CONTRACT OF GUARANTEE

LEARNING OUTCOMES

(1) What is a guarantee, and what are the differences between an indemnity and a
guarantee?
(2) What is the extent of a surety’s/co-surety’s liability, and how does it get discharged?
(3) What are the rights of a surety against (i) the principal debtor, (ii) the creditor, and (iii)
co-sureties?
(4) What is a continuing guarantee?
(5) What is a bank guarantee? When can a beneficiary invoke a bank guarantee, and under
what circumstances can a party move to enjoin encashment of a bank guarantee?
 GUARANTEE DEFINED

“An undertaking to answer for the payment or performance of

another person's debt or obligation in the event of a default by the
person primarily responsible for it.”
-- Oxford English Dictionary
 DEFINITION AS PER ICA

Section 126 in The Indian Contract Act, 1872:

“Contract of guarantee”, “Surety”, “Principal Debtor” and “Creditor” --

• A ‘contract of guarantee’ is 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’.

• A guarantee may be either oral or written.

 ILLUSTRATION

• Two friends P and S go to an electronic goods shop. S says to the

shop-owner C “let P purchase a washing machine on credit. I will
pay you if P is unable to do so”. On this assurance, the sale is
confirmed. This is a Contract of Guarantee.
Three Contracts exist among the
parties:
1. Between Principal Debtor &
Creditor: The Principal
Contract to perform the
contractual obligations.
2. Between Surety & Creditor:
A Secondary Contract to
discharge the liabilities of the
Principal Debtor if he fails to
do so himself.
3. Between Principal Debtor &
Surety: An Implied Contract
that the Principal Debtor will
reimburse the Surety.
 ESSENTIALS OF A CONTRACT
OF GUARANTEE

Section 127 in The Indian Contract Act, 1872:

Consideration for Guarantee --

“Anything done, or any promise made, for the benefit of the principal
debtor, may be a sufficient consideration to the surety for giving the
guarantee.”

That is to say, a guarantee without consideration is void but there need

not be direct consideration between surety and creditor.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

Section 127 in The Indian Contract Act, 1872:

Consideration for Guarantee --

Anything done, or any promise made, for the benefit of the principal
debtor, may be a sufficient consideration to the surety for giving the
guarantee.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

Section 128 in The Indian Contract Act, 1872:

Surety's liability --
The liability of the surety is co-extensive with that of the principal
debtor, unless it is otherwise provided by the contract.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

Sections 129, 130 & 131 in The Indian Contract Act, 1872:
Continuing Guarantee --
A guarantee which extends to a series of transactions, is called, a "continuing
guarantee".
Revocation of continuing guarantee --
A continuing guarantee may at any time be revoked by the surety, as to future
transactions, by notice to the creditor.
Revocation of continuing guarantee by surety’s death --
The death of the surety operates, in the absence of any contract to the contrary, as a
revocation of the continuing guarantee, so far as regards to future transactions.
 DISTINCTION BETWEEN
A CONTRACT OF INDEMNITY AND A CONTRACT OF GUARANTEE.

SL. CONTRACT OF GUARANTEE

CONTRACT OF INDEMNITY (SECTION 124)
NO. (SECTION 126)
1.  Two Parties: It is a bipartite agreement between Three Parties: It is a tripartite agreement between the
the Indemnifier and Indemnity-holder. Creditor, Principal Debtor, and Surety.

2.  Liability of the indemnifier is contingent upon Liability of the surety is not contingent upon any loss.
the loss. It exists from the moment of entering into the contract
but crystallizes on the Principal Debtor’s default.

3.  Liability of the indemnifier is primary to the Liability of the surety is co-extensive with that of the
contract. principal debtor although it remains in suspended
animation until the principal debtor defaults. Thus, it is
secondary to the contract and consequently if the
principal debtor is not liable, the surety will also not be
liable.
 DISTINCTION BETWEEN
A CONTRACT OF INDEMNITY AND A CONTRACT OF GUARANTEE

SL. CONTRACT OF INDEMNITY (SECTION CONTRACT OF GUARANTEE

NO. 124) (SECTION 126)
4.   The undertaking in indemnity is original. The undertaking in a guarantee is collateral to the
original contract between the creditor and the
principal debtor.
5.  There is only one contract in a contract of There are three contracts in a contract of guarantee -
indemnity - between the indemnifier and the an original contract between Creditor and Principal
indemnity holder. Debtor, a contract of guarantee between creditor and
surety, and an implied contract of indemnity between
the surety and the principal debtor.

