Contract of Guarantee under the Indian Contract Act, 1872

A contract of guarantee is a tripartite promise in which one person (the surety or guarantor) agrees to answer for the debt or default of a third person (the principal debtor) in favour of a creditor. Section 126 of the Indian Contract Act explicitly defines it:

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’.

Unlike a simple contract between two parties, a guarantee involves three parties and is accessory to a principal contract between the creditor and debtor. In practice, this means the surety’s promise arises only upon the default of the principal debtor; until then, the principal debtor remains primarily liable for the debt. The surety’s liability is co‑extensive with that of the principal debtor (unless the guarantee specifies otherwise). Notably, Section 126 allows guarantees to be oral or written, though in commercial practice written guarantees (often evidenced by a “guarantee deed” or bank guarantee) are preferred.

Essential Elements and Validity

For a contract to qualify as a valid guarantee under the Act, several essentials must be satisfied:

• Tripartite Agreement: The contract must be made with the knowledge and consent of all three parties. That is, the principal debtor, creditor, and surety must agree. The surety’s promise must be given at the request (express or implied) of the principal debtor or for that party’s benefit. A surety cannot impose himself on an unaware debtor or unknowing creditor; all three must be linked.

• Existing Liability or Promise: There must be a debt, obligation, or promise by the principal debtor (the principal liability) in existence. If no principal debt exists, the contract cannot operate as a guarantee. In other words, the guarantee is collateral to an underlying contract; if the principal contract is void, unenforceable or time‑barred, the surety’s obligation generally fails.

• Consideration: There must be sufficient consideration for the surety’s promise. Under Section 127, “Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety”. In practice, the consideration is usually the original loan or benefit extended by the creditor to the principal debtor. Sometimes, forbearance by the creditor (e.g. tolerating a short delay or refraining from immediate legal action) has been held sufficient consideration. For example, in State Bank of India v. Premco Saw Mill (1983), the Supreme Court held that the Bank’s forbearance from suing the debtor constituted valid consideration for the husband’s promise to act as surety.

• Secondary Liability: The surety’s obligation must be secondary, arising only on the debtor’s default. The surety does not promise to pay unless the principal debtor fails to do so. Accordingly, a guarantee presupposes a valid underlying contract. If the principal contract lacks essential validity requirements (free consent, lawful consideration, lawful object), then a subsidiary guarantee cannot stand on its own. In short, all the usual essentials of a valid contract (offer, acceptance, capacity, lawful object, free consent, etc.) must apply to the guarantee as well.

• Good Faith (No Misrepresentation or Concealment): Although a contract of guarantee is not absolutely uberrimae fidei (of “utmost good faith”), Indian law still demands that the creditor disclose all material facts affecting the surety’s liability. Sections 142–143 explicitly void any guarantee obtained by fraud, misrepresentation or concealment by the creditor. For instance, if the creditor knowingly conceals relevant information (e.g. the debtor’s insolvency risks) or misstates material facts to induce the surety, the guarantee can be invalidated.

In summary, a valid guarantee must have all three parties’ assent, a genuine underlying obligation, lawful consideration, and no unfair suppression of material facts.

Types of Guarantees

The Act itself explicitly recognises only one special type – the continuing guarantee (Section 129) – but Indian law and practice recognise several categories of guarantee contracts:

• Specific (Ordinary) Guarantee: A specific guarantee covers a single transaction or a specific debt. Once that debt is discharged (by payment or performance), the guarantee ceases. For example, if A guarantees B’s repayment of a single Rs.10,000 loan, that is a specific guarantee. The surety is not liable for any further transactions beyond that specified debt.

• Continuing Guarantee (Section 129): A continuing guarantee is one which “extends to a series of transactions”. Under Section 129, a surety may guarantee multiple credit transactions (e.g. several deliveries of goods, repeated borrowings, etc.) up to a specified limit. The guarantee remains in force for all covered transactions until revoked. For instance, if C guarantees that A will pay any bills B draws on A up to ₹50,000 over a year, that is a continuing guarantee. Law requires the surety to expressly limit the scope (e.g. amount or time) or revoke the guarantee; otherwise, it continues indefinitely for covered dealings.

• Prospective vs. Retrospective Guarantee: (Sometimes discussed) A guarantee given for a future debt (not yet incurred) is a prospective guarantee. One given for an existing or past debt is a retrospective guarantee. Both are recognised. For example, promising to guarantee a loan that will be taken next week is prospective; promising to guarantee an already overdue debt is retrospective.

