Nature and scope of contract of guarantee

Introduction
Under the Indian Contract Act, 1872, a contract of guarantee is a special type of contract
defined in Section 126. It involves a three-party arrangement where one party (the surety)
promises to take on the responsibility of repaying a debt or fulfilling an obligation if the
primary party (the principal debtor) defaults on their commitment to a third party (the
creditor). This contract serves as a form of financial assurance to the creditor, ensuring that
they will be compensated even if the principal debtor fails to meet their obligations.
A contract of guarantee is distinct because it involves an ancillary promise: the surety’s
promise depends on the debtor’s failure. This "conditional" liability means the surety only
steps in if the debtor defaults. Contracts of guarantee can be either specific, covering a single
transaction, or continuing, which extends to multiple transactions over time. The Act also
allows such contracts to be either written or oral, though written agreements are generally
preferred for enforceability.
This type of contract is crucial in commercial transactions and banking, where it helps secure
loans and credit facilities by reducing the risk for lenders. It also establishes the roles and
liabilities of the parties involved, detailing that the surety’s liability is secondary, while the
principal debtor’s liability remains primary

Essentials and Nature of contract of guarantee

The nature of a contract of guarantee is that of a security mechanism providing the creditor
with a fallback in case of the principal debtor’s failure to fulfil their obligations. It is
characterized by a three-party arrangement, secondary and conditional liability of the
surety, absence of direct benefit to the surety, reliance on utmost good faith, and legal
enforceability upon fulfilment of all contractual requirements. The surety also holds rights of
subrogation and indemnity, which help balance the risks involved. This structure is designed
to protect creditors in commercial and financial transactions, ensuring that the creditor has
recourse if the debtor defaults.
1. Tripartite Agreement Between the Parties
A contract of guarantee inherently involves three parties:
Principal Debtor: The person who has a primary liability or obligation to fulfil.
Creditor: The party to whom the principal debtor owes an obligation or debt.
Surety: The party that promises to discharge the debt or fulfil the obligation if the principal
debtor fails to do so.
All three parties must be in agreement about the terms of the guarantee. This triangular
relationship is central to a contract of guarantee, distinguishing it from other contracts
where there are only two parties. Importantly, all three parties do not have to sign the same
document; an agreement can be established by conduct or separate acknowledgments of
the terms.

2. Consideration
Under Section 127 of the Act, consideration is necessary for a contract of guarantee.
However, the consideration in a contract of guarantee does not flow directly from the
creditor to the surety. Instead, the consideration is what the creditor does or refrains from
doing for the benefit of the principal debtor, such as providing a loan or extending credit.
Sufficient Consideration: The mere act of providing credit to the principal debtor by the
creditor is considered adequate consideration for the surety’s promise.
Past Consideration: Past consideration can also support a contract of guarantee, provided it
was given at the principal debtor's request and with an understanding of surety’s promise.
3. Consent of the Surety
It is essential that the surety’s consent is obtained freely and without any coercion, undue
influence, misrepresentation, or fraud. A contract of guarantee must be entered into
voluntarily by the surety, fully aware of the nature and extent of the guarantee.
If the surety’s consent is influenced by misrepresentation or coercion, the guarantee can be
voided by the surety. Thus, the creditor must ensure that the surety is well-informed and
agrees to the terms under no pressure or deception.
4. Liability of the Surety is Secondary
In a contract of guarantee, the liability of the surety is secondary, which means it only arises
if the principal debtor defaults. The primary obligation to fulfil the terms of the contract lies
with the principal debtor. The creditor can approach the surety only if the debtor fails to
meet the obligations.
Extent of Liability: The surety’s liability is limited to the extent specified in the contract of
guarantee. If no limit is mentioned, the surety’s liability can cover the entire obligation of the
debtor.
Conditions Precedent: The surety’s liability arises only after the principal debtor’s default,
making it conditional and dependent on the debtor’s performance.

