Guarantee is defined under section 126 of the Indian Contract Act 1872 to mean a contract to perform the promise, or discharge the liability, of a third person in the case of the default of such third person. It also provides that a contract of guarantee can be made either orally or in writing. A contract of guarantee is characterised by the presence of three parties – the creditor, to whom the guarantee is given; the guarantor or surety, who gives the guarantee; and the debtor on whose behalf the guarantee is given. The main purpose for a contract of guarantee is to provide the creditor with an additional security in the form of a promise to discharge an obligation by the guarantor in the event of a default of the debtor. It is usually a promise to pay the sum owed by the debtor to the creditor.
As such, a contract of guarantee envisages a set of three contracts between the parties. The first contract is between the creditor and the debtor concerning the principal transaction. The second contract is between the creditor and the guarantor with respect to the liability of the guarantor in the case of a default by the debtor. And the third contract is an implied contract between the debtor and the guarantor whereby the debtor undertakes to indemnify the guarantor wherein, due to the default of the debtor, the guarantor has to pay the sum owed by the debtor to the creditor. Section 145 of the Indian Contract Act provides that in every contract of guarantee, there is an implied promise by the debtor to indemnify the guarantor, and the guarantor is entitled to recover from the debtor whatever sum he has rightfully paid under the guarantee, but no sums which he has paid wrongfully
The guarantor’s right to recover the payment made under the guarantee from the debtor is one of the aspects of acontract of guarantee that differentiates it from a contract of indemnity. Indemnity is defined in the Oxford English Dictionary as a security or protection promised against a loss or other financial burden. To indemnify has been defined therein to mean to compensate someone for harm or loss and to secure someone against legal responsibility for their actions. Section 124 of the Indian Contract Act defines a contract of indemnity to be a contract by which one party promises to save the other from loss caused to him by the conduct of the indemnifier himself or by the conduct of any other person. A contract of indemnity, therefore, is a single contract between two persons – the indemnifier and the indemnity holder. Unlike a guarantor who has certain rights against the debtor towards recovery of the amount paid to the creditor, once the indemnifier has indemnified the indemnity holder, the former cannot recover the amount so paid. Also, unlike the indemnifier, the liability of a guarantor is only secondary to the liability of thedebtor. The liability of the guarantor arises only when the debtor makes a default. An indemnifier, on the other hand, has a primary liability which arises immediately upon the happening of the contemplated event.
A contract of guarantee requires meeting of minds of three players – the principal debtor, the surety and the creditor. The surety (usually a bank) undertakes an obligation at the request express or implied of the principal debtor (usually the bank’s customer). It is an independent contract between the bank and the beneficiary. It is this very autonomy that makes a contract of guarantee an instrument for growth of business and economy.
The principal that a surety is a favoured debtor dates back to the late 18th Century era of global trading by the East India Company. Over the four centuries this rule has withstood the test of time and still enforced in the contemporary world. There are a plethora of judgments in this connection; the notable ones being Law vs. East Indian Co.; Winston vs. Rives; Blest vs. Brown, amongst others. Further, it is well-settled that the liability of the Surety/Guarantor is co-extensive with that of the principal debtor, unless it is otherwise provided in the agreement itself. If a contract neglects to limit the liability of the guarantor towards the creditor, the guarantor risks being liable for the whole of the debt. In view of this position, guarantees are drafted in such a way that guarantor and the principal debtor are jointly and severally liable in the ordinary course of all times.
The main features of a contract of guarantee are that the contract may be oral or in writing; that there should be a principal debt owed by the debtor to the creditor; that there must be a sufficient consideration benefiting the debtor; and that the consent of the guarantor must not have been obtained by fraud or misrepresentation. Unlike the English law, a contract of guarantee in India may be made either orally or in writing. It is however always advisable to have the contract in writing, and also specify the extent to and the conditions under which the guarantor will be liable towards the debt owned by the debtor to the creditor. In the absence of a limit, the guarantor is deemed to be wholly responsible towards the entire amount or part thereof remaining unpaid by the debtor under the relevant principal transaction. A limit mayfurther ensure that additional losses and expenses incurred by the creditor will not be recoverable by the creditor from the guarantor.
A contact of guarantee pre-supposes the existence of a principal debt owed by the debtor to a creditor. In the absence of a principal debt, where the promise is simply towards compensating another for a loss caused due to the happening of certain events or under certain circumstances, the contract is not one of guarantee, but is a contract of indemnity. The principal debt owed by the debtor must constitute a sufficient consideration to the guarantor to provide the guarantee. Section 127 of the Indian Contract Act provides that anything done, or any promise made for the benefit of the debtor may be sufficient consideration to the guarantor for giving the guarantee. In the absence of the requisite consideration, a guarantor cannot provide a valid guarantee.
