In this article Karan Singh of Jindal Global Law School and Ria Verma, a student at Symbiosis Law School, NOIDA, discusses the Contract of guarantee in the Indian Contract Act, 1872.

The Indian Contract Act , 1872

Section 126 of Indian Contract Act defines Contract of guarantee. It defines a contract of guarantees a contract to perform the promise or discharge the liability of a third person in case of his default. ^[1]

The person who gives the guarantee is called “surety”. The person of whose default the guarantee is given is called the “Principal debtor”. The person to whom the guarantee is given is called the creditor.

Contract of guarantee can be of two types. It can be oral or written. However, for a contract to form in between the parties there should be meeting of minds that means all three parties should be privy to the contract. Contract of guarantee is a promise to answer for the payment of the debt that the principal debtor takes from the creditor or the performance of some duty. IN case the principal debtor fails who is in the first instance liable to pay or perform. Therefore, the primary liability to pay is of the principal debtor. Whereas, the secondary liability is of the Surety i.e. when the principal debtor fails to pay, the surety comes into role.

Therefore, the contract of guarantee is to indemnify if principal debtor fails to fulfil his promise. In this indemnify is not equal to the contract of indemnify in Section 124 of ICA.

Contract of guarantee

A contract of guarantee is precisely stated under Section 126 of the Indian Contract Act, 1872. According to this section, a contract of guarantee can be understood as a contract that requires an individual or a group of individuals to perform a promise made or to discharge their liability under the contract when the third party to the contract failed to fulfill their part of the promise. This guarantee can be oral or written. 

A contract of guarantee requires three parties: the principal debtor, the creditor, and the surety. The individual on whose non-payment the guarantee has to be given is the principal debtor or the borrower, the creditor is the individual who is given the guarantee and the surety is the individual who gives the guarantee.

Surety makes a promise to the creditor that on the principal debtor’s default, they will discharge the third party’s liability or fulfill the promise which was made by the principal debtor. Therefore, the surety gives assurance to the creditor for the principal debtor’s act.

It can be interpreted that the liability of the surety acts as collateral to the principal debtor’s liability. In case the principal debtor defaults, the surety is bound by a conditional promise to be held liable.

There are three essential features of a contract of guarantee:

1. Consideration- It is an essential element of a contract of guarantee. The consideration can be monetary, a future act, personal property, etc. that largely benefits the principal debtor. 
2. Not made in good faith- A contract of guarantee is not an uberrimae fides contract, that is, a contract made in good faith. But there is an obligation to disclose all the material facts to the surety so he can make an informed decision. Therefore, a guarantee obtained by concealment or misrepresentation is invalid. 
3. Either oral or written- The contract can either be oral or written according to Section 126 of the Indian Contract Act, 1872. 

The Act seeks to protect the interest of all the three parties that are involved in a contract of guarantee with emphasis on the interests of the surety.

Difference between contract of guarantee and contract of indemnity

• In contract of indemnity parties involved are 2 i.e. indemnifier and indemnity holder whereas in contract of guarantee there are 3 parties involved i.e. principal debtor, surety and creditor. In contract of guarantee there are 3 contracts, first is between principal debtor and creditor, second is between creditor and surety and third one is between surety and principal debtor.

However, there is no need to have three separate agreements between 3 parties. A single agreement can also make them parties to a contract of guarantee.

• The nature of liability in the contract of indemnity is of the indemnifier i.e. The primary liability is of indemnifier. Whereas, the primary liability in a contract of guarantee is of the principal debtor and secondary liability is of surety.

Section 127 of Indian Contract Act

This section basically talks about the consideration in a contract of guarantee. The consideration for the surety’s promise may move from either the creditor or the Principal Debtor. The consideration may benefit the surety but it is not necessary that surety should receive any benefit from the consideration in contract of guarantee. This section speaks of the consideration i.e any benefit that is received by the principal debtor or creditor at the surety’s request.