5. Written or Oral Guarantee

According to Section 126, a contract of guarantee can be either written or oral. However,
written contracts of guarantee are generally preferred due to the clarity they provide and
their enforceability in court. Courts are also more likely to uphold written agreements over
oral ones, especially when disputes arise regarding the terms or the extent of liability.
Written contracts help clarify the terms of the agreement, specifying the obligations of each
party and reducing the risk of misunderstandings. However, oral guarantees are also valid
and enforceable if there is sufficient evidence to substantiate the terms agreed upon.
6. Existence of a Valid Debt or Obligation
A contract of guarantee is valid only if there is an existing debt or obligation of the principal
debtor. If there is no debt or obligation, the guarantee is meaningless, as there would be no
liability for the surety to cover in case of default. The principal debtor’s obligation to the
creditor forms the foundation of the surety’s liability.
If the debt or obligation is void or unenforceable, the contract of guarantee becomes void.
Therefore, a valid debt or enforceable obligation of the principal debtor is necessary for the
guarantee to hold.
7. No Misrepresentation or Concealment of Material Facts
The contract of guarantee relies on the principle of utmost good faith, particularly from the
creditor’s side. The creditor is obligated to disclose all material facts that could affect the
surety’s decision to undertake the liability. Any misrepresentation or concealment of facts,
particularly regarding the principal debtor’s financial status, can make the contract voidable
at the surety’s option.
Material Facts: Facts that significantly impact the risk taken by the surety, such as the
principal debtor’s financial health or previous defaults, must be disclosed.
Right to Void: If the creditor fails to disclose such facts or misrepresents them, the surety
may have grounds to void the contract.
8. Distinct Promise to Pay upon Default
The contract of guarantee involves a distinct promise by the surety to pay or perform the
obligation if the principal debtor defaults. This promise must be explicit, and the surety must
be aware of the specific liability being guaranteed. Without a clear, distinct promise to step
in upon default, the contract may not be legally recognized as a guarantee.

Kinds of guarantee
The various types of guarantees provide flexibility in commercial and personal agreements,
allowing parties to tailor the terms based on the scope of the obligation, the time frame, and
the specific conditions involved. From single-transaction specific guarantees to ongoing
continuing guarantees, from conditional performance guarantees to unconditional financial
guarantees, each type serves a unique purpose and has specific legal implications under the
Indian Contract Act, 1872. This flexibility helps manage risk and ensures that creditors can
find appropriate assurance according to the nature of the debtor’s obligation.
1. Specific Guarantee
A specific guarantee, also known as a simple guarantee, applies to a single, specific
transaction or obligation. In this type, the surety guarantees the fulfilment of a particular
debt or performance of an obligation by the principal debtor to the creditor. Once that
specific obligation is met or discharged, the surety’s liability under the contract of guarantee
comes to an end.
Example: If a person guarantees repayment of a loan of ₹1 lakh by the principal debtor, the
surety's liability is confined to that particular loan. Once the loan is repaid, the contract of
guarantee ceases to exist.
Termination: A specific guarantee automatically terminates once the guaranteed transaction
or obligation is fulfilled.
2. Continuing Guarantee
A continuing guarantee (as defined in Section 129 of the Indian Contract Act) extends to a
series of transactions between the principal debtor and the creditor. Instead of being limited
to a single transaction, a continuing guarantee applies to all subsequent transactions within
the agreed scope and remains in effect until it is revoked by the surety or the obligation
ends.
Example: If a person guarantees all advances made by a bank to a business up to a limit of
₹5 lakh, this is a continuing guarantee. The surety’s liability covers multiple advances until
the guarantee is either revoked or the total amount reaches the specified limit.
Revocation: A continuing guarantee can be revoked by the surety with respect to future
transactions, by giving notice to the creditor. However, it cannot be revoked for transactions
already executed.
Continuing guarantees are commonly used in commercial settings where recurring
transactions, such as sales, loans, or credit extensions, are involved.
Case laws
Case laws on the contract of guarantee provide insights into how the courts interpret and
enforce these contracts under the Indian Contract Act, 1872. These cases highlight key
principles and clarify issues relating to the rights, duties, and liabilities of the parties
involved in a contract of guarantee. Here are some landmark cases relevant to the contract
of guarantee:

1. Amrit Lal Goverdhan Lalan v. State Bank of Travancore1

Facts: In this case, Amrit Lal provided a guarantee to the State Bank of Travancore on behalf
of a business that had taken a loan. Later, the debtor defaulted, and the bank sought to
recover the debt from Amrit Lal as the guarantor.
Judgment: The Supreme Court of India held that a surety is liable only to the extent stated in
the contract of guarantee. The court ruled that the creditor must act within the terms of the
contract and cannot demand more than what was specified in the guarantee.
Significance: This case established that the liability of the surety is limited to what is
stipulated in the guarantee agreement and clarified the boundaries of the surety’s
obligation.
2. Bank of Bihar Ltd. v. Damodar Prasad & Another2
Facts: Damodar Prasad was the guarantor for a loan taken by a debtor from the Bank of
Bihar. When the debtor defaulted, the bank sought to recover the debt from Damodar
Prasad as the guarantor. The guarantor argued that the bank should first exhaust all
remedies against the principal debtor.
Judgment: The Supreme Court ruled that the bank was not required to exhaust its remedies
against the principal debtor before approaching the guarantor for payment. The creditor has
the right to sue the surety directly without first going after the principal debtor.
Significance: This case clarified that under Section 128 of the Indian Contract Act, the liability
of the surety is co-extensive with that of the principal debtor unless otherwise stated in the
contract. The creditor can directly claim payment from the surety without pursuing the
principal debtor.
3. Syndicate Bank v. Channaveerappa Beleri & Ors3 (2006) 11 SCC 506

1
(1968 AIR 1432)

2
(1969 AIR 297)
3
(2006) 11 SCC 506
Facts: In this case, Syndicate Bank granted loans to a borrower with Channaveerappa Beleri
as the guarantor. When the borrower defaulted, the bank pursued the guarantor to fulfil the
obligation. The guarantor contended that the loan terms were altered without his consent,
thus discharging him from liability.
Judgment: The Supreme Court held that any material alteration to the terms of the contract
without the surety's consent releases the surety from liability. The court ruled in favor of the
guarantor, stating that any significant change in the loan terms, even if beneficial to the
surety, would discharge him from liability.
Significance: This case reinforced the principle under Section 133 that the surety’s liability is
discharged if the terms of the original contract are altered without their consent. The case
highlighted the importance of maintaining the original terms of the contract to hold the
surety liable.
4. Punjab National Bank v. Sri Vikram Cotton Mills & Anr.4
Facts: Sri Vikram Cotton Mills was the principal debtor in a loan transaction with Punjab
National Bank, and a third party was the guarantor. After the borrower defaulted, the bank
went to court to enforce the guarantee against the guarantor.
Judgment: The Supreme Court held that the surety is liable for any outstanding balance after
the sale of securities held by the creditor. However, it must be done fairly and with full
disclosure to the surety. The court ruled that the creditor must act in good faith in handling
the securities.
Significance: This case established that creditors have a duty to disclose relevant information
and to handle securities fairly when recovering debts. It emphasized the obligation of good
faith on the part of the creditor, particularly in dealing with securities held against a debt.
5. Mahajan Brothers v. Union of India5
Facts: In this case, Mahajan Brothers were the guarantors for a government contract. The
government claimed damages from Mahajan Brothers, asserting that they were liable as
guarantors for the contract’s completion.
Judgment: The court held that a guarantee must be clear in its terms and specify the scope
of the guarantor’s liability. In this case, since the guarantee was ambiguous, the court
interpreted it in favor of the guarantors and limited their liability.
Significance: This case highlighted the importance of precision in guarantee agreements,
noting that any ambiguity in the terms will generally be interpreted in favor of the surety. It
emphasized that guarantees must be drafted clearly to define the obligations and limits of
the guarantor’s liability.
6. State Bank of India v. S.N. Goyal6 (2008) 8 SCC 92

