Contract of Guarantee: Features and Kinds | Law of Contracts - CLAT PG PDF Download

Contract of Guarantee

Definition of a Contract of Guarantee

• A contract of guarantee, as per Section 126 of the Indian Contract Act, is an agreement where one party promises to fulfill the obligations or liabilities of a third party in case that third party fails to do so.

 Economic Functions of Guarantee 

• The primary purpose of a contract of guarantee is to facilitate individuals in obtaining loans, goods on credit, or securing employment.
• When someone offers a guarantee, they are essentially vouching for the trustworthiness of the person in need. They assure the lender, supplier, or employer that they will take responsibility in case of any default.
• Guarantees serve as a safety net, providing an additional source of payment if the primary source fails.

 Example of a Contract of Guarantee 

• Consider a scenario where X and his friend Y enter a shop. X tells the shopkeeper Z, "Supply the goods requested by Y, and if he fails to pay, I will." In this case, X is entering into a contract of guarantee, promising to cover Y's liability if Y defaults on the payment.

Parties to the Contract of Guarantee (Section 126)

In a contract of guarantee, there are three key parties involved:

 1. Principal Debtor  (Section 126)

• The principal debtor is the person whose default triggers the guarantee. For example, in a scenario where a loan is guaranteed, the borrower who may fail to repay is the principal debtor.

 2. Creditor  (Section 126)

• The creditor is the individual or entity to whom the guarantee is provided. In the loan example, the bank or financial institution lending the money would be the creditor.

 3. Surety  (Section 126)

• The surety is the person who provides the guarantee. This individual agrees to take responsibility for the principal debtor's obligations in case of default.

A guarantee can be established either orally or in writing.

 Independent Liability vs. Guarantee 

• Independent liability differs from a guarantee in that it does not rely on the default of the principal debtor. A guarantee involves a conditional promise to be liable only if the principal debtor defaults.
• Cases such as  Punjab National Bank v. Vikram Cotton Mills  and  Birkmyr v. Darnell  illustrate the distinction between independent liability and guarantee.

Essential Features of Contract of Guarantee 

A contract of guarantee is a legally binding agreement that involves three parties: the  creditor  , the  principal debtor  , and the  guarantor  . It is important to understand the key features that make a contract of guarantee valid and enforceable.

 Requisites of a Valid Guarantee 

To ensure the validity of a guarantee contract, certain requisites must be met:

• The guarantee must be  written  and signed by the parties involved.
• There should be a clear  intention  to create a legal obligation.
• The terms of the guarantee should be  specific  and unambiguous.
• Consideration, though not always necessary, should be present to support the guarantee.
• The parties involved should have the legal capacity to enter into the contract.
  

Essentials of a Valid Contract

•  Competence of Principal Debtor:  The principal debtor does not need to be competent to contract. If the principal debtor is not competent, the surety is considered the principal debtor and is personally liable to pay.
•  Benefit to Surety:  The surety does not need to be benefited. As per Section 127, anything done or promised for the benefit of the principal debtor can be sufficient consideration for the surety to provide the guarantee.
•  Form of Guarantee:  A guarantee does not have to be in writing. According to Section 126, a guarantee can be either oral or written.

2. Tripartite agreement

Contract of Guarantee: An Overview

A contract of guarantee is a legal agreement involving three parties: the principal debtor, the creditor, and the surety. It is essentially a promise made by the surety to take responsibility for the debtor's obligations if the debtor fails to fulfill them.

 Key Components of a Contract of Guarantee 

•  Contract between Creditor and Principal Debtor: This is the initial agreement where the creditor extends credit to the principal debtor, creating the debt that is being guaranteed.
•  Contract between Surety and Principal Debtor:  In this agreement, the principal debtor agrees to reimburse the surety if the surety has to make a payment on behalf of the debtor.
•  Contract between Surety and Creditor:  This is the guarantee where the surety promises to pay the creditor the debt owed by the principal debtor if the debtor fails to do so.

Principal Debt

In the context of guarantees, principal debt refers to the underlying obligation or liability that the surety agrees to cover in case of default by the principal debtor. The following points elaborate on the key aspects related to principal debt in guarantees:

 a. Recoverable Debt Necessary 

For a valid guarantee and to ensure the payment of debt, the existence of a recoverable debt is essential. This means that there must be a principal debtor who is responsible or liable, and the surety must agree to take on this responsibility in case of the debtor's default.

Case References:

 Swan v. Bank of Scotland  : This case illustrates the necessity of a recoverable debt for a valid guarantee.

 Lima Leitao & Co. Ltd v. UOI, AIR 1968  : This case further emphasizes the requirement of a recoverable debt in the context of guarantees.

 b. Guarantee for void Debt, When enforceable 

In certain situations, a guarantee for a void debt may still be considered enforceable. For example, if the directors of a company guarantee a loan for the company that is void due to being ultra vires (beyond the powers of the company), the directors can still be held liable.