6.  The reason for a contract of indemnity is to The reason for a contract of guarantee is to enable a
make good on a loss if there is any. third person get credit.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

1) Must be made with the agreement of all three parties --

• All the three parties to the contract 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.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

2) Consideration --

• According to S.127, 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.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

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.

• Surety's liability --The liability of the surety is co-extensive with that of the
principal debtor, unless it is otherwise provided by the contract.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

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 void, no liability of the
surety arises.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

5) Need not be a contract of utmost good faith –

• Guarantee is a contract of strictissima juris which means liability of surety is

limited by law; a surety is offered protection by law and is treated as a favored
debtor in the eyes of the law. A contract of guarantee is not a contract of uberrimae
fidei (requiring utmost good faith).

• Still the suretyship relationship is one of trust and confidence and the validity of
the contract depends upon the good faith of the creditor. However, it is not a part
of the creditor’s duty to inform the surety about all his previous dealings with the
principal debtor.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

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.
 SALIENT FEATURES OF A CONTRACT
OF GUARANTEE AS PER ICA

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
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.
 RIGHTS OF THE SURETY

Against the Principal Debtor

Section 140: Right of Subrogation Section 145: Right of Indemnity

 RIGHTS OF THE SURETY

Right of Subrogation --

• “Where a guaranteed debt has become due, or default of the principal debtor to perform a guaranteed
duty has taken place, the surety, upon payment or performance of all that he is liable for, is invested with
all the rights which the creditor had against the principal debtor.”

• Section 140 of the Indian Contract Act, 1872 has stated the right of subrogation. The right of subrogation
means forming a new contract to recover the debt from the parties. As the surety has paid the amount
due in respect to default made by the principal debtor, now the surety takes the place of the creditor and
the principal debtor is entitled to pay the repaid loan amount which was paid on behalf of him to the
creditor in the original contract of guarantee.
 RIGHTS OF THE SURETY

Right of Indemnity --

• “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, but no sums which he has paid wrongfully.”

• Under Section 145 of the Indian Contract Act, 1872 mandates to indemnify the surety. Under the
Contract of Guarantee the principal debtor is obliged to indemnify the surety in respect to the
default of payment at the time of discharging the loan amount. It is not compulsory that the
indemnity clauses should be mentioned in the contract; it is an implied duty of the principal debtor in
respect to default of payment.
 RIGHTS OF THE SURETY

Against the Creditor

Section 141: Right to Securities Right to set-off and share reduction

 RIGHTS OF THE SURETY

Right of Securities --

• Surety’s right to benefit of creditor’s securities: Surety has a right over the security which the
creditor has in his possession at the time when the contract of guarantee was constructed. It
doesn’t matter whether surety was aware of the security or not. The creditor, if without the consent
of the surety gets rid of the security, the surety’s obligation is reduced to the extent of the value of
the security disposed of.

• Section 141 identifies the general rule of equity as observed in a case that the surety is entitled to
redress which the creditor has against the principal debtor, including enforcement of every security.
On paying off the creditor the surety is exactly in the same positions as the creditor was against the
principal debtor. The right exists irrespective of the fact whether the surety knows of the existence
of such security or not.
 RIGHTS OF THE SURETY

Right to set-off --
If the creditor owes anything to the principal debtor, the amount owed can be adjusted in the creditor’s
claim against the surety. The surety can charge from the amount to be given to the creditor if the
creditor has to pay the principal debtor back.

Right to share reduction --

Reduction here refers to insolvency. A gives loan to B, C is the guarantor. Subsequently, B becomes
insolvent. The property of B is attached to recover the loan he had taken. The official receiver in this
particular case will create a list of creditors and pay them proportionate to the sum lent by them. The
surety can ask the receiver about the amount given to A. The amount received by A through this
process can be deducted by the surety.
 RIGHTS OF THE SURETY

Against Co-sureties
(if any)

Section 146: Right to Section 147: Right to

Section 138: Right to get pay the amount as
contribute equally
release from the contract promised
 RIGHTS OF THE SURETY

Right to get release from the contract --

• “Where there are co-sureties, a release by the creditor of one of them

does not discharge the others, neither does it free the surety so released
from his responsibility to the other sureties.”
 RIGHTS OF THE SURETY

Right to contribute equally --

• “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.”

