Contract OF Guarantee - Lecture notes 1 PDF

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CONTRACT OF GUARANTEE Introduction Black laws dictionary defines the term guarantee as the assurance that a legal contract will be duly enforced. A contract of guarantee is governed by the Indian Contract Act,1872 and includes 3 parties in which one of the parties acts as the surety in case the defaulting party fails to fulfill his obligations. Contracts of guarantee are mostly required in cases when a party requires a loan, goods or employment. The guarantor in such contracts assures the creditor that the person in need may be trusted and in case of any default, he shall undertake the responsibility to pay. Thus we can say contract of guarantee is invisible security given to the creditor and shall be discussed further Definition and Meaning Guarantee is an undertaking to answer for another’s liability and collateral thereto. It is a collateral undertaking to pay the debt of another in case he does not pay it. It is a provision to answer for the payment of some debt, or the performance ofsome duty in the case of failure ofsome person who, in the first instance, is liable for such payment or performance. Bouvier’s Law Dictionary gives the meaning of guarantee as a promise to answer for the debt, default, or miscarriage of another person. Guarantee is an. undertaking to be collaterally responsible for the debt, default or miscarriage of another. In a banking context it is an undertaking given by the guarantor to the banker accepting responsibility for the debt of the principal debtor, the customer, should he or she default. The guarantor may or may not be a customer A Guarantee is a promise by one person, who is called the ‘guarantor’ or ‘surety’ to answer for the present or future debt of another person who is called the ‘principal debtor’, such promise being made to the party to whom the principal debtor is, or will become, liable In India, Contract of Guarantee is included in the Indian Contract Act, 1872 and is defined under section 126 as follows : 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. Illustration

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Ankita advances a loan of INR 70000 to Pallav. Srishti who is the boss of Pallav promises that in case Pallav fails to repay the loan, then she will repay the same. In this case of a contract of guarantee, Ankita is the Creditor, Pallav the principal debtor and Srishti is the Surety. A contract of guarantee may either be oral or written. It may be express or implied from the conduct of parties. In P.J. Rajappan v Associated Industries(1983) the guarantor, having not signed the contract of guarantee, wanted to wriggle out of the situation. He said that he did not stand as a surety for the performance of the contract. Evidence showed the involvement of the guarantor in the deal and had promised to sign the contract later. The Kerala High Court held that a contract of guarantee is a tripartite agreement, involving the principal debtor, surety and the creditor. In a case where there is evidence of the involvement of the guarantor, the mere failure on his part in not signing the agreement is not sufficient to demolish otherwise acceptable evidence of his involvement in the transaction leading to the conclusion that he guaranteed the due performance of the contract by the principal debtor. When a court has to decide whether a person has actually guaranteed the due performance of the contract by the principal debtor all the circumstances concerning the transactions will have to be necessarily considered. Essentials of a Contract of Guarantee

1) Must be made with the agreement of all three parties All the three parties to the contract i.e the principal debtor, the creditor, and the surety must agree to make such a contract with the agreement of each other. Here it is important to note that the surety takes his responsibility to be liable for the debt of the principal debtor only on the request of the principal debtor. Hence communication either express or implied by the principal debtor to the surety is necessary. The communication of the surety with the creditor to enter into a contract of guarantee without the knowledge of the principal debtor will not constitute a contract of guarantee.

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Illustration Sam lends money to Akash. Sam is the creditor and Akash is the principal debtor. Sam approaches Raghav to act as the surety without any information to Akash. Raghav agrees. This is not valid. 2) Consideration According to section 127 of the act, anything is done or any promise made for the benefit of the principal debtor is sufficient consideration to the surety for giving the guarantee. The consideration must be a fresh consideration given by the creditor and not a past consideration. It is not necessary that the guarantor must receive any consideration and sometimes even tolerance on the part of the creditor in case of default is also enough consideration. In State Bank of India v Premco Saw Mill(1983), the State Bank gave notice to the debtordefendant and also threatened legal action against her, but her husband agreed to become surety and undertook to pay the liability and also executed a promissory note in favor of the State Bank and the Bank refrained from threatened action. It was held that such patience and acceptance on the bank’s part constituted good consideration for the surety.

3) Liability In a contract of guarantee, the liability of a surety is secondary. This means that since the primary contract was between the creditor and principal debtor, the liability to fulfill the terms of the contract lies primarily with the principal debtor. It is only on the default of the principal debtor that the surety is liable to repay.

4) Presupposes the existence of a Debt The main function of a contract of guarantee is to secure the payment of the debt taken by the principal debtor. If no such debt exists then there is nothing left for the surety to secure. Hence in cases when the debt is time-barred or void, no liability of the surety arises. The House of Lords

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in the Scottish case of Swan vs. Bank of Scotland (1836) held that if there is no principal debt, no valid guarantee can exist.

