A Comprehensive Guide to the Contract Of Guarantee under Indian Law

The Contract of Guarantee is one of the most important forms of a special contract under the Indian Contracts Act, 1872. In this article, the author seeks to understand its scope under Indian law and throw light on the different provisions under the Act with the help of judicial decisions. A brief explanation of the different essentials of a valid contract and how it differs from a normal contract has also been provided.

I. Introduction

The Contract of Guarantee, indisputably one of the most important topics under Contract Law is also known as a contract of surety. The Indian Contracts Act, 1872 contains several provisions which explain the nature and scope of a contract of guarantee in detail.

A historical look at the growth of contract law reveals that the concept of guarantee or suretyship evolved alongside family systems in early civilizations, wherein it was a common practice for family members to step in as surety for the other members of the family. Many legal scholars believe this phenomenon is an outgrowth of the sense of collective liability of the family.[1]

The importance of a contract of guarantee can be attributed to the economic function it fulfils. The credit facilitated by the guarantor goes along in the business world or in commercial transactions. It enables a person to secure a loan or goods on credit and even employment.

II. Definitions

The Halsbury’s Laws of England define a contract of guarantee as-

“An accessory contract, whereby 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”.[2]

In simple terms, it can be said that guarantee is an undertaking by one person to pay the amount due from a third party to another person. In England, the provisions relating to guarantee can be found in the Statute of Frauds, 1677 (Section 4) and the Lord Tenterden’s Act, 1828. Under both these legislations, it has been made very clear that a contract of guarantee is only enforceable if it is in a written format. Even though the basic principles in both English law and Indian law is similar, they differ in certain regards.

Section 126 of the Indian Contracts Act, 1872 provides a comprehensive definition of “Contract of guarantee” as well as the parties involved it. As per the provision, a contract of guarantee is a contract to perform the promise or discharge the liability of a third person in case of his default.

It is evident from this definition that three distinct parties are involved in a contract of guarantee. 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”. Unlike the position in England, in India, it is not compulsory that a guarantee must be in written format. It can either be an oral or written contract.[3]

In the case of PJ Rajappan v. Associated Industries[4], the Kerala HC held that in a case where there is evidence of the involvement of the guarantor, the mere failure on his part in not signing the agreement is not sufficient to demolish otherwise acceptable evidence of his involvement in the transaction.

The court observed that when it has to decide whether a person has actually guaranteed the due performance of the contract by the principal debtor, all the circumstances concerning the transactions will have to be necessarily considered. It must not adopt a very high technical standard that if the guarantor had not signed the agreement, he won’t be held liable.

III. The Nature of Contract of Guarantee

It is very clear from the definition that a contract of guarantee is a specific performance contract since the remedy, in this case, is not merely to pay the damages awarded by the court but rather to perform the promise which he has undertaken under the contract[5].

It can be considered as an equitable relief because in cases where it is not possible to ascertain the actual damage or monetary compensation to be claimed in case of default by a principal debtor, the creditor can insist that the surety must fulfil the requirements of the contract.

A reading of the section clearly indicates that there is the presence of three contracts in a guarantee. The first contract is between the principal debtor and the creditor which is the very basis of a guaranteed contract. Secondly, there is a contract between the creditor and the surety where he undertakes to guarantee the debt of the principal debtor.

Additionally, there is a final contract existing between the surety and principal debtor wherein the latter either expressly or implicitly requests the former to guarantee his debt as repeatedly emphasized by the judiciary in numerous cases.[6] It means that there must be a conditional promise by the surety to be liable on the default of the principal debtor. If such liability does not exist, then there can be no contract of liability.

It is evident that the liability of the surety is a collateral liability which comes into play only when the principal debtor defaults. Thus, it is very important to note that any liability which is “independently” incurred of a “default” is not within the scope of a guaranteed contract.

In the case of United Breweries (Holding) Ltd v. Karnataka State Industrial Investments & Development Corp,[7] the court had held that a recommendation letter issued by a holding company in favour of its associate company stating that the company had the means to meet its contractual and financial obligations, could not be construed as a letter of guarantee under the Act.

IV. Types of Contract of Guarantee

According to the way in which we view contracts of guarantee, they can have different classifications. On the basis of transactions, it can be categorized as a specific guarantee (which extends to a single debt or transaction) and continuing guarantee contracts (extends to series of transactions). On the other hand, the former ends when the guaranteed debt is repaid or when the promise is fulfilled.

In the latter, the liability of the surety extends till all the transactions are completed or till the guarantor revokes the guarantee as to the future transactions.[8] Whereas on the basis of time of the contract, it could be prospective or retrospective guarantee contracts

V. Essentials of a Valid Guarantee Contract

In order to classify as a valid contract of guarantee, it must satisfy certain conditions which are listed below:

• Existence of a Tripartite Agreement: As already explained above, any contract of guarantee is a tripartite agreement between the principal debtor, creditor and the surety. It means that there must be an agreement amongst these parties to contract with each other. It is important to realize that if a surety enters into a contract of guarantee with the creditor without the knowledge of the principal debtor, then it will not qualify as a valid contract of guarantee.
• Existence of a valid Principal Debt: Since the very objective of a guarantee is to secure a debt, the existence of a recoverable debt is essential. It is mandatory that someone must exist as a principal debtor and the surety undertakes to be liable on his default. Thus, if there is no principal debt, there will not be a contract of guarantee. This position was upheld by the House of Lords in the case of Swan v. Bank of Scotland.[9] Thus, if a debt is void by reason of a statute or time-barred, then no liability of the surety arises.

