Contract of Guarantee:

A contract of guarantee is one of the key types of contracts covered under the Indian Contract
Act, 1872. This contract plays a crucial role in commercial transactions by providing security to
creditors. A guarantee involves three parties, namely the creditor, the principal debtor, and the
surety, with the surety agreeing to be liable for the debt or obligation of the principal debtor to
the creditor if the principal debtor defaults.

Definition of Contract of Guarantee

Section 126 of the Indian Contract Act, 1872, defines a 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."

In simpler terms, it is an agreement where the surety agrees to be responsible for the debt or
performance of a contract by the principal debtor to a creditor. If the principal debtor defaults,
the surety becomes liable to fulfill the debt or obligation.

The key components of a contract of guarantee are:

1. The promise of the principal debtor (which may be express or implied).

2. The surety's promise to perform the debtor’s obligations if the debtor defaults.
3. The creditor’s benefit, which is the primary purpose of the guarantee contract.

Objectives of a Contract of Guarantee

The contract of guarantee serves several important objectives in business and legal transactions:

1. To Provide Security: It gives creditors a sense of security by ensuring that they will
receive payment or performance even if the debtor defaults.
2. To Facilitate Credit: The surety's guarantee allows individuals or businesses to obtain
credit or engage in transactions that they may not have otherwise been able to, based on
their own financial capacity.
3. To Encourage Trust: Guarantee contracts help foster trust and confidence between the
parties, particularly when dealing with large or risky transactions.

Nature and Scope of Contract of Guarantee

1. Nature of Guarantee:
 o A guarantee is a secondary liability, meaning the surety only becomes liable
when the principal debtor fails to fulfill his obligations.
o It is an accessory contract, as it is directly related to another primary contract,
typically a loan or credit arrangement.
2. Scope of Guarantee:
o The scope of the surety’s liability depends on the terms of the contract. It may
cover all liabilities of the debtor or may be restricted to a specific amount or
particular obligation.
o A contract of guarantee can be unconditional or conditional depending on
whether it is dependent on a particular event.

Essentials of a valid contract

A valid contract of guarantee must include the following essential features:

1. Presence of Three Parties:

o Principal Debtor: The person who owes the debt or obligation.
o Creditor: The party to whom the debt is owed.
o Guarantor: The person who promises to pay the debt or perform the obligation if
the principal debtor defaults.
2. Written or Oral Agreement: A guarantee contract can be either written or oral, though
certain jurisdictions may require it to be in writing to be enforceable, especially when it
pertains to large amounts.
3. Consent: There must be mutual consent between all parties involved—the principal
debtor, the creditor, and the guarantor. No coercion or undue influence should exist.
4. Consideration: A valid contract requires consideration. For a contract of guarantee, the
guarantor's promise must be supported by some form of consideration, such as the
creditor’s promise to provide goods, services, or other benefits.
5. Clear Terms of Guarantee: The terms of the guarantee must be specific and
unambiguous. This includes defining the amount guaranteed, the conditions under which
the guarantee can be enforced, and the duration of the guarantee.
6. Legal Capacity: All parties must have the legal capacity to enter into the contract. For
example, minors, individuals of unsound mind, or those prohibited by law may not be
able to act as a guarantor.
7. Conditionality: The guarantee is often a secondary or contingent obligation. The
guarantor’s responsibility to pay arises only if the principal debtor defaults or fails to
perform the contract.
8. Legality of Purpose: The contract of guarantee must be for a legal purpose. A guarantee
cannot support an illegal debt or obligation.
9. No Duress or Undue Influence: The contract must be free from any undue pressure or
influence. The guarantor must voluntarily agree to take on the responsibility.
10. Notice of Default (if applicable): In some cases, the creditor must notify the guarantor
of the principal debtor’s default, triggering the guarantee obligation. However, in some
cases, this may not be required.
Rights and Duties of Surety

1. Rights of the Surety:

o Right of Subrogation (Section 140): The surety, upon discharging the principal
debtor’s liability, has the right to step into the shoes of the creditor and pursue the
principal debtor for reimbursement.
o Right to Securities (Section 141): If the creditor holds any security from the
principal debtor, the surety is entitled to claim the benefit of such security if he
has discharged the liability.
o Right to be indemnified: The surety has the right to be indemnified by the
principal debtor for any payments made on their behalf.