• Fidelity Guarantee: This is essentially a guarantee of good conduct rather than payment of money. In a fidelity guarantee, the surety assures the employer (obligee) of an employee’s honesty or skill. For example, an employer might require a bond that a cashier will not embezzle funds. Section 139(3) (illustration at [6]) explicitly acknowledges fidelity guarantees. In practice, fidelity guarantees (often backed by insurance) protect against loss from a servant’s dishonesty or negligence. Note: A fidelity guarantee is not a continuing guarantee; it typically arises from one instance of misconduct.

• Performance Guarantee: Often used in contracts for construction or supply, a performance guarantee is a form of specific guarantee where the surety promises the purchaser or employer that the contractor will duly perform its obligations. If the contractor fails, the surety must compensate for non‑performance. In Indian practice, performance guarantees are usually issued by banks or insurance companies (called performance bonds). They are generally time‑limited and tied to contract milestones. (Under Section 124–125 of the Contract Act, a bank’s promise to compensate for non-performance is technically an indemnity, but most “bank guarantees” operate as guarantees by bank/surety). As one commentator puts it, a performance guarantee “assures that specific conditions… will be fulfilled… especially for construction projects”.

• Financial Guarantee: A financial guarantee assures the creditor that a borrower’s financial obligations will be met. In credit and loan arrangements, a third-party surety (often a bank or corporate parent) guarantees repayment of the debt or interest. Under this category fall most bank guarantees against financial loss. The Financial Guarantee ensures that if the debtor fails to pay, the guarantor covers the payment to the lender. Such guarantees are prevalent in corporate borrowing and bond issuances. (Note: A simple loan guarantor, or a parent company guaranteeing its subsidiary’s loans, exemplify financial guarantees).

In summary, guarantees can be classified by scope or subject: specific vs. continuing, or by purpose: fidelity (honesty), performance (contractual duty), and financial/payment guarantees. Each type operates under the same fundamental rules of suretyship in the Act, although the context (e.g. an employer-employee relationship in fidelity guarantees) may invoke other legal principles.

Rights and Duties of the Parties

The law of guarantee confers certain rights on each party and imposes duties or restrictions on others, to protect the secondary nature of the surety’s obligation:

• Rights of the Surety

  1. Right to Securities (Section 141): If the creditor holds any collateral or security for the debt at the time of contract, the surety is entitled to the benefit of that security. Thus, after paying the debt, the surety can call on the creditor to enforce the security and apply proceeds against the principal’s liability. If the creditor surrenders or loses the security without the surety’s consent, the surety is discharged pro tanto (to the value lost). Example: C advances ₹2,000 to B on A’s guarantee, securing it with B’s mortgaged furniture. If C later cancels the mortgage without A’s knowledge, A is discharged to the extent of the furniture’s value.

  2. Subrogation (Section 140): When the surety pays off the creditor, he “steps into the shoes” of the creditor (subrogation). The surety then acquires all rights that the creditor had against the principal debtor, including legal remedies. For example, he can sue the principal debtor for the debt just as the original creditor could. This principle is firmly recognized in Indian law. In Babu Rao Ramchandra Rao v. Babu Manaklal (Kerala HC), it was held that once the surety pays, he may “claim all the rights that the creditor had” and recover indemnity from the principal.

  3. Right to Indemnity: Closely related to subrogation, every surety has an implied right to be indemnified by the principal debtor after performing under the guarantee. Although not codified as a section, the Contract Act (by Section 145 and general principles) implies that the principal debtor must reimburse the surety for all sums paid on his behalf. Thus, the surety can recover from the principal any amount (and even litigation costs) he had to pay to the creditor.

  4. Set‑Off (Equitable Right): Equity allows the surety to set off any claim that the creditor has against the principal debtor in a separate transaction, when the creditor seeks to enforce the guarantee. In other words, the surety need not pay more than the net liability. For example, if A guaranteed B’s debt to C, but C owes A money on a different account, A can deduct that from what he pays C under the guarantee.

  5. Contribution from Co‑Sureties (Sections 146–147): If two or more sureties jointly guarantee the same debt, they share liability. Absent an agreement to the contrary, co-sureties are presumed to contribute equally. If one surety pays more than his share, he can claim contribution from the others. If the original guarantee specifies different amounts for co-sureties, each pays in that proportion.

