This article has been written by Rashmi Sajanikar pursuing a Diploma in International Contract Negotiation, Drafting, and Enforcement, and has been edited by Shashwat Kaushik.
It has been published by Rachit Garg.
Table of Contents
The title of this paper makes it clear that it is an exhaustive topic in which we will take a trail into the ambit of surety’s rights.
A surety is a person who guarantees in the event of a debtor’s default. Guarantees are crucial documents that minimise the risk and uncertainty of any commercial transaction. At the outset, indemnification and surety seem similar, but they differ with respect to their object and level of responsibility. The object of a contract of guarantee is the security of the creditor. A contract of indemnity is for the protection of the promisee in the event of a likely loss. The liability of a surety is coextensive with that of the primary debtor, and the liability of an indemnifier is to protect the promise made by the primary debtor in case of default.
Who is surety
‘Surety’ is a person who takes responsibility in case of default to repay the loan taken by a person who is a ‘primary debtor’ from a person who is a ‘creditor.’
Section 126 of the Indian Contract Act, 1872 states that in a contract of guarantee, a person who gives a guarantee is a “surety”. Under the Indian Contract Act, the entire role of a surety is covered from Section 126 to Section 147. Under Section 5(22) of the Insolvency Bankruptcy Code, 2016 “personal guarantor” means an individual who is the surety in a contract of guarantee to a corporate debtor;
Let’s take a look at some important provisions pertaining to the rights of a surety. Rights and liabilities are two sides of a coin. Let’s begin with the liabilities of surety.
Liabilities of surety
Under Section 128 of the ICA, the liability of the surety is ‘coextensive’ with that of the principal debtor unless otherwise provided by the contract. If the principal debtor’s liability is reduced, for example, by selling some of the debtor, the liability of the surety is also reduced accordingly.
In Narayan Singh vs. Chattar Singh (1973), it was held that if the principal debtor’s liability is scaled down, the liability of the surety will also pro tanto be reduced.
A suretyship agreement follows the rules of an ordinary contract. Hence, these agreements must be free from coercion, undue influence, and misrepresentation. Therefore, the creditor owes a duty to confirm the fairness and free consent criteria for the suretyship agreement. A suretyship agreement must not be an unconscionable bargain.
Discharge of surety from liability
In the following situations, surety is discharged from liability:
- By revocation of the continuing guarantee by the surety (Section 130);
- By surety’s death (Section 131);
- By variance in the terms of the contract (Section 133);
- By release or discharge of principal debtor (Section 135); and
- By creditor’s act or omission impairing surety’s eventual remedy (Section 139).
Rights of surety
Obviously, ‘surety’ cannot come forward just to repay the loan money unless he has certain rights. Here, we will discuss rights accrued to a surety after payment of a loan. The rule of equity must always be considered in the guarantee contract. Before moving to Section 140 of the Indian Contract Act, 1872, i.e., rights of surety, let’s take a look at Section 130, which speaks about revocation by the surety. This Section states that a surety may at any time revoke the continuing guarantee as to future transactions by issuing a notice to the creditor.
Thus, Section 130 of the ICA indirectly envisages the surety’s right to discharge himself from liability. An exception to Section 130 of the ICA is when the surety enters into an agreement of continuous guarantee that expressly states that this agreement is to continue and remain in operation for all future transactions. The surety would not be open to recourse under Section 130.
Another important indirect right of a surety to absolve itself from liability is under Section 133. A surety enters into a contract of guarantee and incurs liability under certain terms. If these terms are changed, surety has every right to revoke the guarantee agreement.
A surety has threefold rights that are against the principal debtor, the creditor, and the co-sureties.
Rights against the principal debtor
- Right of subrogation- When the principal debtor makes a default in payment of debt and surety makes payment of debt, surety is liable for all the rights against the principal debtor as that of the creditor. In other words, the principal debtor steps in the shoes of the creditor. (Section 140)
- Right of Indemnity against the principal debtor- In case the principal debtor makes default in payment of a debt, Surety has to pay off the debt. Such rightfully paid sum under guarantee can be recovered by surety from the principal debt. Surety can not recover wrongfully paid debt. (Section 145)
Rights against the creditor
The surety is entitled to benefit from every security that the creditor has at the time when the contract of suretyship is entered into. If the creditor chooses to recover debt from the surety instead of the principal debtor, the surety will have the same rights as the creditor, whether the surety knows of the existence of such a security or not. If the creditor loses such security without the consent of the surety. The surety is discharged to the extent of the value of the security.
Here we are considering a few scenarios to illustrate rights against creditors.
- When the creditor receives securities at the time of the contract of guarantee.
If the creditor loses securities that he had at the time of the contract of guarantee, it results in the discharge of the surety’s liability to that extent.
