Contract Law in Guarantee Agreements Application

In law, a contract is a binding legal agreement that is enforceable in a court of law or by binding arbitration. That is to say, a contract is an exchange of promises with a specific remedy for breach.

Agreement is said to be reached when an offer capable of immediate acceptance is met with a “mirror image” acceptance (i.e., an unqualified acceptance). The parties must have the necessary capacity to contract and the contract must not be trifling, indeterminate, impossible, or illegal. Contract law is based on the principle expressed in the Latin phrasepacta sunt servanda (usually translated “pacts must be kept”, but more literally “agreements are to be kept”). [2] Breach of contract is recognized by the law and remedies can be provided.

As long as the good or service provided is legal, any oral agreement between two parties can constitute a binding legal contract. The practical limitation to this, however, is that only parties to a written agreement have material evidence (the written contract itself) to prove the actual terms uttered at the time the agreement was struck. In daily life, most contracts can be and are made orally, such as purchasing a book or a sandwich. Sometimes written contracts are required by either the parties, or by statutory law within various jurisdictions for certain types of agreement, for example when buying a house [3]  or land.

Contract law can be classified, as is habitual in civil law systems, as part of a general law of obligations (along with tort, unjust enrichment or restitution).

According to legal scholar Sir John William Salmond, a contract is “an agreement creating and defining the obligations between two or more parties”.

As a means of economic ordering, contract relies on the notion of consensual exchange and has been extensively discussed in broader economic, sociological and anthropological terms (see “Contractual theory”, below). In American English, the term extends beyond the legal meaning to encompass a broader category of agreements. [4]

This article mainly concerns contract law in common law jurisdictions (approximately coincident with the English-speaking world and anywhere the British Empire once held sway). However, contract is a form of economic ordering common throughout the world, and different rules apply in jurisdictions applying civil law (derived from Roman law principles), Islamic law, socialist legal systems, and customary or local law.

The guarantee agreement is a contract where one party approaches to pay some money or to perform an obligation it is a promise to be responsible for another person’s default. The guarantee provides for the guarantor liability to pay or perform if the relevant 3rd party fails to pay or perform. The guarantor’s liability only becomes effective upon the default of the parties by the principal debtor a party. The guarantee normally sets out the principal obligations together with provisions relating to protection of the creditor, an indemnity, avoidance or discharge of the guarantee provisions together with express rights of the guarantor.

Research Methodology:

The research methodology followed in the research of this project has been the doctrinal method, using materials gathered from the NALSAR University of Law, Hyderabad library, as well as personal materials accompanied by extensive use of Internet resources. It is assured that no part of this project has been plagiarized from any other source.

Aims and Objectives:

The aim of the researcher in this project is to trace, through judgments of the apex court and lower courts, the application of guarantee agreements in Contract Law and its discuss its features and essentials.

Contract Vs. Agreement

Discussion about agreements and contracts can sometimes read like the “chicken and the egg” question. It is true that you cannot have a contract without an agreement. But it does not necessarily follow that an agreement will necessarily be the same as a contract. Why is that?

A contract requires agreement on the terms, consideration (usually but not always money) and an intention by both parties to be legally bound to each perform their respective promises. But an agreement may not be intended to be legally binding on the parties. This is often the case when parties want to formally record their ‘agreement’ even though they may not have concluded all the details of the entire transaction. Commonly such agreements may be called “Heads of Agreement” or “Memorandum of Understanding” or “letter of intent”. These latter forms are often put together to indicate good faith and ongoing commitment to each other to pursue the negotiations with a view to entering into an enforceable contract at some later stage. But an agreement ‘to agree’ (at some future point) is not enforceable and the courts have always been reluctant to step into parties’ shoes to try and work out what should have been included, but for some reason, was not.

I am often asked whether or not an MOU is binding. It is usually the case that it is not and indeed in many cases parties enter an MOU or a Heads of Agreement because they have not concluded all the matters to be agreed that would enable them to be considered to be bound. But of course the legal system it is not a science and it is often the case that a lawyer, when faced with such questions, will answer “well that depends.” On what does it depend?