Furthermore, sections 142 and 143 of the Indian Contract Act provide that a contract of guarantee is vitiated if the consent of the guarantor is obtained by fraud or misrepresentation of facts. The free consent of a party entering into a contract has been defined in section 14 of the Indian Contract Act to include those not caused by fraud or misrepresentation of facts. However, while the explanation to section 17 of the Indian Contract Act provides that mere silence as to the facts likely to affect the willingness of a person to enter into a contract may not constitute a fraud, section 143 of the Act mandates that obtaining a person’s consent to act as a guarantor either by misrepresentation, or keeping silent as to a materialcircumstance or condition affecting the debtor or the transaction between the debtor and the creditor will render the contract of guarantee void. Thus, a guarantor has the right to know the material circumstances that might make him reconsider his decision to act as such. If such information is concealed from him, the contract is a void contract.
The contract of guarantee has been defined in section 126 of the Indian Contract Act, 1872 as 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 contract of guarantee is executed to give assurance to the creditor in lieu for his money. Hence, there have to be three parties (in case the contract is between two parties). The liability of the surety/ guarantor is secondary and arises when principal debtor fails to fulfill his commitments under the agreement.
The liability of a surety/guarantor will be equal to that of the principal debtor where the liability of the surety/guarantor is not specifically provided in the contract. Further, where the contract of guarantee is unconditional, no condition can be put to it afterwards either by the surety, creditor or court. Hence, the surety/guarantor is sometimes called a favoured debtor. The surety/guarantor as a favoured debtor can insist on a strict adherence to the terms of his obligations. The surety’s/guarantor’s liability is limited to the amount which he has undertaken to pay. He cannot be made liable for more than he has undertaken on the default of the principal debtor.
It is obvious that in case of failure on the part of the debtor to discharge his liability, the surety/guarantor will be asked to discharge the liability. Section 128 of the Indian Contract Act, 1872 says that the liability of the surety is co- extensive with that of the principal debtor, unless it is otherwise provided by the contract. It has been held by a Full Bench of the Madras High Court in Subramania Chettiar vs. M.P. Narayanaswami Gounder that if the liability of the principal debtor is scaled down under the provisions of the Act, the liability of the surety is also to that extent reduced.
We have already discussed above that the surety/guarantor is a ‘favoured debtor’ in the eyes of law. Where the contract of guarantee is unconditional, no condition can be put to it afterwards either by the surety, creditor or court.
Section 128 of the Indian Contract Act provides that the liability of a guarantor is co-extensive with that of the debtor, unlessit is otherwise provided by the contract. The Rajasthan High Court in the case of Narayan Singh vs. Chhatar Singh [AIR 1973 Raj 347] has opined that the liability of the guarantor is co-extensive with that of the principal debtor and if the latter’s liability is scaled down in an amended decree or otherwise extinguished in whole or in part by a statute, the liability of the guarantor would also pro tanto be reduced or extinguished. The Supreme Court in the case of M.S.E.B., Bombay vs. Official Liquidator [AIR 1982 SC 1497] has further clarified that a guarantor is no doubt discharged under section 134 of the Indian Contract Act by any contract between the creditor and the principal debtor by which the principal debtor is released or by any act or omission of the creditor, but a discharge which a principal debtor may secure by operation of law in bankruptcy/liquidation proceedings does not absolve the guarantor of its liability.
Furthermore, it was observed in the case of Lachhman Joharimal vs. Bapu Khandu [(1869) 6 Bom HCR 241] that a creditor isnot bound to exhaust his remedy against the principal debtor before suing the guarantor and that when a decree is obtained against the guarantor, it may be enforced in the same manner as a decree for any other debt. Thus the rule of law states that a creditor cannot be restrained from action against the guarantor on the ground that the debtor is solvent or that the creditor may have relief against the debtor in other proceedings. In Bank of Bihar Ltd. vs. Damodar Prasad [AIR 1969 SC 297] the court has held that the creditor is not required to exhaust all his remedies available against the debtor before enforcing his claim against the guarantor.
