A guarantee is a promise to answer for the payment of some debt, or the performance of some duty, in case of the failure of another party, who is in the first instance, liable to such payment or performance. A security, in the form of a right of action against a third party is known as guarantee.
A guarantee is an accessory contract by which the promisor undertakes to be answerable to the promisee for the debt, default or miscarriage of another person, whose primary liability to the promisee must exist or be contemplated.
The words “debt, default or miscarriage” is descriptive of failure to perform legal obligations, existing or future, arising from any source, not only from contractual promises, but in any other factual situations capable of giving rise to legal obligations, such as those resulting from bailment, tort, or unsatisfied judgments.
A letter of comfort is a recommendatory letter, and may not be a guarantee unless there is a specific undertaking to discharge liability in case of default.
What are the essential elements of a contract of Guarantee? What is a continuing Guarantee and what are its modes of revocation. What are the rights of Surety? When is Surety discharged of Guarantee? What is the extent of Surety’s liability?
Section 126 of Indian Contract Act 1872 defines a contract of guarantee as follows : “A contract of guarantee is a contract to perform the promise, or to discharge the liabilities of a third person in case of his default. The person who gives the guarantee is called Surety, the person in respect of whose default the guarantee is given is called Principal Debtor, and the person to whom the guarantee is given is called Creditor. A Guarantee may be either oral or written.”
For example, when A promises to a shopkeeper C that A will pay for the items being bought by B if B does not pay, this is a contract of guarantee. In this case, if B fails to pay, C can sue A to recover the balance. The same was held in the case of Birkmyr vs Darnell 1704, where the court held that when two persons come to a shop, one person buys, and to give him credit, the other person promises, “If he does not pay, I will”, this type of a collateral undertaking to be liable for the default of another is called a contract of guarantee.
Section 126: There are three parties to a contract of Guarantee-Principle debtor, Creditor and Surety.
Example X and his friend Y enter a sho and X says to Z “Supply the goods required by Y and if he does not pay you, I will.” It is acontract of guarantee.
The person in respect of whose default the guarantee is given is called the 'Principal debtor'. Y is the principal debtor in the aforesaid example.
The person to whom the guarantee is given, is called the 'creditor'. Z is the creditor in the aforesaid example.
The person who gives the guarantee is called the 'Surety'. X is the surety in the aforesaid example.
The economic function of a guarantee is to enable a credit-less person to get a loan or employment or something else. Thus, there must exist a principal debtor for a recoverable debt for which the surety is liable in case of the default of the principal debtor.
In the case of Swan vs Bank of Scotland 1836, it was held that a contract of guarantee is a tripartite agreement between the creditor, the principal debtor, and the surety.
There must be a distinct promise by the surety to be answerable for the liability of the Principal Debtor.
Only if the liability of the principal debtor is legally enforceable, the surety can be made liable.
For example, a surety cannot be made liable for a debt barred by statute of limitation.
As with any valid contract, the contract of guarantee also must have a consideration. The consideration in such contract is nothing but any thing done or the promise to do something for the benefit of the principal debor. Section 127 clarifies this as follows :
“Any thing done or any promise made for the benefit of the principal debtor may be sufficient consideration to the surety for giving the guarantee.”
However, there is no uniformity on the issue of past consideration. In the case of Allahabad Bank vs S M Engineering Industries 1992 Cal HC, the bank was not allowed to sue the surety in absence of any advance payment made after the date of guarantee. But in the case of Union Bank of India vs A P Bhonsle 1991 Mah HC, past debts were also held to be recoverable under the wide language of this section. In general, if the principal debtor is benefitted as a result of the guarantee, it is sufficient consideration for the sustenance of the guarantee.
Section 142: specifies that a guarantee obtained by misrepresenting facts that are material to the agreement is invalid, and section 143 specifies that a guarantee obtained by concealing a material fact is invalid as well.
In the case of London General Omnibus vs Holloway 1912, a person was invited to guarantee an employee, who was previously dismissed for dishonesty by the same employer. This fact was not told to the surety. Later on, the employee embezzled funds but the surety was not held liable.
As per section 129, a guarantee which extends to a series of transactions is called a continuing guarantee.
