Q1. What is Contract of Guarantee ? What are the rights of Surety under the Contract of Guarantee?

Guarantee:

In simple terms, Guarantee means, the promise to pay another's debt, or fullfil another's contractual
obligations, if the party fails to pay the debt or fails to perform its obligations.

Function of Guarantee:

The function of a contract of guarantee is to enable a person to get loan or goods on credit or an
employment. Some person comes forward and tells the lender, or the supplier or the employer that he
may be trusted and in case of any default I undertake to be responsible.

Object:

The object of contract of guarantee is to provide additional security to the creditor in the form of a
promise by the surety to fulfill a certain obligation, in case the principal debtor fails to do that.

What is a Contract of Guarantee according to Contract Act?

A contract of guarantee according to Section 126 of the Contract Act ”it is a contract to perform
the promise or discharge the liability of a third person in case of default. The contract of
guarantee consists of three parties. These are the surety, the principal debtor and the creditor”.

Parties in the Contract of Guarantee:

There are three parties in the contract of guarantee:

Surety : A surety is a person who gives the guarantee to pay in case of default.

Principal Debtor : The person for whom the guarantee has been taken by the surety is the
principal debtors.

Creditor : A promise of guarantee is given to the creditor to whom the payment has to be made.

Example : Seema gives a loan of Rs. 50,000 to Aditi on the promise that Jasalleq will repay the
loan to Seema if Aditi defaults in her payment. This is a contract of guarantee. Seema is the
creditor. Aditi is the principal debtor and Jasalleq is the surety or guarantor.

Essential Features of a Valid Contract of Guarantee

Valid Contract : A contract of guarantee must have all the essentials of a valid contract like
competence of parties, free consent and consideration to make the contract valid. But there are
certain exceptions :

A.The principal debtor may not be competent to contract. If he is not competent the surety will
become the principal debtor and will be liable personally to make the payment.
b. A surety that makes a promise for the benefit of the principal debtor need not be given
consideration. Any promise that a surety makes is sufficient consideration for giving a guarantee.

Example Ibrahim asks Jasalleq to deliver 50 watches to him on credit. Jasalleq agrees and
Musawir guarantees the payment for the goods. Musawir states that he would stand guarantee for
the payment in consideration of Jasalleq ’s promise to deliver the 50 watches.

Tripartite Agreement : In a contract of guarantee there is the involvement of three contracts.

Contract 1 : It is a contract between the principal debtor and the creditor on the basis of which a
guarantee for the debt arises..

Contract 2 : It is an agreement between the principal debtor and the surety in which the principal
debtor accepts the responsibility to indemnify the surety if the payment is required to be made by
the surety.

Contract 3 : It is a contract between the creditor and the surety in which the surety promises to
undertake the payment of the debt of the principal debtor in case the principal debtor defaults on
his payments.

Consent : Since the contract of guarantee involves the creditor, principal debtor and the surety, it
is necessary that all the three parties agree to the contract.

There Should be no Misrepresentation of Facts : A guarantee should be obtained after disclosing

Contract may be Oral or in Writing : A contract of guarantee may be either oral or written as
given in section 126 of the Act. The position as per English Law is different from that the Law.
Under English Law the contract must be in writing but Law does not specify this. Hence in
both oral and written contracts are acceptable.

There Should be a Principal Debt : There has to be a primary liability of a person who is other
than the surety to the contract of guarantee. The surety becomes liable only if the principal
debtor is unable to discharge his obligation. If there is no principal debtor, there cannot be a
contract of guarantee. In situations where there is a promise by one of the parties for
compensating another without involving a third party, the contract becomes a contract of
indemnity.

To summarize : 1. According to Section 142 of the Contract Act “an invalid guarantee is one
which is obtained by the creditor through misrepresentation regarding a material part of the
transaction”. 2. Section 143 states “that any guarantee in which he creditor maintains silence as
to the material facts of the case also makes the contract of guarantee invalid”. 3. Under Section
144 “when a co-surety does not give guarantee though it is necessary for him to give guarantee
along with the surety, the contract of guarantee will not be valid”. 4. If there is no consideration
between the creditor and the principal debtor, the surety will be discharged from his liability as
the contract will not be valid.

