Concept of Contract of Guarantee | Law Optional Notes for UPSC PDF Download

What is a Contract of Guarantee?

• Definition: A contract of guarantee, as per Section 126 of The Indian Contract Act, 1872, involves a promise to perform or discharge the liability of a third party in case of their default.
• Key Parties Involved: The individual providing the guarantee is called the 'surety,' the person whose default triggers the guarantee is the 'principal debtor,' and the recipient of the guarantee is the 'creditor.'
• Explanation: Think of a guarantee as a safety net where if the principal debtor fails to fulfill their obligation to the creditor, the surety steps in to settle the debt.
• Illustrative Example: For instance, consider a scenario where Party A and Party B have a contract, with Party C acting as the surety. If Party B owes Party A Rs. 1000 but fails to pay, Party C, as the surety, becomes responsible for paying the amount to Party A.

Understanding Contract of Guarantee vs. Indemnity

Contract of Indemnity

• In a contract of indemnity, one party promises to compensate another party for losses caused by the promisor or any other person.
• The key distinction lies in the fact that in a contract of indemnity, the promisor has primary liability, whereas in a contract of guarantee, the surety's liability is secondary to the principal debtor's.
• This type of contract involves only two parties - the promisor and the promisee, unlike a contract of guarantee which involves three parties.

Illustrative Example

• Consider a scenario where A promises to protect B from losses caused by C. If C indeed causes losses to B, in a contract of indemnity, A directly compensates B. However, in a contract of guarantee, A steps in to fulfill the liability only if C fails to do so.

Basic Essentials for Contract of Guarantee under the Indian Contract Act

• Agreement by all Parties: All involved parties—the creditor, principal debtor, and surety—must agree to the contract terms.
• Liability: In a contract of guarantee, the creditor can only seek payment from the surety if the principal debtor fails to fulfill their obligation.
• Existence of debt: A valid contract of guarantee necessitates the presence of a debt accepted by law. If the debt is time-barred or void, the surety's liability is void.
• Consideration: Any benefit received by the principal debtor can serve as suitable consideration.
• Two forms of a guarantee contract: Guarantee contracts can be either verbal or written.
• Essentials of a Valid Contract: Similar to other contracts, a contract of guarantee requires common elements such as acceptance, intention to contract, ability to contract, legality, creation of a legal relationship, lawful object, consideration, consent, performance standards, and legal formalities.
• All facts must be brought to light: The creditor must disclose all relevant information to the surety that impacts their liability. Concealing facts can invalidate the contract.
• No misrepresentation of facts: Obtaining a guarantee through misrepresentation is prohibited. Facts affecting the surety's liability must be accurately communicated. Section 142 of The Indian Contracts Act addresses this issue.

Understanding Continuing Guarantee under Indian Contract Act

• A continuing guarantee, defined by Section 129 of the Indian Contracts Act, 1872, extends to a series of transactions, remaining valid until the surety revokes it for future transactions by informing the creditor.
• Illustration:
  • Party A acts as a surety between B (the creditor) and C (the principal liability) for a specific transaction or a series of transactions. If C fails to fulfill payment obligations to B, A is then liable. After the transactions are completed, A can choose to end the guarantee or continue as the surety for future transactions between B and C.
  • For example, if A guarantees payment of Rs. 5,000 on behalf of C to B for rent collection, this arrangement continues until the specified transactions are completed or revoked.
• Contracts of indemnity differ from specific contracts of guarantee in that guarantees of continuity cover a defined number of transactions stipulated in the contract.

Revocation of Continuing Guarantee

• Revocation by Notice (Section 130): A continuing guarantee can be revoked by the surety for future transactions by simply giving notice to the creditor. This means that the surety can inform the creditor at any time that they no longer wish to be bound by the guarantee for upcoming transactions.
• Revocation by Death (Section 131): In the event of the surety's death, the continuing guarantee is automatically revoked concerning future transactions. However, it's important to note that the surety's estate remains responsible for obligations that were established before their passing. This ensures that any previous commitments are still upheld even after the surety's death.
• Revocation due to Changes in Terms by the Principal Debtor (Section 133): A continuing guarantee can also be revoked if there are alterations in the terms of the agreement between the principal debtor and the creditor without the surety's consent. Any changes made without the surety's agreement release the surety from responsibility for transactions that occur after these modifications. This highlights the importance of the surety's consent in any modifications to the original terms of the agreement.

