Introduction
How often have we come
across requests from close friends and relatives to stand as a guarantor
for a loan proposed to be taken by them? The loans could be housing
loans or for business. Further, one is also conversant with promoters of
companies/partners of firms standing as guarantors for loans obtained
by their entities. This is even true in case of large listed companies
where the promoters, managing directors, etc., are required to furnish
promoter guarantee. If the going is good and the original debtor meets
his dues, then all is well that ends well. However, what happens if the
original debtor cannot/does not meet his dues and the creditor/bank
invokes the guarantee furnished by the guarantor? Does the creditor have
to first approach the primary borrower or can he directly approach the
guarantor who may be in a better financial position than the borrower?
Let us look at some of the issues arising in this important aspect of
trade and commerce.
Meaning of Guarantee
Section
126 of the Indian Contract Act, 1872 defines a ‘contract of guarantee’
as a contract to perform the promise or discharge the liability of a
third person in the case of the third person’s default. Performance
guarantees/bank guarantees are also instances of contracts of guarantee.
For instance, Mr. A agrees to pay the housing loan amount borrowed by
Mr. C from a bank if Mr. C cannot/does not pay the loan. This is a
contract of guarantee.
A contract of guarantee is not a contract
in respect of a primary transaction but it is an independent
transaction containing independent and reciprocal obligations —
Industrial Finance Corp. v. Cannanore Spg. and Wvg. Mills, (2002) 5 SCC
54.
The person who gives the guarantee is called a surety or a
guarantor, the person to whom the guarantee is given is called the
creditor and the third person on whose behalf the guarantee is given is
called the principal debtor. Thus, the essentials of a guarantee are as
follows:
(a) It is a contract and so all the elements of a valid
contract are a must. Without a contract this section has no
application. Since a contract is a must, it goes without saying that all
the prerequisites of a contract also follow. Thus, if the contract has
been obtained by fraud, misrepresentation, coercion, etc., then it is
void ab initio and the section would also fail — Ariff v. Jadunath,
(1931) AIR PC 79. The contract may be oral or written.
(b) There
must be a principal debtor-creditor relationship. Without this there
can be no contract of guarantee. The surety’s obligations arise only
when the principal debtor defaults and not otherwise.
(c) It is a tri-partite arrangement, involving the surety, the principal debtor and the creditor.
(d) There must be a consideration for the surety. If there is no consideration at all, then the surety agreement is void.
However,
anything done or any promise made for the benefit of the principal
debtor is sufficient consideration to the surety for giving the
guarantee. A contract of guarantee is a complete contract by itself and
separate from the underlying contract. Enforcement of an on-demand bank
guarantee in accordance with the terms of the bank guarantee would not
be the subject-matter of judicial intervention. The only reason why
Courts would interfere if the invocation is not as per the terms of the
guarantee or it has been obtained by fraud — National Highways Authority
of India v. Ganga Enterprises, (2003) 7 SCC 410.
Nature of liability
The
liability of the surety is co-extensive with that of the principal
debtor. However, the contract may provide otherwise. Thus, the guarantor
has to pay all debts, interest, penal charges, etc., payable by the
principal debtor. He is liable for whatever the debtor is liable. Where
the liability arises only on the happening of some event, then the
guarantee cannot be invoked till such contingency has happened. Even if
winding-up proceedings have been filed against the principal debtor, the
surety would remain liable to pay to the creditor. A discharge of the
principal debtor by operation of law does not absolve the surety of his
liability — Maharashtra State Electricity Board v. OL, (1982) 3 SCC 358.
Continuing Guarantee
A guarantee which extends
to a series of transactions is a continuing guarantee. Whether or not a
contract is a continuing guarantee is to be ascertained from the
language of the transaction. For instance, Mr. A guarantees payment of
all dues by Mr. X to Mr. C in respect of goods supplied by Mr. C. This
is an example of continuing guarantee and does not come to an end with
the clearance of the first payment. A continuing guarantee can be
revoked at any time by giving notice to the creditor. However, the
revocation operates only in respect of future transactions.
Alternatively, the death of a surety revokes all future transactions
under a continuing guarantee.
Alterations
Any
variation made in the contract of guarantee without the guarantor’s
consent by the principal debtor and the creditor, discharges the
guarantor from all transactions after the variation. For instance, Mr. C
agrees to lend money on 1st June to Mr. B, repayment of the same
guaranteed by Mr. A. Mr. C instead lends on 1st April. The surety is
discharged from his obligations since the creditor may now demand a
repayment earlier than what was originally agreed upon. However, if
there is an unsubstantial alteration which is to the surety’s benefit,
then the surety is not discharged from his liability. However, if the
alteration is to the disadvantage of the surety, then the surety can
claim a discharge.
Discharge
The guarantor is
discharged by any contract between the creditor and the principal debtor
by which the debtor is released of by any act of the creditor which
results in the discharge of the debtor. For instance, A guarantees the
repayment of the loan taken by X Ltd from C Ltd provided C Ltd supplies
certain goods to X Ltd. C Ltd does not supply the goods as agreed. A is
discharged from his guarantee. Similarly, a contract between the
creditor and the principal debtor under which the creditor gives a
concession or extends the time for repayment to the principal debtor,
releases the guarantor from his obligations.