5) Must contain all the essentials of a valid contract Since a contract of guarantee is a type of contract, all the essentials of a valid contract will apply in contracts of guarantee as well. Thus, all the essential requirements of a valid contract such as free consent, valid consideration offer, and acceptance, intention to create a legal relationship etc are required to be fulfilled. 6) No Concealment of Facts The creditor should disclose to the surety the facts that are likely to affect the surety’s liability. The guarantee obtained by the concealment of such facts is invalid. Thus, the guarantee is invalid if the creditor obtains it by the concealment of material facts. 7) No Misrepresentation The guarantee should not be obtained by misrepresenting the facts to the surety. Though the contract of guarantee is not a contract of Uberrima fides i.e., of absolute good faith, and thus, does not require complete disclosure of all the material facts by the principal debtor or creditor to the surety before he enters into a contract. But the facts, that are likely to affect the extent of surety’s responsibility, must be truly represented Kinds of guarantee Contracts of guarantees may be classified into two types: Specific guarantee and continuing guarantee. When a guarantee is given in respect of a single debt or specific transaction and is to come to an end when the guaranteed debt is paid or the promise is duly performed, it is called a specific or simple guarantee. However, a guarantee which extends to a series of transactions is called a continuing guarantee (Section129). The surety’s liability, in this

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case, would continue till all the transactions are completed or till the guarantor revokes the guarantee as to the future transactions. Illustrations a) S is a bookseller who supplies a set of books to P, under the contract that if P does not pay for the books, his friend K would make the payment. This is a contract of specific guarantee and K’s liability would come to an end, the moment the price of the books is paid to S. b) On M’s recommendation S, a wealthy landlord employs P as his estate manager. It was the duty of P to collect rent every month from the tenants of S and remit the same to S before the 15th of each month. M, guarantee this arrangement and promises to make good any default made by P. This is a contract of continuing guarantee.

Continuing guarantee A continuing guarantee is defined under section 129 of the Indian Contract Act,1872. A continuing guarantee is a type of guarantee which applies to a series of transactions. It applies to all the transactions entered into by the principal debtor until it is revoked by the surety. Therefore Bankers always prefer to have a continuing guarantee so that the guarantor’s liability is not limited to the original advances and would also extend to all subsequent debts. The most important feature of a continuing guarantee is that it applies to a series of separable, distinct transactions. Therefore, when a guarantee is given for an entire consideration, it cannot be termed as a continuing guarantee. Illustration K gave his house to S on a lease for ten years on a specified lease rent. P guaranteed that S, would fulfill his obligations. After seven years S stopped paying the lease rent. ‘K sued him for the payment of rent. P then gave a notice revoking his guarantee for the remaining three years. P would not be able to revoke the guarantee because the lease for ten years is an entire indivisible 5

consideration and cannot be classified as a series of transactions and hence is not a continuing guarantee.

Revocation of Continuing 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 continuing guarantee can be revoked for future transactions. In that case, the surety shall be liable for those transactions which have already taken place. A contract of guarantee can be revoked in the following two ways-

1) By giving a notice (Section 130) Continuing guarantees can be revoked by giving notice to the Creditor but this applies only to future transactions. Just by giving a notice the surety cannot waive off his responsibility and still remains liable for all the transactions that have been placed before the notice was given by him. If the contract of guarantee includes a clause that a notice of a certain period of time is required before the contract can be revoked, then the surety must comply with the same as said in Offord v Davies (1862). Illustration A guarantees to B to the extent of Rs. 10,000, that C shall pay for all the goods bought by him during the next three months. B sells goods worth Rs. 6,000 to C. A gives notice of revocation, C is liable for Rs. 6,000. If any goods are sold to C after the notice of revocation, A shall not be, liable for that.

2) By Death of Surety(Section 131) Unless there is a contract to the contrary, the death of surety operates as a revocation of the continuing guarantee in respect to the transactions taking place after the death of surety due to the absence of a contract. However, his legal representatives will continue to be liable for 6

transactions entered into before his death. The estate of deceased surety is, however, liable for those transactions which had already taken place during the lifetime of the deceased. Surety’s estate will not be liable for the transactions taking after the death of surety’even if the creditor had no knowledge of surety’s death.

Period of Limitation The period of limitation of enforcing a guarantee is 3 years from the date on which the letter of guarantee was executed. In State Bank Of India vs Nagesh Hariyappa Nayak And Ors, against the advancement of a loan to a company, the guarantee deed was executed by its directors and subsequently a letter acknowledging the load was issued by same directors on behalf of the company. It was held that the letter did not have the effect of extending the period of limitation. Recovery proceedings instituted after three years from the date of the deed of guarantee were liable to be quashed.

Rights of a Surety After making a payment and discharging the liability of the principal debtor, the surety gets various rights. These rights can be studied under three heads: (i) rights against the, principal debtors. (ii) rights against the creditor, and (iii) rights against the co-sureties.

(i) Rights against the Principal Debtor

1) The right of surety on payment of debt or the Right of subrogation(Section 140)

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The right of subrogation means that since the surety had given a guarantee to the creditor and the creditor after getting the payment is out of the scene, the surety will now deal with the debtor as if he is a creditor. Hence the surety has the right to recover the amount which he has paid to the creditor which may include the principal amount, costs and the interest.