For example- A gives an advance of Rs. 3000 to B. For this transaction, C is surety. B’s bicycle is also mortgaged to A for Rs. 3000 as additional security. A cancels a mortgage, and B becomes insolvent. Then C is discharged from the loan liability to the extent of the price of the bicycle.
- When the creditor loses securities.
The surety gets discharged from his liabilities if the creditor loses the securities. If, however, the hypothecated securities are lost without any negligence on the part of the creditor, the surety is not discharged.
- When the creditor receives securities, after the contract of guarantee.
Section 141 of the ICA states that a surety is entitled to the benefit of every security that the creditor has at the time when the contract of suretyship is entered into. Hence, if a creditor parted with the securities that he had obtained subsequent to the contract of guarantee, the surety would not be discharged as a consequence of the loss of such securities.
This point of a surety’s right is different in India and the UK. As per English law, a surety is liable for the benefit with respect to those securities that the creditor received after making the contract of guarantee.
- When the creditor has no possession of goods
Section 141 covers situations where the goods are in the possession of the creditor. For hypothecation, goods remain in the possession of the principal debtor. Thus, in the case of hypothecated goods, the creditor does not have possession of the goods, and the surety can not ask for rights.
Rights against the co-sureties
- Right of contribution against co-sureties (Section 146)
Section 146 speaks about equal contributions by the co-sureties when a guarantee agreement fulfils the following conditions.
- When two or more persons are co sureties;
- For the same debt or duty;
- Jointly or severally;
- For same or different contracts;
- With or without the knowledge of each other;
- No contract to the contrary.
- Co-sureties bound in different sums (Section 147)
Section 147 speaks about the different contribution amounts made by each surety. Then, in such cases, each surety is liable to pay equally as far as the limits of their respective obligations permit. If one of the co-sureties is released from liability, the other co-sureties may still be liable.
Surety’s rights vis-a-vis bank guarantee
A bank guarantee is the most important and reliable type of guarantee in today’s business world. Bank guarantees mitigate risk in commercial transactions. A bank guarantee is a guarantee given by the bank so that if there is a failure on the part of the debtor or creditor, the bank will indemnify the party who has suffered the loss. Courts in India consistently held that the contract created between the creditor and the bank is separate from the original contract between the buyer and the seller, and because the bank’s undertaking to the creditor is absolute and unconditional, there is no need for any interventions from courts, as interventions from courts may destroy the very essence of the bank guarantee.
Rights of the bank as a surety
As stated above, courts in India are not inclined towards interfering in bank guarantee agreements or granting an injunction to restrain a bank guarantee. However, Indian courts do recognise the rights of a bank as a surety, even if the guarantee is unconditional and irrevocable, and allow banks to revoke their guarantee in the case of the following two exceptions.
By applying the basic principles of fair and informed contract acceptance, any kind of fraud vitiates the bank guarantee agreement.
- Irretrievable harm or injustice
If allowing the encashment of an unconditional bank guarantee would result in irretrievable harm or injustice to one of the parties, the bank, as a surety, has every right to not adhere to the guarantee agreement.
State of Madhya Pradesh vs. Kaluram (1966)
In this case, an auction was held by the forest officer in the state of Madhya Pradesh for the sale of fallen trees. Jagatram won the auction as he was the highest bidder, and the contract was executed between Jagtram and the Government of MP, where it was decided that the payment would be made in instalments. Nathuram and Kaluram were made sureties in the event of a default in payment by Jagatram. Jagatram cleared the trees and made the first instalment, but he failed to pay the due amount of the second instalment. So the surety was asked to pay the outstanding amount as listed in the contract. The Hon’ble Supreme Court held that the authorities were negligent and should not have let Jagatram clear the forest without the complete payment of the loan. The Court was of the view that this mistake was on the part of the creditor, so the surety cannot be held liable to pay the amount.
Rajappan vs. Associated Industries Pvt. Ltd. (1990)
In this case, an agreement of guarantee was drafted between the plaintiff and the defendant on account of a loan given to him. The plaintiff is the creditor, the first defendant is the principal debtor, and the second defendant is the surety. At the time of the signing of the contract, the second defendant, who is the surety, didn’t actually sign it and left the plaintiff’s office, stating that he was getting late for some urgent business and told them that he would sign it later. When the principal debtor failed to clear the debt, the creditor asked the surety to pay the money. But the surety refused to pay the outstanding amount because he never actually signed the contract. The plaintiff filed a suit in this regard. The Hon’ble Kerala High Court said that the surety cannot take the defence of not signing the contract and cannot be discharged from his liability. The Court further stated that it’s not necessary to sign the contract, but implied consent would also be considered consent.
Surety gives certainty to many business transactions. Most of the time, the rights of the surety arise after the surety pays money after the principal debtor defaults. As considered above, the surety’s rights are different for the creditor, the principal debtor, and other co-sureties. It is a duty of the judiciary to protect the interests of a surety who has given timely help in a crisis or who has helped in uplifting any business venture.
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