  6. Right Against Released Co‑Sureties (Section 138): If the creditor releases one co-surety, the others are not discharged. The released surety still owes contribution to his co-sureties if those co-sureties paid part of his share. Conversely, the release of one surety does not free the others.

• Duties and Restrictions on the Creditor

  The creditor (the beneficiary of the guarantee) has certain duties and limitations designed to protect the surety’s rights:

  1. Fair Dealing: The creditor must not do anything to prejudice the surety’s eventual remedy against the principal. Section 139 provides that if the creditor acts in a way inconsistent with the surety’s rights, or omits any duty owed to the surety, and this impairs the surety’s remedy against the principal, the surety is discharged. For example, in State of M.P. v. Kaluram (1966) the Supreme Court held that if a creditor allows the principal debtor to dispose of security (thereby harming the surety’s ability to recover), the surety is discharged.

  2. No Release of Principal without Surety: Under Section 134, if the creditor releases or discharges the principal debtor by any act or agreement (without the surety’s consent), the surety is also discharged. For instance, if the principal is declared insolvent or settles with the creditor, the surety’s obligation ends. Similarly, any act which makes the principal’s obligation void (e.g. B’s promise without fulfilling a condition) discharges the surety.

  3. No Unauthorized Variation: By Section 133, any unilateral change to the terms of the principal contract (loan agreement, terms of supply, etc.) without the surety’s consent discharges the surety as to future transactions. For example, increasing the interest rate or extending time for the principal debtor without notifying the surety will free the surety from liability for defaults after the change.

  4. Promises of Time/Forbearance (Sections 135–137): Generally, if the creditor makes an independent agreement to extend time or composition with the principal debtor, the surety is discharged unless he consents (Sec.135). However, if the delay or forbearance arises from an agreement with a third party, the surety remains liable (Sec.136). Mere forbearance by the creditor (simply not suing for a period) does not discharge the surety absent a specific agreement (Sec.137).

  5. Disclosure of Material Facts: Although not codified as a duty per se, the creditor should not obtain a guarantee by fraud or material non-disclosure. As noted above, misrepresentation or concealment by the creditor voids the guarantee (Secs.142–143).

In effect, the creditor cannot unilaterally alter the risk or prejudice the surety’s recourse. If the creditor does so, the law heavily favors the surety and discharges his liability.

• Duties of the Principal Debtor

  The principal debtor’s duty is the primary obligation to the creditor: to pay the debt or perform as promised. The guarantor is only secondary. After the surety pays, the principal is bound to reimburse the surety (by implied indemnity). If the principal injures the guarantee relationship (e.g. by contract variation without surety’s knowledge), he effectively frees the surety under Sections 133–135. In short, the principal must cooperate in ensuring the creditor’s remedy (e.g. preserving security); otherwise, he risks losing the surety’s aid.

Discharge of the Surety (Sections 130-139)

Indian law provides many ways in which a surety is discharged (i.e. freed from future liability). Key provisions include:

• Section 130 (Revocation by Notice): A surety under a continuing guarantee can revoke the guarantee as to future transactions by giving notice to the creditor. Once validly revoked, the surety is not liable for any further dealings. (Liability already accrued before revocation remains).

• Section 131 (Death of Surety): The death of the surety likewise revokes a continuing guarantee as to future transactions. The surety’s estate remains liable for obligations already incurred, but no new obligation can attach after death.

• Section 132 (Two-person Arrangement): If two persons make a joint promise to a creditor and privately agree that one will be liable only upon the other’s default (a private surety arrangement unknown to the creditor), the creditor can still sue either independently as jointly liable. (In effect, undisclosed side‑agreements between co‑obligors cannot prejudice the creditor or the public).

• Section 133 (Contract Variation): Any variation of the principal contract without the surety’s consent discharges the surety as to future liability. For example, changing the debtor’s obligations or increasing the debt amount voids the continuing guarantee for any defaults after the change.

• Section 134 (Release of Principal): If the principal debtor is released or discharged (by contract, law, or operation of law) by the creditor’s act, the surety is also discharged. This includes formal releases, settlements in bankruptcy, or tortious prevention of performance (illustration: if the creditor’s wrongful act makes performance by the principal impossible, the surety is freed.

• Section 135 (Composition/Time): A composition (settlement) with the principal debtor, or the creditor promising to give time or not to sue, discharges the surety unless he consents. This aligns with the principle that the surety contracts for strict performance, and cannot complain if the creditor agrees to extend credit.

