What is Contract Of Guarantee

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 fails 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

What is a contract of guarantee?

Section 126 of the Indian contract act defines a contract of guarantee as a contract to perform the
promise or discharge the liability of the defaulting party in case he fails to fulfill his promise.

Thus here we can infer that there the 3 parties to the contract

Principal Debtor – The one who borrows or is liable to pay and on whose default the guarantee is
given

Creditor – The party who has given something of value to borrow and stands to receive the payment
for such a thing and to whom the guarantee is given

Surety/Guarantor – The person who gives the guarantee to pay in case of default of the principal
debtor

Also, we can understand that a contract of guarantee is a secondary contract that emerges from a
primary contract between the creditor and the principal debtor.

Illustration

Ankita advances a loan of INR 70000 to Pallav. Srishti who is the boss of Pallav promises that in case
Pallav fails to repay the loan, then she will repay the same. In this case of a contract of guarantee,
Ankita is the Creditor, Pallav 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 wriggle 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.

Essentials of a Contract of Guarantee

1) Must be made with the agreement of all 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. Here 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
Sam lends money to Akash. Sam is the creditor and Akash is the principal debtor. Sam approaches
Raghav to act as the surety without any information to Akash. Raghav agrees. This is not valid.

2) Consideration
According to section 127 of the act, anything is 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.

To know more about the essentials of a valid contract, please read this

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

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 (Section129). 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.

Illustrations

a) S is a bookseller who supplies a set of books to P, under the contract that if P does not pay for the
books, his friend K would make the payment. This is a contract of specific guarantee and K’s liability
would come to an end, the moment the price of the books is paid to S.

b) On M’s recommendation S, a wealthy landlord employs P as his estate manager. It was the duty of
P to collect rent every month from the tenants of S and remit the same to S before the 15th of each
month. M, guarantee this arrangement and promises to make good any default made by P. This is a
contract of continuing guarantee.

Continuing guarantee
A continuing guarantee is defined under section 129 of the Indian Contract Act,1872. A continuing
guarantee is a type of guarantee which applies to a series of transactions. It applies to all the
transactions entered into by the principal debtor until it is revoked by the surety. Therefore Bankers
always prefer to have a continuing guarantee so that the guarantor’s liability is not limited to the
original advances and would also extend to all subsequent debts.

The most important feature of a continuing guarantee is that it applies to a series of separable,
distinct transactions. Therefore, when a guarantee is given for an entire consideration, it cannot be
termed as a continuing guarantee.

Illustration

K gave his house to S on a lease for ten years on a specified lease rent. P guaranteed that S, would
fulfill his obligations. After seven years S stopped paying the lease rent. ‘K sued him for the payment
of rent. P then gave a notice revoking his guarantee for the remaining three years. P would not be
able to revoke the guarantee because the lease for ten years is an entire indivisible consideration and
cannot be classified as a series of transactions and hence is not a continuing guarantee.

Revocation of Continuing Guarantee

So far as a guarantee given for an existing debt is concerned, it cannot be revoked, as once an offer is
accepted it becomes final. However, a continuing guarantee can be revoked for future transactions. In
that case, the surety shall be liable for those transactions which have already taken place.

A contract of guarantee can be revoked in the following two ways-

1) By giving a notice (Section 130)

Continuing guarantees can be revoked by giving notice to the Creditor but this applies only to future
transactions. Just by giving a notice the surety cannot waive off his responsibility and still remains
liable for all the transactions that have been placed before the notice was given by him. If the contract
of guarantee includes a clause that a notice of a certain period of time is required before the contract
can be revoked, then the surety must comply with the same as said in Offord v Davies (1862).

Illustration

A guarantees to B to the extent of Rs. 10,000, that C shall pay for all the goods bought by him during
the next three months. B sells goods worth Rs. 6,000 to C. A gives notice of revocation, C is liable for
Rs. 6,000. If any goods are sold to C after the notice of revocation, A shall not be, liable for that.

2) By Death of Surety(Section 131)

Unless there is a contract to the contrary, the death of surety operates as a revocation of the
continuing guarantee in respect to the transactions taking place after the death of surety due to the
absence of a contract. However, his legal representatives will continue to be liable for transactions
entered into before his death. The estate of deceased surety is, however, liable for those transactions
which had already taken place during the lifetime of the deceased. Surety’s estate will not be liable for
the transactions taking after the death of surety’even if the creditor had no knowledge of surety’s
death.