The word “done” in this section is the past benefit to the principal debtor that can be considered as good consideration.^[2]

Nature of liability of surety

As laid down in Section 128 of the Indian Contract Act, 1872, the liability of the surety is coextensive. It has the same extent as that of the principal debtor. It emphasizes the maximum degree as well as the scope of the surety’s liability.

Coextensive

‘Coextensive’ is an attribute to the word extent and refers to the amount or the quantum of the principal debt. This particular section only explains the ambit of the extent of surety’s obligation when no limit has been stipulated against the validity of the principal debtor’s obligation. 

The Section further explains how the surety may, however, in the agreement impose certain limits to the extent of his liability entering into a special contract. They can make a declaration and impose a certain limit or restriction to their liability. 

Unless it is expressly mentioned in the terms of the contract, neither can the surety be held liable by the creditor nor can he sue him, till the principal debtor makes a default. Therefore, the surety’s liability is secondary or peripheral in nature.

It is encouraging to take note of the fact that even before the Indian Contract Act, 1872 was enacted the Indian courts perceived the principle of co-extensiveness. In the case of Lachman Joharimal v. Bapu Khandu and Another (1869), the Bombay High Court explained how it is not binding on the creditor to extinguish his remedies before suing the principal debtor. On obtaining a decree against the surety, it may be upheld in a similar way as a pronouncement or a decree for any obligation of the party or any debt which has not been repaid.

Condition precedent to the surety’s liability

Where there is a condition precedent to the surety’s liability, he will not be liable unless that condition is first fulfilled. Section 144 is based on this principle to an extent. For example, when an individual gives a guarantee to undertake a task unless another individual joins as a co-surety, the guarantee will be invalid if another co-surety does not join the contract. 

In National Provincial Bank of England v. Brackenbury (1906), a guarantee was signed by the defendant. The defendant signed the contract on the condition that three more individuals would also sign the contract, as part of a joint and several guarantee. However, one of the three individuals did not sign the contract of guarantee. The Court held that no agreement took place since there was a condition to the contract that was not fulfilled. Hence, the defendant was held not liable. 

The extent of liability of surety

It is still a critical issue to measure the maximum extent of surety’s liability and to what extent it is being invoked presently. Herein the question is at what time the surety’s liability comes under scrutiny- when the debtor has not fulfilled their part of the promise of all the remedies that have been availed by the creditor against the debtor.

Is creditor bound to exhaust his remedies before suing the surety

The surety’s liability is not removed in case of the omission of the creditor in suing the borrower. The creditor does have to necessarily exhaust his remedies against the principal debtor before they sue the surety. They can still maintain a suit if no proceedings have been initiated beforehand against the borrower. However, the surety cannot be held liable until the contingency takes place.

Difficulties arise in interpreting the principle of co-extensiveness when the surety has guaranteed performing a contractual liability to make payments by way of installments to the creditor. 

Prominent case laws

The reference point for these difficulties was brought to light and elucidated in Lep Air v. Moschi (1973). In this particular case, the debtor did not make the payment in installments to the creditor who had performed their end of the contract. The contract was repudiated by the creditor. The issue here was whether the creditor could initiate proceedings against the surety at the time of repudiation for the amount entitled to the creditor under the contract, regardless of the fact that when the repudiation was accepted the debtor now had a secondary and not a primary obligation to pay damages. 

The surety had an obligation to observe the debtor’s performance of his contractual obligations, so on his default, the surety was obligated to make a payment to the creditor for the loss incurred to him. However, it was visualized in this case that the obligation of the surety and the debtor would be coextensive and no pronouncement could breach this basic principle.

The principle of co extensiveness was further enforced in the following cases of Bank of Bihar Ltd v. Damodar Prasad and Another (1968) wherein the Supreme Court explained how the sole condition required was to demand the payment pertaining to the principal debtor’s liability for the implementation of the bond. On the fulfillment of the condition and despite constant demands, both the principal debtor and the surety did not fulfill their end of the contract. 

The liability being co-extensive and immediate in nature made the surety liable to pay the whole sum in question. There was no delay and no anticipation for the remedies to be extinguished by the creditor against the principal debtor.

