Critical Appraisal of the Role of Surety in Contract of Guarantee

Written by Tanmay Mehta, the author is a law student currently pursuing BBA.LLB from Symbiosis Law School Pune

Introduction

Section 126 of the Indian Contract Act 1872 stipulates 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.”[1]

Why do we need guarantee contracts?

“A Guarantee is a promise for payment of some debt or performance of some duty for the failure of the principal person liable for the payment or performance.”[2] A contract of guarantee provides a second pocket to the creditor to recover his debt or to have an assurance to get a return for his services or goods given on credit. It provides a second pocket if the first is unable to pay back to the creditor[3]. It helps the Principal debtor to get credit, as a guarantee by the surety which aids in gaining the creditor's confidence, and it works as a security for the creditor. For example – A guarantees B to give goods to C on credit, saying, if C defaulted to pay, I will pay you.[4] A contract of guarantee is a tripartite agreement that considers the Principal debtor, the creditor, and the surety. [5] It is a collateral engagement to be liable for the debt of another in case of his default.

Parties To The Contract Of Guarantee

Principal Debtor – The Principal Debtor is the person who has the primary liability for availing the benefit of the loan, credit, or employment, etc. He is the person in respect of whom the surety gives a guarantee to the creditor.

Surety – The Surety is the person on whose promise or behalf the creditor gives a loan, credit, or employment to the Principal Debtor. He is the person who gives a guarantee on behalf of the Principal Debtor to the creditor. The liability of the surety is secondary and he is liable to make the payment or perform the duty in case the Principal Debtor defaults.

1. Creditor – A creditor is a person who gives a loan, credit, or employment to the Principal Debtor. He is the person to whom the guarantee is given by the surety.

Essentials of Guarantee 

1. Existence of Principal debt

The existence of a recoverable debt is a prerequisite for a existence of contract of guarantee. The main purpose of a guarantee is to secure in the interest of the creditor in case of default on the part of the debtor. Hence it can be understood that the aforesaid arrangement finds its genesis in the existence of a recoverable debt. [6] The same has been ascertained by the court in the case of of Swan v. Bank of Scotland, the bank sued the defendant for his overdraft from the bank account which was contrary to the statutes, imposing a penalty on him as well as making it void. The defendant defaulted, since there was no existence of the principal debt, no liability arises and surety was not liable as well.[7]

2. Consideration

A contract devoid of consideration is not valid as it would not be legally enforceable. For a contract to be a valid contract, consideration is must. Section 127 of the Indian Contract Act, of 1872 talks about the consideration involved in the contract of guarantee

“Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee.”[8]

This section states that when the creditor gives a loan to the principal debtor or refrains from suing the debtor, the credit so given or the promise not to sue the debtor works as sufficient consideration for the surety for his guarantee. The benefit to the principal debtor is treated as sufficient consideration for the surety.

3. Misrepresentation and concealment

The third essential for the contract of guarantee is that it should not be obtained through misrepresentation or by any concealment of a material fact from the surety, else under sections 142 & 143 of the Indian Contract Act, 1872 it would become invalid. In the case of London General Omnibus Co v. Holloway, the defendant was required to furnish a guarantee for the loyalty of a servant, the plaintiff who is the employer didn’t disclose the fact that the servant was already in the past and was dismissed due to his activities. The servant again committed embezzlement.

The court held that since there was concealment of a material fact which could have altered the decision of the guarantor to become a surety. The judge, in this case, added that it should be assumed that the surety in the absence of material fact which should have been told to him, must have presumed that he is taking the guarantee of an honest man. Subsequently, it was held that the surety could not be held liable in such situations.[9]

4. In Writing or Oral

In English law, according to the Statute of Frauds, a contract of guarantee is not enforceable unless it is written and signed by the parties to the contract. Whereas in Indian law, Section 126 of the Indian Contracts Act 1872 expressly mentions that a contract of guarantee may be in either form, written or oral.

Multidimensional personality of the surety

In a contract of guarantee surety under goes multi-personality roles as of principal debtor, as of creditor, and as his own as surety. The multi-personality roles of surety are discussed in detail below-

Co-extensive

According to section 128 of the Indian Contracts Act of 1872, the liability of surety in a contract of guarantee is co-extensive with that of the principal debtor. The section states that “The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract.”[10]

The word co-extensive shows the maximum extent of the surety’s liability. It states the surety is only liable to the creditor to the extent of the principal debtor in case of his default. The liability of the surety is equivalent to that of the surety until any restriction is mentioned in the terms of the contract.