• Section 136 (Extension to Third Party): If the creditor grants time to a third party (not the principal debtor) for payment, without the principal debtor’s involvement, the surety is not discharged. The logic is that the principal debtor’s position has not changed by a collateral arrangement between creditor and someone else.

• Section 137 (Forbearance to Sue): Mere forbearance by the creditor to sue the principal debtor does not, in itself, discharge the surety. (Except as noted, formal agreements to give time do affect liability, but passive waiting by the creditor does not).

• Section 138 (Release of Co-surety): As noted, releasing one co-surety does not release the others. Each surety remains liable for his share, and the released surety remains bound to co-sureties for contribution if applicable.

• Section 139 (Creditor’s Prejudicial Act): If the creditor does any act inconsistent with the rights of the surety, or omits any duty toward the surety, and thereby impairs the surety’s remedy against the principal, the surety is discharged. Examples include prepaying or prematurely cancelling the debt without the surety’s knowledge.

In practice, these provisions mean a surety is discharged when the risk he agreed to cover has materially changed or vanished without his consent. Any action by creditor or principal that widens the surety’s risk or cuts off his recourse will free the surety from further obligation.

Judicial Illustrations

Indian courts have further clarified these rules in various cases:

• In Addanki Narayanappa v. Bhaskara Krishnappa (1966), the Supreme Court held that once a person voluntarily steps into the role of surety, he cannot withdraw except on grounds of law (fraud, undue influence, etc.). The surety’s obligation remains “co‑extensive” with the principal’s debt.

• In Rajappa v. Associated Industries (Kerala HC, 1990), it was held that even an unsigned guarantor can be bound by a guarantee if the evidence shows his clear intention to guarantee the debt. The court noted that “[a] contract of guarantee is a tripartite agreement” and the guarantor’s involvement in the transaction can bind him even if he did not formally sign.

• In State of Madhya Pradesh v. Kaluram (1966), the Supreme Court ruled that the creditor’s actions could discharge the surety. There, the creditor had allowed the principal debtor to dispose of collateral securing the loan; the court held this prejudicial act discharged the surety from liability. This underscored Section 139’s protection of the surety’s interests.

• In Babu Rao Ramchandra Rao v. Babu Manaklal Nehmal, a Kerala High Court case, it was affirmed that once the surety paid the creditor, he acquired all the creditor’s rights against the debtor and could claim indemnity. This case illustrates the subrogation right: the surety steps into the creditor’s shoes after payment.

• A recent Supreme Court decision (Civil Appeal No. 4565/2021, decided July 2024) reiterated these principles in the insolvency context. The Court emphasized that under Section 128 “the liability of the surety and the principal debtor is co-extensive” and that the creditor may proceed against the surety without first exhausting remedies against the principal. The Court quoted Section 126 verbatim (see above) to remind that a guarantee is an independent, tripartite contract.

These cases illustrate key themes: a guarantee is strictly construed in favour of the surety, who cannot be saddled with new obligations without consent, but also that a voluntarily assumed guarantee cannot be lightly escaped. The courts balance the surety’s protection (against surprise and prejudice) with enforcement of commercial confidence.

Conclusion

Under Indian law (Contract Act, 1872, Chapter VIII), guarantees play a vital role in commerce by providing security to creditors. The Act’s provisions carefully delineate the scope, elements, and limits of a surety’s liability. A valid guarantee must involve three consenting parties, a real debt, and lawful consideration, and be free of fraud. Different types of guarantees (specific, continuing, fidelity, performance, financial) serve different needs but rest on the same principles. The surety enjoys robust statutory rights (subrogation, indemnity, securities, contribution) to prevent unjust burden. Simultaneously, creditors are bound by duties not to alter the risk (e.g. by varying terms, releasing the principal, or misusing securities). Discharge provisions (Sections 130–139) outline when a surety is freed — for instance, upon revocation of a continuing guarantee, death, or prejudicial acts by creditor or principal.

In sum, the Contract Act treats the guarantee as an accessory yet solemn commitment: secondary in liability, but enforceable with the protection of detailed safeguards. Law students and practitioners must appreciate how these rules have been fleshed out by Indian courts (from Narayanappa to recent judgments) to ensure that suretyship remains a fair and predictable institution in Indian contract law.

References: Text of the Indian Contract Act (Sections 126–139) indiacode.nic  legal commentary and case summaries legalserviceindia.com lawbhoomi.com api.sci.gov.in.