Period of Limitation
The period of limitation of enforcing a guarantee is 3 years from the date on which the letter of
guarantee was executed. In State Bank Of India vs Nagesh Hariyappa Nayak And Ors, against the
advancement of a loan to a company, the guarantee deed was executed by its directors and
subsequently a letter acknowledging the load was issued by same directors on behalf of the company.
It was held that the letter did not have the effect of extending the period of limitation. Recovery
proceedings instituted after three years from the date of the deed of guarantee were liable to be
quashed.

Rights of a Surety
After making a payment and discharging the liability of the principal debtor, the surety gets various
rights. These rights can be studied under three heads:

(i) rights against the, principal debtors.

(ii) rights against the creditor, and
(iii) rights against the co-sureties.

(i) Rights against the Principal Debtor

1) The right of surety on payment of debt or the Right of

subrogation(Section 140)
The right of subrogation means that since the surety had given a guarantee to the creditor and the
creditor after getting the payment is out of the scene, the surety will now deal with the debtor as if he
is a creditor. Hence the surety has the right to recover the amount which he has paid to the creditor
which may include the principal amount, costs and the interest.

2) The right of Indemnity(Section 145)

In every contract of guarantee, there is an implied promise by the principal debtor to indemnify the
surety, and the surety is entitled to recover from the principal debtor whatever sum he has rightfully
paid under the guarantee. This is because the surety has suffered a loss due to the non-fullfillment of
promise by the principal debtor and therefore the surety has a right to be compensated by the debtor

Illustration
Luthra and co has taken a loan from Khaitan and co where Amarchand acts as security on behalf of
Luthra. Khaitan demands payment from Amarchand and on his refusal sues him for the amount,
Amarchand defends the suit having reasonable grounds for doing so, but he is compelled to pay the
amount of the debt with costs. He can recover from Luthra the amount paid by him for costs, as well
as the principal debt.

(ii) Rights against the Creditor

1) Right to securities given by the principal debtor(section 141)

On the default of payment by the principal debtor, when the surety pays off the debt of the principal
debtor he becomes entitled to claim all the securities which were given by the principal debtor to the
creditor. The Surety has the right to all securities whether received before or after the creation of the
guarantee and it is also immaterial whether the surety has knowledge of those securities or not.
Illustration
On the guarantee of Priya, Anita lent rs 100000 to Sita. This debt is also secured by security for the
debt which is the lease of Sita’s house. Sita defaults in paying the debt and Priya has to pay the debt.
On paying off Sita’s liabilities Priya is entitled to receive the lease deed in her favor.

2) Right to set off

When the creditor sues the surety for the payment of principal debtor’s liabilities, the surety can claim
set off, or counterclaim if any, which the principal debtor had against the creditor.

(iii) Rights against the Co-sureties

1) Release of one co-surety does not discharge others (Section 138)

When the repayment of debt of the principal debtor is guaranteed by more than one person they are
called Co-sureties and they are liable to contribute as agreed towards the payment of guaranteed debt.
The release by the creditor of one of the co-sureties does not discharge the others, nor does it free the
released surety from his responsibility to the other sureties. Thus when the payment of a debt or
performance of duty is guaranteed by co-sureties and the principal debtor has defaulted in fulfilling his
obligation and thus the creditor compels only one or more of the co-sureties to perform the whole
contract, the co-surety sureties performing the contract are entitled to claim contribution from the
remaining co-sureties.

2) Co-sureties to contribute equally (Section 146)

According to Section 146, in the absence of any contract to the contrary, the co-sureties are liable to
contribute equally. This principle will apply even when the liability of co-sureties is joint or several,
and whether under the same or different contracts, and whether with or without the knowledge of
each other.

Illustration
A, B, C, and D are co-sureties for a debt of Rs. 2,0000 lent by Z to R. R defaults in repaying the loan.
A, B, C, and D are liable to contribute Rs. 5000 each.

3) Liability of co-sureties bound in different sums(Section 147)

When the co-sureties have agreed to guarantee different sums, they have to contribute equally
subject to the maximum of the amount guaranteed by each one.

Illustration
A, B and C, sureties for D, enter into three separate bonds, each in a different penalty, A for Rs.
10,000, B for Rs. 20,000 and C for Rs. 40,000. D makes default to the extent of Rs. 30,000. A B and C
are liable to pay Rs. 10,000 each. Suppose this default was to the extent of Rs. 40,000. Then A would
be liable for Rs. 10,000 and B and C Rs. 15,000 each.

