What is Contract of Guarantee?
“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.” (Sec. 126).
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Example: A asks B to give a loan of ₹1,000 to C promising that if C does not return the amount, he (A) will pay the amount.
In the above example, A is the surety, B is the creditor and C is the principal-debtor. A guarantee is a promise to pay a debt owed by a third person in case the latter does not pay. Any guarantee given may be oral or written. From the above definition, it is clear that in a contract of guarantee there are, in effect three contracts:
- A principal contract between the principal debtor and the creditor.
- A secondary contract between the creditor ad the surety.
- An implied contract between the surety and the principal debtor whereby principal debtor is under an obligation to indemnify the surety; if the surety is made to pay or perform.
The right of surety is not affected by the fact that the creditor has refused to sue the principal debtor or that he has not demanded the sum due from him.
Features of Contract of Guarantee
A contract of guarantee is a species of general contract and as such, all the essentials of a valid contract must be present. However, it has the following special features:
- Surety’s Obligation is Dependent on Principal Debtor’s Default
- Separate Consideration for Guarantee Not Necessary
- Principal-debtor Need Not Be Competent to Contract
- There Must Be Existing Debt or Promise Whose Performance Is Guaranteed
Surety’s Obligation is Dependent on Principal Debtor’s Default
There must be a conditional promise to pay on the default of the principal-debtor. If the promise is not conditional on default, it will not be a contract of guarantee but of indemnity.
Example: A asks B to sell certain goods on credit to C promising “I will pay the amount in case C fails to pay.” It is a contract of guarantee as the promise is contingent on the default of C.
Separate Consideration for Guarantee Not Necessary
For a contract of guarantee, like any other contract, consideration is necessary. But 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.
Thus, there is no need for separate consideration between the principal-debtor and the surety. Consideration received by the principal-debtor is sufficient for the surety. For example, in the example given above, goods to be received by the buyer is sufficient consideration for the surety and no separate consideration is necessary.
Principal-debtor Need Not Be Competent to Contract
Although the creditor and the surety must be capable of entering into the contract, yet, the principal-debtor need not be competent to contract. In such a case the principal-debtor is not liable but the surety is liable as the principal-debtor.
There Must Be Existing Debt or Promise Whose Performance Is Guaranteed
For a contract of guarantee, there must be an existing debt or a promise whose performance is guaranteed. In case there is no such debt or promise, there cannot be a valid guarantee. Actually speaking, the debt or promise is the basis of a guarantee, i.e., it is the consideration received by the debtor. Hence, if there is no consideration, there is no contract or guarantee.
However, the debt may even be void. In that case, the surety himself will be liable to pay the debt. Strictly speaking, a contract of guarantee is not a contract of uberrimae fidei, i.e., a contract of good faith requiring full disclosure of material facts likely to affect the willingness of the guarantor. However, there should not be any misrepresentation or active concealment of material facts by the creditor.
Difference between Contract of Indemnity and Contract of Guarantee
Following are points of difference between contract of indemnity and contract of guarantee:
Difference between Contract of Indemnity and Contract of Guarantee
| Basis | Indemnity | Guarantee |
| 1. Meaning | It is a contract to make good the loss of the other party. | It is a contract to perform the promise or discharge the liability of a third party in case of his default. |
| 2. Parties | There are only 2 parties i.e., the indemnifier and the indemnified. | There are 3 parties i.e., the surety, the creditor and the principal-debtor. |
| 3. Number of Contracts | It is a simple contract consisting only of one agreement between the indemnified and indemnity-holder. | In a contract of guarantee, there are three agreements. One agreement between the creditor and the principal debtor, the second between the creditor and the surety and the third between the surety and principal- debtor. |
| 4. Contingency | In the case of indemnity, the liability of the indemnifier is dependent on the happening of a contingency. | In the case of guarantee, there is an existing debt or duty, the performance of which is guaranteed. However, the liability is contingent upon non-payment. |
| 5. Nature of surety’s liability | The liability of the indemnifier is primary. | The liability of the surety, is secondary i.e.,” the surety is liable only if the principal- debtor does not pay the amount. The liability of the principal- the debtor is primary. |
| 6. Right to sue after the performance | In the case of indemnity, except in rare cases, the indemnifier cannot recover his loss from a third party. | In case of guarantee, if the surety has paid the debt, he steps into the shoes of the creditor and can recover his loss from the principal-debtor. |
| 7. Indemnity holder cannot sue in his own name | An indemnity-holder cannot sue a third party in his own name. Assignment in favour of indemnity-holder is necessary. | A surety can sue in his own name. No such assignment is necessary. |
| 8. Request to act | Indemnifier does not act at the request of the indemnified. | A surety has to act at the request of the debtor. |
| 9. Capacity to contract | All the parties must be capable of contracting. | The principal-debtor may be a minor. In that case, the surety will be liable. |
Types of Guarantee
A guarantee is given for the performance of a promise or discharge of a liability. Thus guarantee may be of the following types of guarantee:
- Fidelity guarantee
- Guarantee for Repayment of a Debt
- Specific Guarantee
- Continuing Guarantee
- Retrospective Guarantee
- Prospective Guarantee
- Guarantee for the Entire Debt
- Guarantee for a Part of the Debt
Fidelity guarantee
Fidelity guarantee: Guarantee given for good conduct and honesty of an-employee is called fidelity guarantee.
Guarantee for Repayment of a Debt
Guarantee for repayment of a debt: A guarantee given for repayment of a loan or debt is called a guarantee for repayment of debt.