2) The right of Indemnity(Section 145) In every contract of guarantee, there is an implied promise by the principal debtor to indemnify the surety, and the surety is entitled to recover from the principal debtor whatever sum he has rightfully paid under the guarantee. This is because the surety has suffered a loss due to the nonfullfillment of promise by the principal debtor and therefore the surety has a right to be compensated by the debtor Illustration Luthra and co has taken a loan from Khaitan and co where Amarchand acts as security on behalf of Luthra. Khaitan demands payment from Amarchand and on his refusal sues him for the amount, Amarchand defends the suit having reasonable grounds for doing so, but he is compelled to pay the amount of the debt with costs. He can recover from Luthra the amount paid by him for costs, as well as the principal debt.

(ii) Rights against the Creditor

1) Right to securities given by the principal debtor(section 141) On the default of payment by the principal debtor, when the surety pays off the debt of the principal debtor he becomes entitled to claim all the securities which were given by the principal debtor to the creditor. The Surety has the right to all securities whether received before or after the creation of the guarantee and it is also immaterial whether the surety has knowledge of those securities or not. Illustration On the guarantee of Priya, Anita lent rs 100000 to Sita. This debt is also secured by security for

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the debt which is the lease of Sita’s house. Sita defaults in paying the debt and Priya has to pay the debt. On paying off Sita’s liabilities Priya is entitled to receive the lease deed in her favor.

2) Right to set off When the creditor sues the surety for the payment of principal debtor’s liabilities, the surety can claim set off, or counterclaim if any, which the principal debtor had against the creditor.

(iii) Rights against the Co-sureties

1) Release of one co-surety does not discharge others (Section 138) When the repayment of debt of the principal debtor is guaranteed by more than one person they are called Co-sureties and they are liable to contribute as agreed towards the payment of guaranteed debt. The release by the creditor of one of the co-sureties does not discharge the others, nor does it free the released surety from his responsibility to the other sureties. Thus when the payment of a debt or performance of duty is guaranteed by co-sureties and the principal debtor has defaulted in fulfilling his obligation and thus the creditor compels only one or more of the co-sureties to perform the whole contract, the co-surety sureties performing the contract are entitled to claim contribution from the remaining co-sureties.

2) Co-sureties to contribute equally (Section 146) According to Section 146, in the absence of any contract to the contrary, the co-sureties are liable to contribute equally. This principle will apply even when the liability of co-sureties is joint or several, and whether under the same or different contracts, and whether with or without the knowledge of each other. Illustration A, B, C, and D are co-sureties for a debt of Rs. 2,0000 lent by Z to R. R defaults in repaying the loan. A, B, C, and D are liable to contribute Rs. 5000 each.

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3) Liability of co-sureties bound in different sums(Section 147) When the co-sureties have agreed to guarantee different sums, they have to contribute equally subject to the maximum of the amount guaranteed by each one. Illustration A, B and C, sureties for D, enter into three separate bonds, each in a different penalty, A for Rs. 10,000, B for Rs. 20,000 and C for Rs. 40,000. D makes default to the extent of Rs. 30,000. A B and C are liable to pay Rs. 10,000 each. Suppose this default was to the extent of Rs. 40,000. Then A would be liable for Rs. 10,000 and B and C Rs. 15,000 each.

Discharge of Surety from Liability Under any of the following circumstances a surety is discharged from his liability: i) by the revocation of the contract of guarantee, ii) by the conduct of the creditor, or iii) by the invalidation of the contract of guarantee We have already discussed above the first circumstance in which how a surety can be discharged i.e by Revocation of the Contract of Guarantee. This includes by giving notice or death or the surety. (ii) Conduct of the Creditor

1) Variance in terms of the contract(Section 133) When a contract of guarantee has been materially altered through an agreement between the creditor and principal debtor, the surety is discharged from his liability. This is because a surety

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is liable only for what he has undertaken in the guarantee and any alteration made without the surety’s consent will discharge the surety as to transactions subsequent to the variation. Illustration A becomes surety to C for B’s conduct as a manager in C’s bank. Afterward, B and C contract, without A’ s consent, that B’ s salary shall be raised, and that he shall become liable for onefourth of the losses on overdrafts. B allows a customer to over-draw, and the bank loses a sum of money. A is discharged from his suretyship by the variance made without his consent and is not liable to make good this loss.

2) Release or discharge of the principal debtor(Section 134) A surety is discharged if the creditor makes a contract with the principal debtor by which the principal debtor is released, or by any act or omission of the creditor, which results in the discharge of the principal debtor. Illustration A supplies goods to B on the guarantee of C. Afterwards B becomes unable to pay and contracts with A to assign some property to A in consideration of his releasing him from his demands on the goods supplied. Here, B is released from his debt, and C is also discharged from his suretyship. But, where the principal debtor is discharged of his debt by operation of law, say, on insolvency, this will not operate as a discharge of the surety.

3) Arrangement between principal debtor and creditor According to section 135 when the creditor, without the consent of the surety, makes an arrangement with the principal debtor for composition, or promise to give him time to, or not to sue him, the surety will be discharged.However, when the contract to allow more time to the principal debtor is made between the creditor and a third party, and not with the principal debtor, the surety is not discharged (Section 136).

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Illustration C, the holder of an overdue bill of exchange drawn by ...