January 23, 2022

Contract of Guarantee under Indian Contract Act

contract

The Concept of 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.

This can be better understood through the following illustration:

Assuming party A and party B enter into a contract with Party C as the surety. Now according to this contract of guarantee Party B has to pay Party A a sum of Rs. 1000, but fails to do so for any variety of reasons. Now Party C will now be liable to discharge the 1000 Rs. to Party A.

Definition of Contract of Guarantee: As Distinguished from indemnity

A contract of indemnity can be defined as a contract where one party promises to save a person from the loss caused by the promisor itself, or any other person.

Now, how this differs from a contract of guarantee is in a contract of indemnity the promisor faces primary liability unlike in a contract of guarantee where the surety only discharges the liability in the case that the principal debtor does not discharge the liability. Additionally, another conclusion we can make is that in a contract of indemnity the contract is between two parties unlike the three parties in a contract of guarantee.

This can be further understood using the following illustration:

In a contract of indemnity if A promises to save B from the losses caused to B by C, and then C causes some losses to B.  Party A will be the one who pays Party B, unlike in a contract of guarantee where A would only be the second source of liability after Party C.

 Basic Essentials for a Contract of Guarantee

Along the lines of every other type of contract, a contract of guarantees also has certain basic essentials that make it valid. Those essential can be classified into the following:

1. Agreement by all Parties

All three parties who are the creditor, principal debtor and surety must agree to the terms of the contract.

2.Liability:

In all contracts of guarantee, the creditor can only ask the surety to discharge the liability after the principal debtor has not discharged his promise i.e. the liability.

3.Existance of debt:

No contract of guarantee can exist without a debt for consideration which is accepted by the law. Additionally, if the debt is barred by a time limit or has become void, the surety will not be liable.

4. Consideration:

 This means that any benefit received by the principal debtor can be considered as a suitable consideration.

5. Two forms of a guarantee contract:

Contracts of guarantee can be of two forms, either verbal or written

6. Essentials of a Valid Contract:

This means that just like any other contract, a contract of guarantees requires certain common essentials of a contract such as acceptance, intention to contract, acceptance, ability to contract, the legality of the contract, creation of a legal relationship, lawful object if any, legal consideration, free and fair consent, performance standards, legal formalities etc.

7. All facts must be brought to light:

The creditor must inform the surety of all the facts that affect his liability. Concealment of any facts will invalidate the contract. This is highlighted in section 143 of the Indian Contracts Act, 1872

8.No misrepresentation of facts:

The guarantee should not be obtained through misrepresenting facts to the surety. Though not all facts need to be mentioned to him, any facts that affect the surety’s extent in the liability must be brought to his notice accurately. This can be seen in Section 142 of The Indian Contracts Act.

Continuing Guarantee

As per the Section 129 of the Indian Contracts Act,1872 a continuing guarantee can be defined as “A guarantee which extends to a series of transactions.”

This contract will continue to exist for all transactions until revoked for future transactions by the surety upon informing the creditor.

This can be better understood using the following illustration:

  • Party A agrees to be a surety for a contract between B ’the creditor’ and C ’the principle liability’ for a particular transaction or a particular distinct series of transactions as per the contract. If C fails to pay B for any one of those contracts, A is liable to pay for it. Once these transactions are over then A can either inform B and leave the contract for future transactions or choose to remain as the surety between transactions for B and C. 
  • A, in consideration that B will hire C in amassing the rentsof B zamindari, guarantee B to be accountable, to the quality of Rs. 5,000, for due series and fee via C of these rents. This is a preserving with assure.

Contracts of indemnity can be further understood by comparing it to the other types of contracts of guarantee, specific contracts of guarantee.

Unlike specific contracts of guarantee which can only last for one transaction or event, guarantees of continuity last for the specified amount of transactions as mentioned in the contract.

Revocation Of Continuing Gurantee: –

A continuing guarantee may be revoked by the surety, as to future transactions in any of the following points: –

  1. By notice (section 130):- a surety may at any time revoke continuing guarantee as to future transactions by giving notice to the creditor.
  2. By death (section 131):_ the death of the surety operates as a revocation of a continuing guarantee, so far as regards future transactions are concerned. After death, the estate of the surety is liable for discharge of all obligations created prior to his death.
  3. By charge in variance terms by principal debtor to the surety (section 133):_ a continuing guarantee may also be revoke by the same modes by which a surety is discharged. Any variance made without the surety’s consent, in the terms of the contract between the principal debtor and the creditor, discharged the surety as to transactions subsequent to the variances.  Any variance made without the surety consent in the terms of the consent between the principal debtor and the creditor, discharged the surety as to transactions subsequent to the variance.