Distinction between Contracts of Indemnity & Contracts of Guarantee

Contracts of indemnity can be distinguished from contracts of guarantee in the following matter
:

Parties to the Contract : Contracts of indemnity comprise two parties. These are the indemnifier
and the indemnity holder. Contracts of guarantee are made with three parties. These are the
principal debtor, the creditor and the surety.

Number of Contracts : Contracts of indemnity are between the indemnifier and the indemnity
holder. Only one contract is made between them. However, contracts of guarantee are made out
of free contracts. One contract is between the principal debtor and creditor. The second contract
is between the surety and the creditor and the third is between the surety and the principal debtor.

Nature of Liability : The indemnifier is independent and has primary liability in contracts of
indemnity, but in contracts of guarantee the surety has collateral or secondary liability whereas
the primary liability is of the principal debtor.

Purpose of Contract : Contracts of indemnity provide security against losses whereas contracts
of guarantee provide security to creditors against default of the principal debtors.

Request : In an indemnity contract the indemnifier does not have to act at the request of the
indemnity holder. In contracts of guarantee the surety can act only when the principal debtor
requests him to do so.

Occurrence of Liability : In contracts of indemnity liability will arise on the happening of the
contingency but in contracts of guarantee liability will arise when an existing promise of
payment of a debt is not performed.

Interest in the Contract : In indemnity contracts the promisor usually has his own interest in the
contract, but in a contract of gurantee the surety does not have any interest in the transaction.

Right to Sue Third parties: The indemnifier does not have any right to sue a third party in his
own name because he does not have any privity of contract. Only in transactions where there is
an assignment in his favour may he sue third parties in contracts of indemnity. In contracts of
guarantee the surety has the right to sue the principal debtor in his own name after he discharges
his debt.

Kinds of Guarantee

There are two categories of guarantees. These are called

 specific guarantees
 continuing guarantees.
Specific Guarantee A specific guarantee pertains to a single debt or a single transaction. It is a
simple guarantee or a specific guarantee when the debt is discharged, then the duty is performed
and the contract of guarantee comes to an end. In a specific guarantee if a new transaction has to
be made between two parties a fresh guarantee will have to be taken as the guarantee on the
single debt is completed. Guarantee can be for an existing debt or for a prospective debt or a
future transaction.

Example A guarantees the payment for 5 computers to Ali. The computers are to be delivered to
Khan in March. Ali delivers the computers to Khan and payment is made to him. A’s contract of
guarantee ends on the payment. He is not liable for any further contracts because it is a specific
contract pertaining to only five computers. If Khan paid for the computers then A would have
been liable to make the payment to Ali.

Continuing Guarantee

According to Section 129 a continuing guarantee extends to a series of transactions. The surety is
liable for all the transactions as his guarantee extends to all of them until the guarantee is
removed.

Example Syed was employed as a driver by Mr. Ibrahim on the recommendation of Jasee for
collection of credit payments from Peshawar . Jasee guaranteed Syed’s honesty and promised to
pay in case of any default in payments collected by him (Syed). This is a contract of continuing
guarantee.

Revocation of Continuing Guarantee

When a guarantee is cancelled it is called revocation of a guarantee. If the guarantee is cancelled

By Notice of Revocation : A surety can give a notice of revocation to the creditor. After the
notice is given the surety does not have any future liability but he continues to be liable under
Section 130 for any transactions that have already been entered into by him.

Example Shahkarm guarantees to Marram an amount of Rs. 50,000 that Moti will pay his debt
in 30 days time. Marram agrees and the contract of guarantee is formed. Before the debt is
cleared Shahkarm gives a notice of revocation. Moti defaults in making his payment on the due
date. Shahkarm is liable to pay as it is an existing debt guaranteed by him.

By Death of Surety: In case of a continuing guarantee if the surety dies the contract is
automatically revoked even if no notice of death of surety is given. But, under Section 131 of the
Act the surety is liable for the existing transactions to which he had given a guarantee before his
death.

Example Mulla guarantees the payment of Rs. 500 to Asraf a book seller for any book that he
supplies to Musawir from time to time. Asraf supplies to Musawir a book whose price is Rs. 200.
After this transaction Mulla dies. After the death of Mulla, Asraf supplies another book priced at
Rs. 100. Mulla’s representative is liable only for the payment for the book of Rs. 200 to Asraf
and not for the book of Rs. 100 because that book was supplied after his death.