Liability of Surety with no specific terms of restriction

In the case of Indian Over Seas Bank v G Ramulu, the plaintiff sued the defendant along with two of his surety for repaying his debt along with the interest and all other charges. The borrower, the defendant, defaulted in making the payment. The court held that the surety is liable to pay back the debt along with the interest and all other charges due. The court held that the liability of the surety is co-extensive to the principal debtor, hence they are liable to pay to the extent which the principal debtor was supposed to pay[11].

Liability of surety is limited to the terms of the guarantee

In the case of Central Bank of India v Virudhunagar Steel Rolling Mills Ltd, the plaintiff bank sued the guarantor to recover the debt pre-existing to the contract of guarantee, which was not mentioned in the terms of the contract.

The Supreme Court held that the surety is only liable to the extent to the terms for which the contract of guarantee is given and not more than that. SC also mentioned that it doesn’t mean that pre-existing liability can never be fastened upon the guarantor, it can be, provided that it is mentioned in the terms of the contract of guarantee.[12]

Liability of surety in case of a minor as a principal debtor

In Coutts & Co v. Browne Lecky, the plaintiff sued the defendant, the guarantor of an infant's loan to repay his debt. The court held that the contract of the loan with an infant is void under Section 1, of the Infant’s Relief Act, 1874 hence infant cannot be made liable, so there is no debt, which means no default by the principal debtor, so eventually surety cannot be made liable.[13]

Whereas this is not the case in the Indian Context, in India it has been held that where the minor’s debt is guaranteed knowingly, the surety is liable to the creditor for the minor's default. In Kashiba Bin Narsapa Nikade v. Narshiv Shripat, the Bombay high court held that irrespective of the fact that the contract with a minor makes the whole contract void, the surety would be held liable. [14]

The rationale behind this could be that the surety concealed the fact of the minority of debtor from the creditor or it can be that the minor might have been supplied with the goods of necessity, making surety to reimburse the creditor.

A suit against surety before the principal debtor

Judiciary has intervened in multiple occasssion in an attempt to rationalize the concerned issue, for instance,

1. In the case of Bank of Bihar Ltd v. Damodar Prasad, the defendant guaranteed a bank loan, for default of which the plaintiff sued the surety to pay back the debt. The trial court gave a decree to the plaintiff to first proceed against the principal debtor and then the surety, which was upheld by the Patna High Court.[15]

2. The Supreme Court of India overruled the judgement by the Patna High Court, stating that it would defeat the very objective of the contract of guarantee if the creditor is not able to sue and recover his money from the surety in case of default by the debtor. The Allahabad High Court also gave a similar ruling as the SC without mentioning it.[16]

3. In SBI v. Indexport, the Delhi High Court gave his judgement that a decree holder must proceed against the mortgaged property, and then to the surety. Which was overruled by the Supreme Court, Yogeshwar Dayal J. said that “it is up to the decree-holder to whom to proceed against first, he can proceed in any form”.[17]

Therefore it can be concluded from the Judgement of the Supreme Court that the suit can be filed against surety first and there is no hard and fast rule to first proceed against the principal debtor. It is totally up to the creditor or the decree-holder to choose whom to sue first.

The surety assumes the rights and position of the creditor.

Section 140 of the Indian Contracts Act, of 1872 states that

“Where a guaranteed debt has become due, or default of the principal debtor to perform a guaranteed duty has taken place, the surety upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the principal debtor.”[18]

The section stipulates that when the principal debtor defaults in performing perform his duty, the surety as a guarantor pays or performs all the duties the principal debtor was liable for. Then the surety assumes the role of the creditor, and he is assigned all the rights and remedies which the creditor had against the principal debtor, the aforesaid principle is also referred to as the Right of Subrogation. 

“Doctrine of subrogation is a legal doctrine whereby one person assumes the rights and remedies granted to a creditor against the principle debtor”. [19]In the case of a contract of guarantee, it is the surety who assumes the role of the creditor and takes all his rights and remedies against the principal debtor after performing the duty which the debtor failed to perform. it must be observed that the liability of the surety is co-extensive to that of the principal debtor falling him in the shoes of the principal debtor. Now we will see that the rights which he (surety) gets are not less co-extensive than that of the creditor after he performs his duty of guarantee.