By understanding these points, it becomes clear how a continuing guarantee can be revoked under different circumstances, ensuring that the surety is not indefinitely bound to future transactions without their consent.

Nature of Surety's Liability in Guarantee Contract

• Definition of Surety's Liability:
  • The surety's liability in a guarantee contract is described in Section 128 of The Indian Contracts Act.
  • The surety's liability is coextensive with that of the principal debtor unless the contract states otherwise.
  • Unless specified in the contract, the surety is obligated to pay the same amount as the principal debtor to the creditor.
• Example of Surety's Liability:
  • If the contract requires the surety to pay interest or additional charges beyond the principal amount, the surety is liable for those as well.
  • In the absence of specific terms in the contract, the surety is only responsible for the amount the principal debtor would have to pay.
• Legal Precedent:
  • In the case of Maharaja of Benares v. Har Narain Singh, the court ruled that the surety's liability is coextensive with that of the principal debtor.
  • Since the contract did not mention interest for the surety, the court held that the surety was not liable to pay interest on the principal debt.
• Nature of Surety's Liability:
  • The surety's liability is secondary in nature, contrasting with the primary liability of the principal debtor.

Duration and Termination of Such Liability in Guarantee Contract

• The duration of a surety's liability is determined by the contract terms. In a specific contract, the liability persists until the specified transaction is completed.
• In the case of a continuing contract, the liability extends to the series of transactions outlined or until the surety notifies the creditor of their intention to withdraw from future transactions.
• Termination of these contracts occurs upon the completion of the specified transactions or when the surety communicates their decision to exit future obligations in continuing contracts.
• Aside from contract completion, the surety's liability can be discharged prematurely through various methods, which will be discussed in detail in the upcoming section on 'discharge of surety liabilities'.

Rights of Surety and Their Legal Position in a Contract of Guarantee under the Indian Contract Act

Rights Against the Principal Debtor

• The right of subrogation: When a surety settles the debts of the principal debtor to the creditor, they can step into the shoes of the creditor and claim back the amount paid, along with any interests or costs.
• The right of indemnity: Upon fulfilling their duty of paying the principal debtor's debts, the surety has the right to be reimbursed by the principal debtor for the amount paid to the creditor.
• The right to security: This right allows the surety to utilize any remedies the creditor has against the principal debtor, including enforcing any security held by the creditor.

Rights against the Creditor

• Right to securities provided by the principal debtor: Under Section 41 of the Indian Contracts Act, a surety is entitled to benefit from any security the creditor holds against the principal debtor at the time of entering into the surety contract. If the creditor loses this security without the surety's consent, the surety's liability is reduced by the value of the lost security.
• Right to set off: This allows the surety to deduct any amounts already paid by the principal debtor to the creditor from the surety's new liability.

In a Contract of Guarantee under the Indian Contract Act, the surety is afforded certain rights that help protect their interests. These rights can be categorized into those against the principal debtor and those against the creditor.

Position of the Surety in the Eyes of the Law

• Sureties are viewed more favorably in the eyes of the law compared to the principal debtor, with their debt being legally restricted.
• The law shows a particular consideration for sureties due to their crucial role in facilitating transactions, despite not directly benefiting from them.
• This sympathetic stance of the court towards sureties was exemplified in the legal case of State vs Churchill.