Other Reasons : A continuing guarantee can also be revoked in the following conditions.

1. When there is a variance in the terms of a contract. (Section 133)

2. When the principal debtor is discharged or released. (Section 134)

3. When there is an agreed arrangement with the principal debtor. (Section 135)

4. When the creditor is responsible for an act or its omission which impairs the remedy of a
surety. (Section 139)

5. When there is a loss of security.

Rights of Surety

A surety also has certain rights against the principal debtor, the creditor and the cosureties. Each
of these is explained below :

Rights Against the Principal Debtor

The surety has the right of subrogation and the right to claim indemnity from the principal
debtor.

Rights of Subrogation : When a surety makes a payment to a creditor on behalf of the principal
debtor in case of a default, he acquires the rights of a creditor against the principal debtor. He can
recover the entire amount that he has paid to the creditor. This is called the right of subrogation.

Section 140 of the Contract Act states that when a surety has performed the duty or made a
payment on behalf of the principal debtor he acquires the rights of the creditor. He is entitled to
claim all the sums he has rightfully paid to the creditor. He also gets the benefits of security that
were given to the creditor when the contract was entered into.

(ii) Rights of Indemnity : When a contract of guarantee is entered into there is an implied
promise that the principal debtor will indemnify the surety for all the payments rightfully made
by him. If he has made any payments wrongfully he will not be able to recover any amounts.
This has been stated in section 145.

Example Shahkar has to pay Rs. 2,00,000 to Ibrahim. Maamay is the surety for the debt. Ibrahim
demands the payment from Shahkar on the due date. Shahkar fails to pay the amount. Maamay
who is the surety is compelled to make the payment on behalf of Shahkar. Maamay has the right
to recover the amount from Shahkar with all the benefits promised to Ibrahim as he has now
acquired the right of a creditor.

Rights Against the Creditor

Right to Claim Securities : According to section 141 of the Act, the surety has the right of
subrogation after performing his duty or making a payment to the creditor. All the rights of the
creditor are passed on to the surety. Accordingly the surety gets the right to the benefit of every
security, which the creditor has against the principal debtor even if the surety he has no
knowledge of the existence of such securities. If the creditor loses the security the surety is
discharged of his responsibilities limited to the value of his security.

Example A gives B Rs 10,000 on the guarantee of C. A has a further security of B’s office table
which is made of teak and is of the value of Rs.4000. A cancels the security. B becomes
insolvent and cannot pay his dues. A sues C on his guarantee. C is discharged of his
responsibility for the value of the office teak table.

Right of Set off : If the creditor sues the surety, he can claim set-off or counter claim, which the
debtor had against the creditor.

Jasee took a loan from Abdullah for Rs. 8,50,000. Shah guaranteed the loan. Shah also had a
claim on Abdullah for Rs. 3,00,000. In case of Jasee defaulting in repayment of the loan, Shah is
liable to pay Rs. 5,50,000 to Abdullah . Shah will also claim the benefit of this set-off although
he does not have any personal claim on Abdullah .

Right to Share Reduction : If the surety has paid the amount to the creditor on behalf of the
principal debtor and the debtor becomes insolvent the amount has to be recovered from him, then
the surety can claim from the creditor a reduction in his liability to the extent of the amount of
dividend that is claimed by the creditor from the official receiver of the debtor.

J gave a guarantee to B for payment of the goods sold by him to another person A up to an
amount of Rs 1,000. B supplied goods for Rs 2,000. To A. A became insolvent and B supplied
the goods. He asked J to pay. J paid him Rs 1000. B received from the official receiver 25% of
Rs 2,000 as dividend in insolvency. It was held that J was entitled to receive a part of the
dividend out of the whole received that is 50% of Rs 1000. This is Rs. 500

Right to ask the Creditor to Terminate the Debtor’s Services : When a person gives a guarantee
for the honest performance of another employee and the employee defaults, the surety has a right
to demand that the employee be dismissed. Such dismissals are usually in the case of fidelity
contracts, for contracts relating to insurance.

