Author- Manik Tindwani

Abstract

This research paper discusses the fundamentals of a valid contract of guarantee and kinds of contracts of guarantee while stating some important case laws.

Introduction

Section 126 of the Indian Contract Act, 1872 defines Contract of Guarantee as a contract wherein a person assumes the responsibility either of performing a promise or discharging the liability of a third person in case of his or her default.

Contract of Guarantee is a tripartite agreement involving ‘surety’, ‘principal debtor’, and ‘creditor’. ‘Surety’ is the person who gives the guarantee; ‘principal debtor’ is the person in respect of whose default the guarantee is given and ‘creditor’ is the person to whom such guarantee is given. When more than one surety is involved in the Contract they are called ‘co-sureties’. When default occurs on part of the debtor then the amount which comes due is known as ‘guaranteed debt’. It is explicit under the provisions of the aforesaid section that a guarantee may be given either orally or in written form and can be express or implied.

In the case of P.J. Rajappan v. Associated Industries the ‘surety’ gave an oral guarantee. After the ‘principal debtor’ was unable to discharge liabilities, the ‘surety’ tried to escape liability taking the defense of not signing the agreement. Hon’ble Kerala High Court held that since the evidence proves the involvement of the ‘surety’ and contract of guarantee is a tripartite agreement, involving principal debtor, surety, and creditor. So, mere failure on his part in signing the agreement is not sufficient ground to discharge the surety from his obligation. Involvement of the surety itself implies surety’s consent for the due performance of the contract. The court also held that when the court is entitled to decide the involvement of a surety then all facts and circumstances of the transaction are to be taken under consideration.

Rights of ‘Surety’

Indian Contract Act, 1872 guarantees rights to a surety against the creditor, principal debtor, and co-sureties protecting his interests. These rights are entitled to protect the interest of ‘surety’. No party to the contract can violate these rights. Any provision violating any of these rights can make the contract void. The rights are enumerated as follows:

1. The ‘surety’ has two rights against the ‘principal debtor’ namely, ‘Right to Indemnity’ and ‘Right to Subrogation’.
   1. Guaranteed under Section 140, ‘Right to Subrogation’ allows the surety to recover the amount paid to the creditor from the principal debtor in case of default.
   1. Right to Indemnity is guaranteed under Section 145 provides that whenever the contract of guarantee is signed it is assumed that debtor has made an implied promise to indemnify the surety in case of his default.
2. The surety has two rights
   1. Section 141 guarantees ‘Right over Securities’ to the surety. When default occurs and surety makes the payment of ‘guaranteed debt’ to the ‘creditor’, the right over the securities gets transferred to the ‘surety’. Knowledge about such securities to the creditor is immaterial for this purpose. This right would arise only after complete payment to the creditor as was held in Goverdhan Das v Bank of Bengal.
   1. Other than this, surety also has the right to set-off which means that on the institution of a suit by the creditor against the surety, the surety has the right to get the amount reduced to the extent of debt owed by the creditor towards the surety or the principal debtor. Like if creditor owes Rs. 20,000 to debtor and debtor owes Rs. 25,000 to the creditor, and if a default occurs and a suit is instituted then surety can settle the debt by paying off Rs. 5,000.
   1. The case of State of MP v. Kaluram was filed before the Hon’ble Supreme Court. The facts of the case were that State sold numerous felled trees to the defendant and a contract was signed for payment of dues in four installments. Also, it was provided that on the failure of payment of any installment, the State would be entitled to the right to prevent further cutting of trees. Even after default was made by the defendant but State did not stop the cutting of timber trees. It was held by the Hon’ble Court that surety was not liable because the ‘creditor’ (State) failed to mitigate the loss and ‘surety’ cannot be made liable for loss which could have been reasonably avoided.
3.  The Surety has rights against co-sureties as well.
   1. Section 138 allows the ‘creditor’ to discharge any co-surety from payment of the liabilities. The co-sureties paying the dues have the right to claim compensation from the discharged sureties.
   1.  Section 146 provides that all the co-sureties are liable to equally contribute whether they knew of each other’s presence or not unless the contract provides for the contrary. If co-sureties have guaranteed for unequal amounts then they are liable to pay equally subject to the maximum limit guaranteed by them. For example: if the amount guaranteed by A, B, C was 10,000, 30,000, and 40,000 respectively and the default of 30,000 occurred then each surety will pay 10,000 only.