Some of the critical issues include:

By applying an objective test, does it appear that the parties intended to be bound? How did they act? What did they say? Of what they said, how much of it (and what) was recorded formally?

What were the commercial circumstances at the time – of the parties, the subject matter of the contract, (what was being contracted for)?

What were the dynamics of the negotiation process? If a term is later asserted by one party to be essential to the contract but it is not in the document, what does that indicate about what is said that they appear to have agreed as important?

If you do want to put together a ‘preliminary agreement’, remember these rules as a guideline but always seek the advice of a lawyer to be sure.

When you intend to be bound immediately but you also want to record the detail of the agreement later. The terms in the formal agreement will be essentially the same but perhaps explained in more detail but do not change. Where this happens, you are likely to be bound by the terms of the first agreement even though a formal document is not signed.

When you intend to be bound but not until a formal contract is signed. In other words, you have reached agreement and the formal agreement won’t vary any terms, but until the formal agreement is in fact signed, neither party will be ‘bound’.

When you do not intend to be bound unless and until each party executes a formal agreement. This usually (with some significant legal exceptions) means that either party may withdraw at any time if they have not signed the formal agreement.

The greatest danger is in not understanding the effect of using certain words in legal or quasi-legal documents. While in ordinary English use they may have a common understanding and effect, it is not always the case that they have the same ‘ordinary’ meaning when they are used in legal documents. What is of most significance is to make a clear and unambiguous statement about whether or not the agreement (or memorandum or letter) is intended to bind the parties. At a practical level this can have other important flow-on effects, like for example, whether costs and commitments and other activities might or should be incurred until the formal agreement is signed, and whether someone else might incur costs thinking that you intend to proceed.

Often people will avoid such issues as they don’t want to stifle the commercial process or offend the other party. Commercial pragmatism should always be balanced against legal risk and they are not mutually exclusive. It costs less to be sure than to fight it out later.

Guarantee

The Contract of guarantee is defined in section 126 of the Act as follows:

126. “Contract of guarantee”,”Surety”,”Principal debtor” and “creditor’. – A “contract of guarantee” is a contract of to perform the promise or discharge the liability, of the third person in case of his default. The person who gives the guarantee is called the “Surety”; the person in respect of whose the default the guarantee is given is called the “principal debtor”, and the person to whom the guarantee is given is called the “Creditor”. A guarantee may be either oral or written.

Economic function of guarantee

The function of a contract of guarantee is to enable a person to get a loan, or goods on credit, or an employment. Some person comes forward and tells the lender, or the supplier or the employer that he (the person in need) may be trusted and in case of any default,”I undertake the responsibility”. For example in the old case of Birkmyr v Darnell [5] the court said: “If two come to a shop one buys and the other to give him credit, promises the seller, ‘If he does not pay you, I will’.”

This type of collateral undertaking to be liable for the default of another is called a “Contract of guarantee”. In English law a guarantee is defined as “a promise to answer for the debt, default or miscarriage of another [6] .” It is collateral engagement to be liable for the debt of another in case of his default. “Guarantee are usually taken to provide a second pocket to pay if the first should be empty [7] .”

PARTIES

The person who gives guarantee is called the “surety”, the person in respect of whose default the guarantee is given is called the “principal debtor” and the person to whom the guarantee is given is called the “creditor”. [8]

Essential Features of guarantee

The followings are the requisites of a valid guarantee:

Principal debt

Recoverable Debt Necessary

The purpose of a guarantee being to secure the payment of a debt, the existence of a recoverable debt is necessary. [9] It is of the essence of a guarantee that there should be someone liable as the principal debtor and the surety undertakes to be liable on his default. [10] If there is no principal debt, there can be no valid guarantee. [11] ” A contract of guarantee is a tripartite agreement which contemplates the principal debtor, the creditor and the surety.” [12] This was so held by the house of the lords in the Scottish case of Swan v Bank of Scotland [13] , decided in early as 1836.

The payment of the overdraft of a banker’s customer was guaranteed by the defendant. The overdrafts were contrary to a statute [14] ,which not only imposed penalty upon the parties to such drafts but also made them void.

