Contract of Guarantee under Indian Contract Act 1872

Topics Covered:

Define a contract of Guarantee.
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.

A contract of guarantee has the following essential elements –

1. Existance of Creditor, Surety, and Principal Debtor – 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.

2. Distinct promise of surety – There must be a distinct promise by the surety to be answerable for the liability of the Principal Debtor.

3. Liability must be legally enforceable – 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.

4. Consideration – 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.”

Illustrations:
    1. A agrees to sell to B certain goods if C guarantees the payment of the price of the goods. C promises to guarantee the payment in consideration of A’s promise to deliver goods to B. This is a sufficient consideration for C’s promise.
    2. A sells and delivers goods to B. C, afterwards, requests A to forbear to sue B for an year and promises that if A does so, he will guarantee the payment if B does not pay. A forbears to sue B for one year. This is sufficient consideration for C’s guarantee.
    3. A sells and delivers goods to B. Later on, C, without any consideration, promises to pay A if B fails to pay. The agreement is void for lack of consideration.

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.

5. It should be without mispresentation or concealment – 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.

Illustrations –
1. A appoints B for collecting bills. B fails to account for some of the bills. A asks B to get a guarantor for further employment. C guarantees B’s conduct but C is not made aware of B previous mis-accounting by A. B, afterwards, defaults. C cannot be held liable.

2. A promises to sell Iron to B if C guarantees payment. C guarantees payment however, C is not made aware of the fact that A and B had contracted that B will pay 5 Rs higher that the market prices. B defaults. C cannot be held liable.

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.

Continuing Guarantee
As per section 129, a guarantee which extends to a series of transactions is called a continuing guarantee.
Illustrations –
1. A, in consideration that B will employ C for the collection of rents of B’s zamindari, promises B to be responsible to the amount of 5000/- for due collection and payment by C of those rents. This is a continuing guarantee.

2. A guarantees payment to B, a tea-dealer, for any tea that C may buy from him from time to time to the amount of Rs 100. Afterwards, B supplies C tea for the amount of 200/- and C fails to pay. A’s guarantee is a continuing guarantee and so A is liable for Rs 100.

3. A guarantees payment to B for 5 sacks of rice to be delivered by B to C over the period of one month. B delivers 5 sacks to C and C pays for it. Later on B delivers 4 more sacks but C fails to pay. A’s guarantee is not a continuing guarantee and so he is not liable to pay for the 4 sacks.

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.

Revocation of Continuing Guarantee

1. 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. 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.

This illustration is based on the old English case of Oxford vs Davies.
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 guarateed 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.

2. 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.

Rights of the Surety

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.

Rights against principal debtor

1. Right of Subrogation
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.

2. Right to Indemnity
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.

Illustrations –
B is indebted to C and A is surety for the debt. Upon default, C sues A. A defends the suit on reasonable grounds but is compelled to pay the amount. A is entitled to recover from B the cost as well as the principal debt.

In the same case above, if A did not have reasonable grounds for defence, A would still be entitled to recover principal debt from B but not any other costs.

A guarantees to C, to the extent of 2000 Rs, payment of rice to be supplied by C to B. C supplies rice to a less amount than 2000/- but obtains from A a payment of 2000/- for the rice. A cannot recover from B more than the price of the rice actually suppied.

This right enables the surety to recover from the principal debtor any amount that he has paid rightfully. The concept of rightfully is illustrated in the case of Chekkara Ponnamma vs A S Thammayya AIR 1983. In this case, the principal debtor died after hire-purchasing four motor vehicles. The surety was sued and he paid over. The surety then sued the legal representatives of the principal debtor. The court required the surety to show how much amount was realized by selling the vehicles, which he could not show. Thus, it was held that the payment made by the surety was not proper.

Rights against creditor

1. Right to securities
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.

Illustrations –
C advances to B, his tenant, 2000/- on the guarantee of A. C also has a further security for 2000/- by a mortgage of B’s furniture. C cancels the mortgage. B becomes insolvent and C sues A on his guarantee. A is discharged of his liability to the amount of the value of the furniture.

C, a creditor, whose advance to B is secured by a decree, also receives a guaratee from A. C afterwards takes B’s goods in execution under the decree and then without the knowledge of A, withdraws the execution. A is discharged.

A as surety for B makes a bond jointly with B to C to secure a loan from C to B. Afterwards, C obtains from B a further security for the same debt. Subsequently, C gives up the further security. A is not discharged.

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.

2. Right of set off
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.

Rights against co-sureties

1. Effect of releasing a surety
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.

2. Right to contribution
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.

Illustrations –
A, B, and C are surities to D for a sum of 3000Rs lent to E. E fails to pay. A, B, and C are liable to pay 1000Rs each.

