The Indian Contract Act, 1872 delineates the legal framework governing various types of contracts, including contracts of guarantee. Section 126 of the Act provides a comprehensive definition of terms for understanding the dynamics of such contracts.
Table of Content
Meaning of Contract of Gurantee
A "contract of guarantee" as elucidated under Section 126 pertains to an agreement wherein one party, known as the surety, undertakes to perform the promise or discharge the liability of a third party, termed as the principal debtor, in case of their default. This contractual arrangement embodies a tripartite relationship among the surety, the principal debtor, and the creditor, who is the party to whom the guarantee is provided.
The role of the surety is central to the efficacy of a contract of guarantee. As per Section 126, the surety is the individual who provides the guarantee, thereby assuming responsibility for the fulfillment of the obligation in the event of default by the principal debtor. The surety's commitment serves as a safeguard for the creditor, ensuring that the obligation is discharged even if the principal debtor fails to fulfill their duties.
Conversely, the principal debtor is the party whose default triggers the surety's obligation under the contract of guarantee. This individual is bound by the terms of the underlying contract or agreement for which the guarantee is provided. Should the principal debtor fail to fulfill their obligations, the surety becomes liable to perform or discharge the same.
The creditor, as delineated under Section 126, is the beneficiary of the guarantee. It is the party to whom the guarantee is provided and who stands to benefit from the surety's assurance of performance in case of default by the principal debtor. The creditor holds the right to enforce the guarantee and demand fulfillment of the obligation from the surety if the need arises.
The parties involved in a contract of guarantee play distinct roles:
Surety: The individual providing the contract of gurantee is known as the surety. The surety undertakes the responsibility of ensuring the fulfillment of obligations in case of default by the principal debtor. Their assurance enhances the creditor's confidence in the transaction.
Principal debtor: This is the party on whose behalf the guarantee is provided. The principal debtor is obligated to fulfill the terms of the underlying transaction, and their default triggers the surety's liability under the contract of guarantee.
Creditor: The creditor is the beneficiary of the guarantee. They are the party to whom the guarantee is provided, and they rely on the surety's commitment to secure their interests in the transaction.
In the case of Bank of Bihar Ltd. v. Damodar Prasad and Others, wherein the Supreme Court of India emphasized the principle that a contract of guarantee must be construed strictly according to its terms. The court reiterated that the liability of the surety cannot be extended beyond the scope of the guarantee agreement.
Another notable case is United Bank of India v. Naresh Kumar and Others, where the Calcutta High Court elucidated that the liability of the surety under a contract of guarantee is secondary and arises only upon the default of the principal debtor. The court underscored the importance of establishing the default of the principal debtor to enforce the surety's liability.
Furthermore, in State Bank of India v. Mula Sahakari Sakhar Karkhana Ltd. and Others, the Supreme Court elucidated that the discharge of the principal debtor by operation of law does not absolve the surety of their liability under the contract of guarantee unless expressly provided otherwise in the agreement.
ECONOMIC FUNCTION OF GUARANTEE
The economic functions of a contract of guarantee are pivotal in facilitating various transactions such as obtaining loans, acquiring goods on credit, or securing employment opportunities. Essentially, a contract of guarantee acts as a form of assurance, instilling trust among parties involved in a transaction. This trust enables individuals to engage in economic activities with reduced risk, thereby fostering economic growth and development.
For instance, in the case of Birkmyre v Darnell, the court emphasized the significance of a guarantee whereby one party assures a seller that if the buyer fails to pay, they will assume responsibility. This scenario exemplifies the essence of a contract of guarantee, where trust is established through a collateral undertaking to be liable for the default of another party.
One of the primary functions of contract of guarantees is to mitigate risk for creditors. By obtaining a guarantee, creditors enhance their confidence in extending credit or goods on credit, knowing that they have a secondary source of payment available in case the primary debtor defaults. Guarantees effectively serve as a safety net, ensuring that creditors are not left uncompensated in scenarios where the primary debtor fails to fulfill their obligations.
INDEPENDENT LIABILITY DIFFERENT FROM GUARANTEE
The concept of independent liability differs fundamentally from that of a contract of guarantee. While a guarantee entails a conditional promise to be liable upon the default of the principal debtor, independent liability arises irrespective of any default. Therefore, liabilities incurred independently of a default fall outside the purview of the definition of a guarantee.
In the case of Birkmyre v Darnell, the court distinguished between a guarantee and an independent undertaking. If a companion of a buyer were to state, "Let him have the goods, 'I will be your paymaster' or 'I will see you paid'," it would constitute an undertaking for oneself and not a guarantee.