The customer having defaulted was sued for the loss.

Consideration

Like every other contract the contract of guarantee must also be supported by some Consideration. A guarantee without consideration is void [15] .but there need be no direct consideration between the surety and the creditor [16] Section 127 clearly states that-

127. Consideration for Guarantee – Anything done, or any promise made, for the benefit of the principal debtor, maybe a sufficient consideration to the surety of giving the guarantee.

Misrepresentation and Concealment

A contract of guarantee is not a contract uberrimae fides or one of absolute good faith. [17] Thus where a banker receives a guarantee with knowledge of circumstances seriously affecting the credit of the customer, it was held that there was no duty to disclose this fact to the surety. [18] Yet it is the duty of the party taking a guarantee to put the surety in possession of all the facts likely to affect the degree of his responsibility; and if he neglects to do so it is at his peril. Sections 142 – 143 implement these principles.

142. Guarantee obtained by misrepresentation, invalid – Any guarantee obtained by means of misrepresentation made by the creditor or with his knowledge and assent concerning a material part of the transaction is invalid.

143. Guarantee obtained by concealment invalid – Any guarantee which the creditor has obtained by means of keeping silent as to material circumstances is invalid.

Writing not necessary

Section 126 expressly declares that a guarantee may be either oral or written. [19] But in England under the provision of statute of frauds a guarantee is not enforceable unless it is in writing and signed by party to be charged. [20]

Extent of Surety’s Liability: The fundamental principle of surety’s liability as laid down by section 128 is that the liability of the surety is a coextensive with that of the principal debtor. The surety may however by an agreement place a limit upon the liability.

Section 128. Surety’s Liability – The liability of surety is coextensive with that of principal debtor unless it is otherwise proved by the contract.

Co – extensive

The principal governing surety’s liability is that it is co – extensive to that of principal debtor. This expression shows the maximum extent of surety’s liability. He is liable for the whole amount for which the principal debtor is liable and he is liable for no more. [21] The only illustration appended to the section says that if the payment of loan bond is guaranteed the surety is liable not only for the amount of the loan but also for any interests and charges which may have become due on it. [22] Where the principal debtor acknowledges liability and this has effect of extending the period of limitation against him the surety also becomes affected by it. [23]

Condition precedent: Where there is a condition precedent to the surety’s liability, he will not be liable unless that condition is first fulfilled. A partial recognition of this principle is to be found in section 144 which says [24]

Section 144 – Guarantee on Contract that creditor shall not act on it until co-surety joins – Where a person gives a guarantee upon a contract that creditor shall not act upon it until another person has joined in it as co-surety, the guarantee is not valid if the other person does not join.

LIABILITY UNDER CONTINUING GUARANTEE

Section 129: Continuing Guarantee – A guarantee which extends to a series of transactions is called continuing guarantee.

Liability under Bank Guarantee:

A bank guarantee is a sought of absolute undertaking to pay amount whenever demanded by guarantee holder. It has nothing to do with the state of relationships between the guarantee holder and the person on whose behalf the guarantee was given. While ordinary guarantees are linked to and dependent on the underlying transaction, a bank guarantee is an agreement where the guarantee is independent of underlying transactions. There are professional guarantors to whom the issue of guarantee is a financial service namely banks, insurance companies and bond companies who charge nominal fees for providing guarantees. [25]

Variation in terms of Contract:

The High Court of Delhi has expressed the view that a clause in bank guarantee to the affect that the parties may vary the terms of contract without affecting the liability of bank would be valid. All that is necessary is that guarantors’ ultimate remedy against principal debtors should remain unimpaired. [26]

Bank Guarantee separate transaction:

The Court cannot take recourse to surrounding circumstances unless an ambiguity exists in the terms and conditions of a contract. A bank guarantee is a separate transaction.It has to be construed on its own terms. [27]

Period of Limitation

The period of limitation of enforcing a guarantee is 3 years from the date on which the letter of guarantee was executed. [28] Whereas against the advancement of loan to a company, the guarantee deed was executed by its directors and subsequently a letter acknowledging the load was issued by same directors on behalf of the company, it was held that the letter did not have the effect of extending the period of limitation. Recovery proceedings instituted after three years from the date of the deed of guarantee were liable to be quashed. [29]

Discharge of Surety from liability

A surety is said to be discharged from liability when the liability comes to an end. It can be done by following modes of discharge:

1. By Revocation (Section-130)

Ordinarily a guarantee is not revocable when once it is acted upon .But section 130 provides revocation of continuing guarantee.