4
(1970 AIR 1973)
5
(1978 AIR 1063)
6
(2008) 8 SCC 92
Facts: State Bank of India extended a loan to a borrower, with S.N. Goyal acting as the
guarantor. When the borrower defaulted, the bank attempted to enforce the guarantee
against Goyal. The guarantor claimed that the guarantee was unenforceable due to lack of
consideration.
Judgment: The Supreme Court clarified that consideration for a contract of guarantee lies in
the benefit provided to the principal debtor, and no direct consideration is needed for the
guarantor. The court ruled in favor of the bank, holding the guarantor liable.
Significance: This case clarified the nature of consideration in a contract of guarantee,
reinforcing that the consideration lies in the creditor’s actions toward the principal debtor.
This ruling affirmed that a guarantor’s liability does not require direct consideration from the
creditor to the guarantor.

Scope
The scope of a contract of guarantee under the Indian Contract Act, 1872, encompasses the
extent of rights, obligations, and liabilities of the parties involved (the principal debtor,
creditor, and surety). The scope varies depending on the terms of the contract, the type of
guarantee, and the rights and duties conferred by law. Here’s a detailed analysis of the scope
of a contract of guarantee:

1. Scope of Liability of the Surety

Co-extensive Liability: According to Section 128 of the Indian Contract Act, the liability of the
surety is co-extensive with that of the principal debtor, meaning the surety is liable to the
same extent as the principal debtor unless otherwise stipulated. This allows the creditor to
hold the surety responsible for the entire obligation if the principal debtor defaults.

Limited and Unlimited Liability: The scope of the surety’s liability can be limited or unlimited
based on the contract’s terms. A limited guarantee restricts the surety’s liability to a specific
amount or time period, while an unlimited guarantee holds the surety liable for all
obligations incurred by the principal debtor up to the full debt amount.

Conditional and Unconditional Liability: The surety’s liability may depend on certain
conditions. In a conditional guarantee, the surety’s liability arises only when specific
conditions are met, whereas, in an unconditional guarantee, the surety’s liability is
immediate upon the principal debtor’s default.

Nature of the Debt or Obligation: The scope of the guarantee is directly related to the nature
of the debt guaranteed. For example, in a financial guarantee, the surety is responsible for
repaying the debt if the principal debtor defaults, whereas in a performance guarantee, the
surety is obligated to ensure the completion of a specified task or contract.

2. Rights of the Surety

The scope of the contract of guarantee includes specific rights that the surety has to
safeguard their interests:

Right to be Indemnified (Section 145): Upon paying the debt or fulfilling the obligation of the
principal debtor, the surety has the right to be indemnified by the debtor. The surety is
entitled to recover from the principal debtor all amounts paid on their behalf.

Right of Subrogation (Section 140): Once the surety fulfils the obligation, they step into the
shoes of the creditor and gain all rights against the principal debtor that the creditor
originally had. This means that the surety can claim any collateral or security the creditor
held against the debtor.

Right to Securities (Section 141): The surety has a right to benefit from any security held by
the creditor against the principal debtor. If the creditor loses or impairs the security without
the surety’s consent, the surety’s liability is reduced to the extent of the value of the lost
security.

Right to Claim Contribution from Co-sureties (Section 146): If there are multiple sureties for
the same debt or obligation, each surety is liable to contribute equally. If one surety pays
more than their share, they have the right to seek proportionate contributions from other
co-sureties.

3. Duties of the Creditor

The scope of the guarantee also defines the duties of the creditor, which include obligations
to act in good faith and fairness towards the surety:

Duty to Disclose Material Facts (Section 143): The creditor must disclose any material facts
or information that could influence the surety’s decision to enter into the contract. Failure to
disclose important information, such as the principal debtor’s financial instability, can
discharge the surety’s liability.
Duty Not to Vary Terms of the Contract (Section 133): Any variation in the terms of the
contract between the creditor and the principal debtor without the surety’s consent can
discharge the surety’s liability. This ensures that the surety is not bound by terms they did
not agree to.