Nature of surety’s liability

Along the lines of the definition given in section 128 of The Indian contracts act the liability of the surety’s is defined as coextensive with that of the principal debtor unless provided otherwise by the contract.

What this means is that unless the contract specifically mentions that the surety will have only a certain liability or a defined liability, the surety will have to pay the same amount that the principal debtor would need to pay to the creditor.

For example, the contract could mention that the surety needs to pay for any interest due, or further charges apart from the original amount, then the surety is liable to pay for that as well.

But, if not mentioned he will only have to pay the corresponding amount the principal debtor would have had to pay.

This principle can be seen laid down in the case of Maharaja of Benares v. Har Narain Singh[i],1 where the plaintiffs ‘the creditor in this case’ had asked for interest on the liabilities owed by the principal debtor to the defendants’ the surety’. In the contract of guarantee, there was no mention of any interest on the rent for the principle liability nor the surety, thereby the court declared that the liability of the surety is coextensive to the principal debtor and since there was no specific mention of interest for the surety in the contract, it was not payable.

Apart from the nature of co extensiveness, we can see as mentioned earlier that the nature of the surety’s liability is only secondary in nature unlike the primary nature of the principal debtor’s liability.

Duration and Termination of Such Liability

The duration of a surety liability depends on the duration specified in the contract. If it is a specific contract then it only lasts until that transaction has been completed and in the case of a continuing contract it will last for the series of transactions mentioned in the contract or until the surety informs the creditor that he wishes to leave the contract for future transaction.

The termination of these contracts as mentioned earlier will only terminate once the specified transactions under the contracts have been completed or as mentioned earlier in respect to continuing contracts, when the surety informs the creditor and leaves for future contracts. 

Other than the standard termination of the contract through the completion of the transaction specified in the contract, the liability of the surety can also be discharged earlier by various methods which will be described in detail in one of the upcoming paragraphs of ‘ discharge of surety liabilities’.

 Rights of Surety, Position of Surety In The Eye of The Law under Contract of Guarantee

In the case that the surety has to discharge the liabilities of the principal debtor and has now paid the creditor, he/she is left with certain rights he can avail which are as follows:

a) Rights Against the Principal Debtor

i) The right of subrogation:

Once the surety has discharged the liability of the principal debtor to the creditor on non-payment by the principal debtor, the surety can now be treated as the new creditor. What this means is in a similar fashion to the original creditor the surety can claim the amount he paid to the creditor along with the corresponding interests, costs, etc, if any.

ii) The right of Indemnity: 

Along with the duty of the surety to discharge the liabilities of the principal debtor incase of non-payment, he in turn receives the right to be indemnified by that amount from the principal debtor. Therefore he is entitled to receive the sum he paid to the creditor back from the principal debtor.

iii) The right to security:

This right enables the surety to avail every remedy the creditor has against the principal debtor, including enforcing security.

b) Rights against the creditor:

i) Right to securities given by the principal debtor

As per Section 41 of the Indian Contracts Act, 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.

This means that if the creditor loses whatever security the principal debtor may have given him, whether or not the surety knew of its existence, his liability is discharged to the value of the security lost.

ii) Right to set off:

This means that the surety has the right to set off, or in other terms, any amount which the principal debtor had previously paid to the creditor, will be subtracted to get the new liability of the surety.

The rights of the creditor in respect to co sureties will be shortly explained in the paragraph of co surety and manner of sharing liabilities and rights. It too is one of the rights given to the surety.

Position of the surety in the eyes of the law:

In regards to the position of the surety in the eyes of the law, a surety is considered to be more favoured in the eyes of the law as opposed to the principal debtor. His debt is limited by the law.

The reason for this is the significant roles that surety’s play in enabling transactions even though they gain nothing out of it. This sympathetic nature of the court towards sureties could be first seen in the case of State vs Churchill[ii].

 Various Judicial Interpretations to Protect The Surety

i) Favourable position of the Surety:

As mentioned earlier the surety, in the eyes of the law is treated as a favoured debtor.

This can also be seen in the case of Law vs. East India company[iii] where the court had held that where anything is done by the creditor which has the effect of injuring the surety, the court is very glad to lay hold of it in favour of the surety as it must be noted that there is no moral obligation, beyond the legal obligation of the surety.

ii) Liability of the surety:

In accordance with section 128 of The Act the liability of the surety is coextensive with that of the principal debtor unless specifically mentioned in the contract.

iii) Conditioning precedents in respect to surety’s liability:

Section 144 of the act states that “where a person gives a guarantee upon a contract that the creditor shall not act upon it until another person has joined in it as a co-surety, the guarantee is not valid if the other person does not join.