The extent of the liability undertaken by the guarantor, unless limited by the contract, is deemed to be co-extensive with the liability of the debtor. A guarantor cannot be made liable for more than what he has undertaken in the contract. However, in the absence of the limiting factors in a contract, the guarantor who guarantees the payment of a bill will be liable for all that the debtor will be liable for. The Allahabad High Court in Zaki Hussain vs. Dy. Commr.Gonda [AIR 1929 All 687] has said that the liability of the guarantor extends not only to the debt undertaken by the debtor, but also the interest recoverable by the creditor on that debt. It is generally understood that in the absence of a limit, the guarantor is also liable to pay for the reasonable expenses incurred by the creditor for recovering the sums due from the debtor and the guarantor. However, in the absence of a contract to the contrary, a guarantor is not liable for a liability of the debtor incurred prior to the contract of guarantee.
A guarantor is not discharged from his liability if the creditor terminates his contract with the debtor. There is, however, a difference of opinion on the enforceability of the contract between the creditor and the guarantor in case where the original contract between the creditor and the debtor is rendered void. In Kashiba vs. ShripatNarshiv [(1885) 19 Bom. 697] and SohalLal vs. Puran Singh [(1916) 54 P.R. 1916] it has been held that that a bond passed by a minor, or in cases wherein the original contract between the debtor and the creditor was void, the guarantor was still liable despite the original contract being void. The same has been reiterated in Chhaju Singh vs. Emperor AIR 1921 Lah 79. However, in Edaven Kavungal Kelappan Nambiar vs. Moolakal Kunhi Raman AIR 1957 Mad 164, the Madras High Court has held that if a guarantor guaranteed a debt by a minor (an agreement that will be considered void; vide sections 10 and 11 of the Indian Contract Act), he incurred no liability as his liability was co-extensive with that of the principal debtor, whose contract was void.
It is pertinent to note that the contract of guarantee may provide for conditions that limit not only the sum recoverable from the guarantor, but also state the explicit conditions under which the guarantee can be invoked. The Guwahati High Court in Chittaranjan Banerjee vs. Dy. Commr. Of Lakhimpur [AIR 1980 Gau 62] held that a guarantor in the eye of law is a “favoured debtor” and the surety bonds are to be construed strictly. A guarantor can only be held to be bound if the condition of the liability has been fulfilled. Being a “favoured debtor”, a guarantor is entitled to insist upon a rigid adherence to the term of his obligation by the creditor and cannot be made liable for more than he has undertaken. The nature of the contract cannot be equated with that of an insurer or uberrima fides. It is one of strictissimijuris.
The contract may also mention the procedure of invoking the guarantee, and if it is provided therein that the creditor must first extinguish all available remedies against the debtor before invoking the guarantee, then fulfilment of such a condition is mandatory before invoking the guarantee. The same principle is applicable in the case of co-guarantors. In the absence of a definite limit in the contract the creditor has the right to sue all the parties together or any party or combination thereof. Section 146 of the Indian Contract Act provides that in the absence of a contract between the coguarantors, the co-guarantors are liable, as between themselves, to pay an equal share of the whole debt, or of that part which remains unpaid by the principal debtor.
The guarantor, having discharged the guarantee in favour of the creditor upon the default of the debtor, is entitled to the guarantor’s right of subrogation. That is to say, where a guaranteed debt has become due, or default of the principal debtor to perform a guaranteed duty has taken place, the guarantor, upon payment and performance of all that he is liable for, is invested with all the rights which the creditor had against the debtor. These rights also include a right to the benefit of every security that the creditor has against the debtor at the time when the contract of guarantee was entered into (pursuant to sections 140 and 141 of the Indian Contract Act). Thereafter, section 145 of the Indian Contract Act contemplates an implied contract of indemnity between the guarantor and the principal debtor. It provides that the guarantor is entitled to recover only such sums from the debtor as has been rightfully paid by the guarantorand not such amounts as have been paid otherwise.
In a contract of guarantee, it is, therefore, important to carefully set the limits of liability of the guarantor towards the creditor. The rights of the guarantor towards the debtor and the creditor are statutorily provided, and serve to enhance the position of the guarantor only once he has discharged his liabilities. The liability to discharge the full extent of the liabilities of the debtor may not be palatable for most guarantors since the said liabilities not only take into account the principal sum, but also other amounts such as interest and costs that may inflate the net guarantee payable. By limiting the guarantee payable, the contingencies under which such guarantee shall be payable, and by directing the procedure applicable for the creditor to seek a relief in case of a default by the debtor, the guarantor will ensure a greater level of clarity for the parties to the arrangement. The aim of a contract of guarantee is to facilitate a receipt of benefit by a debtor which may not have been possible otherwise. For the guarantor, it is important to remember that while he may be willing to display his generosity by placing his assets at stake, at the end of the day, he must not bite more than he is willing to chew!
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