Discharge of Surety from Liability

Under any of the following circumstances a surety is discharged from his liability:
i) by the revocation of the contract of guarantee,
ii) by the conduct of the creditor, or
iii) by the invalidation of the contract of guarantee
We have already discussed above the first circumstance in which how a surety can be discharged i.e
by Revocation of the Contract of Guarantee. This includes by giving notice or death or the surety.

(ii) Conduct of the Creditor

1) Variance in terms of the contract(Section 133)

When a contract of guarantee has been materially altered through an agreement between the creditor
and principal debtor, the surety is discharged from his liability. This is because a surety is liable only
for what he has undertaken in the guarantee and any alteration made without the surety’s consent
will discharge the surety as to transactions subsequent to the variation.

Illustration

A becomes surety to C for B’s conduct as a manager in C’s bank. Afterward, B and C contract, without
A’ s consent, that B’ s salary shall be raised, and that he shall become liable for one-fourth of the
losses on overdrafts. B allows a customer to over-draw, and the bank loses a sum of money. A is
discharged from his suretyship by the variance made without his consent and is not liable to make
good this loss.

2) Release or discharge of the principal debtor(Section 134)

A surety is discharged if the creditor makes a contract with the principal debtor by which the principal
debtor is released, or by any act or omission of the creditor, which results in the discharge of the
principal debtor.

Illustration
A supplies goods to B on the guarantee of C. Afterwards B becomes unable to pay and contracts with
A to assign some property to A in consideration of his releasing him from his demands on the goods
supplied. Here, B is released from his debt, and C is also discharged
from his suretyship. But, where the principal debtor is discharged of his debt by operation of law,
say, on insolvency, this will not operate as a discharge of the surety.

3) Arrangement between principal debtor and creditor

According to section 135 when the creditor, without the consent of the surety, makes an arrangement
with the principal debtor for composition, or promise to give him time to, or not to sue him, the surety
will be discharged.
However, when the contract to allow more time to the principal debtor is made between the creditor
and a third party, and not with the principal debtor, the
surety is not discharged (Section 136).

Illustration
C, the holder of an overdue bill of exchange drawn by A as surety for B, and accepted by B, contracts
with M to give time to B, A is not discharged.

4) Loss of security(Section 141)

If the creditor parts with or loses any security given to him at the time of the guarantee, without the
consent of the surety, the surety is discharged from liability to the extent of the value of the security.
Illustration
A, as surety for B, makes a bond jointly with 3 to C to secure a loan from C to B. Later on, C obtains
from B further security for the same debt. Subsequently, C gives up further security. A is not
discharged.

(iii) By Invalidation of the Contract

A contract of guarantee, like any other contract, may be avoided if it becomes void or voidable at the
option of the surety. A surety may be discharged from liability in the following cases:

1) Guarantee obtained by misrepresentation(Section 142)

When a misrepresentation is made by the creditor or with his knowledge or consent, relating to a
material fact in the contract of guarantee, the contract is invalid

2) Guarantee obtained by concealment(Section 143)

When a guarantee is obtained by the creditor by means of keeping silence regarding some material
part of circumstances relating to the contracts, the contract is invalid

3) Failure of co-surety to join a surety(Section 144)

When a contract of guarantee provides that a creditor shall not act on it until another person has
joined in it as a co-surety, the guarantee is not valid if that other person does not join.E

Extent of a surety’s liability

In the absence of a contract to the contrary, the liability of a surety is co-extensive with that of the
liability of the principal debtor. It means that the surety is liable to the same extent to which the
principal debtor is liable.

Illustration
A guarantees to B the payment of a bill of exchange by C, the acceptor. On the due date, the bill is
dishonored 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.

Conclusion
The contract of guarantee is a specific contract for which the Indian Contract Acy has laid some rules.
As we have discussed, the basic function of a contract of guarantee is to protect the creditor from loss
and to give him confidence that the contract will be enforced with the promise of the surety. Every
contract of guarantee has three parties and there exist two types of guarantees i.e specific guarantee
and continuing guarantee. The type of Guarantee used depends on the situation and the terms of the
contract. The surety has some rights against the other parties and liability of the surety is considered
to be co-extensive with that of the principal debtor unless it is otherwise provided by the contract. In
case the contracts are entered into by misrepresentation made by the creditor regarding material
circumstances or by concealment of material facts by the creditor, the contract will be considered
invalid