130. Revocation of continuing guarantee:

A continuing guarantee may at any time be revoked by the surety , as to future transactions , by notice to the creditors.

2. By death of surety (Section-131)

A continuing guarantee is also determined by the death of the surety unless there is a contract to the contrary. Once again, the termination becomes effective only for the future transaction. [30] The surety heirs can be sued for liability already incurred .The section clearly points this out.

131. Revocation of continuing guarantee by surety’s death

The death of surety operates, in the absence of any contract to the contrary, as a revocation of a continuing guarantee, so far as regards future transactions.

3. By Variance (Section-133)

Courts of law and equity have always taken zealous care of a surety’s interests.” A surety is considered a favored debtor and his liability is in strictissimi juris [31] .Initially a contract of guarantee may not be one of the utmost good faith, but once formed the duty of utmost good faith is imposed on the creditor.

133. Discharge of surety by variance in terms of contract-

Any variance, made without the surety’s consent, in the terms of the contract between principal [32] (debtor) and the creditor, discharges the surety as to transactions subsequent to the variance.

4. By Release or discharge of Principal Debtor

134. Discharge of surety by release or discharge of principal:

The surety is discharged by any contract between creditor and principal debtor, by which the principal debtor is released, or by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor.

5. By composition, extension of time and promise not to sue (Section 135)

135. Discharge of surety when creditor compounds with, gives time to, or agrees not to sue principal debtor- A contract between the creditor and the principal debtor, by which the creditor makes a composition with, or promises to give time to, or not to sue the principal debtor, discharges the surety, unless the surety assents to such contract

The section provides 3 modes of discharge from liability:

Composition;

Promise to give time, and

Promise not to sue the principal debtor.

136. Surety not discharged when agreement made with third person to give time to principal debtor- Where a contract to give time to the principal debtor is made by the creditor with a third person, and not with the principal debtor, the surety is not discharged.

137. Creditor’s forbearance to sue does not discharge surety.- Mere forbearance on the part of creditor to sue the principal debtor or to enforce any other remedy against him does not, in the absence of any provision in the guarantee to the contrary, discharge the surety.

6. By impaired Surety’s Remedy (Section 139)

139. Discharge of Surety by creditor’s act or omission impaired surety’s eventual remedy- If the creditor does any act which is inconsistence with the right of the surety, or omits to do any act which his duty of surety requires him to do, and the eventual remedy of the surety himself against the principal debtor is thereby impaired, the surety is discharged.

Conclusion

The Contract of guarantee is defined in section 126 of the Act as follows:

126. “Contract of guarantee”,”Surety”,”Principal debtor” and “creditor’. –

A “contract of guarantee” is a contract of to perform the promise or discharge the liability, of the third person in case of his default. The person who gives the guarantee is called the “Surety”; the person in respect of whose the default the guarantee is given is called the “principal debtor”, and the person to whom the guarantee is given is called the “Creditor”. A guarantee may be either oral or written.

The function of a contract of guarantee is to enable a person to get a loan, or goods on credit, or an employment. Some person comes forward and tells the lender, or the supplier or the employer that he (the person in need) may be trusted and in case of any default,”I undertake the responsibility”. For example in the old case of Birkmyr v Darnell [33] the court said: “If two come to a shop one buys and the other to give him credit, promises the seller, ‘If he does not pay you, I will’.”

This type of collateral undertaking to be liable for the default of another is called a “Contract of guarantee”. In English law a guarantee is defined as “a promise to answer for the debt, default or miscarriage of another [34] .” It is collateral engagement to be liable for the debt of another in case of his default. “Guarantee are usually taken to provide a second pocket to pay if the first should be empty [35] .”

Hence Guarantee Agreement has a great significance in Contract law.