Various Judicial Interpretations to Protect The Surety in Contract of Guarantee in Contract Act

• Favorable Position of the Surety: The surety is considered a favored debtor in legal terms. For instance, in the case of Law vs. East India company, the court emphasized that actions by the creditor harming the surety are viewed favorably by the court. This underscores that the surety's obligations are strictly legal rather than moral.
• Liability of the Surety: According to Section 128 of The Act, the surety's liability aligns with that of the principal debtor unless the contract specifies otherwise.
• Conditioning Precedents Regarding Surety’s Liability: Section 144 of the act acknowledges that a surety can set conditions before agreeing to become a co-surety. For example, in The National Provincial Bank of England vs Brackenbury, the court ruled in favor of a surety who had set a condition for three co-sureties to join, and not all conditions were met.
• Discharge of Surety Due to Variance in the Contract: As outlined in Section 133 of the act, if the creditor alters the contract terms without the surety's consent, the surety's liability is discharged. This principle was established in the case of Pratap Singh vs Keshavlal, emphasizing the importance of mutual agreement in contractual changes.
• Right of Subrogation: The right of subrogation grants the surety the ability to step into the shoes of the creditor upon paying the principal liability. Section 140 of the Act supports this right, ensuring fair treatment for the surety.
• Right to Security: Section 141 of the act recognizes the surety's entitlement to pursue remedies against the principal debtor, including enforcing security measures. This provision safeguards the surety's interests in the contractual agreement.

Co-surety and Manner of Sharing Liabilities and Rights under Contract of Guarantee in Contract Law

• Liability of Co-sureties:
  • According to section 126 of the Indian Contracts Act, when multiple sureties guarantee the principal debtor's liability, they are termed as co-sureties.
• Sharing of Liabilities and Rights among Co-sureties:
  • Section 138 of the Act specifies that the release of one surety by the creditor does not release the other sureties from their obligations.
  • All sureties involved in a contract, whether jointly or severally, are obligated to pay the liability equally unless otherwise stated. For instance, if A and B are sureties for C in a contract with E for 10,000 Rs., they must each pay 5000 Rs. to fulfill the total.
  • Co-sureties with varying liability limits must contribute proportionately up to their respective maximum amounts as defined in the contract. For example, if A can cover up to 10,000 Rs. and B up to 5000 Rs., and the debtor owes 10000 Rs., A will pay 5000 Rs., while B's responsibility ends at 5000 Rs.

The Liability of Surety under Contract of Guarantee

• By default, the liability of a surety is considered to be the same as that of the principal debtor, unless specified otherwise in the contract.
• If the principal debtor is liable to pay a certain amount along with interests and costs, the surety is also responsible for these additional charges as per the contract.
• Case law, such as Zaki Husain v. Deputy Commissioner of Gonda, has established that the surety must fulfill the obligations of the principal debtor, including paying interests and costs if stipulated in the contract.
• If the contract does not mention interests or costs for either the principal debtor or the surety, then the surety is not obligated to pay these additional amounts.
• Although the principle of co-extensiveness usually applies, a surety can limit their liability when entering into a contract as per Section 128 of the Indian Contract Act.
• For instance, a surety like A can restrict their liability to a specific amount, such as Rs. 10,000, in a contract between the creditor (B) and the principal debtor (C).

Discharge of Surety’s Liability under Contract of Guarantee

• Discharge by revocation: Section 130 of the act allows the surety to revoke their liability for future transactions in continuing contracts.
• Discharge by the death of the surety: Under Section 131, the death of the surety releases them from future liabilities in continuing contracts, while legal heirs may be liable for specific contracts.
• Discharge by variance: Section 133 states that any changes in the contract without the surety's consent discharge the surety, as seen in the case of M.S Anirudhan v Thomco’s Bank Ltd.
• Discharge by the release of the principal debtor: According to Section 134, if the principal debtor is released, the surety is also discharged, except in cases of insolvency or liquidation.
• Promise not to sue: Section 135 emphasizes that agreements between the creditor and principal debtor can discharge the surety, but mere forbearance of not suing the principal debtor does not release the surety.
• Discharge when surety’s remedy is hampered: Section 139 stipulates that any actions by the creditor impeding the surety's rights lead to discharge. Post discharge, the creditor must not interfere with the surety's rights regarding the principal debtor.