Contracts of Guarantee (Part 1)

This is the first blog post in a three-part series based on Contract of Guarantee.

What is a Contract of Guarantee?

A contract of guarantee is defined as, “a contract to perform a promise or discharge a liability, of the third person if he makes any default” (Section 126 of Indian Contract Act, 1872). There are three types of parties involved in a contract of guarantee namely:

  1. Creditor: The person extending some form of credit (either in the form of money, loan or by delivering goods with a promise to receive payment later) to another person. The guarantee is given to the Creditor.
  2. Borrower: The person who borrows from the Creditor and on whose behalf the guarantee is provided, in case of default on the promise to make payment.
  3. Guarantor: The person providing the guarantee on behalf of the Borrower.

Typically, the Guarantor assures the Creditor that a Borrower may be trusted. He further assures the Creditor that in case of any default by the Borrower, the Guarantor shall undertake the responsibility to pay. Contracts of guarantee typically enable a person to obtain a loan or goods on credit. The Borrower is primarily liable to pay, and Guarantor is liable to the extent of the Borrower’s liability, if and when the Borrower defaults.

Consideration plays an important role in such contracts. The Creditor’s promise to do something in order for the Guarantor to provide the guarantee is known as consideration. This may be in form of monetary value, or a promise to do something else in return for providing the guarantee. A contract of guarantee without consideration is void in law. “Anything done or any promise made for the benefit of the borrower may be a sufficient consideration to the guarantor” (Indian Contract Act, 1872). For instance, Ram requests Shyam to sell and deliver to him certain goods on credit. Shyam agrees to do so, provided Sita guarantees the payment of the price of the goods if Ram neglects to pay. Sita promises to guarantee the payment in consideration of Shyam’s promise to deliver the goods. This is sufficient consideration for Sita’s promise. Here, Ram is the Borrower, Shyam is the Creditor and Sita is the Guarantor.

Kinds of Guarantee

Contracts of guarantee may be classified into two types:

  1. Specific Guarantee: This is a type of guarantee which is given for a specific transaction or a particular promise. A specific guarantee ends as soon as the transaction is performed or the promise is fulfilled. For example, Sam, a jeweler, sells jewelry to Joy on credit. Sam, Joy, and Joy’s friend, Tom, agree that if Joy fails to pay does not pay the price of the jewelry, Tom would be liable to do so. In this case, Tom’s liability will end the moment the price of the jewelry is paid to Sam.
  2. Continuing Guarantee: This is a type of guarantee which applies to a series of distinct transactions entered into by the Borrower. Continuing guarantees are usually preferred by banks to ensure that the Guarantor’s liability isn’t limited to current EMIs but extends to all the subsequent EMI debts. For example, HDFCI Bank extends a loan to Babu, which Babu is liable to repay in 30 monthly installments. The loan is guaranteed by Mathew. While Babu is liable to pay every installment, the guarantee involves an assurance by Mathew that Mathew will make payment of any and all installments (out of the 30) that Babu defaults.

Part 2 of this series is coming soon which will cover Section 133 of Indian Contract Act. Stay Tuned.

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