A similar judgment was held in State Bank of India v. Indexport Registered (1992), wherein the Supreme Court explained how the surety solely because of the creditor’s omission in initiating proceedings against the surety does not become free from their liability to pay the debt. It was reinstated that the creditor is not confined to having his remedies and a suit is still maintainable before suing the principal debtor. 

The Supreme Court explained how prima facie there can be proceedings against the surety despite the absence of demand and without proceeding against the principal debtor first. They explained the lack of any such prerequisite for the creditor to request payment from the principal debtor or sue him for not fulfilling his part of the promise and they can directly initiate proceedings against the surety unless it has been expressly stipulated in the contract.

In the case of Hukumchand Insurance Co Ltd v. Bank of Baroda (1977), the Karnataka High Court observed the nature and the incidents that occurred are the two main factors which decide the liability, the extent, and manner of the enforcement. Although the principal debtor and the surety’s liability arising from the same bargain, the two liabilities are not alike. These principles laid down were further reinforced in a number of cases. 

It is the choice of the creditor which remedy they find fit to pursue and neither the defaulter nor the surety can compel the creditor in any manner and advise them to take recourse to a particular remedy. It falls in the exclusive domain of the creditor.

In the case of State Bank of India v. G.J. Herman and others (1998), the Kerala High Court observed that the surety’s liability being joint and several, would not bind the creditor to initiate proceedings against the principal debtor or the other sureties in the contract. If such a direction would be binding, it would be a direct violation of the principle of co extensiveness. 

They are to be liable till the extent to which they stood guarantee and can face proceedings by the creditor. It is solely the discretion and the decision of the creditor against whom he wants to initiate the proceedings- the principal debtors or any of the sureties.

A suit against principal debtor alone

The creditor can initiate a suit against the principal debtor alone without initiating any proceedings against the surety. In Union Bank of India v. Noor Dairy Farms (1996), it was held that such a suit would be maintainable. The liability of the surety in a contract of guarantee is not absolved on the dismissal of a suit against the principal debtor. 

A suit against surety alone

A suit against the surety without initiating proceedings against the principal debtor has been held to be maintainable. In N.Narasimhaiah v. Karnataka State Financial Corporation (2004), the creditor showed sufficient reasons for not proceeding against the principal debt in his affidavit. A contract of guarantee was made enforceable by the terms stipulated against the guarantors severally and jointly with that of the principal debtor’s company. The Court held that the creditor has the option to sue the company and the surety as co-defendants or the surety alone.

Proceedings against surety’s mortgaged property

A financial corporation cannot take possession of the surety’s mortgaged property of the guarantor without prior notice. The corporation also cannot issue any public notice to sell the property without informing the surety. This is because the surety’s liability is secondary in nature and would arise only when the principal debtor fails to repay the amount. 

The property of the surety which has been offered as a security can be proceeded against without exhausting the available remedies against the principal debtor.

Death of principal debtor

In case of the death of the principal debtor, any suit against him would be void ab initio. However, the surety would not be discharged of his liability to pay the amount. 

In Orissa Agro Industries Corpn Ltd v. Sarbeswar Guru,(1985), it was held that the dismissal of the suit against the principal debtor, under Order 1 of Code of Civil Procedure, 1908 would not automatically absolve the surety of its liability. 

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

The surety may put a restriction on the extent of his liability in the agreement. He can expressly declare his guarantee to a fixed amount and in such a case the surety cannot be liable for any amount beyond the fixed amount. 

The principal debtor owes a greater amount but it is not the responsibility of the surety to be responsible for even a single rupee more than what was stated in the agreement.  For example, in Hobson v Bass (1871) the surety expressly declared that “my liability under this guarantee shall not at any time exceed the sum of £250“. 