The reason for this distinction lies in the consequences of voidness. When a contract of guarantee is void due to a company acting ultra vires, the implications are different from voidness caused by explicit legal language in a statute.

 c. Guarantee of minor’s Debt 

When a minor's debt is knowingly guaranteed by the surety, the surety assumes the role of a principal debtor. This means that the surety becomes liable for the debt as if they were the original borrower.

Case Reference:

 Kashiba Bin Narsappa Nikade v. Narshiv Shripat 1984 1LR  : This case illustrates the principle that a surety who guarantees a minor's debt becomes liable as a principal debtor.

 Consideration in Guarantee 

Consideration in the context of a guarantee is defined in Section 127 of the Indian Contract Act, 1872. According to this section, anything done or any promise made for the benefit of the principal debtor can constitute sufficient consideration for the surety.

 Key Points from Section 127: 

• Consideration in a guarantee involves actions or promises made for the benefit of the principal debtor.
• Such actions or promises can be deemed sufficient consideration for the surety's commitment.

 Illustrations of Consideration in Guarantee 

•  Illustration (a):  B requests A to sell and deliver goods on credit, with C guaranteeing payment. C's promise to guarantee payment in consideration of A's promise to deliver the goods constitutes sufficient consideration for C's promise.
•  Illustration (b):  A sells goods to B, and C requests A to forbear suing B for a year, promising to pay for the goods if B defaults. A's agreement to forbear is sufficient consideration for C's promise.
•  Illustration (c):  A sells goods to B, and C, without consideration, agrees to pay for them if B defaults. This agreement is void.

 Example of Guarantee 

• When A requests B to lend ₹10,000 to C, guaranteeing that C will repay within the agreed time, and that A will pay B if C fails to do so, a contract of guarantee is formed. In this scenario, B is the creditor, C is the principal debtor, and A is the surety.

 Guarantee for Past Debt 

•  Invalidity of Guarantee for Past Debt:  Guarantees for past debt are generally considered invalid. The principle is that "anything done for the benefit of the principal debtor" constitutes good consideration.
•  Case Example - SICOM Ltd. V. Padmashri Mahipatrai Shah (2005):  In this case before the Bombay High Court, a guarantee was executed after the financial assistance had already been provided to the borrower. The court ruled that there was consideration for the guarantee, emphasizing that "past consideration is valid consideration."

 Past and Future Debt in Guarantee 

• A guarantee covering both past and future debt is enforceable as long as some further debt is incurred after the guarantee is established.
• There must be a clear commitment to be liable for a past debt, and once a new obligation is created, the liability for all obligations is linked together.
• This principle was illustrated in the case of "Morell v. Cowan."

 Benefit to Principal Debtor as Sufficient Consideration 

• If the principal debtor receives a benefit, it is sufficient to uphold the guarantee.
• It is not important whether the principal debtor requested the guarantee, or if it was provided without their knowledge or consent.

 Counter Guarantee 

• A counter guarantee serves to protect the original guarantor.
• When the original guarantor is called upon to fulfill their obligation and has done so, they can invoke the counter guarantor to reimburse them.

 Is a Contract of Guarantee a Contract of Uberrimae Fidei? 

A contract of guarantee does not fall under the category of a contract of uberrimae fidei, which involves absolute good faith. Therefore, it is not mandatory for the principal debtor or the creditor to disclose all material facts to the surety before entering into the contract.

 Example: 

• In the case of a guarantee provided to a bank, the bank is not obligated to inform the surety about matters affecting the creditworthiness of the principal debtor.

However, Sections 142 and 143 of the relevant legal provisions offer some protection to the surety by rendering certain types of guarantees invalid.

 Guarantee Not to be Obtained by Misrepresentation [Section 142] 

• A guarantee obtained through misrepresentation by the creditor, either knowingly or with consent, regarding a material aspect of the transaction, is considered invalid.

 Guarantee Not to be Obtained by Concealment [Section 143] 

• A guarantee obtained by the creditor through silence on material circumstances is deemed invalid, as illustrated in the case of London Omnibus Co v. Holloway.

 Example: 

•  X  sells goods to  Y  . Later, X requests  Z  to pay if Y defaults. Z agrees. Z cannot become surety without Y's consent.

 Kinds of Guarantee 

Guarantee can be classified into two categories:

 Specific Guarantee 

A specific guarantee covers a single debt or a specific transaction. The surety's liability ends when the guaranteed debt is discharged or the promise is fulfilled.

 Example:  A specific guarantee is when X guarantees payment to Y for the price of five bags of flour to be delivered by Y to Z and paid for in a month. X's guarantee is limited to the payment for the first five bags of flour delivered at one time.