In Indian Contract Act, 1872, a contract of guarantee is defined as an agreement where one person that is surety agrees to carry on the obligation of a second person meaning principal debtor, if in any case the principal fails to discharge it. In simple words, it is a kind of an agreement that involves a third party filling in for a debt or a liability that the primary party cannot pay. The importance of this provision lies in ensuring that the creditors have a fall back in case the borrower credits his or her contract. The contract of guarantee involves three parties, that is the principal debtor, the surety that means the one who promises to pay in case of the debtor’s default and the creditor that is the person who owes a debt.
Section 126 of Indian Contract Act, 1872 defines the roles and responsibilities of these parties and specifically emphasises that liability of the surety only arises if the principal debtor fails to perform his duty. Commercial transactions and securing debts in India also depend on this Section.
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Contract of Guarantee under Section 126 of Indian Contract Act:
A contract of guarantee under Section 126 of Indian Contract Act, 1872 means that there are three parties in an agreement under which one party agrees to pay to the other to whom some other person is bound to perform if the latter default.
The section reads as: "Contracts of guarantee are contracts to perform the promise or to discharge the liability of a third person in case of his default."
In short a guarantee means a promise given by a person called the surety to pay for the obligations of a borrower (the principal debtor) in case the principal debtor doesn’t pay. The creditor is the person or entity to whom the obligation is owed.
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Parties Involved in a Contract of Guarantee:
A contract of guarantee under Section 126 of Indian Contract Act, 1872 involves three distinct parties, these are:
Principal Debtor: According to Section 126 of Indian Contract Act, 1872, principal debtor is a person or party against whom the promise or debt as the case may be, is made. A surety is one who steps in and pays the creditor so they won't lose any amount if the debtor defaults on their obligation.
Surety or Guarantor: According to section 126 of Indian Contract Act, 1872, the person who promises to satisfy the debt or the obligation for which the principal debtor is liable, is called surety. The surety is liable only when the principal debtor defaults on his or her obligations.
Creditor: The person or party to whom the promise or debt is owed is called the creditor. As they can hold the surety liable in case the principal debtor defaults from its obligation; They are the beneficiary of the guarantee.
It should be noted that the liability of the surety is subsidiary so, it is only liable after the liability of the principal debtor who promised or discharged is not fulfilled.
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How is Independent Liability Different from Guarantee under the Indian Contract Act?
The Indian Contract Act 1872 contains one of its important distinctions between independent liability and guarantee. They are both about a third party taking on a debt or liability, but there are some key differences.
Independent Liability: A person is said to be liable independently if he is liable to pay a debt or liability, regardless of the default of the principal debtor. In an independent liability agreement, liability of the third party party is not dependent on the default of the principal debtor. The obligation of the third party is entirely independent of what the debtor does.
For example, a supplier has agreed with a buyer to deliver goods. Since the supplier will need a guarantee that the payment will be performed, a third party also accepts separate liability. That means the third party must pay the supplier for the goods regardless of whether the buyer makes his payment or not.
Guarantee: Where the liability of a surety in a contract of guarantee depends on a default by the principal debtor. The liability of surety lies only in case the principal debtors fail to discharge their duty. However, if the debtor performs their promise the surety is not liable.
To sum up, the third party has its direct liability in the independent liability and is only liable in the case of guarantee when the principal debtor defaults.
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Essential Elements of Contract of Guarantee:
For a contract of guarantee to be valid under Section 126 of Indian Contract Act, 1872, certain essential elements must be present:
Three Parties: The guarantee contract is always between the principal debtor, surety and the creditor. For Example, A borrows a loan from a bank (the creditor) and agrees that, in the event that A defaults, B will pay the loan.
A Primary Debt or Obligation: The principal debtor must have clear obligation or debt to the principal debtor. It may be a promise to pay money or to do something. For instance, when your friend owes money to the bank, their debt is the principal obligation.