• Section 146 of the Indian Contract Act, 1872 has mentioned that the liabilities of co-securities
are joint. If the contract does not mention the liability of co-securities as joint, it must be
implied that all the co-securities will share equally the debt not paid by the principal debtor.
 RIGHTS OF THE SURETY

Right to pay the amount as promised --

• “Co-sureties who are bound in different sums are liable to pay equally as far as
the limits of their respective obligations permit.

• As per Section 147 if the co-securities have promised a particular amount to pay
in the sum of debt then they are obligated to pay that sum if the principal debtor
causes default in payment of the loan.
 DISCHARGE OF SURETY

BY REVOCATION OF THE CONTRACT

1. Notice by Surety: You have learnt that a contract of guarantee may be specific or
continuing. A specific guarantee cannot be revoked if the liability has already accrued. A
continuing guarantee may at any time be revoked by the surety, as to future
transactions, by notice to the creditor.

Q: If A lends B a certain sum of the guarantee of C, then C cannot revoke the contract of
guarantee. But, if A has not yet given the sum to B, even though the guarantee has been
executed by C, can C revoke this contract?
 DISCHARGE OF SURETY

BY REVOCATION OF THE CONTRACT

2. Death of Surety - In the absence of a contract to the contrary, a continuing guarantee is revoked
by the death of the surety as to the future transactions.
*The estate of deceased surety is, however, liable for those transactions which had already taken
place during the lifetime of the deceased.

Q: Will the surety's estate be liable for the transactions taking place after the death of surety if the
creditor had no knowledge of surety's death?
 DISCHARGE OF SURETY

BY REVOCATION OF THE CONTRACT

3. Novation - A contract of guarantee is discharged by novation when a fresh contract being

entered into, either between the same parties or between other parties, the consideration being the
mutual discharge of the old contract. The original contract of guarantee comes to an end and so the
surety stands discharged with regard to the old contract.

*Section 62 in The Indian Contract Act, 1872: Effect of novation, rescission, and alteration of contract.—If the parties
to a contract agree to substitute a new contract for it, or to rescind or alter it, the original contract need not be
performed. —If the parties to a contract agree to substitute a new contract for it, or to rescind or alter it, the original
contract need not be performed.
 DISCHARGE OF SURETY

BY CONDUCT OF THE CREDITOR

1. Variance in terms of the contract (Section 133) - A surety is discharged by such conduct of the
creditor which has the effect of materially altering the terms of the contract of guarantee.

Q: C contracts to lend B Rs. 5,000 on 1st January. A guarantees repayment of said lending. However, C
pays the amount to B on 31st August without knowledge or consent of A. Is A is discharged from the
liability as the contract has been varied?
 DISCHARGE OF SURETY

BY CONDUCT OF THE CREDITOR

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.
But, where the principal debtor is discharged of his debt by operation of law, such as insolvency,
this will not operate as a discharge of the surety.
Q: A contracts with B for a fixed price to build a house for B within a specified time, B supplying the
necessary timber. C guarantees A's performance of the contract. However, B omits to supply the
timber. Is A discharged from performing the contract or C is discharged from his suretyship or both of
them are discharged?
 DISCHARGE OF SURETY

BY CONDUCT OF THE CREDITOR

Arrangement between principal debtor and creditor - Where 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 (Section 135).
*However, mere forbearance by the creditor to sue the principal debtor or to enforce any other remedy against
him, in the absence of any provision in the guarantee to the contrary, does not discharge the surety.

Illustration: A owes Rs. 10,000 to K. The debt is guaranteed by M. The debt becomes payable but K
does not sue A for six months after the debt has become payable. This will not discharge M.
 DISCHARGE OF SURETY

BY CONDUCT OF THE CREDITOR

By creditor's act or omission impairing surety's eventual remedy (Section 139) - If the creditor does any act
which is against 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.
Illustration: B, a shipbuilder, contracts to build a ship for C for a given sum, to be paid in instalments as the
work reaches certain stages (the last instalment not to be paid before the completion of the ship). A becomes
surety to C for B's due performance of the contract. C, without the knowledge of A, prepays the last instalment
to B. A is discharged by this payment.