A, B, and C are surities to D for a sum of 1000Rs lent to E and there is a contract among A B and C that A and B will be liable for a quarter and C will be liable for half the amount upon E’s default. E fails to pay. A and B are liable for 250Rs each and C is liable for 500Rs.

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.

Illustrations –
A, B and C as surities to D, enter into three several bonds, each in different penalty, namely A for 10000Rs, B for 20000 Rs, and C for 30000Rs with E. D makes a default on 30000Rs. All of them are liable for 10000Rs each.

A, B and C as surities to D, enter into three several bonds, each in different penalty, namely A for 10000Rs, B for 20000 Rs, and C for 40000Rs with E. D makes a default on 40000Rs. A is liable for 10000Rs while B and C are liable for 15000Rs each.

A, B and C as surities to D, enter into three several bonds, each in different penalty, namely A for 10000Rs, B for 20000 Rs, and C for 40000Rs with E. D makes a default on 70000Rs. A, B and C are liable for the full amount of their bonds.

Discharge of Surety

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 –

1. Section 130 – By a notice of revocation – discussed above.

2. Section 131 – By death of surety – discussed above.

3. 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.

Illustrations –
A becomes a surety to C for B’s conduct as manager in C’s bank. Afterwards, B and C contract without A’s consent that B’s salary shall be raised and that B shall be liable for 1/4th of the losses on overdrafts. B allows a customer to overdraft and the bank loses money. A is not liable for the loss.

A guarantees C against the misconduct of B in an office to which B is appointed by C. The conditions of employment are defined in an act of legislature. In a subsequent act, the nature of the office is materially altered. B misconducts. A discharged by the change from the future liablity of his guarantee even though B’s misconduct is on duty that is not affected by the act.

B appoints C as a salesperson on a fixed yearly salary upon A’s guarantee on due account of sales by C. Later on, without A’s consent, B and C contract that C will be paid on commission basis. A is not liable for C’s misconduct after the change.

C promises to lends 5000Rs to B on 1st March. A guarantee the repayment. C gives the money to B on 1st January. A is discharged of his liability because of the variance in as much as C may decide to sue B before 1st march.

4. Section 134 – By discharge of principal debtor – 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.

Illustrations
A gives a guarantee to C for goods to be delivered to B. Later on, B contracts with C to assign his property to C in lieu of the debt. B is discharged of his liability and A is discharged of his liability.

A contracts with B to grow indigo on A’s land and deliver it to B at a fixed price. C guarantees A’s performance. B diverts a stream of water that is necessary for A to grow indigo. This action of B causes A to be discharged of the liability. Consequenty C is discharged of his suretyship as well.

A contracts with B to build a house for B. B is to supply timber. C guarantees A’s performance. B fails to supply timber. C is discharged of his liability.

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. This was held in the case of Maharashtra SEB vs Official Liquidator 1982.

5. Section 135 – By composition, extension of time, or promise not to sue – 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.
Illustration –
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.

6. Section 139 – By imparing surety’s remedy – 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.

Illustrations –
C contracts with B to build a ship the payment of which is to be made in installments at various stages of completion. A guarantee’s C’s performance. B prepays last two installments. A is discharged of his liability.

A appoints M as an apprentice upon getting a guarantee of M’s fidelity by B. A also promises that he will at least once a month see M make up the cash. A fails to do this. M embezzeles. B is discharged of his suretyship.

A lends 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.

State of MP vs Kaluram – Discussed above.

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.

Extent of Surety’s Liability

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.

Q. Differentiate between a contract of Indemnity and a contract of Guarantee.

Contract of Indemnity (Section 124)	Contract of Guarantee (Section 126)
It is a bipartite agreement between the indemnifier and indemnity-holder.	It is a tripartite agreement between the Creditor, Principal Debtor, and Surety.
Liability of the indemnifier is contingent upon the loss.	Liability of the surety is not contingent upon any loss.
Liability of the indemnifier is primary to the contract.	Liability of the surety is co-extensive with that of the principal debtor although it remains in suspended animation until the principal debtor defaults. Thus, it is secondary to the contract and consequenty if the principal debtor is not liable, the surety will also not be liable.
The undertaking in indemnity is original.	The undertaking in a guarantee is collateral to the original contract between the creditor and the principal debtor.
There is only one contract in a contract of indemnity – between the indemnifier and the indemnity holder.	There are three contracts in a contract of guaratee – an original contract between Creditor and Principal Debtor, a contract of guarantee between creditor and surety, and an implied contract of indemnity between the surety and the principal debtor.
The reason for a contract of indemnity is to make good on a loss if there is any.	The reason for a contract of guarantee is to enable a third person get credit.
Once the indemnifier fulfills his liability, he does not get any right over any third party. He can only sue the indemnity-holder in his own name.	Once the guarantor fulfills his liabilty by paying any debt to the creditor, he steps into the shoes of the creditor and gets all the rights that the creditor had over the principal debtor.