A contract of guarantee involves a promise by one party (the surety) to fulfill the obligations of a second party (the principal debtor) to a third party (the creditor) if the principal debtor defaults. This legal arrangement is pivotal in financial and commercial transactions, providing assurance to creditors and facilitating economic activity.

DEFINITION AND PARTIES INVOLVED

Section 126 of the Indian Contract Act, 1872, defines a contract of guarantee as “a contract to perform the promise, or discharge the liability, of a third person in case of his default.” The three parties involved are:

• Principal Debtor: The individual or entity who owes the debt or is obligated to perform the duty.

• Creditor: The individual or entity to whom the debt is owed or the obligation is due.

• Surety: The individual or entity who guarantees to discharge the liability in case of the principal debtor’s default.

Illustration: If person A lends money to person B, and person C promises to repay the money if B fails to do so, A is the creditor, B is the principal debtor, and C is the surety.

ESSENTIALS OF A VALID CONTRACT OF GUARANTEE

1. AGREEMENT OF ALL THREE PARTIES
   All three parties—principal debtor, creditor, and surety—must consent to the contract. The surety’s obligation arises only at the principal debtor’s request. Without the principal debtor’s knowledge or consent, a contract between the creditor and surety does not constitute a valid guarantee.

2. CONSIDERATION
   As per Section 127 of the Indian Contract Act, “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.” The surety’s promise doesn’t require direct benefit; the benefit to the principal debtor suffices.

   Case Law: In State Bank of India v. Premco Saw Mill (1983), the court held that the bank’s forbearance from immediate legal action against the debtor constituted valid consideration for the surety’s promise.

3. LIABILITY OF THE SURETY
   The surety’s liability is secondary and arises only upon the principal debtor’s default. However, this liability is co-extensive with that of the principal debtor, meaning the surety is liable for the same amount as the principal debtor unless otherwise agreed.

4. EXISTENCE OF A RECOVERABLE DEBT
   A valid contract of guarantee presupposes an existing enforceable debt or obligation. If the principal debtor’s obligation is void or unenforceable, the surety cannot be held liable.

5. COMPLIANCE WITH VALID CONTRACT ESSENTIALS
   The contract of guarantee must fulfill all essential elements of a valid contract under the Indian Contract Act, including free consent, lawful object, and competency of parties.

6. NO MISREPRESENTATION OR CONCEALMENT
   The creditor must not misrepresent or conceal material facts from the surety. Any guarantee obtained through misrepresentation or concealment is invalid.

TYPES OF GUARANTEES

1. SPECIFIC GUARANTEE
   A guarantee limited to a single transaction or debt. The surety’s liability ends once the specific transaction is completed.

   Illustration: If person D guarantees the payment for goods sold by person E to person F, D’s liability ceases once F pays for the goods.

2. CONTINUING GUARANTEE
   A guarantee that extends to a series of transactions. The surety’s liability continues until it is revoked or the series of transactions concludes.

   Illustration: Person G guarantees payment for all goods that person H may supply to person I over a year. This is a continuing guarantee covering multiple transactions.

REVOCATION OF CONTINUING GUARANTEE

A continuing guarantee can be revoked for future transactions by:

• Notice by the Surety: The surety can revoke the guarantee by notifying the creditor. However, the surety remains liable for transactions already undertaken.

• Death of the Surety: Unless there’s a contract to the contrary, the death of the surety revokes the guarantee for future transactions.

DISCHARGE OF SURETY FROM LIABILITY

A surety can be discharged from liability under the following circumstances:

1. VARIANCE IN TERMS (SECTION 133)
   Any material alteration in the terms of the contract between the principal debtor and creditor without the surety’s consent discharges the surety for transactions subsequent to the variation.

2. RELEASE OF PRINCIPAL DEBTOR (SECTION 134)
   If the creditor releases the principal debtor or acts in a way that discharges the principal debtor, the surety is also discharged.

3. ARRANGEMENT GIVING TIME (SECTION 135)
   If the creditor, without the surety’s consent, agrees to give the principal debtor more time to perform the obligation, the surety is discharged.

4. IMPAIRMENT OF SURETY’S REMEDY (SECTION 139)
   If the creditor does any act that impairs the surety’s eventual remedy against the principal debtor, the surety is discharged.

RIGHTS OF THE SURETY

1. AGAINST THE PRINCIPAL DEBTOR

   • Right of Subrogation (Section 140): Upon fulfilling the principal debtor’s obligation, the surety steps into the shoes of the creditor and gains all rights against the principal debtor.

   • Right of Indemnity (Section 145): The surety is entitled to recover from the principal debtor all payments rightfully made under the guarantee.

2. AGAINST THE CREDITOR

   • Right to Securities (Section 141): The surety is entitled to the benefit of every security the creditor holds against the principal debtor at the time of the contract.

3. AGAINST CO-SURETIES

   • Right of Contribution (Section 146): When two or more sureties are liable for the same debt, they are equally bound to contribute to the liability.