Surety’s Liability

Under section 128 of ICA, the liability of surety is co-extensive that of the principal debtor that means the surety is liable to the same extent as the principal debtor. For example if the principal debtor is not liable for debt for some reason, then surety is also not liable for the same.  Also, the principal debtor is discharged from his debt by the creditor for some reason then surety will be discharged too. This section depends on the contract as well. Therefore, the surety’s liability depends on the terms of the contract and is not liable to pay more than the principal debtor has taken.^[3]

Example-  “A guarantees to B the payment of a bill of exchange by C, the acceptor. The bill is dishonoured by C. A is liable, not only for the amount of the bill, but also for any interest and charges which may have become due on it. A guarantees to B the payment of a bill of exchange by C, the acceptor. The bill is dishonoured by C. A is liable, not only for the amount of the bill, but also for any interest and charges which may have become due on it.”

The liability of the surety is joint and connected with the principal debtor. It is the choice of the creditor to recover the amount either from the principal debtor after his default or from surety. He may file a suit against both the principal debtor and the surety or may file a suit against the surety only or the principal debtor only.

In Bank of Bihar v Damodar Prasad^[4] it was held that the creditor do not have exhaust all the remedies against principal debtor before suing the surety. It is the duty of the surety to pay the debt if principal debtor does not pay. The purpose of contract of guarantee is defeated if the creditor is asked to postpone his remedies against the surety. The liability of surety is immediate.

Continuing guarantee

Section 129 of ICA defines continuing guarantee. A guarantee which extends to a series of transactions is called continuing guarantee. It is not confined to a single transaction. In this guarantee, surety is liable to pay the creditor for all the transactions. However, it is very important to find out if the guarantee is a continuing one or not. ^[5]

Difference between continuing guarantee and simple guarantee

• A continuing guarantee can be revoked by the surety any time either by the notice to the creditor or until the surety’s death. Whereas, simple guarantee can not be revoked in any circumstances.
• In continuing guarantee, the transaction can go for long period of time therefore the surety will be held liable for long time as well whereas in simple guarantee the surety liability is over when the debt is paid or the performance is done.

To understand the nature of a guarantee, you must look at :

• The intention of the parties as expressed by the language in the contract.
  • surrounding circumstances to see what was the subject matter which the parties examine.

Example of a continuing guarantee: A in consideration that B will employ C in collecting the rents of B’s zamindari, promises B to be responsible to the amount of Rs 5000 for the due collection and payment by C of those rents. This is a continuing guarantee.

Section 130 of ICA explains the revocation by notice. A continuing guarantee may be revoked anytime by the surety for the future transactions only by notice to the creditor.

The main ingredients in this section is :

• As to future transactions
• Notice to the creditor

Continuing guarantee extends to a series of transactions, surety has a right to withdraw such guarantee. As soon as the surety sends the notice of revocation to the creditor, the surety does not remain liable for any transaction that happens after he has given notice, However, the surety continues to remain liable for any transactions that has already taken place. if the mode of revocation by notice is mentioned in the contract, then notice must be given in that mode only and if no mode is given in the contract then the notice may be given in any form.^[6]

Section 131 of ICA explains the revocation by death of surety.The liability for any transactions that took place prior to the death of the surety will be borne by his heirs. This contract could be implied from the circumstances.^[7]

Discharge of Surety

Section 133 -139 explains all the circumstances in which surety is discharged. All these section can be called the rights of the surety as the surety will not be liable on the guarantee any more.

Contract of guarantee is a contract and can be discharged as a normal contract.

Section 133 of ICA explains discharge of surety by variance.

“Discharge of surety by variance in terms of contract.—Any variance, made without the surety’s consent, in the terms of the contract between the principal 1[debtor] and the creditor, discharges the surety as to transactions subsequent to the variance. —Any variance, made without the surety’s consent, in the terms of the contract between the principal 1[debtor] and the creditor, discharges the surety as to transactions subsequent to the variance.”

This section essentially the outcome of the general rule that is all the parties should be privy to the contract. It stated that when a amendment takes place in the contract without taking surety, the surety is discharged.  Surety cannot be bound to something for which he has not contracted.