Rights Against Co-sureties

When there is more than one surety to guarantee a debt they are called co-sureties. In case of
default all the sureties become liable towards the contribution of the guarantee amount. The
following

Right to Contribution : Under Section 146 of the Contract Act wherever there are co-sureties for
the same amount, they are liable to share an equal amount of the debt which remains unpaid by
the principal debtor. If a surety pays more than his share he has the right to ask the other sureties
to participate in contributing an equal amount towards the debt.

Example A, B and C are sureties to D for Rs. 6,00,000 that is given as a loan to E. On the date
of payment E defaults. A, B and C are liable between themselves to pay Rs. 2,00,000 each to
clear the date.

Bound in Different Sums : If co-sureties are bound in different sums their liability will be shared
equally, subject to the maximum amount guaranteed by each of them.

Example Ibrahim, Khan and Abas are sureties for Shahkar. They enter into a contract that
Ibrahim will pay Rs. 1,00,000, Khan will pay Rs. 2,00,000 and Abas will pay to the extent of Rs.
4,00,000 if Shahkar makes a default in payment of an amount of Rs. 6,00,000 to Jasee. Ibrahim
is liable to pay Rs. 1,00,000, Khan Rs. 2,00,000 and Abas Rs. 3,00,000.

Surety’s Liabilities

The surety has several liabilities since he has guaranteed the debt. These are discussed below :

Co-extensive : The nature and extent of a surety’s liability is co-extensive with that of the
principal debtor according to section 128 of the Contract Act. “This means that the surety has
the same liability as the principal debtor. If the principal debtor does not pay on time, the surety
will be required to pay to the creditor”.

Example Maamay has taken a loan of Rs 1,00,000 from Ibrahim and Mujo has guaranteed it. If
Amit fails to pay the amount to Ibrahim on the due date, Mujo will have to pay the amount to the
creditor. If an interest rate has been fixed, Mujo is also liable to pay the amount of interest.

Reduction in Liability : When the principal debtors liability is reduced, the liability of the
surety will also be reduced.

Secondary Liability : A suretys liability is secondary and comes into force only when the
principal debtor defaults in his payment. If the surety himself becomes insolvent before the
principal debtor defaults on his payment he will not be liable to pay any amount guaranteed by
him.

Liability Restricted to Valid Contract : If a contract of guarantee is valid the surety will be
liable. If the creditor makes a contract with representation or fraud, then the surety has the right
to treat it as a voidable contract at his option.

Liability When the Original Contract between Creditor and Principal Debtor is Void or Voidable
: The surety and the creditor have a contract that is independent from the principal debtor.
Sometimes the original contract between the creditor and the principal debtor is not valid, but the
surety is still liable for the principal debtor.

Liability for Default by Principal Debtor : The surety becomes liable immediately on default by
the principal debtor. Before the default the surety does not have to pay as his liability only begins
if the principal debtor does not pay. At the same time, the principal debtor does not have to send
any notice of default to the surety. The creditor can sue the surety for the amount immediately on
default. Procedurally, he is not required to sue the principal debtor first. He can immediately sue
the surety for the amount owed to him.

Discharge of Surety

The surety and the so-surety are discharged from their liabilities in the following circumstances :

Revocation of Contract by Surety (b) By Act or Conduct of Creditor (c) By Invalidation of the
Contract of Guarantee

Revocation of Contract by Surety

A contract can be revoked by a surety either by

By Notice : A specific guarantee can be revoked by the surety by giving notice to the creditor.
However, this is possible only before the liability of the surety accrues. If action has already been
taken, the gurantee can be revoked. A continuing guarantee can be revoked for future
transactions but the surety cannot be relieved of his liabilities from transactions that have already
taken place (Section 130).

By Death of Surety : In the event of death, the surety is not liable to pay for any transactions
entered into by the principal debtor and the creditor after his death. He is however liable for the
past transactions. After his death his property cannot be attached for any new contracts made by
the creditor and the principal debtor. His liability ceases after his death even though notice is not
given. As already stated, in a continuing guarantee the same rule will apply. (Section 131)

By Novation : When a new contract of guarantee is made and it replaces the old contract either
between the same parties of the contract or a continuation between at least one of the old parties
with a new party, the old contract is discharged. The contract of guarantee made originally is also
discharged. (Section 62)

By Act or Conduct of Creditor

The surety is discharged from his liabilities due to certain acts or the conduct of the creditor.