If the creditor
does anything which affects the rights of the surety or omits to do
anything which we was required to do to the surety, then the guarantee
contract comes to an end. Thus, the creditor cannot gain out of any
negligence on his own accord.
However, it has been held that the
discharge of the principal debtor by virtue of a Statute/Notification
does not discharge the guarantor — SBI v. Saksaria Sugar Mills, (1986) 2
SCC 145.
Guarantor steps into shoes of creditor
On
discharge of the liability of the principal debtor, the guarantor steps
into the shoes of the creditor, i.e., he becomes entitled to all
actions and rights against the principal debtor which the creditor had.
He also becomes entitled to the benefit of all security which the
creditor had against the debtor, whether or not the surety is aware of
the security. The term ‘security’ includes all rights which the creditor
had against the property of the principal debtor on the date of the
contract — State of MP v. Kaluram, AIR 1967 SC 1105.
In case the creditor loses or parts with security without consent of the security, then the surety is discharged to the extent of the value of the security. In one case, the debtor gave a guarantee and a pledge of his goods as security for loan to a bank. The surety was aware of the pledge. However, the bank lost the goods due to its own fault. Held, that the surety was discharged from his obligations — State Bank v. Chitranjan Raja, 51 Comp. Cases 618 (SC).
Must creditor first proceed against debtor?
The law in this respect is very clear. The creditor is free to directly proceed against the guarantor instead of first approaching the principal debtor and then failing him, the guarantor/surety.
In Bank of Bihar Ltd. v. Damodar Prasad, (1969) 1 SCR 620, the Supreme Court held that it is the duty of the surety to pay the amount. On such payment he will be subrogated to the rights of the creditor under the Indian Contract Act, and he may then recover the amount from the principal debtor. The very object of the guarantee is defeated if the creditor is asked to postpone his remedies against the surety. In that case the creditor was a bank. It was held that a guarantee is a collateral security usually taken by a banker. The security will become useless if his rights against the surety can be so easily cut down.
In State Bank of India v. M/s. Indexport, (1992) 3 SCC 159, it was held that the decree-holder bank can execute the decree against the guarantor without proceeding against the principal borrower and then proceeded to observe:
“The execution of the money decree is not made dependent on first applying for execution of the mortgage decree. The choice is left entirely with the decree-holder. The question arises whether a decree which is framed as a composite decree, as a matter of law, must be executed against the mortgage property first or can a money decree, which covers whole or part of decretal amount covering mortgage decree can be execute earlier. There is nothing in law which provides such a composite decree to be first executed only against the principal debtor.”
In Industrial Investment Bank of India
Limited v. Biswanath Jhunjhunwala, (2009) 9 SCC 478, it was held that the liability of the guarantor and principal debtor is co-extensive and not in alternative and the creditor/decree-holder has the right to proceed against either for recovery of dues or realisation of the decretal amount.
SARFAESI Act vis-à-vis Surety
A related question which arises is what is the position of the guarantor under the SARFAESI Act in case he gives a security for a loan borrowed by the principal debtor from a bank/financial institution. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (‘the SARFAESI Act’) ensures that dues of secured creditors including banks, financial institutions are recovered from the defaulting borrowers without any obstruction. Secured creditors have been empowered to take steps for recovery of their dues without intervention of the Courts or Tribunals by directly taking over the properties of the borrowers.
In the case of Union Bank of India v. Satyawati Tondon, (2010) 8 SCC 110, the Supreme Court had an occasion to consider the position of the guarantor under the SARFAESI Act. In this case, the guarantor mortgaged her property as security for the loan given by the bank to the principal debtor. She also executed an agreement of guarantee for the principal and interest amount. The loan account became an NPA and the bank directly approached the guarantor for the amounts due. On her failure to repay, the bank invoked
the provisions of the SARFAESI Act against her and took possession of her mortgaged property. The Supreme Court held that nothing prevents the bank from directly approaching the guarantor without first approaching the debtor. It further held that the action taken by the bank for recovery of its dues by issuing notices under the SARFAESI Act cannot be faulted on any legally permissible ground.
It further held that if the guarantor had any tangible grievance against the recovery proceedings under the
SARFAESI Act, then she could have availed remedy by filing an application u/s.17(1) of the Act before the Debt Recovery Tribunal. The expression ‘any person’ used in the Act is of wide import. It takes within its fold, not
only the borrower but also guarantor or any other person who may be affected by the action taken under the Act. Both, the DRT and the Appellate Tribunal are empowered to pass interim orders under the Act and are required to decide the matters within a fixed time schedule. It is thus evident that the remedies available to an aggrieved person under the SARFAESI Act are both expeditious and effective.
Epilogue
The guarantor’s liability is like the proverbial ‘Sword of Damocles’ which is hanging by a very slender thread and can come down at any time. One may even rephrase the legal maxim of ‘Caveat Emptor’ to say ‘Guarantor be aware of what you guarantee’. Thus, it is very important that before giving any promoter/ personal guarantee, a person is well aware of the risks and consequences of the same.