In Lamplugh Iron Oreiron ore co, the surety, the director of the company under liquidation, guaranteed the rent and paid it on the default of the company to pay. It was held that the time he performed his duty to pay the rent as surety, he stepped in the foot of the creditor. He was entitled to be indemnified for all the expenses, in this case, rent, incurred by him from the principal debtor, and can use all the remedies and rights available with the creditor to indemnify his loss from the debtor. [20]

A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not; and if the creditor loses, or, without the consent of the surety, parts with such security, the surety is discharged to the extent of the value of the security.[21]

Section 141 recognises and incorporates Craythorne v. Swinburne stating that the surety is entitled only to those securities which the creditor had at the time of guarantee from the principal debtor. [22]

The question arises, as to what extent the surety is entitled to the securities. The question is answered in various cases across different periods

1. In the case of Forbes v. Jackson, the defendant took a loan of $200 for which he had given two securities to the plaintiff. On the same securities, he took another loan from the plaintiff. He defaulted on his payment of 1st debt, on which surety was called, who paid it. The surety after discharging his duty of guarantee for the 1st debt claimed the securities, but the creditor demanded the repayment of the second debt. The court held that Surety’s rights were not affected by further debts and he is entitled to the securities.[23]

2. However the above judgement was not satisfying, then comes the judgement of the Bombay High Court in the case of Goverdhandas Goculdas Tejpal v. Bank of Bengal, where the court held that the surety is only entitled to the part of the property for which he has given the guarantee for. [24]

Right to Indemnity

Section 145 of the Indian Contract Act, of 1872 talks about the implied promise between the principal debtor and the surety to indemnify surety, it states that

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, but, no sums which he has paid wrongfully.[25]

There are three contracts formed in the contract of guarantee, between

1. Principal debtor and the creditor – Primary contract

2. Surety and the creditor – Secondary contract

3. Surety and the principal debtor – Implied contract

The third contract between the surety and principal debtor is an implied contract. The surety steps in the shoes of the creditor to recover what he had paid for the debtor to the creditor, by the way of indemnity. The surety gets a right to recover the entire sum which he has lawfully paid to the creditor.

Illustration from section 145

C lend B a sum of money, A being surety to it. B defaults in payment, subsequently, C asks A for repayment. A without any reasonable cause refuses to pay, and C sues A. A had to pay the debt along with the cost of legal proceedings. A then asks B to indemnify him for the debt and the cost. He was able to recover only the debt amount.[26] The reason for non-recovery being that there was no reasonable cause for A to refuse to pay. So he was entitled to the debt amount which he lawfully paid but not for the cost which he paid wrongfully.

Surety as Surety

A surety is a person who gives a guarantee for the principal debtor to the creditor. Surety as surety has its rights, remedies and duties which are stated as follows according to the Indian Contract Act, of 1872

Right of Surety

1. Most of the rights of surety are already covered above such as

   a. Right of subrogation (S.140)

   b. Right of Indemnity (S.145)

   c. Right to security (S.141)

Surety has the Right to revoke the continuing guarantee at any time by notice to the creditor of future transactions. (S.130), by death (S.131)

 Surety’s right as co-surety to contribute equally (S.146)

Rights of surety before payment of debt

It is the duty of the surety to see that creditor is been paid, due to this reason few rights are given to the surety before he performs his duty such as

Temporary Injunction – the court can grant a temporary injunction to surety if it sees that the principal debtor is trying to dispose of his property and the ultimate burden will shift on the surety.

To compel principal debtor  - Surety has a right to sue the principal debtor to ensure the timely performance of the debtor's duty of making payment or performance. He has a right to compel principal debtor, as when the duty becomes due, to exonerate themselves from the liability or to relieve themselves from the necessity to pay out of their pockets.

Discharge of Surety from his Duty

1. Various instances in which surety, as a surety is being released from his duties, are as follows-

2. The principal debtor doesn’t default at all, surety is released

3. Surety has discharged the debt by payment or performance of the contract

4. Revocation of continuing guarantee by notice or by death

5. Invalidation of the contract by

   a. Misrepresentation or Fraud

   b. Lacks essential elements of contract

6. By variance in the terms of the contract by the creditor and principal debtor, without surety’s consent

7. Release or discharge of the principal debtor

8. Arrangement by the creditor with the principal debtor

9. Creditor's act or omission impairing securities harming the eventual remedy of the surety

In all the above instances the surety is released from his duties partially or fully as the case may be.