Specific Guarantee
Specific guarantee: A specific guarantee is given in respect of a single debt or transaction. For example, A asks B to give a loan of ₹500 to C promising to pay the amount on the failure of C to pay the amount.
Continuing Guarantee
Continuing guarantee: Where the guarantee extends to a number of transactions, it is called continuing guarantee. Even a fidelity guarantee is also a continuing guarantee as it continues for a period of time.
Example: A asks a shopkeeper to sell goods on credit to B up to a limit of ₹1,000 during the next month, promising to pay the amount on B’s default. This is a continuing guarantee and A is liable up to ₹1,000 on default of B.
Retrospective Guarantee
Retrospective guarantee: The retrospective guarantee is given for existing debt.
Prospective Guarantee
Prospective guarantee: Prospective guarantee is given for future debt, i.e., a debt to be taken in future.
Guarantee for the Entire Debt
Guarantee for the entire debt: Where the whole of the debt is guaranteed, it is called a guarantee for the entire debt.
Guarantee for a Part of the Debt
Guarantee for a part of the debt: A surety can limit his liability, where he feels that he cannot undertake responsibility for the whole of the debt. He may guarantee a part of the debt.
Revocation of Guarantee
So far as a guarantee given for an existing debt is concerned, it cannot be revoked, as once an offer is accepted it becomes final. However, a guarantee for a future debt or continuing guarantee can be revoked for future transactions. In that case, the surety shall be liable for those transactions which have already taken place.
How Continuing Guarantee Revoked?
A continuing guarantee can be revoked in any of the following ways:
- By Notice: A continuing guarantee may at any time be revoked by the surety as to future transactions by notice to the creditor (Sec. 130).
Examples: (1) A gives a loan of ₹1,000 to B on the guarantee of C. C cannot revoke his guarantee. (2) A stands surety for any credit purchases upto ₹1,000 to be. made by B from a shop-keeper. After the shop-keeper has supplied goods worth ₹500, A gives a notice to the shop- keeper not to sell goods to B in future. A is liable for the purchases already made. However, he will not be liable for any purchases made after the notice of revocation. - By Death: The death of a surety operates in the absence of a contract to the contrary, as a revocation of a continuing guarantee, so far as regards future transactions (Section 131). However, it should be noted that the notice of death is not necessary.
Rights of Surety
A contract of guarantee confers the following rights on the surety:
Rights Against the Creditor
- Rights before making payment: In case of continuing guarantee or fidelity guarantee, a surety can ask the creditor not to sell goods on credit or to give credit in future. Similarly, in the case of a fidelity guarantee, the surety can ask the creditor (employer) to dismiss the employee.
Where the surety discovers that the employee had misconducted himself in that post or had been dishonest. A surety can also file a suit for declaration that only the principal-debtor shall be liable to pay the amount. - Rights at the Time of Making Payment: At the time of making payment, a surety can compel the creditor to release those securities first, which are in the creditor’s possession.
- Rights After Making Payment: Rights to securities (Section 141). A surety is entitled to the benefit of every security which the creditor has against the principal-debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not.
If the creditor loses or without the consent -of the surety, parts with such security, the surety is discharged to the extent of the value of the security.
Example. C advances to B, his tenant, 2,000 rupees on the guarantee of A. C has also a further security for the 2,000 rupees by mortgage of B’s furniture. C cancels the mortgage. B becomes insolvent, and C sties A on his guarantee.
A is discharged from his liability to the extent of the value of the furniture. (ii) Right to claim set-off – A surety can ask the creditor to set off or adjust any claim which the debtor has against the creditor.
Rights Against Principal Debtor
- Rights of subrogation (Sec. 140): Where a guaranteed debt has become, due, the surety upon payment or performance of all that he is liable for, is ‘invested with all the rights which the creditor had against the principal-debtor. In simple words a surety steps into the shoes of the creditor on making, the payment of the debt.
- Rights of indemnity (Sec. 145): In every contract of guarantee there is an implied promise by the principal-debtor to indemnify the surety. The surety is entitled to recover from the principal-debtor all payment properly made, i.e., amount paid with interest and any damage or cost incurred
Example: B is indebted to C, and A is surety for the debt. C demands payment from A, and on his refusal sues him for the amount. A defends the suit, having reasonable grounds for doing so, but is compelled to pay the amount of the debt with costs.
He can recover from B the amount paid by him for the costs including the principal debt. If, in the above example, A defends himself without reasonable ground, then he can recover the principal debt but not the costs.
Rights against Co-sureties
When a debt is guaranteed by two or more sureties, each of them is called a co-surety.
Co-sureties liable to contribute equally (Sec. 146)
Where two or more persons are co-sureties for the same debt or duty, either jointly or severally, and whether under the same or different contracts, and even with or without the ‘knowledge of each other, the co-sureties, in the absence of any contract to the contrary, are liable as between themselves, to pay each an equal share of the whole debt, or of that part of it which remains unpaid by the principal-debtor.
Examples: 1. A, B and C jointly guarantee a sum of ₹3,000 lent by D to E. E makes a default in payment. A, B and C are liable to contribute 1,000 rupees each. 2. If A, B and C agree to share the guarantee in the ratio of 3: 2: 1 then their liability is 1,500, 1,000 and 500 rupees respectively.
Liability of Co-sureties Bound in Different Sums (Section 147)
Co-sureties who are bound in different sums are liable to pay equally as far as limits of their respective obligations permit.
Example: In the above case, if E makes default of ₹1,500, then each of them is liable to 500 rupees. Supposing E makes default of ₹2,000, then C will be liable to pay 500 rupees, and A and B to the extent of 750 each.
