A contract of guarantee is defined under Section 126 of the Indian Contract Act, 1872 and is a tripartite agreement involving a creditor, a principal debtor and a surety, where the surety undertakes to fulfill the debtor’s obligations if they default, providing the creditor with added security. Creditors have the right to sue the surety directly for the debt, as the surety’s liability is co-extensive with the debtor’s liability and can retain securities provided by the debtor until the surety pays, after which they must be transferred. However, creditors must fulfill obligations to maintain the guarantee’s validity: they cannot alter contract terms without the surety’s consent, release the debtor without agreement, misrepresent or conceal material facts or impair the surety’s recovery rights, such as by losing securities. These rights and obligations ensure a balance between the creditor’s ability to recover dues and the surety’s protections under the law.
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Definition and Parties Involved in Contract of Guarantee
Section 126 of the Indian Contract Act, 1872, defines a contract of guarantee as a “A ‘contract of guarantee’ is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the 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’. A guarantee may be either oral or written.”
The three parties involved are:
Creditor: The individual or entity to whom the debt or obligation is owed.
Principal Debtor: The person primarily responsible for fulfilling the obligation.
Surety: The individual who guarantees to fulfill the debtor’s obligation in case of default.
This framework ensures that creditors have a fallback mechanism, making contracts of guarantee essential in financial transactions like loans or credit agreements.
Interaction with the Insolvency and Bankruptcy Code, 2016
While the Indian Contract Act governs traditional guarantee contracts, the Insolvency and Bankruptcy Code, 2016 (IBC), introduces nuances. Creditors can pursue guarantors post-Corporate Insolvency Resolution Process (CIRP) without a moratorium applying to guarantors (Section 14, IBC). However, they cannot recover more than the debt due (Dr. Vishnu Kumar Agarwal v. M/S Piramal Enterprise Ltd.). This interplay enhances the rights of a creditor but restricts rights of the surety like subrogation under the IBC, which creates a complex legal landscape.
Rights of the Creditor in Contract of Guarantee
Creditors in a contract of guarantee are endowed with specific rights to enforce the guarantee and recover dues, which is given under Sections 128 and 141.
1. Right to Sue the Surety
Section 128 states: “The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract.” This provision allows the creditor to sue the surety directly if the principal debtor defaults, which he can do without first pursuing the debtor. The surety’s liability mirrors that of the debtor like covering the debt, interest and any associated charges unless the contract specifies otherwise.
In Chokalinga Chettiar v. Dandayunthapani Chattiar (1928), the court held that the creditor has the flexibility to proceed against either the principal debtor or the surety, reinforcing the creditor’s autonomy in enforcement. Similarly, Bank of Bihar v. Damodar Prasad & Anr (1969) clarified that creditors are not obligated to exhaust remedies against the debtor before suing the surety, which also enhances the ability of a creditor to recover dues efficiently.
2. Right to Hold Securities
While not explicitly framed as a creditor’s right, Section 141 implies that creditors have the right to hold and manage securities provided by the principal debtor. This section states: “A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not.” Consequently, creditors can retain securities (e.g., property or collateral) but must account for them if the surety fulfills the debt. Losing or parting with these securities without the surety’s consent can discharge the surety to the extent of the security’s value.
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Obligations of the Creditor in Contract of Guarantee
To ensure the enforceability of the guarantee and protect the surety’s interests, creditors must adhere to several obligations. Failure to comply may discharge the surety from liability, as outlined in Sections 133, 134, 135, 139, 141, 142 and 143.
1. Not to Vary the Terms of the Contract
Section 133 provides: “Any variance, made without the surety’s consent, in the terms of the contract between the principal debtor and the creditor, discharges the surety as to transactions subsequent to such variance.”
Illustration: A becomes surety to C for B’s conduct as a manager in C’s bank. Later, B and C agree, without A’s consent, to raise B’s salary and make him liable for one-fourth of overdraft losses. B allows a customer to overdraw, causing a loss. A is not liable for this loss due to the unauthorized variance.
This obligation ensures that the creditor does not alter the contract in a way that increases the surety’s risk without their agreement.
2. Not to Release or Discharge the Principal Debtor
Section 134 states: “The surety is discharged by any contract between the creditor and the 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.”