This distinction was reaffirmed in the US case of Taylor v Lee, where a landlord assured a store owner that the tenant would purchase goods and the landlord would ensure payment. This was deemed an original promise, not a collateral promise to be liable for another's default, and thus not a guarantee.
Similarly, a bank guarantee represents an independent obligation payable on demand. It is unrelated to the contractual relations between the parties and serves as a method of securing payment in commercial dealings. The beneficiary of a bank guarantee is entitled to realize the entire amount under the guarantee regardless of any ongoing disputes between the parties involved.
In instances where only an assurance for repayment is provided, such as through a letter, it does not constitute a deed of guarantee unless it explicitly includes a conditional promise to be liable upon default. Likewise, a letter of comfort issued by a holding company to its associate company, asserting its capabilities to meet financial and contractual obligations, does not constitute a guarantee unless it contains provisions indicating an understanding to discharge the associate's liability in case of default.
ESSENTIAL FEATURES OF CONTRACT OF GUARANTEE
The essential features of a valid guarantee encompass several requisites, each crucial to the validity and enforceability of the agreement:
Principal Debt: A fundamental prerequisite for a valid guarantee is the existence of a recoverable debt. The purpose of a guarantee is to secure the payment of a debt, and thus, there must be a principal debt owed by the debtor to the creditor. The guarantee operates as a secondary obligation, with the surety undertaking to be liable in the event of the principal debtor's default.
In the absence of a principal debt, there can be no valid guarantee. The tripartite nature of a guarantee, involving the principal debtor, the creditor, and the surety, underscores this essential element.
This principle was underscored in the case of Swan v Bank of Scotland, decided by the House of Lords in 1836. In this case, the defendant had guaranteed the payment of overdrafts by a banker's customer. However, as the overdrafts were contrary to statute and thus void, the customer defaulted, and the surety was sued for the loss.
The court held that without an actual debt due, there could be no liability incurred by the co-obligers, emphasizing the necessity of a recoverable debt for the enforceability of a guarantee.
GUARANTEE FOR VOID DEBT WHEN ENFORCEABLE
In certain circumstances, a guarantee for a void debt may still be held enforceable, despite the debt's nullity. This scenario often arises when the debt in question is void due to being ultra vires or incurred by a minor.
For instance, if directors of a company guarantee their company's loan, which is rendered void as ultra vires, they may still be held liable. The rationale behind this decision lies in the distinction between voidness resulting from the express language of a statute and that arising from the ultra vires acts of a company. In such cases, the voidness of the contract to guarantee the debt may not necessarily absolve the guarantors of liability.
Similarly, when a minor's debt is guaranteed, the issue of enforceability arises. In the case of Coutts & Co v Browne Lecky, where a bank loaned money to an infant, rendering the debt void under the Infants' Relief Act, 1874, the guarantors could not be held liable. The court reasoned that since the loan was void by statute due to the minor's incapacity, the guarantors could not be considered liable for a non-existent debt, default, or miscarriage.
The same principle was upheld in India, where the Bombay High Court ruled in Kashiba Bin Narsapa Nikade v Narshiv Shripat that a surety to a bond passed by a minor for borrowed money could be held liable if the surety knowingly guaranteed the debt. The court reasoned that while the debt may be void, the contract of the surety was not collateral but a principal contract. Therefore, the surety could be held liable as a principal debtor himself, especially if the surety was aware of the minor's incapacity when providing the guarantee.
CONSIDERATION FOR CONTRACT OF GURANTEE
Consideration is a crucial element in any contract, including a contract of guarantee. Without consideration, a guarantee is deemed void. However, it's noteworthy that there doesn't need to be direct consideration between the surety and the creditor. Section 127 of the Indian Contract Act, 1872 clarifies that anything done or promised for the benefit of the principal debtor can constitute sufficient consideration for the surety to provide the guarantee.
Moreover, even refraining from suing the principal debtor can serve as valid consideration for providing a contract of guarantee. For instance, if a creditor refrains from pursuing legal action against the principal debtor after a debt becomes due, this act of forbearance can be considered sufficient consideration for the surety to give the guarantee.
However, if consideration fails, the guarantee becomes invalid. This was illustrated in a case involving a contract for cutting and removing timber from a forest, where the forest authorities did not permit the cutting, resulting in the failure of consideration. In such cases, neither the bank guarantee could be invoked nor could the contractor's earnest money be forfeited.
