Introduction to Contract of Guarantee

INTRODUCTION

A contract of guarantee is a legal agreement involving three parties: the creditor, the principal debtor, and the guarantor. Under this contract, the guarantor agrees to take responsibility for the obligations of the principal debtor if they fail to fulfil their commitment. This type of contract is commonly used to ensure the repayment of loans, secure performance under contracts, or uphold financial obligations. For the contract to be legally valid, it must involve mutual consent, be supported by consideration, and follow the relevant legal requirements. There are different types of guarantees, such as financial guarantees to ensure debt repayment and performance guarantees to ensure contractual duties are met. The guarantor’s liability arises only if the principal debtor defaults on their obligations. This contract provides creditors with added security and fosters trust in financial and contractual arrangements.

ECONOMIC FUNCTIONS OF GUARANTEE

Section 126 of the Indian Contract Act of 1872 defines a contract of guarantee to be “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.” The function of a contract of guarantee is to enable a person to get a loan, or goods on credit, or an employment. Some person comes forward and tells he lender, or the supplier or the employer that he (the person in need) may be trusted or and in case of any default, “I undertake to be responsible”. For example, in the old case of Birkmyr v. Darnell,[i] the court said: “If two come to a shop and one buys, and the other to give him credit, promises the seller, ‘If he does not pay you, I will’.” This type of collateral undertaking to be liable for the default of another is called a “contract of guarantee”. In English law a guarantee is defined as “a promise to answer for the debt, default or miscarriage of another”.[ii] It is a collateral engagement to be liable for the debt of another in case of his default. “Guarantees are usually taken to provide a second pocket to pay if the first should be empty.”[iii]

PARTIES

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”.

INDEPENDENT LIABILITY DIFFERENT FROM GUARANTEE

There must be a conditional promise to be liable on the default of the principal debtor. A liability which is incurred independently of a “default” is not within the definition of guarantee.[iv] To refer again to Birkmyr v. Darnell, where referring to the buyer’s companion, the court further said that if the companion had said: “Let him have the goods, I will be your pay master or I will see you paid. This would have been an undertaking as for himself and is not a guarantee.”[v] This principle was applied in Taylor v. Lee[vi] decided in the US: A landlord and his tenant went to the plaintiff’s store. The landlord said to the plaintiff: Mr Parker will be on our land this year, and you will sell him anything he wants, and I will see it paid. This was held to be an original promise, and not a collateral promise to be liable for the default of another and, therefore, not a guarantee. The undertaking by a bank in the shape of a bank guarantee is also in the nature of an independent obligation payable on demand. It has nothing to do with the state of relations between the parties to the contract. It is a suitable method of securing payment in commercial dealings. The beneficiary is entitled to realise the whole of the amount under the guarantee irrespective of pending disputes between the parties.[vii] Where only an assurance for repayment of amount due from the loanee was given by means of a letter, the court said that it could not be construed as a deed of guarantee. The writer of the letter was accordingly held not liable.[viii] Where a letter of comfort was issued by a holding company in favour of its associate company that it had capabilities of meeting its financial and contractual obligations, the court said that the letter was in the nature of a recommendatory document. It could not be construed as a guarantee there being nothing in it showing that the holding company was understanding to discharge any liability of its associate in the event of the latter’s default.[ix]

EXTENT OF A SURETY’S LIABILITY

The fundamental principle about the surety’s liability, as laid down in Section 128, is that the liability of the surety is co-extensive with that of the principal debtor. There surety may however, by an agreement place a limit upon his liability. This is stated in Section 128 that the “the liability of the surety is co- extensive with that of the principal debtor, unless it is otherwise provided by the contract.”