For example: A becomes surety to C for B’s conduct as a manager in C’s bank. Afterwards B and C contract without surety’s consent, that B’s salary sell be raised. In this Surety that is A is discharged as A did not know about the contract between B and C.

Exception of this Section:

In this if the alteration is made in the agreement without the surety’s consent that is beneficial to the surety, the surety is not discharged. The alteration should be unsubstantial/immaterial, then surety is not discharged. In Anirudhan v The Thomco’s Bank Ltd it was held that the surety is not discharged as the contract between the principal debtor and creditor is beneficial to the surety.^[8]

Section 134 – Discharge of surety by release of Principal Debtor

In this section states that if the principal debtor is release because of any contract between creditor and principal debtor or by any act or omission of the creditor, then the surety is released. This section is connected with the section 128 of ICA which says that the liability of the surety is co-extensive with that of principal debtor.  The reason for the discharge of surety is with the principal debtor that this release of the principal debtor extinguishes the principal obligation, to begin with.

In this section 2 types of release are mentioned.

1. Express release: This is a situation in where an express contract between the credit and the principal debtor results in discharge/release
2. Implied release: In the section the words “by any act or commission of the creditor, the legal consequence of which is the discharge of the principal debtor” refers to an implied release/discharge.

 The acts or omissions by this section are referred to in section 39, 53, 54, 55, 67 of ICA.

1. Section 39- when a party to a contract has refused to perform or disabled himself from performing his promise.
2. Section 53- when a contract contains reciprocal promises and one party to the contract prevents the other from performing his promise.
3. Section 54- when a contract contain reciprocal promises such that one of them cannot be performed till the other has been performed.
4. Section 55- When a party to a contract promises to do certain things at or before a specific time and fails to do any such thing within that time
5. Section 67- If a promisee neglects to afford the promisor, reasonable facilities for the performance of his promise.^[9]

Section 135– A contract between the creditor and the principal debtor without surety assent to

• to make a composition/compromise with
• promise to give time to
• not to sue the principal debtor
• discharges the surety

“To make composition with”- This essentially mean if the creditor makes any sort of compromise with the principal debtor with respect to the debt them surety will be discharged.

“Promise to give time to”- where the creditor extends time for the payment of debt without the consent of surety, then surety will be discharged.

“Not to sue the principal debtor”- If the creditor agrees with the principal debtor to not to ever sue against him, the surety will be discharged.^[10]

Section 136– Where a contract to give time to the principal debtor is made by the creditor with a third person and not with the principal debtor, then the surety is not discharged.

For example- A agrees with B to supply 500 tons of steel in consideration of Rs 5 Lakhs. C stands surety to A . A agrees with D (B’s father) to extends the delivery date. C is not discharged as D is the third party and not the principal debtor.^[11]

Section 137– Mere Forbearance on the part of the creditor to sue the principal debtor or to enforce any other remedy against him does not discharge the surety.

Mere forbearance means own its own. When creditor does not sue the principal debtor on its own then the surety is not discharged.^[12]

Section 139– In this section consists of the following elements:

• The creditor either does something which is inconsistent with the rights of the surety or omits to do his duty towards the surety
• And because of this the eventual remedy of the surety that he had against the principal debtor is impaired(weakened) , the surety is discharged.

The object of this section is to ensure that no arrangement different from that contained in the surety’s contract is forced upon him. Duty of care is owned by the creditor.^[13]

Section 140– The meaning of this section is that the surety steps into the shoes of the creditor after he has paid the guaranteed debt or performed whatever he was liable for. This right of the surety to step into the shoes of the creditor is known as the surety’s right of subrogation.

Automatic subrogation : Once the surety has paid the guarantee amount to the creditor. The surety is invested with this right automatically without any pre-conditions attached to it.^[14]

Section 141– A surety is entitled to every security which the creditor has against the principal debtor at the time when the suretyship is entered into. Or if the creditor loses or parts with such security the surety is discharged to the extent of the value of the security. This section is applied even when the surety’s consent is not there. The words “if the creditor loses security” refer to deliberate action by the creditor and not a mistaken situation beyond the control of the creditor.