Thus, it can be seen that a continuing guarantee is given to allow multiple transactions without having to create a new guarantee for each transaction. In the case of Nottingham Hide Co vs Bottrill 1873, it was held that the facts, circumstances, and intention of each case has to be looked into for determining if it is a case of continuing guarantee or not.
As per section 130, a continuing guarantee can be revoked at any time by the surety by notice to the creditor.
Once the guarantee is revoked, the surety is not liable for any future transaction however he is liable for all the transactions that happened before the notice was given.
Illustrations - 1. Oxford vs Davies: A promises to pay B for all groceries bought by C for a period of 12 months if C fails to pay. In the next three months, C buys 2000/- worth of groceries. After 3 months, A revokes the guarantee by giving a notice to B. C further purchases 1000 Rs of groceries. C fails to pay. A is not liable for 1000/- rs of purchase that was made after the notice but he is liable for 2000/- of purchase made before the notice.
In the case of Lloyd’s vs Harper 1880, it was held that employment of a servant is one transaction. The guarantee for a servant is thus not a continuing guarantee and cannot be revoked as long as the servant is in the same employment. However, in the case of Wingfield vs De St Cron 1919, it was held that a person who guaranteed the rent payment for his servant but revoked it after the servant left his employment was not liable for the rents after revocation.
2. A guarantees to B, to the amount of 10000 Rs, that C shall pay for the bills that B may draw upon him. B draws upon C and C accepts the bill. Now, A revokes the guarantee. C fails to pay the bill upon its maturity. A is liable for the amount upto 10000Rs.
As per section 131, the death of the surety acts as a revocation of a continuing guarantee with regards to future transactions, if there is no contract to the contrary.
It is important to note that there must not be any contract that keeps the guarantee alive even after the death. In the case of Durga Priya vs Durga Pada AIR 1928, Cal HC held that in each case the contract of guarantee between the parties must be looked into to determine whether the contract has been revoked due to the death of the surety or not. If there is a provision that says death does not cause the revocation then the constract of guarantee must be held to continue even after the death of the surety.
Section 128: The liability of the surety is co-extensive with that of the principal debtor unless it is otherwise provided by the contract.
Example : A guarantees to B the payment of a bill of exchange by C, the acceptor. The bill is dishonoured by C. A is liable not only for the amount of the bill but also for any interest and charges which may have become due on it.
A contract of guarantee being a contract, all rights that are available to the parties of a contract are available to a surety as well. The following are the rights specific to a contract of guarantee that are available to the surety.
As per section 140, where a guaranteed debt has become due or default of the principal debtor to perform a duty has taken place, the surety, upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the princpal debtor. This means that the surety steps into the shoes of the creditor. Whatever rights the creditor had, are now available to the surety after paying the debt.
In the case of Lampleigh Iron Ore Co Ltd, Re 1927, the court has laid down that the surety will be entitled, to every remedy which the creditor has against the principal debtor; to enforce every security and all means of payment; to stand in place of the creditor to have the securities transfered in his name, though there was no stipulation for that; and to avail himself of all those securities against the debtor. This right of surety stands not merely upon contract but also upon natural justice.
In the case of Kadamba Sugar Industries Pvt Ltd vs Devru Ganapathi AIR 1993, Kar HC held that surety is entitled to the benefits of the securities even if he is not aware of theire existence.
In the case of Mamata Ghose vs United Industrial Bank AIR 1987, Cal HC held that under the right of subrogation, the surety may get certain rights even before payment. In this case, the principal debtor was disposing off his personal properties one after another lest the surety, after paying the debt, seize them. The surety sought for temporary injunction, which was granted.
As per section 145, in every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety; and the surety is entitled to recover from the the principal debtor whatever sum he has rightfully paid under the guarantee but no sums which he has paid wrong fully.
As per section 141, a surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into whether the surety knows about the existance of such securty or not; and if the creditor loses or without the consent of the surety parts with such security, the surety is discharged to the extent of the value of the security.
This section recognizes and incorporates the general rule of equity as expounded in the case of Craythorne vs Swinburne 1807 that the surety is entitled to every remedy which the creditor has agains the principal debtor including enforcement of every security.