Illustration: A guarantees payment for goods supplied by C to B. B later becomes financially distressed and assigns his property to creditors, including C, in exchange for release from their demands. Since C releases B, A is discharged from his suretyship.
This obligation prevents the creditor from undermining the surety’s liability by releasing the debtor without consent.
3. Not to Compound, Give Time, or Agree Not to Sue Without Consent
Section 135 specifies: “A contract to give time to the principal debtor is a contract by which the creditor makes with the principal debtor a new contract for the consideration of guaranteeing the punctual payment of the debt, not to sue the principal debtor for a given period, and thereby discharges the surety unless the surety consents to such a contract.”
Illustration: C, holding an overdue bill of exchange drawn by A as surety for B, contracts with A to give B more time. This agreement discharges A unless A consents.
This ensures that creditors do not extend leniency to the debtor in ways that prejudice the surety’s position.
4. Not to Impair the Surety’s Eventual Remedy
Section 139 states: “If the creditor does any act which is inconsistent with the rights of the surety, or omits to do any act which his duty to the surety requires him to do, and the eventual remedy of the surety himself against the principal debtor is thereby impaired, the surety is discharged.”
Illustration: B contracts to build a ship for C, with payments in installments. A guarantees B’s performance. C, without A’s knowledge, prepays the last two installments. A is discharged due to this prepayment, as it impairs A’s remedy against B.
This obligation requires creditors to act in ways that preserve the surety’s ability to recover from the debtor.
5. To Disclose All Material Facts
Sections 142 and 143 render guarantees invalid if obtained through misrepresentation or concealment of material facts. Section 142 states: “Any guarantee which has been obtained by means of misrepresentation made by the creditor, or with his knowledge and assent, concerning a material part of the transaction, is invalid.” Section 143 adds: “Any guarantee which the creditor has obtained by means of keeping silence as to material circumstances is invalid.”
Illustration: A employs B to collect money but does not inform C, the surety, of B’s prior failure to account for receipts. B defaults again, and C’s guarantee is invalid due to A’s nondisclosure.
This obligation ensures transparency in the formation of the guarantee contract.
6. To Allow the Surety the Benefit of Securities
Section 141 states: “A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not; and, if the creditor loses, or, without the consent of the surety, parts with such security, the surety is discharged to the extent of the value of the security.”
Illustration: C holds a security against D for a ₹1,000 debt, with A as surety. C later takes another ₹1,000 security from D without A’s knowledge. If D becomes insolvent, A is entitled to both securities, and C must account for them.
In State of Madhya Pradesh v. Kaluram (1966), the court held that allowing the debtor to dispose of security without the surety’s consent discharges the surety, which emphasized the duty of a creditor to preserve securities.
Summing Up
The rights and obligations of creditors in a contract of guarantee under the Indian Contract Act, 1872 create a balanced framework that protects creditors while safeguarding the surety’s interests. Creditors can sue the surety directly and hold securities but must adhere to obligations like preserving contract terms, disclosing material facts and maintaining securities. Judicial precedents, such as Bank of Bihar v. Damodar Prasad and State of Madhya Pradesh v. Kaluram, reinforce these principles and also ensuring fair enforcement. Understanding these provisions is important for creditors in order to navigate guarantee contracts effectively while respecting the legal protections afforded to sureties.
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Rights and Obligations of Creditors: FAQs
Q1. What are the rights and obligations of a creditor?
Creditors can claim timely payments, pursue legal remedies and access debtor financial data. They must follow fair debt collection practices and provide accurate loan terms.
Q2. What is a creditor obligation?
Creditors must adhere to fair lending and collection practices, provide clear terms, avoid harassment, and comply with laws like the Fair Debt Collection Practices Act.
Q3. Are rights of the creditors?
Creditors can recover debts via legal actions like liens or bankruptcy and are entitled to debtor financial transparency in specific cases.
Q4. What are the rights of creditors under IBC?
Under IBC, creditors can initiate insolvency, join the Committee of Creditors, receive resolution plan distributions, enforce security, and challenge fraudulent transactions.
Q5. What are creditor's rights?
Creditors can recover debts, secure collateral, file bankruptcy claims, and receive timely payments, protected by contract law and statutes like UCC or IBC.