1. Co-Extensive

The first principle governing surety’s liability is that it is co-extensive with that of the principal debtor. The expression “co-extensive with that of the principal debtor” shows the maximum extent of the surety’s liability. He is liable for the whole of the amount for which the principal debtor is liable and he is liable for no more. Where the principal debtor acknowledges liability and this has the effect of extending the period of limitation against him, the surety also becomes affected by it.[x] Where there is a condition precedent to the surety’s liability, he will not be liable unless that condition is first fulfilled. A partial recognition of this principle is to be found in Section 144 which says that “where a person gives a guarantee upon a contract that the creditor shall not act upon it until another person has joined in it as co-surety, the guarantee is not valid if that other person does not join.” Where the liability is otherwise unconditional, the court cannot of its own introduce a condition into it.[xi]

2. Surety’s right to limit his liability or make it conditional

It is open to the surety to place a limit upon his liability. He may expressly declare his guarantee to be limited to a fixed amount, for example that “my liability under this guarantee shall not at any time exceed the sum of INR 250.” In such a case, whatever may be owing from the principal debtor, the liability of the surety cannot go beyond the sum specified. Whether the obtaining of a collateral security by a lender is a term or condition precedent to liability being imposed on a guarantor under his guarantee depends on a proper analysis of the contractual relationship between the lender and the guarantor.

LIABILITY UNDER CONTINUING GUARANTEE

Section 129 defines continuing guarantee as a guarantee which extends to a series of transactions. A guarantee of this kind is intended to cover a number of transactions over a period of time. The surety undertakes to be answerable to the creditor for his dealings with the debtor for a certain time. A guarantee for a single specific transaction comes to an end as soon as the liability under that transaction ends. A bank guarantee is a sort of an absolute undertaking to pay the amount whenever demanded by the guarantee-holder. It has nothing to do with the state of relations between the guarantee-holder and the person on whose behalf the guarantee was given. While ordinary guarantees are linked to and dependant on the underlying transaction, a bank guarantee is an arrangement where the guarantee is independent of the underlying transaction. There are professional guarantors for whom the issue of guarantees or bonds is a financial service, namely banks, insurance companies or bond companies who issue guarantees at a certain fee.[xii] A guarantee for the appointment of an agent has been held to be not a continuing guarantee.  

CONCLUSION

A contract of guarantee is thus a vital legal mechanism that provides financial security and trust in various transactions by ensuring that obligations are met even if the principal debtor defaults. It involves three parties—the creditor, the principal debtor, and the guarantor (or surety)—and can take different forms, such as financial guarantees, performance guarantees, and bank guarantees. The surety’s liability is generally co-extensive with that of the principal debtor unless limited by contractual terms. Furthermore, a continuing guarantee extends to a series of transactions over time, offering flexibility and assurance in ongoing financial and commercial relationships. Understanding the distinctions between independent obligations and guarantees, as well as the scope of the surety’s liability, is essential to ensure clarity and fairness in contractual dealings. These principles, as outlined under the Indian Contract Act and common law, foster confidence in economic activities and provide legal recourse in case of defaults.   [i] Birkmyr v. Darnell, 91 ER 27: 1 Salk 27. [ii] Section 4, Statute of Frauds 1677, 29 Car, II C 3. [iii] Wood, Law and Practice of International Finance (1980) 295. [iv] Punjab National Bank v. Sri Vikram Cotton Mills, (1970) 1 SCC 60. [v] Observations to the same effect in Nanak Ram v. Mehin Lal, ILR (1877) 1 All 487. [vi] Taylor v. Lee, (1924) 121 SE 659. [vii] Pollen Dealcom (P) Ltd. v. Chambal Fertilizers & Chemicals, (2010) 92 AIC 695 (Cal). [viii] Indian Overseas Bank v. SNG Castorete (P) Ltd., AIR 2002 Del 309. [ix] Untied Breweries (Holding) Ltd. v. Karnataka State Industrial Investment and Development Corporation, AIR 2012 Kar 65 (DB). [x] Bank of India v. Surendra Kumar Mishra, (2003) I BC 45 (Jhar). [xi] Bank of Bihar Ltd. v. Damodar Prasad, AIR 1969 SC 297. [xii] State Trading Corporation of India Ltd. v. Golodetz Ltd., (1989) 2 Lloyd’s Rep 277 (CA).