety has pay all the debts to the creditor, then he is liable to get back the rest of the money from other sureties, which he was not entitled to pay. In this there is no need to take the consent of the other sureties.
4.Discharge of Contract by Performance
The liability of a surety can be discharged before the end of the contract or stipulated dates due to various reasons which are as follows:
i) Discharge by revocation:
As per Section 130 of the act, the surety can inform the creditor that he wants to leave the surety, but he can only do this in the cases of revocation for future transactions and not an ongoing transaction. This applies only to continuing contracts.
ii) Discharge by the death of the surety:
As per Section 131 of the act, the death of the surety leads to his discharge on liabilities of future contract in the case of a continuing contract, but in regards to a specific contract or existing contract, the legal heirs of the surety will be liable to pay for it.
iii) Discharge by variance:
As per Section 133 of the act, if the creditor changes any terms of the contract or the nature of the contract without the consent of the surety, the surety will be discharged from his liability. This is due to the fact that the surety can only be liable to the extent of what he has consented to.
However, this only applies to changes in the contract that have any relevance or effect on the surety’s role in the contract. This was made clear in the case of M.S Anirudhan v Thomco’s Bank Ltd.
iv) Discharge by the release of the principal debtor:
According to section 134 of the act, the surety is discharged by any contract between the creditor and the principal debtor, by which the principal debtor is released, or by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor.
An exception to this is regarding insolvency laws or liquidation of a company where even if the principal debtor is discharged due to lack of assets the surety must still pay the creditor.
v) Promise not to sue:
Section 135 of the act states that a contract between the creator and the principal debtor, by which the creditor makes a composition with, or promises to give time to, or not to sue, the principal debtor, discharges the surety unless “the surety assents to such contract. But an exception to this under section 137 states that mere forbearance of not suing the principal debtor doesn’t amount to the discharge of the surety’s liability.
vi) Discharge when surety’s remedy is hampered:
As per Section 139 of the Act any act done by the creditor that hampers with any of the rights of the surety. After the surety has discharged his liability the creditor should also do nothing to interfere with his rights in regards to the principal debtor.
Conclusion
The contract of guarantee is a special type of agreement governed by specific provisions under the Indian Contract Act. Its primary purpose is to safeguard the creditor from potential losses and to provide assurance that the obligations will be fulfilled through the surety’s commitment. A contract of guarantee typically involves three parties and can take the form of either a specific guarantee or a continuing guarantee, depending on the circumstances and the terms of the agreement. The surety’s liability is generally co-extensive with that of the principal debtor unless stated otherwise in the contract. Furthermore, if the contract is based on misrepresentation by the creditor regarding key facts or if material information is concealed, the contract may be deemed invalid.