The Extent of Liability of a ‘Surety’

1. The extent of liability of ‘surety’ is discussed under Section 128 of the Act wherein the surety can only be held liable to the same extent as the principal debtor is. The liability of surety and the principal debtor is “co-extensive”. Though this fact cannot be ignored that the liability of the surety may be secondary but in case of default ‘creditor’ is entitled to the right to directly sue the ‘surety’ for discharge of liabilities. The surety is liable unless or until he is discharged from such obligation.
2. The act provides that a surety can be discharged from such obligation, unless the contract provides for the contrary, under the conditions as provided under the Act.
   1. Section 131 provides that the death of surety discharges the surety from his obligations.
   1. Under Section 130   surety can be discharged on the revocation of such contract by issuing a notice to the creditor.
   1.  It is explicit under Section 133that if any variation is made in the terms of the contract without the consent of the surety then the surety will be discharged from the date of effect of such variation.
   1. As per Section 134, if by any act or omission of a creditor, the principal debtor is released from liability or a part of liability, the surety will also be discharged to the same extent as the principal debtor is released.
   1.  Section 135makes it clear that if the creditor and the principal debtor enter into a contract through which the creditor promises to give time for payment or promises not to sue the principal debtor, then the surety will be discharged except for when surety gives his consent and agrees with such contract.
   1. Section 139 expressly states that if in any manner the rights of sureties are violated by any party, the surety will be discharged. The rights of a ‘surety’ are absolute and are not subject to the provisions of the contract. If the contract contains any provision which infringes surety’s rights then the contract shall be expressly void from the date of effect of such provision(s).
   1. It is implied from Section 139 and Section 141that if the creditor sells any security or part of security received from the principal debtor without surety’s consent, the surety will be discharged from the obligation.
3. Where other provisions of the Act provide grounds for discharge of surety, Section 137 provides that mere forbearance of the creditor to not sue the principal debtor or not to enforce any remedy against him may not discharge the surety unless or until the contract provides for the contrary. This affirms the fact that though the liability of the surety is secondary, the creditor has the right to directly sue the surety unless the contract provides for the contrary.

Prerequisites for a Valid Contract of Guarantee

There are majorly 8 prerequisites or essentials for a valid Contract of Guarantee, enumerated as follows;

1. AGREEMENT
   1.  Section 2(e)of the Act defines ‘agreement’ as a set of promises made by the parties to a contract forming sufficient consideration for each other. In simple words when consent is given for entering into a contract in exchange for valid considerations it is termed as Agreement.
   1. Whereas, Section 10 provides for grounds on which an agreement becomes a valid contract. It states an agreement becomes a contract when it is made by the free consent of parties competent to contract, for a lawful consideration, and a lawful object.

2. CONSIDERATION: Section 127 provides that 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. It was observed in Ram Narain v. Lt. Col. Hari Singh that past consideration is of no use for a new contract therefore every contract needs new consideration. Tolerance on part of the creditor is also deemed to be sufficient consideration as it benefits the debtor by providing more time to meet the liabilities, it was observed in the case of State Bank of India v Premco Saw Mill.

3. NO PROVISION VIOLATING RIGHTS OF SURETY: The contract shall be devoid of any provision which infringes the rights of any surety. The presence of any such provision will make the contract void from the date of effect of such provision.

4. UBERIMAE FEDAI: The contract of guarantee is based on uberimae fedai which means ‘utmost good faith’. This principle states that such contract shall be made out with disclosure of all material facts, without misrepresentation, and without malice. A fact is considered ‘material’ when it can influence any party’s decision to agree with the contract. In the case of London General Omnibus vs Holloway[1], a person was invited to be ‘surety’ of an employee, who made default previous time also but this fact was not disclosed to the surety. The employee later misappropriated the funds but the surety was not held liable because ‘material’ fact was not disclosed.

5. NON-AMBIGUITY OF CONTRACT TERMS: The terms of a contract must be clear and free from ambiguity. Any ambiguity in a provision within the contract which is material to the interests of parties can make the contract void.

6. EXISTENCE OF OBLIGATION: In absence of any legal obligation, either to perform a task or to discharge a liability, while making the contract fails to make up sufficient consideration to ‘surety’. This can make an agreement void. The House of Lords in the Scottish case of Swan vs. Bank of Scotland[2] observed that no valid guarantee can exist in absence of any ‘principal debt’. The court in Manju Mahadev Shetti v. Shivappa Shetti held that the liability shall be legally enforceable.

7. ALL ESSENTIALS OF A VALID CONTRACT: For a valid contract of guarantee the contract must be palatable with the pre-requisites for a valid contract i.e. the contract must satisfy Section 10 and the parties to the contract must be competent as defined under Section 11 which states that he or she must not be of unsound mind or a minor or disqualified from entering into the contract by law.

8. SECTION 144 OF ACT: Section 144 of the Act provides that if the contract provides for the creditor to not act unless the co-surety joins then if in contravention to this if the creditor acts, the guarantee shall be deemed invalid if the other person does not join.

Classification of Contract of Guarantee

Contract of Guarantee can be classified on two bases i.e. ‘on the basis of time’ and ‘on the basis of transaction’.