Q: A puts M as apprentice into B’s company and gives a guarantee to B for M’s loyalty. B promises on
his part that he will, at least once a month, see M makes up the cash. B omits to see as promised, and
M embezzles. Is A liable to B on his guarantee?
 DISCHARGE OF SURETY

BY CONDUCT OF THE CREDITOR

Loss of security - 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 security (Section 141).

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 a further security for the same debt. Subsequently, C gives up
the further security. A is not discharged.
 DISCHARGE OF SURETY

BY INVALIDATION OF THE CONTRACT

1. Guarantee by misrepresentation (Section 142) - A surety can be discharged of his liability if the
contract of guarantee is invalidated (void or voidable). ICA provides that if a contract of guarantee
has been entered into owing to the misrepresentation of a material fact which was known to the
creditor, it would invalidate the contract.
 DISCHARGE OF SURETY

BY INVALIDATION OF THE CONTRACT

2. Guarantee obtained by concealment - 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. (Section 143).

*Suppressio Veri or Suggestio Falsi?

 DISCHARGE OF SURETY

BY INVALIDATION OF THE CONTRACT

3. Failure of co-surety to join a surety: 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.
 BANK GUARANTEE

Bank Guarantee can be defined as:

A unilateral legal contract in which a bank (surety) undertakes an obligation to pay

the beneficiary (creditor) a certain amount of money so specified in the guarantee
bond, if the customer (debtor) from the original contract is unable to fulfil his
contractual obligations.
 BANK GUARANTEE

Illustration—

XYZ company is a newly-established textile factory in Surat that wants to purchase

Rs. 50 lacs worth of fabric raw materials. The fabric vendor requires XYZ to
provide a bank guarantee to guarantee payments before they ship the raw material
to Surat.
XYZ applies to HDFC Bank and obtains a guarantee of the same amount from the
lending institution that keeps its cash accounts. Thus, if XYZ now defaults in
payment, the fabric vendor can recover it from the bank.
 ESSENCE OF BANK GUARANTEE

Objective?

Parties?

Essentials: A valid Bank guarantee should be specific, for a specific amount and
the purpose of the guarantee should be clearly stated and should be enforced
based on the terms existing between the bank and the beneficiary.
 SAMPLE BANK LETTER OF GUARANTEE
 
To Whomsoever It May Concern
Dear Sir/Madam:
 
This letter will serve as your notification that ______ (Bank Name) ______ will irrevocably honor and
guarantee payment of any check(s) written by ______ (Customer's Name) ______ up to the amount of
______ (Amount Guaranteed) ______ and drawn on account number: ______ (Customer's Account
Number).
 
This guarantee is for the purpose of our customer purchasing vehicles or other property in connection with the
_____________ (Purpose).
 
This letter of guarantee came into effect on _______ and is good until ______ (Period of Guarantee). If
further information is required, please feel free to contact this office.
Sincerely,
  __________________________ (Bank Officer's Signature and Seal)
 
___________________________ (Customer's Signature)
 DIFFERENCE BETWEEN A BANK GUARANTEE
AND A USUAL GUARANTEE

• 1. A usual guarantee is governed by Section 126 of the Indian Contract Act while a
bank guarantee is not directly governed by the ICA .

• 2. In an ordinary guarantee, the contract between the surety and the creditor arises as
a subsidiary to the contract between the creditor and the principal debtor. The bank
guarantee is independent of the main contract.

• 3. An ordinary guarantee usually does not have any time limit before which the debt
has to be claimed. Bank guarantees generally have a specific time within which they
are functional.
 WHEN CAN A BENEFICIARY INVOKE
A BANK GUARANTEE?

• The beneficiary needs to invoke the Bank Guarantee on or before the expiry date
of the guarantee.
• If the Bank does not receive any claim on or before the validity period mentioned, the
Bank is discharged from its liability.
• The beneficiary needs to send a letter to the Bank stating the circumstances that
arose leading to the encashment of the guarantee.