Understanding Contract of Guarantee
In the world of commerce and finance, transactions often involve an element of trust — but trust alone is rarely enough. To secure credit and ensure performance, law provides the concept of guarantee. A Contract of Guarantee acts as a safety net for creditors by involving a third person who promises to discharge the liability of another if they fail to do so.
According to Section 126 of the Indian Contract Act, 1872, “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 for whom the guarantee is given is the principal debtor, and the person to whom the guarantee is given is the creditor.
In simple terms, a contract of guarantee is a three-party contract where the surety undertakes to fulfill the debt or duty of the principal debtor if the latter defaults.
Essential Characteristics of a Contract of Guarantee
A valid contract of guarantee must possess the essentials of a valid contract under the Indian Contract Act (Sections 10 and 126–128), along with specific features that distinguish it from other contracts. These characteristics are discussed below:
1. Three Parties and Tripartite Agreement
A contract of guarantee necessarily involves three parties —
- Creditor, who provides goods, services, or money;
- Principal Debtor, who is primarily liable; and
- Surety, who undertakes to discharge the liability if the debtor defaults.
Although there are three parties, there is only one contract, but it embodies three distinct relationships — between creditor and debtor, debtor and surety, and surety and creditor.
Example:
If A borrows ₹1,00,000 from B and C guarantees repayment, there is one contract of guarantee involving all three parties.
2. Consideration (Section 127)
For a guarantee to be valid, consideration must exist. However, consideration received by the principal debtor is sufficient for the surety. The Act expressly provides that “anything done, or any promise made, for the benefit of the principal debtor is sufficient consideration to the surety.”
Example:
If B gives a loan to A on C’s guarantee, the loan itself serves as consideration for C’s promise. C need not receive any direct benefit.
3. Consent of the Surety Must Be Free
The consent of the surety must be obtained freely and without coercion, misrepresentation, or concealment of material facts. According to Section 142 and Section 143, any guarantee obtained by misrepresentation or concealment is invalid.
Example:
If a creditor conceals the debtor’s insolvency while obtaining the surety’s consent, the guarantee is void.
4. Existence of a Principal Debt
A guarantee presupposes the existence of a debt or obligation enforceable against the principal debtor. If there is no enforceable debt, there can be no guarantee.
Example:
If A promises to pay B for goods supplied to C, but the supply itself is unlawful, the guarantee is void because the principal obligation is illegal.
5. Liability is Secondary and Conditional
The liability of the surety is secondary — it arises only if the principal debtor defaults. The principal debtor remains primarily liable, while the surety’s obligation is collateral. According to Section 128, “the liability of the surety is co-extensive with that of the principal debtor, unless otherwise provided by the contract.”
Example:
If A defaults in paying the loan, B (creditor) can demand the same amount directly from C (surety), since their liabilities are co-extensive.
6. Written or Oral Agreement
Unlike some contracts that must be in writing, a contract of guarantee may be oral or written as per Section 126. However, in practice, written guarantees are preferred for clarity and evidence.
7. Intention to Create Legal Relationship
A guarantee must be entered into with the intention of creating legal obligations. Social or moral promises are not enforceable as guarantees.
Difference between Indemnity and Guarantee
Though both indemnity and guarantee provide security against loss, they differ in their nature, parties involved, and extent of liability. The distinctions are outlined below:
| Basis of Difference | Contract of Indemnity | Contract of Guarantee |
|---|---|---|
| 1. Definition | Defined under Section 124 as a contract where one party promises to save the other from loss caused by the conduct of the promisor or another person. | Defined under Section 126 as a contract to perform the promise or discharge the liability of a third person in case of default. |
| 2. Number of Parties | Involves two parties — Indemnifier and Indemnified. | Involves three parties — Creditor, Principal Debtor, and Surety. |
| 3. Number of Contracts | Only one contract exists between indemnifier and indemnified. | Three relationships exist within a single contract — between creditor, debtor, and surety. |
| 4. Nature of Liability | Liability of indemnifier is primary and absolute. | Liability of surety is secondary and conditional on the debtor’s default. |
| 5. Existence of Debt | No existing debt or duty is necessary. | Guarantee presupposes an existing or future debt. |
| 6. Rights after Payment | Indemnifier cannot sue third parties in his own name after paying the loss. | Surety becomes entitled to all rights of the creditor against the debtor after paying the debt (Section 140). |
| 7. Objective | Protects against possible loss. | Ensures performance of an obligation or repayment of debt. |
Real-Life Example: Banking and Loan Transactions
In banking practice, contracts of guarantee are extremely common. When a borrower takes a loan, the bank often requires a third person (surety) to guarantee repayment.
For example, when a parent guarantees their child’s education loan, they enter a contract of guarantee with the bank. If the student (principal debtor) fails to repay, the bank can demand the payment from the parent (surety).
In contrast, in an insurance policy, the insurer promises to compensate the insured for any financial loss — this is a contract of indemnity, as it involves only two parties and protects against loss, not debt.
Mnemonic to Remember the Essentials and Differences — “3CLIS DIFF”
Use the mnemonic “3CLIS DIFF” to recall key points easily:
Essentials of Guarantee (3CLIS):
- 3 – Three Parties (Creditor, Debtor, Surety)
- C – Consideration under Section 127
- L – Liability is secondary (Section 128)
- I – Intention to create legal relations
- S – Surety’s consent must be free
Differences (DIFF):
- D – Debt exists in Guarantee, not in Indemnity
- I – Involves 3 parties vs 2 parties
- F – Form of liability (Secondary vs Primary)
- F – Focus (Performance vs Protection from loss)
Mnemonic Sentence:
“3 Clever Lawyers Instantly See Distinct Important Financial Features.”
This quick phrase helps law students remember both essentials of guarantee and differences from indemnity during revision or exams.
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