Definition: Contract of Guarantee refers to a contractual arrangement in which one party gives a guarantee for another regarding the fulfillment of a promise or repayment of the debt when the latter fails to discharge the liability or perform the undertaking.
That is to say, guarantee means to stand for another person and in a contract of guarantee, the surety assures repayment of the loan on behalf of the one, who has taken the loan but failed to repay. Therefore, it aims at protecting the other party from suffering loss.
Parties Involved in a Contract of Guarantee
The three parties that take part in a contract of guarantee are:
- Principal Debtor: He/she is the one who defaults in the payment of debt and therefore, guarantee is given by another party.
- Creditor: One who extends credit to the Principal Debtor and to whom the guarantee is given.
- Surety: The one who gives assurance to the creditor that he/she will pay the debt in case the principal debtor defaults.
Let us understand the parties with an example:
Suppose Mr. Shah gives a promise to Mr. Joshi, that if he extends 5 lakh rupees to Mr. Rao, for a period of 2 years at an interest of 5% and Mr. Rao defaults in payment, Mr. Shah will repay the debt. This creates a contract of guarantee between Mr. Shah (surety) and Mr. Joshi (the creditor). Here, Mr. Rao is the principal debtor.
Salient Features of Contract of Guarantee
1. Principal Debt: The main objective of guarantee is to ensure payment of the loan amount, so there must exist a debt. Hence it is the nucleus of the contract of guarantee that someone must be liable for the payment of debt and surety commits to fulfill the liability when the former defaults. Therefore, in the absence of any principal debt, no valid guarantee can take place.
2. Consideration: A contract is always backed by adequate consideration, as without any consideration, the contract stands void. However, in the case of a contract of guarantee, no direct consideration exists amidst surety and creditor. This is due to the fact that the consideration which the principal debtor obtains is adequate to the surety to provide a guarantee except when there is past consideration.
Moreover, the contract remains valid, irrespective of the incompetence of the principal debtor. But there will not be any contract if the surety is incompetent.
3. Liability: The existence of a liability or promise is a must, whose discharge or performance is assured by the surety. Also, the liability or promise must have legal enforceability and it is not invalidated on the grounds that the stipulated time has expired.
4. Free from any misrepresentation or concealment: When the guarantee is secured from the surety using misrepresentation made by creditor or concealment of a material fact of the transaction which the creditor has knowledge of, or any guarantee obtained by the creditor by remaining silent on the matter which is material, makes the contract invalid.
5. Oral or written: As per section 126 of the Indian Contract Act, 1872, the contract can either be expressed orally or in written form. So, the writing of a contract is not necessary.
6. Co-sureties: Guarantee given by the surety on the condition that another party must enter as a co-surety, and no one joins as a co-surety, in that case also, contract stands invalid.
7. Tripartite Contract: There are three types of Contract:
- Contract of Indemnity: It exists amidst Surety and Principal Debtor, which is an Implied Contract.
- Loan Agreement: It exists amidst Principal Debtor and Creditor which is a Principal Contract.
- Contract of Guarantee: It exists amidst Surety and Creditor which is a Secondary Contract.
Such Contracts are popularly known as Tripartite Contracts.
The contract of guarantee is purely based on the breach of the loan contract by the principal debtor. And so, in a contract of guarantee, the debtor is not a party, as well as the surety is not directly involved in the primary obligation.
So, the contract of guarantee is mainly between surety and creditor wherein the former guarantees the fulfillment of obligations of the principal debtor. And the principal liability is required to be fulfilled by the principal debtor and the liability of the surety is secondary.
Types of Guarantee
Based on Transaction
- Specific Guarantee: The form of guarantee that sticks to a single debt or a particular transaction is called a specific guarantee. In such a guarantee, as and when the debt is repaid or the promise is fulfilled, the liability is discharged.
- Continuing Guarantee: A type of guarantee that stretches to a number of transactions is continuing guarantee. In such a guarantee, the liability of the surety continues till it is revoked.
Based on Time
- Retrospective Guarantee: A guarantee given by the surety for an existing debt or promise, is a retrospective guarantee.
- Prospective Guarantee: Any guarantee given by the surety for the ensuing debt or promise is a prospective guarantee.
A Word from Business Jargons
A Contract of Guarantee is suitable for those who want to raise money or avail goods on credit, wherein the surety acts as a guarantor, who assures payment of the money in case of failure in payment by the actual debtor.