Introduction
When it comes to financial transactions, understanding the intricacies of a contract of guarantee can save you from potential pitfalls. In this guide, we’ll delve into the essentials of a contract of guarantee, exploring its definition, key components, and the rights and liabilities of the involved parties. Whether you’re a creditor, a principal debtor, or a surety, this post aims to provide you with a clear and concise understanding of this critical legal concept.
What is a Contract of Guarantee?
A contract of guarantee is a legal agreement wherein one party (the surety) promises to fulfil the obligation or discharge the liability of a third party (the principal debtor) in the event of the latter’s default. This contract involves three key players:
- Principal Debtor: The individual or entity who guarantees the obligation.
- Surety: The person who provides the guarantee.
- Creditor: The party to whom the guarantee is given.
Sections 126-147 of the Indian Contract Act, of 1872, clearly define these roles and the nature of their commitments. A contract of guarantee can be either oral or written, offering flexibility in its formation.
Example
Imagine a situation where A takes a loan from a bank. A promises to repay the loan, and B, acting as a surety, assures the bank that if A defaults, B will cover the repayment. Here, A is the principal debtor, B is the surety, and the bank is the creditor. This setup provides the bank with additional security, knowing that if A fails, B will step in to fulfil the obligation.
Essential Features of a Contract of Guarantee
For a contract of guarantee to be valid, several essential requisites must be met:
Agreement of All Three Parties
All involved parties—the principal debtor, the creditor, and the surety—must consent to the arrangement. The surety’s responsibility arises from the principal debtor’s request.
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.
Consideration
According to Section 127 of the Act, any act or promise benefiting the principal debtor is sufficient consideration for the surety’s guarantee. This can include new promises or acts, not past considerations.
Case Law: State Bank of India v Premco Saw Mill (1983) – The bank refrained from taking legal action based on the surety’s promise, which the court deemed as good consideration.
Illustration: B requests A to sell and deliver goods on credit. A agrees, provided C guarantees the payment. C’s promise constitutes sufficient consideration for the guarantee.
Secondary Liability
The surety’s liability is secondary, activated only upon the principal debtor’s default. The primary responsibility to fulfil the contract lies with the principal debtor.
Existence of a Debt
A guarantee presupposes an existing debt or obligation. Without a debt, the surety has nothing to secure.
Case Law: Swan vs. Bank of Scotland (1836) – The court held that without a principal debt, no valid guarantee can exist.
Validity of the Contract
All essentials of a valid contract—free consent, lawful consideration, offer and acceptance, and the intention to create legal relations—must be present.
No Concealment of Facts
The creditor must disclose any facts that could affect the surety’s liability. Concealment renders the guarantee invalid.
No Misrepresentation
The guarantee must not be obtained through misrepresentation. While not requiring absolute good faith, any significant misrepresentation affecting the surety’s responsibility invalidates the guarantee.
Case Law: London General Omnibus Co. vs. Holloway – The employer’s failure to disclose a servant’s past dishonesty invalidated the surety’s liability.
Distinguishing Between Guarantee and Indemnity
Though both contracts of guarantee and indemnity aim to protect against loss, they differ significantly:
- Number of Parties: Indemnity involves two parties (indemnifier and indemnified), while guarantee involves three (principal debtor, creditor, and surety).
- Nature of Obligation: In indemnity, the indemnifier’s liability is primary. In guarantee, the surety’s liability is secondary, contingent upon the principal debtor’s default.
- Contracts Involved: Indemnity involves one contract. Guarantee involves three: between principal debtor and creditor, surety and creditor, and an implied contract where the principal debtor indemnifies the surety.
Rights and Liabilities Under a Contract of Guarantee
Surety’s Rights Against Principal Debtor
- Right of Subrogation (S. 140): After fulfilling the obligation, the surety gains the creditor’s rights against the principal debtor.
- Right to Indemnity (S. 145): The surety can recover any rightful payments made from the principal debtor.
Surety’s Rights Against Creditor
- Right to Securities (S. 141): The surety is entitled to any securities held by the creditor against the principal debtor.
- Right to Set-off: The surety can use any defences available to the principal debtor against the creditor.
The Surety’s Rights Against Co-Sureties
- Right to Contribution (Ss. 146-147): If multiple sureties exist, they must contribute equally to the extent of the default.
Types of Guarantees
Specific or Simple Guarantee
Applies to a single debt or transaction, discharging upon fulfilment of the obligation.
Continuing Guarantee (Sec 129)
Extends to multiple transactions over time, continuing until explicitly revoked.
Illustrations:
- A guarantees payment to B, a tea dealer, for any tea supplied to C up to 100 pounds. B supplies tea worth 200 pounds. C fails to pay. A is liable for up to 100 pounds.
- A guarantees payment to B for five sacks of flour to be delivered to C. B delivers and C pays for the five sacks. Further deliveries are not covered by the guarantee.
Revocation and Discharge of Guarantee
A continuing guarantee can be revoked by the surety at any time concerning future transactions. The death of the surety also terminates the guarantee for future dealings unless otherwise agreed.
Additionally, the surety can be discharged by:
Variance in Contract Terms (Sec 133): Any change in the contract terms without the surety’s consent.Case Law: Bonar vs. Macdonald – Changes in a bank manager’s contract without informing the surety discharged the surety’s liability.
Release of Principal Debtor (Sec 134): Any action releasing the principal debtor also discharges the surety.
Illustrations:
A contract with B to grow indigo. B prevents irrigation, discharging surety C from liability. A contract with B to build a house with B’s timber. B fails to supply the timber, discharging surety C.
Composition, Extension of Time, and Promise Not to Sue (Sec 135): Agreements between the creditor and principal debtor can discharge the surety unless the surety consents.
Case Law: Offord vs. Davies – The surety discharged its obligation by giving notice of revocation despite continued transactions.
Impairing Surety’s Remedy (Sec 139): Any act by the creditor impairing the surety’s remedy against the principal debtor discharges the surety.
Case Law: State of M.P. vs. Kaluram – The creditor’s inaction discharged the surety.
Conclusion
Understanding the nuances of a contract of guarantee is essential for all parties involved. Whether you’re acting as a surety, principal debtor, or creditor, being aware of your rights and obligations can safeguard your interests and ensure the smooth execution of financial agreements. By adhering to the legal provisions and maintaining transparency, you can navigate the complexities of guarantees with confidence.
FAQ about the contract of guarantee
Difference between specific and continuing guarantees:
Specific guarantee: Covers a single debt or transaction. Continuing guarantee: Extends to multiple transactions over time.
Liability for debts beyond the initial agreement:
Generally, guarantors are liable only for debts within the initial agreement’s scope. However, if the contract permits, guarantors may be liable for additional debts.
Legal recourse for non-fulfilment of obligations:
Creditors can enforce terms of the agreement if a guarantor fails to fulfil obligations. Legal actions may include debt recovery, seizing assets, or other remedies.
Also Read: Difference between Indemnity and Guarantee
Reference: Ipleaders