1. On the basis of Time
   1. Prospective Guarantee: It is a form of guarantee given in respect of future transactions.
   2. Retrospective Guarantee: It is a form of guarantee given in respect of past transactions.
   3. Time-barred Guarantee: Under such contract surety guarantees payment to the creditor for a fixed period whereafter the surety may be discharged from any liability. For any default arising after lapse of such period, ‘surety’ will not be liable.
   4. Deferred Guarantee: Such a contract guarantees payment of a debt after a certain period has expired. For example, if A purchases an asset from B under a deferred payment contract and promises to pay the value of the asset (Rs.20 Crore) on a deferred payment basis (Rs.4 Crore after every 4 months), and C accepts to be surety of A. Then the Contract of Guarantee of C will come into effect after a period of 4 months is expired and the extent of liability will be up to Rs.4 Crore only.
2. On the basis of Transaction
   1. Specific Guarantee: It is a type of guarantee which is given pertaining to some specific transaction or discharge of a specific debt.
   2. Continuing Guarantee
      1. Meaning:- It is defined under Section 129 as a guarantee which extends to a series of distinct transactions involving multiple considerations and agreements. It continues until the ‘surety’ is either discharged from such contract or the guarantee is revoked. A guarantee given in respect of an entire consideration cannot be considered as a ‘continuing guarantee’.
         For example, if a house is given to A by B for 20 years on lease for a monthly rent of Rs. 10,000 where C becomes the ‘surety’. After 15 years A stops giving rent and B sues C. C tries to revoke the contract by giving notice, but C will not be able to revoke it because the guarantee under this contract is not given for a ‘series of transaction’ but only for a single transaction and is not a contract of ‘continuing guarantee’.
         In the case of Nottingham Hide Co v. Bottrill (1873)^[1], it was observed that facts and circumstances of the case must be taken into consideration for identifying whether it’s a case of ‘continuing guarantee’ or not.
         
      2. Revocation of Continuing Guarantee: Section 130 allows revocation of ‘continuing guarantee’ only for future transactions by issuing a notice to the creditor by the surety. If the contract of guarantee provides that the notice for revocation must be issued prior to a certain period, then the surety must adhere to the same, as was held in Offord v Davies^[2]. Section 131 allows revocation of the guarantee on ‘death of surety’ unless or until the contract provides for the contrary. The legal representatives will however be liable for the defaults that occurred before his death. The estate of the ‘surety’ can only be used to settle transactions that have already taken place during the lifetime of the deceased, like as in the aforementioned example, if the surety dies after default occurred then only the estate of the surety can be used for discharge of such liability.
         
      3. Limitation Period for Suits:- Article 42 and 43 under Part –II of First Division of The Limitation Act, 1963 provide that a suit can be filed by the ‘surety’ against the ‘principal debtor’ within 3 years of payment of dues by him to the ‘creditor’. ‘Surety’ can file suit against the ‘co-sureties’ within 3 years of payment of anything excess of his share. The date of payment made by ‘surety’ to the ‘creditor’ is known as ‘date of execution of guarantee deed’.
         
         Article 54 under the same part provides for the specific performance of a contract. It states that a suit can be instituted within 3 years of the date of performance of such contract. If no such date is fixed then the suit can be filed within 3 years of the date when it comes to the plaintiff’s notice that the performance is refused. Guarantee also being a type of Contract is under the ambit of Article 54 and thus the limitation period for enforcement of a guarantee is also 3 years.
         
         In the case of State Bank Of India vs Nagesh Hariyappa Nayak And Ors  the defendants took a loan from the plaintiff for a Company while the directors guaranteed the payment through a guarantee deed. It was held by the Hon’ble Court that since the recovery proceedings were commenced after three years from the date of payment made by ‘surety’ to the ‘creditor’, the defendants were liable.
         
         Section 28 of the Indian Contract Act, 1872 provides that any such contract is illegal and void which restrains the right to institute any legal proceedings. Exception 3 under the same section provides that the contract of guarantee made with Banks pertaining to the loan taken from banks may not be void for adding a clause restraining the right of the bank to not institute legal proceedings against the ‘principal debtor’. This clause provides a grace period to the debtor for settlement of due and disputes and this grace period must not be less than one year.

Conclusion

The purpose of Contract of Guarantee has been to provide a strict legal remedy against all the debtors reducing probabilities of arrear and mitigating the loss arising from their nonfeasance while protecting the interests and rights of the sureties. It is a great tool for corporations and financial agencies. In my opinion, the prospective guarantee and retrospective guarantee can be considered as types of continuing guarantee also. The limitation period of suits is decided with acumen and should be strictly adhered to, subject to the exceptions enumerated under Limitation Act.

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Manik Tindwani is a first-year law student at University Five Year Law College, University of Rajasthan.

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[1] London General Omnibus v Holloway, [1912] 2 K.B. 72 (11 March 1912).

[2] Swan vs. Bank of Scotland, (1836) 10 Bligh NS 627.

[2] Offord v Davies, (1862) 12 CBNS.