The expression “security” in section 141 means all rights which the creditor had against property at the date of the contract. This was held by the SC in the case of State of MP vs Kaluram AIR 1967. In this case, the state had sold a lot of felled trees for a fixed price in four equal installments, the payment of which was guaranteed by the defendent. The contract further provided that if a default was made in the payment of an installment, the State would get the right to prevent further removal of timber and the sell the timber for the the realization of the price. The buyer defaulted but the State still did not stop him from removing further timber. The surety was then sued for the loss but he was not held liable.
It is important to note that the right to securities arises only after the creditor is paid in full. If the surety has guaranteed only part of the debt, he cannot claim a propertional part of the securities after paying part of the debt. This was held in the case of Goverdhan Das vs Bank of Bengal 1891.
If the creditor sues the surety, the surety may have the benefit of the set off, if any, that the principal debtor had against the creditor. He is entitled to use the defences that the principal debtor has against the creditor. For example, if the creditor owes the principal debtor something, for which the principal debtor could have counter claimed, then the surety can also put up that counter claim.
As per section 138, Where there are co-sureties, a release by the creditor of one of them does not discharge the others; neither does it free the surety so released from his responsibilty to the other surities.
A creditor can release a co-surety at his will. However, as held in the case of Sri Chand vs Jagdish Prashad 1966, the released co-surety is still liable to the others for contribution upon default.
As per section 146, where two or more persons are co-surities for the same debt jointly or severally, with or without the knowledge of each other, under same or different contractx, in the absernce of any contract to the contrary, they are liable to pay an equal share of the debt or any part of it that is unpaid by the principal debtor.
As per section 147, co-sureties who are bound in different sums are liable to pay equally as fas as the limits of their respective obligations permit.
A surety is said to be discharged from liability when his liability comes to an end. Indian Contract Act 1872 specifies the following conditions in which a surety is discharged of his liability -
Section 130:A specific guarantee may be revoked by a surety by notice to the creditor if the liability of the surety has not yet accrued. A continuing.guarantee may at any time be revoked by the surety as to future transactions by notice to the creditor. However, the surety remains liable for the past transactions which have already taken place.
Section 131: In the absence of any contract to the contrary, the death of a surety operates as a revocation of a continuing guarantee as to future transactions taking place after the death of surety. However, the deceased surety's estate remains liable for the past transactions which have already taken place before the death of the surety but will not be liable for the transactions taking place after the death of surety even if the creditor has no notice of surety's death
Section 133: By variance in terms of contract - A variance made without the consent of the surety in terms of the contract between the principal debtor and the creditor, discharges the surety as to the transactions after the variance.
But variation which is not substantial or material or which is beneficial to the surety will not discharge him of his liability. In M.S. Anirudhan v. Thomeo's Bank, the surety guaranteed overdraft provided by the bank to the prinCipaldebtor only upto Rs 25,000. Subsequently since the bank was willing to provide overdraft only upto Rs 20,000, the principal debtor reduced the amount in the guarantee form to Rs 2,000. On default by the principal debtor the court held the surety liable as the alteration was beneficial to him and it was not of a substantial nature.
Section 134: The surety is discharged by any contract between the creditor and the principal debtor by which the principal debtor is discharged; or by any action of the creditor the legal consequence of which is the discharge of the principal debtor.
Maharashtra SEB vs Official Liquidator 1982: If the principal debtor is released by a compromise with the creditor, the surety is discharged but if the principal debtor is discharged by the operation of insolvancy laws, the surety is not discharged.
Section 135: A contract between the principal debtor and the creditor by which the creditor makes a composition with, or promises to give time to, or promises to not sue the principal debtor, discharges the surety unless the surety assents to such a contract.
It should be noted that as per section 136, if a contract is made by the creditor with a third person to give more time to the principal debtor, the surety is not discharged. However, in the case of Wandoor Jupitor Chits vs K P Mathew AIR 1980, it was held that the surety was not discharged when the period of limitation got extended due to acknowledgement of debt by the principal debtor.
Further, as per section 137, mere forbearance to sue or to not make use of any remedy that is available to the creditor against the principal debtor, does not automatically discharge the surety.
