Contract of Guarantee

Contract of Guarantee is an important legal instrument under the Indian Contract Act, 1872 (Section 126) that plays a significant role in commercial and financial transactions. It is designed to provide a security mechanism for the repayment of debts or the performance of obligations by a third party. The essence of this contract lies in the involvement of three parties and the promise made by one to discharge the liability of another in case of default.

Definition (Section 126 of the Indian Contract Act, 1872)

Contract of Guarantee is a contract to perform the promise or discharge the liability of a third person in case of his default. It involves three parties:

1. Creditor: The person to whom the guarantee is given

2. Principal Debtor: The person in respect of whose default the guarantee is given

3. Surety: The person who gives the guarantee

Characteristics of a Contract of Guarantee:

• Tripartite Agreement

Although the contract may not be signed by all three parties at the same time, it must be made with the knowledge and consent of all parties.

• Primary and Secondary Liability

The principal debtor has primary liability to pay the debt. The surety’s liability is secondary and arises only when the principal debtor defaults.

• Consideration

A guarantee is valid only if there is valid consideration. The consideration received by the principal debtor is treated as sufficient for the surety as well.

• Written or Oral

Under Indian law, a contract of guarantee may be either oral or written. However, for legal clarity and enforceability, it is usually documented in writing.

Essentials of a Valid Contract:

As with any valid contract, a contract of guarantee must have:

• • Free consent

  • Lawful consideration

  • Lawful object

  • Competent parties

  • Offer and acceptance

Types of Guarantee:

• Specific Guarantee

It is given for a single transaction or debt and comes to an end once that specific transaction is completed.

• Continuing Guarantee (Section 129)

This is a guarantee that extends to a series of transactions. It remains in force until it is revoked by the surety or by death (in case of the surety).

Revocation of Guarantee:

• By Notice (Section 130):

A continuing guarantee can be revoked by the surety at any time for future transactions by giving notice to the creditor.

• By Death (Section 131):

The death of the surety also revokes a continuing guarantee for future transactions unless otherwise agreed.

Liability of Surety (Section 128):

• The liability of the surety is co-extensive with that of the principal debtor unless it is otherwise stated in the contract.

• This means that the surety is liable to the same extent as the principal debtor, and the creditor can proceed directly against the surety without first exhausting remedies against the principal debtor.

Rights of the Surety:

1. Against Principal Debtor

   • Right of Subrogation (Section 140): Once the surety pays the debt, he steps into the shoes of the creditor and gains all the rights the creditor had against the principal debtor.

   • Right of Indemnity (Section 145): The surety is entitled to be indemnified by the principal debtor for all payments lawfully made by him.

2. Against Creditor

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

   • If the creditor loses or parts with such security without the surety’s consent, the surety is discharged to that extent.

3. Against Co-sureties (Section 146–147)

   • When multiple sureties are involved, they share liability equally unless there is a contract stating otherwise.

   • If one surety pays more than his share, he can recover the excess from co-sureties.

Discharge of Surety from Liability:

A surety is discharged from liability in the following circumstances:

1. Revocation of guarantee (Sections 130–131)

2. Variance in terms of the contract (Section 133) without the consent of the surety

3. Release or discharge of the principal debtor (Section 134)

4. Creditor’s act or omission impairing surety’s remedy (Section 139)

5. Loss of security by the creditor (Section 141)

Invalid Guarantees:

A contract of guarantee becomes invalid if:

• It is obtained by misrepresentation or concealment of material facts

• The surety signs under coercion or undue influence

• The contract lacks consideration

Examples of Contract of Guarantee:

1. A bank providing a loan to a borrower, backed by a guarantor.

2. A person guarantees payment for goods supplied to another.

3. A student’s fees guaranteed by a parent.