Duty to Preserve Security (Section 141): If the creditor holds any security for the principal
debtor’s debt, they are obligated to preserve it. If the creditor loses or impairs the security
without the surety’s knowledge or consent, the surety is discharged

they would have been entitled to. This duty ensures that the surety's liability is fairly limited,
given that the security, which is a key factor in their decision to guarantee the debt, is
preserved.

4. Liabilities and Limitations of the Surety’s Obligations

Extent of Surety's Liability: The surety’s liability is co-extensive with that of the principal
debtor. However, the scope of this liability depends on the terms of the guarantee. For
instance, if the guarantee is limited to a specific amount, the surety is liable only for that
amount, even if the debtor owes more.

Discharge of Surety’s Liability: The surety may be discharged from liability under specific
circumstances:

Revocation by Notice (Section 130): In a continuing guarantee, the surety can revoke the
guarantee with respect to future transactions by giving notice to the creditor. However, this
does not affect the liability for past transactions.
Death of the Surety: The death of a surety automatically revokes a continuing guarantee for
future transactions unless the contract specifies otherwise. However, the estate of the
deceased surety may still be liable for debts incurred before death.
Release of Co-Sureties: If one co-surety is released from liability, it does not automatically
discharge the other co-sureties, unless the release affects their contribution rights or other
aspects of their liability.
Invalid or Fraudulent Contract: If the contract of guarantee is obtained by misrepresentation
or fraud, or lacks consideration, the surety is not bound by it.
5. Scope of the Surety’s Rights Against the Principal Debtor
The surety's rights against the principal debtor play a crucial role in determining the scope of
the guarantee:
Right of Indemnity Against Principal Debtor (Section 145): After the surety fulfills their
obligation by paying off the creditor, they are entitled to recover the amount from the
principal debtor. This is based on the idea that the principal debtor, as the primary party
liable, should ultimately bear the financial burden.

Right to Call Upon the Debtor to Settle the Debt: Before being called upon to pay, a surety
may request the principal debtor to settle the debt with the creditor to avoid having to fulfill
the guarantee.

Right to Limit the Obligation Through the Contract’s Scope: A surety can limit their liability
by explicitly defining the terms in the contract of guarantee, such as the amount, duration,
or the specific transaction. This limitation gives sureties control over the scope of their risk.

6. Creditor’s Rights Against the Surety

The creditor has several rights against the surety within the scope of the contract of
guarantee:

Right to Direct Recourse Against the Surety: The creditor has the right to directly enforce the
contract of guarantee against the surety in the event of a default by the principal debtor,
without first exhausting remedies against the debtor. This principle, established in Bank of
Bihar v. Damodar Prasad, affirms that the surety’s liability is immediate and not conditional
upon the creditor’s efforts to recover from the principal debtor.

Right to Demand Payment Up to the Guaranteed Amount: The creditor can demand the
payment up to the amount stipulated in the guarantee, or for the entire debt in cases of
unlimited guarantees. This is fundamental in financial guarantees where the creditor
depends on the surety as a source of repayment security.

Right to Enforce Continuing Guarantee: If the contract specifies a continuing guarantee, the
creditor can claim multiple times against the surety for recurring debts or obligations that
arise until the guarantee is revoked.

Conclusion
In conclusion, the contract of guarantee under the Indian Contract Act, 1872, serves as a
pivotal tool for enhancing the security and reliability of financial transactions, commercial
agreements, and employment contracts. By defining the roles and responsibilities of the
principal debtor, surety, and creditor, a guarantee ensures a structured recourse in case of a
debtor’s default, ultimately encouraging a more stable and predictable environment for
lending and contractual performance