B owes C a debt guarateed by A. The debt becomes payable. However, C does not sue B for an year. This does not discharge A from his suretyship.
It must be noted that forbearing to sue until the expiry of the period of limitation has the legal consequence of discharge of the principal debtor and thus as per section 134, will cause the surety to be discharged as well. If section 134 stood alone, this inference was correct. However, section 137 explicitly says that mere forbearance to sue does not discharge the surety. This contradiction was removed in the case of Mahanth Singh vs U B Yi by Privy Council. It held that failure to sue the principal debtor until recovery is banned by period of limitation does not discharge the surety.
Section 139: If the creditor does any act that is inconsistent with the rights of the surety or omits to do an act which his duty to surety requires him to do, and the eventual remedy of the surety himself against the principal debtor is thereby impaired, the surety is dischared.
State of MP vs Kaluram: Alends money to B with C as surety. A also gets as a security the mortgate to B’s furniture. B defaults and A sells his furniture. However, due to A’s carelessness very small amount is received by sale of the furniture. C is discharged of the liability.
In the case of State Bank of Saurashtra vs Chitranjan Ranganath Raja 1980, the bank failed to properly take care of the contents of a godown pledged to it against a loan and the contents were lost. The court held that the surety was not liable for the amount of the goods lost.
Creditor’s duty is not only to take care of the security well but also to realize it proper value. Also, before disposing of the security, the surety must be informed on the account of natural justice so that he can have the option to take over the security by paying off the debt. In the case of Hiranyaprava vs Orissa State Financial Corp AIR 1995, it was held that if such a notice of disposing off of the security is not given, the surety cannot be held liable for the shortfall.
However, when the goods are merely hypothecated and are in the custody of the debtor, and if their loss is not because of the creditor, the suerty is not discharged of his liability.
Section 62: A contract of guarantee is said to be discharged by novation when a fresh contract is entered into either between the same parties or between other parties, the consideration being the mutual discharge of the old contract. The original contract of guarantee comes to an end and the surety under original contract is discharged.
Section 142: Any guarantee which has been obtained by means of misrepresentation made by a creditor or with his knowledge and assent, concerning a material part of the transaction, is invalid.
Section 143: Any guarantee which a creditor has obtained by means of keeping silence to material circumstances is invalid Example:- X employs Y as a clerk to collect money for him. Y fails to account for some of his receipts and X, in consequence calls upon Z to furnish security for his duly accounting. Z gives guarantee for Ys duly account. X does not inform Z about Ys previous conduct. Y, afterwards, makes default. 'z is not liable because the guarantee was obtained by concealment of facts.
Section 144: Where a person gives a guarantee upon a contract that a creditor shall not act upon it until another person has joined in it as co-surety
As per section 128, the liability of a surety is co-extensive with that of the principal debtor, unless it is otherwise provided in the contract.
Illustration - A guaratees the payment of a bill by B to C. The bill becomes due and B fails to pay. A is liable to C not only for the amount of the bill but also for the interest.
This basically means that although the liability of the surety is co-extensive with that of the principal debtor, he may place a limit on it in the contract. Co-extensive implies the maximum extent possible. He is liable for the whole of the amount of the debt or the promises. However, when part of a debt was recovered by disposing off certain goods, the liability of the surety is also reduced by the same amount. This was held in the case of Harigopal Agarwal vs State Bank of India AIR 1956.
The surety can also place conditions on his guarantee. Section 144 says that where a person gives guarantee upon a contract that the creditor shall not act upon it untill another person has joined it as co-surety, the guarantee is not valid if the co-surety does not join. In the case of National Provincial Bank of England vs Brakenbury 1906, the defendant signed a guarantee which was supposed to be signed by three other co-surities. One of them did not sign and so the defendant was not held liable.
Similarly, a surety may specify in the contract that his liability cannot exceed a certain amount.
However, where the liability is unconditional, the court cannot introduce any conditions. Thus, in the case of Bank of Bihar Ltd. vs Damodar Prasad AIR 1969, SC overruled trial court’s and high court’s order that the creditor must first exhaust all remedies against the principal debtor before suing the surety.