Introduction
The Contract of Guarantee is a cornerstone of commercial transactions, lending, and business operations. It provides assurance to creditors that they will be repaid, even if the primary debtor defaults. This legal mechanism ensures trust in financial dealings and strengthens the credit system.
Under the Indian Contract Act, 1872, a contract of guarantee is defined in Section 126, which lays down the relationship between the surety, principal debtor, and creditor. It essentially transfers the risk of default from the creditor to the surety, who promises to discharge the liability of the principal debtor in case of default.
Definition (Section 126)
“A contract of guarantee is a contract to perform the promise or discharge the liability of a third person in case of his default.”
In this contract:
- 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.”
- The person to whom the guarantee is given is called the “Creditor.”
Thus, a contract of guarantee is tripartite in nature involving three distinct parties and three interrelated contracts.
Nature and Purpose of a Guarantee
The main objective of a guarantee is to secure performance or repayment. It assures the creditor that if the debtor fails, the surety will make good the loss. Such contracts are vital in areas like loans, trade credit, and corporate guarantees.
A guarantee can be:
- Specific Guarantee: Given for a single transaction.
- Continuing Guarantee: Extends to a series of transactions until revoked by the surety.
Essentials of a Valid Contract of Guarantee
- Existence of a Principal Debt or Obligation
There must be a primary liability of the principal debtor; otherwise, there can be no secondary liability of the surety. - Consideration
As per Section 127, “Anything done, or any promise made, for the benefit of the principal debtor is sufficient consideration to the surety.”
The surety need not receive direct benefit; consideration to the debtor is sufficient. - Consent of All Three Parties
The agreement must involve all three parties — creditor, debtor, and surety — with mutual consent. - Free Consent and Lawful Object
Like any other contract, a guarantee must be free from coercion, fraud, or misrepresentation. - Written or Oral
Section 126 does not mandate that a guarantee must be in writing; it may be oral or written.
Types of Guarantees
- Specific Guarantee – Limited to a single transaction and ends when that transaction is completed.
Example: A guarantees B’s loan of ₹10,000 from C. - Continuing Guarantee – Covers multiple transactions until revoked by the surety under Section 129.
Example: A guarantees B’s purchases from C for a period of six months. - Conditional Guarantee – Operates only on fulfillment of certain conditions.
- Unilateral Guarantee – Given without any request from the principal debtor but accepted by the creditor.
Rights of Surety
The surety, being secondarily liable, enjoys several legal rights to protect his interests.
1. Rights Against the Principal Debtor
- Right of Subrogation (Section 140): After paying the creditor, the surety steps into the creditor’s shoes and can recover from the debtor.
- Right of Indemnity (Section 145): The debtor is bound to indemnify the surety for all payments rightfully made.
2. Rights Against the Creditor
- Right to Benefit of Securities (Section 141): The surety is entitled to all securities held by the creditor, whether known or unknown at the time of guarantee.
- Right to be Informed: The surety must be made aware of material facts; failure may render the contract voidable.
3. Rights Against Co-sureties
Where multiple sureties exist, each is liable to contribute equally unless otherwise agreed (Sections 146–147).
Liabilities of Surety
- Co-extensive Liability (Section 128)
The surety’s liability is co-extensive with that of the principal debtor unless the contract provides otherwise. This means the creditor can directly proceed against the surety without first suing the debtor. - Extent of Liability
The surety is liable for the entire amount guaranteed, including interest and costs, unless limited by the contract. - Continuing Guarantee (Section 129)
The surety’s liability continues for all transactions covered until the guarantee is revoked.
Discharge of Surety
A surety may be discharged from liability under various circumstances, as specified in Sections 130–139:
- By Revocation (Section 130):
- For future transactions by notice to the creditor.
- By death of the surety (for future dealings).
- By Conduct of the Creditor:
- Any variance in contract terms without surety’s consent discharges him (Section 133).
- Release of principal debtor by the creditor discharges the surety (Section 134).
- Creditor’s act impairing surety’s remedy or securities also releases surety (Section 139).
- By Invalid Contract:
- Guarantee obtained by misrepresentation or concealment of material facts is void (Sections 142–143).
Difference between Indemnity and Guarantee
| Basis | Indemnity | Guarantee |
|---|---|---|
| Parties | Two (Indemnifier & Indemnified) | Three (Surety, Creditor, Principal Debtor) |
| Nature of Liability | Primary | Secondary |
| Number of Contracts | One | Three |
| Consideration | Indemnifier benefits directly | Consideration may move to debtor |
| Purpose | To compensate for loss | To ensure performance or payment |
Important Judicial Decisions
1. State Bank of India v. Premco Saw Mill, AIR 1984 SC 1020
The Supreme Court held that the creditor is not bound to exhaust his remedies against the principal debtor before suing the surety. The surety’s liability is co-extensive with that of the debtor.
2. Bank of Bihar Ltd. v. Damodar Prasad, AIR 1969 SC 297
The Court ruled that the surety’s liability arises immediately upon default by the principal debtor, and the creditor can directly proceed against the surety.
3. Amrit Lal Goverdhan Lalan v. State Bank of Travancore, AIR 1968 SC 1432
Held that the surety is entitled to all securities held by the creditor, even if he was unaware of their existence at the time of the contract.
4. Punjab National Bank v. Bikram Cotton Mills, AIR 1970 SC 1973
It was established that a continuing guarantee can be revoked for future transactions by notice but remains valid for past dealings.
Legal Position in English Law
In English law, similar principles apply, but the guarantee must generally be in writing under the Statute of Frauds, 1677. Indian law, however, recognizes oral guarantees, reflecting a broader and more flexible approach.
Conclusion
A Contract of Guarantee plays a vital role in maintaining confidence and security in financial and commercial transactions. It upholds the principle that a creditor should not suffer loss due to the debtor’s failure while ensuring fairness to the surety through well-defined rights and safeguards. The Indian Contract Act provides a balanced framework where the obligations and protections of all three parties are clearly delineated, ensuring the effective functioning of credit and business systems.
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