Variance in Contract Terms : The liability of the surety extends to the terms of the contract
between the three parties i.e., creditor, principal debtor and the surety. Any variation in terms and
conditions must be approved by the parties concerned. If any changes take place without the
consent of the surety, he will be discharged from his liability after such changes are made
(Section 133). If the contract of guarantee consists of several distinct different duties and
obligations the surety will be discharged from only those duties where there is a variance in the
contract terms. In a continuing guarantee the surety need not perform his duties subsequent to the
variance in the contract as it will discharge him from his liabilities.

Example Sana is a distributor for consumer products. She employs Khan to sell the goods on
commission. Syed is the surety for Khan to Sana for giving the correct amount of money
collected from the sale of goods on which the commission becomes due. After Khan is employed
on his request Sana changes the terms of the contract and begins to pay a salary to him without
giving any information to Syed. The surety (Syed) is discharged from his liabilities.

(b) Release of Principal Debtor : If the principal debtor is released in a contract by the creditor
or by any act or omission of the creditor which has the effect of discharging the principal debtor
from his debt, then the surety is automatically released from his liabilities.

Example Rani makes a contract with Tinu to furnish her office for Rs. 5,00,000 within one
month. Rani promises to supply the furnishing material for the office. Minu guarantees the
performance of Tinu. Rani does not supply the furnishing material. Minu is discharged from her
liabilities as a surety.

(c) Compounding by Creditor with Principal Debtor : When the principal debtor and the creditor
make a composition with each other without the knowledge of the surety. This applies to a
situation in which a variation takes place from the original contract. In such a situation the surety
is discharged from his liability.

Example Mama borrows a sum of Rs. 50,000 from Ibrahim. Jasee is a surety for the payment by
Mama. Before the date of payment Mama and Ibrahim change the terms of the contract by
agreeing that Mama may pay Rs. 30,000 instead of the whole amount. Jasee is discharged from
his liability.

(d) Act or Omission Impairing Surety’s Eventual Remedy : The surety’s liability is discharged
when the creditor acts or fails to act in a certain way. This action or its omission becomes
inconsistent with the rights of the surety impairing his eventual remedy against the principal
debtor, (section 139). If the creditor does not do his duty required towards the surety in the
contract of guarantee, the surety can be discharged from his liability.

Example Kamal contracts to build a hotel in Swat for Ibrahim & Co. with certain specifications
and a fixed date of completion. Sana guarantees the completion and quality of the work to be
done by Kamal. Ibrahim & Co. promised to pay Kamal in installments and according to the
stages of work completed. The last installment was to be paid on the completion and inspection
of the hotel by the competent authorities. Before the work is completed Ibrahim & Co. pay the
complete amount to Kamal. The contractor stops his work after receiving the full payment
without completing the construction of the hotel. Sana is not responsible as surety because
Ibrahim & Co. have paid early and impaired the surety’s eventual remedy.

(e) Loss of Security : The surety is discharged from his liability if the creditor loses the security
given to him by the principal debtor. The surety will be also discharged if the creditor parts with
his security without his consent. However he will not be discharged if the security of the creditor
is lost due to natural calamities, or an act of an enemy of the country.

By Invalidation of the Contract of Guarantee

The surety will be discharged from his liabilities by invalidation of the contract of guarantee in
the following cases :
1 Guarantee Obtained by Misrepresentation : According to section 142 “if a guarantee is
received by misrepresentation made by the creditor or with his knowledge and a major part has
been misrepresented, the surety will be discharged from his liability”.

2 Guarantee Obtained by Concealment : According to section 143 of the contract Act, “if the
creditor has remained silent on certain important and material facts and obtained a guarantee, the
surety will be discharged from his liability”. The surety will be relieved from his liability as such
a guarantee will be obtained by concealment

3 Contract of Guarantee without Consideration : In a contract of guarantee there must be

4 Contract of Guarantee where Co-surety does not Join the Surety : According to section 144,
“in a contract of guarantee involving co-sureties and making it necessary for the contract to be
completed by more than one surety, the guarantee is invalid if the co-surety does not join the
surety in the contract”.