Promise to Pay: A surety has to promise to take responsibility for the debt or obligation of the principal debtor on failure of the former to do so. For example, A is promising the bank that he will pay the loan if B fails to do so.
Contingent Liability: The surety’s liability is contingent, meaning it will only arise if the principal debtor defaults. If your friend repays the loan as agreed, you won't have to pay anything. But if your friend fails to pay, then your responsibility to pay arises.
Written Agreement: Even though a guarantee contract can be made orally, the legitimacy comes more in when the agreement is written. This ensures that all parties are clear on the terms. A written agreement helps avoid misunderstandings. For example, if you promise to pay your friend’s loan in writing, it becomes much easier to enforce the agreement.
Consideration: Like any contract, a guarantee requires consideration. This means something of value must be exchanged for the promise made. It could be money, a service, or even a favor. For example, the creditor may have agreed to provide a loan to your friend because you agreed to back the loan as a surety.
Intention to Create Legal Relations: The promise made by the surety should not be a casual one. There should be a clear intention to create a legally binding relationship. For instance, if you simply tell your friend you will cover their debt without any formal agreement, this may not constitute a valid contract of guarantee. However, if the promise is made seriously and with clear terms, it is enforceable.
Also, Get to Know Difference Between Contract of Indemnity & Contract of Guarantee
Landmark Case Laws Related to Section 126 of the Indian Contract Act:
Over the years, Indian courts have delivered several landmark judgments that have shaped the understanding of Section 126 of the Indian Contract Act, 1872, which deals with contracts of guarantee. Some of these cases are:
Industrial Investment Bank of India Limited v. Biswanath Jhunjhunwala (2009):
The court held that the liability of the surety is co-extensive with the principal debtor unless expressly limited by the terms of the contract. It emphasized that a surety is entitled to be discharged if the creditor alters the contract terms without the surety’s consent.
Kondapalli Lakshminarasayya v. Kondapalli Venkatakrishnayya (2008):
This case clarified that the liability of the surety is conditional upon the default of the principal debtor. The court emphasized that the surety's obligation arises only when the debtor defaults, and any action beyond that is deemed as discharging the surety from liability.
Gollamudi Venkatasubba Rao v. Chaparala Rosayya (1996):
The court ruled that a surety is not liable if the creditor alters the terms of the contract with the principal debtor without the consent of the surety. This case reinforced the principle that the surety’s liability is dependent on the original contract terms being preserved.
State Bank of India v. M/S Indexport Registered and Others (1992):
The Supreme Court held that the liability of the surety is co-extensive with that of the principal debtor unless otherwise provided by the contract. The court also ruled that the creditor can proceed against the surety without first exhausting remedies against the principal debtor.
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Summary
In Indian contract act 1872, Section 126 of contract of guarantee is defined as a promise by one person to discharge the liability of a third party in the event of default of the promisor in performing the promise made by him. This contract involves three parties: the principal debtor, the surety and the creditor. A guarantee has certain essential features, which include the existence of an underlying obligation, the secondary liability of the surety and a contract which is to be binding. The liability of the surety is limited to the extent of the default made by the principal debtor in the performance of his/her obligations. Indian courts have also contributed immensely in the interpretation and elaboration of guarantee contracts through several judicial decisions.
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Section 126 of Indian Contract Act, 1872: FAQs
Q1. Is it possible for a contract of guarantee to be oral?
Yes, a guarantee contract can be oral but it is better to make it written so that there is no confusion when it comes to the contract.
Q2. Is the liability of the surety unqualified?
The liability of the surety is not absolute. it is limited in one way or the other and is dependent on the default of the principal debtor.
Q3. What happens if the principal debtor is discharged from the liabilities?
The surety will also be discharged if the principal debtor is discharged without the surety’s agreement.
Q4. Is the creditor allowed to sue the surety?
Yes, if the principal debtor fails to meet his obligation then the creditor can approach the surety directly for the recovery of the debt.
Q5. Are contracts of guarantee legal without consideration?
No, like any other contract, a guarantee contract is not enforceable without consideration.