Extent of discharge: if the value of the security is less than the liability undertaken by the surety, then the surety must be held to be discharged to the extend of the value of the security and that he will still be required to discharged the liability which exceeds the value of security. However, if the value of the security given is in far excess of the liability, the surety must be held to be discharged wholly.^[15]

Section 142– Guarantee obtained by misrepresentation. Any guarantee obtained by misrepresentation made by the creditor is invalid.^[16]

Section 143– Any guarantee which the creditor has obtained by means of keeping silence as to a material circumstance is invalid.^[17]

Section 144– Guarantee on contract that creditor shall not act on it until co-surety joins. 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 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.^[18]

Section 145– In every contract of guarantee there is an implied contract of indemnity in between the surety and principal debtor. Principal debtor has to indemnify the surety later with the rightfully sum. The surety can sue the principal debtor for the guarantee amount as soon as his liability becomes absolute. The surety may recover all damages, all costs and all sums in accordance with section 125 of ICA.^[19]

Co-sureties

Section 138– When one co-surety is released does not discharge other co-surety. A release by the creditor of one of them does not discharge the others neither does it free the surety so released from his responsibility to the other sureties.^[20]

Section 146-This section defines co-sureties. Where 2 or more persons are co-sureties for the same debt or duty 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. contribution of all the co-sureties should be equal, if not mentioned in the contract. It should be according to the contract if the proportion is mentioned in the contract.^[21]

Section 147– Co-sureties are bond in different sums are liable to pay equally as far s the limits of their respective obligations permit. For e.g.. – A, B and C are sureties for D enter into 3 several bonds. A in the penalty of Rs.10,000, B in that of Rs. 20,000 and C in Rs 40,000. D makes a default to the extent of Rs. 40,000. So, the liability of A will be 10,000 , B’s liability will be 15,000 and C’s liability will be 15,000 as well.^[22]

Conclusion

The principle of co-extensiveness cannot be classified as a rigid principle. The exact degree and extent of the surety’s liability would be governed by the provisions mentioned in the guarantee on the actual constructed document and the parties have the freedom to impose certain restrictions towards the surety’s liability without deviating from the actual nature of the contract of guarantee.

The exact and precise extent will always be under the governance of the provisions of guarantee on how the document has been drafted and the parties enjoy the freedom to add restraints if any to the surety’s liability.

There have been conflicting issues regarding the issue of initiating proceedings, without extinguishing the remedies available in opposition to the principal debtor. The Supreme Court had the same stance in the Damodar Prasad case that the surety can be sued before other remedies are used. The Judiciary has restated this basic principle in many judgments and over the years have and continue to remove the pertinent ambiguities and issues regarding the scope of the surety’s liability. 

Each case has clarified the interpretation of the principle however, there is still a wide scope of improvement. The courts will continue to ponder and expound on the validity of the principle with respect to the nuances of the period.

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References

^[1] Section 126, The Indian Contract Act

^[2] Section 127, The Indian Contract Act

^[3] Section 128, The Indian Contract Act

^[4] Bank of Bihar v. Damodar Prasad AIR 1969 SC 297

^[5] Section 129, The Indian Contract Act

^[6] Section 130, The Indian Contract Act

^[7] Section 131, The Indian Contract Act

^[8] Section 133, The Indian Contract Act

^[9] Section 134, The Indian Contract Act

^[10] Section 135, The Indian Contract Act

^[11] Section 136, The Indian Contract Act

^[12] Section 137, The Indian Contract Act

^[13] Section 139, The Indian Contract Act

^[14] Section 140, The Indian Contract Act

^[15] Section 141, The Indian Contract Act

^[16] Section 142, The Indian Contract Act

^[17] Section 143, The Indian Contract Act

^[18] Section 144, The Indian Contract Act

^[19] Section 145, The Indian Contract Act

^[20] Section 138, The Indian Contract Act

^[21] Section 146, The Indian Contract Act

^[22] Section 147, The Indian Contract Act

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