What is Contract of Guarantee in Sector 124 of Contract Act?

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What is Contract of Guarantee in Sector 124 of Contract Act? 

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Section 124 of the Contract Act applies to the contract of indemnity wherein the section states that it is a contract in which one party promises the other party to save the other party from the breach of the contact done by the promisor himself. 

Contact of Guarantee is a contract wherein one party promises to perform the promise or to discharge the liability incurred by the third party in the event of default. 

Illutrstration : A and B went to a shop where A said to Shop Owner C “ Let B buy the goods and in case he fails in paying, I will pay on his behalf”. Now that A has volunteered and acted as the surety, he will be liable to pay in case B fails in paying. This instance is known as a contract of guarantee. 

There are three parties involved in the Contract of Guarantee namely:
The person who gives the guarantee is known as surety.
The person in default of whose guarantee was given by the surety is called principle debtor.
The person / entity to whom the guarantee is given by the surety is creditor

Since Rakesh is taking the Home Loan, Mohan is acting as a Surety for Rakesh and therefore, the Contract of Guarantee is being executed wherein Surety is Mohan, Principle debtor is Rakesh and the Creditor is Lena Bank. 

Features of Contract of Guarantee are:- 

  1. It is a contract where promise is performed or the liabilities of third person ( principle debtor ) is discharged by the surety in the event of default.
  2. Tripartite Contract

a. There are three parties involved in three agreements as it is an agreement between surety, principle debtor, creditor. If the promise is not fulfilled by the principle debtor, the surety will be liable. 

3. Liability
a. Principle contract is between the principle debtor and the creditor and 

the contract between the surety is a secondary contract. Liability of principle debtor is primary while in the event of default, the secondary liability is of surety. 

4. Consideration and Essentials of Valid Contract: 

a. It has to be a valid contract and must fulfill all elementary prerequisites to be one. For example, both parties should be above 18 years of age, free consent, lawful object, competency of the parties. The consideration by the principal debtor is sufficient for the surety ( Section 127 ). 

5. No Misrepresentation – 

a. Guarantee obtained by misrepresenting as done by creator or with his knowledge ad assent, concerning a material part of transaction is invalid. Surety is not liable in that case. ( Section 142) 

6. Writing not necessary – 

a. Contract of guarantee is not required to be in writing as it can be oral as well. 

7. Concealment – Intentional concealment of the facts makes the guarantee invalid. All important facts which can affect the liability of surety should be communicated. ( Section 143) 

In the event of default, bank can take following steps against Mohan:
1. Liability Fulfillment - Fulfill the liability of Rakesh which means the default 

done by him. For instance if Rakesh owed INR 20 Lacs from Bank and paid INR 5 Lacs back to bank then Mohan will payback the balance INR 15 Lacs to the Bank. Surety is liable for all those amounts the principal debtor is liable for. 

a. This liability is called secondary or contingent as it comes into role when principle debtor fails in fulfilling his part of promise. 

  1. Suing the Surety – Creditor can file a suit against the surety without suing principal debtor.
  2. Holding the Security – Since the amount will be larger than the collateral submitted as security, it will not be diluted first, rather the difference will be taken from the Surety first.
  3. No Notice of Default – Since the surety and the creditor are under contract, and to prevent surety to do any contingency planning, creditor is not required to give notice of default.
  4. Insolvent the Surety – Where surety is found insolvent, the creditor can proceed to initiate surety’s insolvency and get the dividend on pro rate basis.
  5. No postponing of liability – The liability of surety cannot be postponed till other remedies against the principle debtor have exhausted. It can undertake the securities deposited by surety.

Illustration – A guarantees to B that the payment of a bill of exchange by C, the acceptor. The bill is dishonored by C. Since A is the surety, now he is liable for the amount of bill but also the losses and interest incurred by B.