What Is Contract Of Guarantee?

A Contract of Guarantee under Indian law is an agreement involving three parties: the principal debtor, the creditor, and the surety (guarantor). It ensures that the debtor’s obligations are met, with the surety stepping in if the debtor defaults. Governed by the Indian Contract Act, 1872, this contract is crucial in securing financial transactions and reducing risks for creditors. In this blog, we explore its key elements, types, rights, and obligations, shedding light on how it safeguards business dealings and enhances security in financial agreements.

Contract Of Guarantee Section​

“Contract of Guarantee” is defined under Section 126 of the Indian Contract Act as:

A “contract of guarantee” is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the “surety”; the person in respect of whose default the guarantee is given is called the “principal debtor”, and the person to whom the guarantee is given is called the “creditor”. A guarantee may be either oral or written.

Essentials Of Contract Of Guarantee​

For a contract of guarantee to be legally binding under Indian law, it must fulfill certain elements:

1. Three Parties Involved:
   • Principal Debtor: The person who owes the debt or performs the obligation.
   • Creditor: The person to whom the debt is owed.
   • Surety (Guarantor): The person who assures the creditor that the debt will be paid or the obligation performed if the principal debtor defaults.
2. Written Agreement: Although not mandatory, it is advisable to have a contract of guarantee in writing to avoid ambiguity and provide clear evidence of the arrangement.
3. Consideration: A contract of guarantee must have a lawful consideration. Here, the consideration for the surety is the benefit that the principal debtor derives from the credit extended by the creditor.
4. Consent of the Surety: The consent of the surety must be free, and the surety must be fully aware of the terms of the contract.
5. Liability of the Principal Debtor: A guarantee is enforceable only if the primary debt is valid. If the principal debt is void or unenforceable, the surety's liability also becomes void.

Types Of Contracts Of Guarantee

Contracts of guarantee come in various forms to address different financial or transactional needs. These types provide flexibility for one-time or ongoing commitments based on the arrangement between the parties.

Specific Guarantee

A specific guarantee is limited to a single transaction or debt. In this case, the surety provides a guarantee only for a specific obligation or debt, and once that debt is paid or obligation is fulfilled, the guarantee terminates. This type of guarantee does not extend to any further or additional liabilities of the principal debtor.

Continuing Guarantee

A continuing guarantee is broader and applies to a series of transactions or multiple obligations, where the surety’s liability continues until the transactions are completed or the guarantee is revoked. This type of guarantee is particularly common in business or trade contexts where ongoing dealings are involved.

Key aspects of a continuing guarantee

• It covers future debts, transactions, or credits.
• It remains effective until expressly revoked by the surety.
• The surety’s liability extends to all subsequent transactions until termination.

Requirements Of Contract Of Guarantee

• Agreement of All Parties: The principal debtor, creditor, and surety must all agree to the contract. The principal debtor must also interact with the surety, as a guarantee made without the debtor’s involvement is not valid.
• Consideration for the Surety: The guarantee should be supported by consideration benefiting the principal debtor, not necessarily the surety. The creditor's patience or forbearance in case of default can be sufficient consideration.
• Secondary Liability: The surety’s obligation is secondary, meaning the creditor must first seek repayment from the principal debtor before holding the surety liable.
• Existence of a Debt: A guarantee ensures the principal debtor’s obligation is paid. If the debt is void or time-barred, the surety has no obligation.
• No Concealment: The creditor must disclose any material information that affects the surety’s liability; failure to do so invalidates the guarantee.
• No Misrepresentation: The guarantee should not be obtained by misleading the surety about essential facts, even though it is not a contract of utmost good faith.

Rights And Obligations In A Contract Of Guarantee

In a contract of guarantee, both the creditor and the surety have specific rights and obligations that define their roles and protect their interests. These rights and duties ensure fair treatment and clarify each party’s responsibilities in case of a default.

Rights of the Creditor

1. Right to Sue: If the principal debtor defaults, the creditor has the right to sue both the principal debtor and the surety.
2. Right to Interest: The creditor is entitled to claim interest if the contract specifies it.

Rights of the Surety

1. Right of Subrogation: After the surety fulfills the obligation, they step into the creditor’s shoes and acquire the right to recover the amount from the principal debtor.
2. Right of Indemnity: The surety can claim compensation from the principal debtor for any losses incurred due to fulfilling the debtor’s obligation.
3. Right to Securities Held by the Creditor: The surety is entitled to any security that the creditor holds against the principal debtor upon payment.

Obligations of the Surety

1. Liability to Creditor: The surety’s liability is co-extensive with that of the principal debtor, unless stated otherwise in the contract.
2. Responsibility in Case of Default: The surety must fulfill the principal debtor’s obligations upon their default as per the contract’s terms.

Termination Of Contract Of Guarantee

A contract of guarantee can be terminated under the following conditions:

1. Revocation by Surety: For a continuing guarantee, the surety may revoke it by giving notice to the creditor, thereby terminating liability for future transactions.
2. Death of Surety: In cases of a continuing guarantee, the death of a surety terminates the contract concerning future transactions, unless otherwise stated.
3. Discharge of Surety: The surety is discharged if:
   • The creditor, without the surety’s consent, makes changes to the terms of the contract.
   • The creditor releases the principal debtor from liability.
   • The creditor’s act makes it impossible for the surety to enforce his right of subrogation.

Difference Between Contract of Indemnity And Guarantee​

Parties Involved:

• Indemnity involves two parties—the indemnifier (who promises to compensate for loss) and the indemnified (who is protected).
• The guarantee involves three parties: the creditor, the debtor, and the guarantor.

Liability:

• In indemnity, the indemnifier compensates for the actual loss suffered by the indemnified.
• In guarantee, the guarantor’s liability is secondary, and they only pay if the debtor defaults.

Nature of Contract:

• An indemnity contract is independent and does not require a primary contract.
• A guarantee contract is ancillary, supporting a primary contract between the debtor and creditor.

Conclusion

The contract of guarantee under Indian law provides a structured mechanism for risk management and encourages financial transactions by providing a layer of security for creditors. It balances the rights and obligations of all parties. In India’s growing economic landscape, guarantees continue to be instrumental in facilitating trade, investment, and employment, ultimately strengthening the foundation of business relationships.