The surety's co-extensive liability, the grounds of discharge under Sections 133 to 141, how to invoke a guarantee and its position when the principal debtor is insolvent.
A guarantee gives a creditor a second source of payment, and a guarantor is often the party with assets to satisfy the debt. The Indian Contract Act, 1872 sets the rules, and they are more favourable to the guarantor than many creditors expect. This note covers how a guarantee operates, how it can be discharged, and how a creditor should proceed. It is general information, not advice on a particular guarantee.
What a guarantee is
Section 126 defines a contract of guarantee as a contract to perform the promise, or discharge the liability, of a third person in case of his default. Three parties are involved: the creditor, the principal debtor and the surety, or guarantor. A guarantee may be oral or written, though in commercial practice it is written. A guarantee may be specific, for a single debt, or continuing under Section 129, extending to a series of transactions.
The guarantor's liability
Section 128 provides that the liability of the surety is co-extensive with that of the principal debtor, unless the contract provides otherwise. A creditor may therefore proceed against the guarantor on default without first exhausting its remedies against the principal debtor, a position the Supreme Court confirmed in Bank of Bihar v. Damodar Prasad (1969). A guarantee that is conditional, for example one payable only after the creditor has enforced security, will be read according to its terms, so the instrument matters.
How a guarantee is discharged
The Act protects the guarantor against changes made without consent. The principal grounds are these:
- Variation of the contract. Under Section 133, any variation of the terms of the contract between the creditor and the principal debtor, made without the surety's consent, discharges the surety as to transactions after the variation.
- Release or discharge of the principal debtor. Section 134 discharges the surety where the creditor releases the principal debtor, or does an act or omission whose legal consequence is the discharge of the principal debtor.
- Compounding with the principal debtor. Section 135 discharges the surety if the creditor makes a composition with, gives time to, or agrees not to sue the principal debtor, without the surety's consent.
- Impairing the surety's remedy. Section 139 discharges the surety where the creditor does anything inconsistent with the surety's rights, or omits to do something that the surety's remedy against the principal debtor requires.
- Loss of security. Under Section 141, a surety is entitled to the benefit of securities the creditor holds, and if the creditor loses or parts with them without the surety's consent, the surety is discharged to that extent.
Because of these rules, a creditor should obtain the guarantor's written consent before agreeing any extension, restructuring or waiver with the principal debtor. A guarantee often contains clauses in which the guarantor consents in advance to variations, and courts give effect to them if they are clear.
Invoking the guarantee
- Read the guarantee for its conditions: the form of demand, the period for payment, and the sum covered.
- Serve the demand in the form the guarantee requires, on the address it specifies, with a copy of the principal debtor's default.
- State the amount demanded with a computation and the basis for each part.
- If payment is not made, proceed by suit, summary suit where the guarantee is a written contract for a liquidated sum, or in the forum the contract provides.
Limitation and the insolvency of the principal debtor
The period for a claim on a guarantee is calculated on the guarantor's own default, and in general runs from the date of the demand and the guarantor's failure to pay, not from the principal debtor's default. The point should be checked against the terms of the guarantee. Where the principal debtor is a company in insolvency, the moratorium under Section 14 of the Insolvency and Bankruptcy Code protects the company but, by Section 14(3)(b), not the guarantor. A creditor may therefore pursue the guarantor while the company's process continues, subject to the guarantee and to the plan finally approved.
A guarantee is only as good as the care with which it was drawn and then kept alive. The creditor's obligations to the guarantor continue until the debt is paid.
This note is general information on the law at the date of publication. It is not legal advice, and it should not be relied on without advice on the facts of a particular matter.