This section partially recognizes that the surety has the right to set certain conditions, and only if those conditions are met he will join as a surety. This can be seen in the case of The National provincial bank of England vs Brackenbury [iv]where the defendant only agreed to become the surety if three other co sureties joined alongside him. Two co sureties joined but the third one did not. The court held since that there was no new agreement to do away with the third co-surety and since the original agreement had a condition for three co sureties, the defendant is not liable.

But in the case that the contract did not have any precedent conditions, the co-surety cannot later claim for such conditions at a later stage. This can be seen in the case of SBI vs Indexport Registered.[v]

iv)  Discharge of surety due to variance in the contract:

As per Section 133 of the act the suretys’ liability is discharged if the creditor changes any terms or the nature of the contract without the surety’s consent. This principle was even held as early as the case of Pratap Singh vs Keshavlal [vi]where it was held that the surety cannot be held bound by something he did not agree to.

v) Right of subrogation:

This right refers to the right of the surety to become the creditor to the principal liability once he has paid the amount due to the original creditor, due to nonpayment of the principal liability. This is backed by section 140 of the Act.

vii) Right to Security:

Section 141 of the act recognizes that the surety has the right to take every remedy against the principal debtor that the creditor would be able to including enforcement of security.

 Co-surety and Manner of Sharing Liabilities and Rights

In accordance with section 126 of the Indian Contracts Act, the principal debtor’s liability may be guaranteed by more than one surety, in this case, the surety’s are known as cosurety’s

Looking at sections 138, 146 and 147 of the Act we can come to the following conclusions regarding the sharing of liabilities and rights of the co sureties:

i) Section 138 of the act states that the discharge of one surety by the creditor does not discharge the remaining surety’s from their liability.

ii) Unless specifically mentioned all the sureties involved in a contract either jointly, or severally or under the same contract or different ones with or without each other’s knowledge must pay the liability equally. For example, A and B are sureties to C for a contract with E. E doesn’t pay the amount due of 10,000 Rs. Now A and B will have to pay C 5000 Rs. each amounting to a total of 10000 Rs.

iii) Liabilities who are bound by different sums have to discharge the liability to the creditor on non-payment of the principal debtor equally up to their individual maximum amounts as per the terms of the contract.

For example, as per the contract, A is liable to discharge liabilities up to 10,000 Rs. And B up to 5000 Rs. To C the creditor. Assuming D the debtor has to pay C a sum of 10000 Rs., A and B will have to respectively pay 5000 Rs. But if the sum is any higher than this B will not have to pay it as per the terms of his surety since he has already discharged 5000 Rs.

 The extent of surety’s liability under Contract of Guarantee

As mentioned earlier unless specifically mentioned in the contract the liability of the surety is considered to be coextensive as that of the principal debtor.

Therefore the surety is liable to pay for the immediate amount along with interests, costs etc if they are included in the amount due by the principal debtor. This was laid down in Zaki Husain v. Deputy Commissioner of Gonda.[vii]

Such interests, costs, etc in this case would also need to be mentioned in the contract for the principal debtor to need to pay for them in the first place.

On the other hand, if no mention of such interests is mentioned in the contract either for the principal debtor or specifically for the surety no amount for the interests, costs, etc must be paid.

This principle of co extensiveness is not absolute and upon entering the contract the surety can limit his liability.

Section 128 of the act enables the surety to limit his liability to a certain amount while entering into the contract.

For example, A a surety can limit his liability as a surety in a contract between B the creditor and C the liability to a certain amount. eg. 10,000 Rs.

 Discharge of Surety’s Liability under Contract of Guarantee

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.

For more articles on Law of Contracts, Click Here.

For law notes, Click Here.

Endnotes

[i] Maharaja of Benares v. Har narain Singh (1905) 28 All 25

[ii] State vs Churchill  48 ARK. 426 (1886)

[iii]  Law vs. East India company 4 Ves. 824 (1799) 

[iv] National provincial bank of England vs Brackenbury (1906) 22 TLR 797

[v] SBI vs Indexport Registered AIR 1992 SC 1740

[vi] Pratap Singh vs Keshavlal AIR 1935 P.C. 21

[vii] Zaki Husain v. Deputy Commissioner of Gonda AIR 1929 All 687


Author Details: Rohan Mathew Therattil (Student; School of Law, Christ University)

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