However, there are certain instances wherein the guarantee for even a void debt has been held enforceable by the courts. For instance, in the case of Yorkshire Railway Wagon Co v. Maclure,[10] the directors of a company who had guaranteed the company’s loans were held liable in spite of the fact that the loan was ultra vires. The reasoning given by the court was that “the voidness of contract to guarantee the debt of a company acting ultra vires is different in its consequence from the voidness brought out by the express language of a statute.[11]

• Must satisfy the essentials of a valid contract: Since a contract of guarantee is a species of contract, all the essentials of a valid contract shall apply to guarantee as well. Hence, all the requirements such as a valid offer and acceptance, free consent, legality of the object, intention to create a legal relationship, consideration etc must be satisfied.

However, it is the peculiarity of a contract of guarantee that it will be valid even if the principal debtor is not competent to contract. In such circumstances, the law shall regard the guarantee as the principal debtor making him personally liable for the debt.

For instance, when the debt of a minor is guaranteed knowingly by the surety, then he shall be held personally liable. It would mean that the contract of the so-called surety shall become the primary contract and not the collateral. In the case of Kashiba v. Shripat,[12] the Bombay HC held that there was no reason why a person couldn’t guarantee the performance by a third person of a duty of imperfect obligation.

• Consideration: Just like every other form of contract, it is essential that a contract of guarantee be supported by some form of consideration. However, it is not necessary that there should be any direct consideration between the surety and the creditor which is evident from Section 127 of the Indian Contracts Act, 1872.

Under the provision, anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee. Thus, it is not required that the consideration must provide some benefit to the surety. The section provides certain illustrations to depict instances of consideration in a contract of guarantee.

The 3^rd illustration depicts that a contract of guarantee executed afterwards, without any consideration is not valid. It appears that anything done or any promise made for the benefit of the principal debtor must be contemporaneous to the surety’s contract of guarantee in order to constitute proper consideration.

However, a look at the various judicial decisions reveals that there is no uniformity on the issue of past consideration. For instance, the Andhra Pradesh HC in M.N.A Khan v. Commercial and Industrial Bank,[13] held that past consideration was no good in accordance with illustration 3.

However, in the case of Prasnajit Mahtha v. United Commercial Bank,[14] the court took a different view to hold that guarantee given after the execution of the loan document to be valid. Also, in the case of Union Bank of India v. A P Bhonsle,[15] the Maharashtra HC held that past debts were also recoverable under the wide language of S. 127. Thus, a guarantee for past, as well as future debt, is enforceable provided some further debt is incurred after the guarantee.

• There must be no Misrepresentation or Concealment: Sections 142 and 143 of the Act provide that guarantees which are obtained by the creditor by means of misrepresentation or concealment of material circumstances respectively are invalid in law. A good example of this instance is the London General Omnibus v. Holloway[16], in which 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 by the court.

At the same time, it needs to be noted that a contract of guarantee is not a contract of uberrimae fidei (contract of absolute good faith) and hence it is not necessary for either the debtor or the creditor to reveal facts or matters which were not unusual features of the contractual relationship between the creditor and the debtor.

VI. Conclusion

A thorough reading of the provisions of the Indian Contract Act and the judicial decisions reveal that the law regarding the contract of guarantee is well settled in India. The Indian law on the contract of guarantee is similar to the English law to a great extent with the only difference that in India, it is not compulsory that the contract be written.

In this article, I have tried to provide a comprehensive look at the important provisions on the contract of guarantee. The significance of the contract of guarantee stems from the fact that it plays a very important economic function in the commercial world.

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References

[1] William H. Lloyd, The Surety 66 University of Pennsylvania Law Review 40 (1909- 1910).

[2] Simonas, ed., 18 Halsbury’s Laws of England 411 (3rd ed., London, 1957).

[3] S. 126 of the Indian Contract Act, 1872

[4] [1990 (1) All India Banking Law Judgements 321]

[5] Suryash Kumar, A Guide to Contract of Guarantee (Sept 2019), Available Here (Last accessed on 16-11-20).

[6] Major General Mahabir Shum Sher Jung Bahadur Rana v. Lloyds Bank Ltd. and another, A.I.R. 19SS Cal. 371

[7] AIR 2012 Kant 65

[8] Indemnity and Guarantee, Available Here (Last accessed on 16-11-20)

[9] (1836) 10 Bligh NS 627

[10] 19 Ch D 478

[11] Avatar Sing, Business Law (10^th ed., 2014)

[12] ILR (1895) 19 Bom 697

[13] AIR 1969 AP 294

[14] AIR 1979 Pat 151

[15] 1991 Mah LJ 1004

[16] (1912) 2 KB 72

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