Concerning guarantees for past debts, the law is clear that a guarantee for a past debt should be invalid. However, the interpretation of "anything done" in Section 127 has been subject to debate. The Oudh High Court held that even actions done before the guarantee was given could constitute consideration, but this decision has faced criticism.
On the other hand, guarantees for past as well as future debts are enforceable provided that some further debt is incurred after the guarantee. Once fresh obligations are incurred, the liability for all obligations becomes coupled up.
Furthermore, the benefit to the principal debtor is sufficient consideration to sustain the guarantee, regardless of whether the principal debtor requested the guarantee or was aware of its existence. This principle was affirmed by the Patna High Court in a case involving directors of a company who guaranteed the company's loans, even though the company hadn't explicitly requested the guarantee. The court emphasized that as long as the principal debtor receives a benefit, the guarantee can be sustained.
COUNTER GUARANTEE
A counter-guarantee serves as a means of protecting the original guarantor in a contractual arrangement. When the original guarantor fulfills their obligation under their guarantee and is subsequently called upon to pay, they can invoke the counter-guarantee to secure reimbursement.
In practical terms, if the original guarantor is required to fulfill their obligations under the guarantee, and they do so, they can then turn to the counter-guarantor to fulfill their obligations.
The counter-guarantee essentially serves as a secondary layer of protection for the original guarantor, ensuring that they are not left bearing the financial burden alone.
In a legal context, if the counter-guarantor fails to honor their obligations under the counter-guarantee, the original guarantor can pursue legal action against them to enforce the terms of the counter-guarantee agreement.
This was demonstrated in a case where the plaintiff had obtained a counter-guarantee from the defendant to cover potential liabilities arising from a bank guarantee. When the defendant failed to fulfill their obligations under the counter-guarantee, the plaintiff was entitled to seek legal recourse and obtain a decree against the defendant.
MISREPRESENTATION AND CONCEALMENT
A contract of guarantee does not inherently require absolute good faith or full disclosure, unlike contracts uberrimae fides, which demand utmost good faith. While a party receiving a guarantee may not be obligated to disclose circumstances that significantly affect the credit of the debtor, it is nevertheless their duty to inform the surety of all relevant facts likely to impact their responsibility. Failure to do so may render the guarantee invalid under Sections 142 and 143 of the Indian Contract Act, 1872.
Section 142 stipulates that any guarantee obtained through misrepresentation concerning a material part of the transaction, either made by the creditor or with their knowledge and assent, is invalid.
Similarly, Section 143 renders any guarantee obtained through the concealment of material circumstances by the creditor as invalid.
This principle finds application in cases involving guarantees for the good conduct of a servant. In the case of London General Omnibus Co v Holloway, the employer failed to disclose to the surety that the servant had been dismissed for dishonesty in the past. When the servant committed another act of embezzlement, the surety was held not liable because they believed they were guaranteeing an honest individual, not a known thief.
It is crucial for the creditor to disclose any circumstances affecting the risk to the surety, as every surety undertakes the risk of default, which varies depending on the circumstances. For instance, in a case before the Lahore High Court, fresh guarantees were obtained for the fidelity of a bank manager without disclosing his previous defalcations, resulting in the sureties not being liable for further defalcation.
However, there are limitations to the duty of disclosure. Lord Chelmsford observed
that a creditor is not obligated to inform an intended surety of matters affecting the debtor's credit or any transactional circumstances that could render the position hazardous. Similarly, in a Scottish case, it was held that the mere occurrence of suspicious circumstances known to the creditor, but not communicated to the surety, does not release the surety from their obligation.
EXTENT OF SURITY’s LIABILITY
Co-extensive Liability: The surety's liability is deemed to be co-extensive with that of the principal debtor. This means that the surety is responsible for the same obligations and liabilities as the principal debtor. In other words, the surety is liable for the full amount for which the principal debtor is liable, and no more.
The surety's maximum liability is thus determined by the extent of the principal debtor's obligations.
An illustration provided under the section exemplifies this principle, stating that if a loan bond is guaranteed, the surety is not only liable for the principal amount of the loan but also for any interest and charges that may have accrued on it.
Additionally, any actions or acknowledgments of liability made by the principal debtor can affect the surety's liability. For instance, if the principal debtor acknowledges their liability, thereby extending the period of limitation against them, the surety also becomes subject to this extended limitation period. References
https://www.legalserviceindia.com/legal/article-5657-contract-of-guarantee.html
The Modern Contract Of Guarantee - 4/e, 2020 by W Courtney
Special Contracts– Indemnity And Guarantee by Akhileshwar Pathak
Comments