Illustration: If a person guarantees a loan for a friend, and the friend defaults, the surety
may pay the debt and then recover the amount from the friend under the right of
subrogation.

2. Duties of the Surety:

o Duty to Perform the Promise: The surety must perform the principal debtor’s
obligation if the debtor defaults.
o Duty to Pay: If the principal debtor defaults, the surety must repay the creditor
for any unpaid debt or fulfill the promise.
o Duty to Act in Good Faith: The surety must not act in a manner that would
increase the risk or liability of the contract.

Illustration: If the surety guarantees payment of a debt, he must ensure that payment is
made when the debtor defaults. If he fails to do so, he violates his duty under the contract.

Discharge of Surety

Section 130 of the Indian Contract Act provides for the discharge of the surety from his
liabilities. A surety can be discharged in the following circumstances:

1. By Revocation (Section 130): A surety may revoke his guarantee, but revocation does
not affect any liability incurred before the revocation.
2. By the Death of the Surety: The death of the surety discharges him from the liability
unless the contract expressly states otherwise.
3. By Variation of the Terms of the Contract: If the creditor and the principal debtor
agree to a material alteration of the terms of the contract without the consent of the
surety, the surety is discharged.
4. By Release or Discharge of the Principal Debtor: If the creditor releases the principal
debtor from the debt or obligation, the surety is also discharged.
 5. By Payment or Performance: If the surety has discharged the liability by fulfilling the
promise, he is discharged from any further obligations.

Case Law: In Chandermal v. Union of India (1956), the court ruled that a surety is
discharged when the creditor alters the terms of the agreement without the consent of the
surety.

Extent of Surety’s Liability

The extent of the surety’s liability is primarily determined by the terms of the guarantee contract.
It can be:

1. Limited: The liability of the surety can be restricted to a specific amount or a particular
event.
2. Unlimited: If the contract does not limit the surety’s liability, it becomes unlimited, and
the surety is liable for the full amount owed by the principal debtor.

Illustration: If a person guarantees a loan of ₹1,00,000 for a friend, and the principal
debtor defaults, the surety’s liability would typically extend to ₹1,00,000 unless the
contract specifies otherwise.

Co-Surety

A co-surety is a situation where two or more persons are sureties for the same debt or obligation.
Each co-surety is equally responsible for the liability, unless the guarantee provides otherwise.

1. Liability of Co-Sureties: Co-sureties are jointly and severally liable, meaning that the
creditor can choose to recover the full amount from one surety or split the liability among
them.
2. Right to Contribution: If one co-surety pays more than his share, he can claim
contribution from the other co-sureties.

Illustration: If two people co-guarantee a loan of ₹2,00,000, each co-surety is liable for
the full amount, but they have the right to share the burden equally or in the proportion
specified in the contract.

Case Law: In Jai Narain v. Union Bank of India (1994), the court held that where there
are multiple sureties, the sureties are jointly and severally liable.

Difference between Contract of Indemnity and Contract of Guarantee

A contract of indemnity and a contract of guarantee are distinct in several ways:

Aspect Contract of Guarantee Contract of Indemnity

A contract where one party agrees to A contract where one party agrees to
Definition perform the promise of another if the compensate another for a loss suffered due
latter defaults. to the act of the promisor.
Number of Involves three parties: the creditor, Involves two parties: the indemnifier and
Parties the principal debtor, and the surety. the indemnity holder.
Secondary liability: Surety’s liability
Nature of Primary liability: The indemnifier is
arises only upon default of the
Liability directly responsible for the loss incurred.
principal debtor.
A person agreeing to compensate another
A person guaranteeing a loan for a
Example for losses arising from a business
friend.
transaction.
Section in Section 126 (Indian Contract Act,
Section 124 (Indian Contract Act, 1872)
the Act 1872)