Conclusion

In ancient history, there were no such contracts of guarantee per se. The concept of guarantee first emerged in ancient Rome, along with the legal provisions. With the passage of time, these guarantee contracts with legal provisions spread throughout the world through various usages and pieces of literature, such as ‘The Merchant of Venice’ by Shakespeare showing the concept of guarantee.

The provisions related to the contract of guarantee are defined under Chapter VIII of the Indian Contract Act, 1872, from Section 126 to Section 147. Throughout the chapter, the surety changes its rights and duties. The character of ‘surety’ undergoes a ‘multiple-personality’ very much in legal order, and the law gives recognition to this multi-faceted personality of the ‘surety’ through very specific provisions under the Indian Contract Act of 1872. For instance, under Section 128, the surety steps into the shoes of the principal debtor, and Sections 140, 141, and 145 step into the shoes of the creditor and various own rights of the surety itself.

In this modern world of globalization, the contract of guarantee plays a very crucial role. A contract of guarantee serves as a guarantee for a creditor of small stationery to the lender or creditors of a large ship for the transportation of goods. The proper codification of a guarantee contract helps to solve various disputes related to it, and for the things outside the codified law, the judiciary plays an important role.

Recommendations for re-drafting of statute

Section 128 - This section uses the term ‘co-extensive’ to describe the liability of the surety as being equal to that of the principal debtor. In this statute, the term ‘co-extensive’ can be substituted with ‘equivalent’. The word 'equivalent' encompasses both increases and decreases in the surety’s liability, whereas 'co-extensive' tends to imply only an increase in liability.

Section 139- This section addresses only the ‘act’ of the creditor that is inconsistent with the rights of the surety. The term ‘act’ should be replaced with ‘act or abstinence’, which would cover both actions and omissions by the creditor.

Reference

[1] Indian Contract Act, 1872, § 126, No. 9, Act of Parliament, 1872 (India)

[2] Wm.; Hammond Theobald, E. Law of Principal and Surety and Principal and Agent: Chiefly with Reference to Mercantile Transactions (1836).

[3] Wood, Law and practice of international Finance (1980) 295

[4] Birkmyr v. Darnell 91 ER 27

[5] Mahabir Shum Sher v. Lioyds Bank, AIR 1968 Cal 371

[6] Avtar Singh, Contract Act, and Specific Relief pg.601 (Eastern Book Company 12th ed. 2017)(1973)

[7] Swan v. Bank of Scotland (1836) 10 Bligh NS 627

[8] Indian Contract Act, 1872, § 127, No. 9, Act of Parliament, 1872 (India)

[9] London General Omnibus Co v. Holloway (1912) 2 KB 72 (CA)

[10] Indian Contract Act, 1872, § 128, No. 9, Act of Parliament, 1872 (India)

[11] Indian Over Seas Bank v G Ramulu (1999) 2 ALD 104

[12] Central Bank of India v Virudhunagar Steel Rolling Mills Ltd (2016) 2 CHN 98

[13] Coutts & co v. Browne Lecky 1947 KB 10

[14] Kashiba Bin Narsapa Nikade v. Narshiv Shripat ILR (1895) 19 Bom 697

[15] Bank of Bihar Ltd v. Damodar Prasad AIR 1969 SC 297

[16] Avtar Singh, Contract Act, and Specific Relief pg.621 (Eastern Book Company 12th ed. 2017)(1973)

[17] SBI v. Indexport (1992) 3 SCC 159

[18] Indian Contract Act, 1872, § 140, No. 9, Act of Parliament, 1872 (India)

[19] Bhandari, N. (1970) Doctrine of subrogation and its uses in contract of gaurantee, IJARnD. IJARnD. Available at: https://www.ijarnd.com/manuscript/doctrine-of-subrogation-and-its-uses-in-contract-of-gaurantee/  (Accessed: April 15, 2023). 

[20] Lamplugh iron ore co (1927) 1 Ch 308

[21] Indian Contract Act, 1872, § 141, No. 9, Act of Parliament, 1872 (India)

[22] Craythorne v. Swinburne (1807) 12 Ves Jun 160

[23] Forbes v. Jackson (1882) LR 19 Ch D 615

[24] Goverdhandas Goculdas Tejpal v. Bank of Bengal ILR (1891-92) 15 Bom 48

[25] Indian Contract Act, 1872, § 145, No. 9, Act of Parliament, 1872 (India)

[26] Indian Contract Act, 1872, § 145, No. 9, Act of Parliament, 1872 (India)