Contract of Guarantee and it's essential features

INTRODUCTION

A contract of guarantee is a legal agreement that involves three parties: the creditor, the principal debtor, and the guarantor. In this arrangement, the guarantor agrees to take on the responsibility of the principal debtor’s obligations if they fail to meet their commitments. Such contracts are often used to guarantee loan repayments, ensure the fulfillment of contractual duties, or maintain financial commitments. For the contract to be legally enforceable, it must involve mutual consent, have legal consideration, and adhere to the applicable legal standards. Various types of guarantees exist, including financial guarantees (to ensure debt repayment) and performance guarantees (to ensure contractual obligations are met). The guarantor is only held liable if the principal debtor defaults. These agreements offer creditors additional financial assurance and strengthen confidence in economic and contractual transactions.

ESSENTIAL FEATURES

The following are the requisites of a valid guarantee:

1. Principal Debt

The purpose of a guarantee is to secure the payment of a debt; the existence of a recoverable debt is necessary.[i] It is of the essence of a guarantee that there should be someone liable as a principal debtor and the surety undertakes to be liable on his default.[ii] If there is no principal debt, there can be no valid guarantee.[iii] “A contract of guarantee is a tripartite agreement which contemplates the principal debtor, the creditor and the surety.”[iv] Sometimes, a guarantee even for a void debt may be held enforceable. Where for example, the directors of accompany guaranteed their company’s loan which was void as being ultra vires, the directors were nevertheless held liable.[v] The reason “may be that the voidness of a contract to guarantee the debt of a company acting ultra vires is different in its consequences from the voidness brought about by the express and emphatic language of a statute.” A similar problem arises when the debt of a minor has been guaranteed. In India it has been held, following earlier English authorities, that where a minor’s debt has been knowingly guaranteed, the surety should be held liable as a principal debtor himself.[vi] However, if the debt is void, the contract of the so-called surety is not collateral, but a principal contract.

2. Consideration

Like every other contract, a contract of guarantee should also be supported by some consideration. A guarantee without consideration is void.[vii] But there need be no direct consideration between the surety and the creditor. Section 127 clearly says 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.” Thus, where a loan is given or goods sold on credit on the basis of a guarantee, that is sufficient consideration.[viii] A guarantee for a past debt should be invalid. A guarantee for a past as well as a future debt is enforceable provided some further debt is incurred after the guarantee. If the principal debtor gets a benefit, that suffices to sustain the guarantee. It will be of no consequence to say that the principal debtor had never requested for a guarantee or that it was given without his knowledge or consent. A counter guarantee is for protection of the original guarantor. When the original guarantor is called upon to pay and he has fulfilled his obligation under his guarantees, he can call upon the counter guarantor to pay him.[ix]

3. Misrepresentation and concealment

A contract of guarantee is not a contract uberrimae fides or one of absolute good faith. Yet, it is the duty of a party taking a guarantee to put the surety in possession of all the facts likely to affect the degree of his responsibility; and if he neglects to do so, it is at his peril. A surety ought to be acquainted with the whole contract entered into with his principal. Section 142 and 143 implement these principles.

JOINT-DEBTORS AND SURETYSHIP

Section 132 of the Act states that where two persons contract with a third person to undertake a certain liability, and also contract with each other that one of them shall be liable only on the default of the other, the third person not being a party to such contract, the liability of each of such two persons to the third person under the first contract is not affected by the existence of the second contract, although such third person may have been aware of its existence. The section is based upon the principle that the liability of persons who are primarily liable as joint-debtors is not affected by any arrangement between them as to the order of their liability. The principle of the section is that whatever be the arrangement between joint-debtors as to their liability to the creditor, they remain joint debtors. The creditor is not concerned with their mutual agreement that one would be the principal and the other a surety. Where, however, the creditor knows of any such arrangement, he must refrain from doing anything which would have the effect of discharging the surety under Sections 133, 134 or 135. Unless there is a specific agreement between the surety and the creditor to the effect that the principal debtor alone would be liable in the first instance, the creditor can proceed again the surety to the same extent as if he were himself the principal debtor. It would not be necessary first the realise the amount from the principal debtor.[x] A personal guarantee executed by the guarantor providing that the guarantee was to remain in force till the borrower paid the full loan amount on demand was held to be a continuing guarantee. The period of limitation started running on refusal by the borrower to fulfil the demand. After notice of revocation, any amount due from the surety in respect of pre-existing transactions, the payment for the same must be claimed within three years failing which it would become time-barred.

CONCLUSION

A contract of guarantee is thus an important legal agreement that ensures financial security by holding the guarantor responsible for the principal debtor’s obligations in the event of default. The validity of such contracts depends on essential features like the existence of a principal debt, legal consideration, proper disclosure of facts, and adherence to the relevant legal principles. The concepts of joint liability, suretyship, misrepresentation, and continuing guarantees further define the roles and responsibilities of the parties involved. These agreements provide creditors with additional assurance while offering legal clarity in complex financial transactions. Understanding the nuances of a contract of guarantee is essential for safeguarding the interests of all parties involved and promoting confidence in financial dealings. [i] Mountstephen v. Lakeman, (1871) LR 7 QB 196, 202. [ii] Harburg India Rubber Comb Co. v. Martin, (1902) I KB 778 (CA). [iii] Manju Mahadev v. Shivappa Manju Shetti, ILR (1918) 42 Bom 444. [iv] Mahabir Shum Sher v. Lloyds Bank, AIR 1968 Cal 371. [v] Yorkshire Railway Wagon Co. v. Maclure, 1881 19 Ch D 478. [vi] Narsapa Nikade v. Narshiv Shripat, ILR (1895) 19 Bom 697. [vii] Janaki Paul v. Dhokar Mall Kidarbux, (1935) 156 IC 200. [viii] SBI v. Kusum Vallabhdas Thakkar, (1994) 1 GLH 62. [ix] Karnataka State Industrial Investment Corporation v. State Bank of India, (2005) 1 CLT 437 (Kant, DB). [x] Medisetti Ravi Babu v. Pramida Chit Fund (P) Ltd., (2003) 2 BC 527.