CMPTEB If

CONTRACT OF
GUARANTEE
 CHAPTER IV

CONTRACT OF GUARANTEE

Definition and Meaning

Guarantee is an undertaking to answer for anothers liability and

collateral thereto. It is a collateral undertaking to pay the debt of another
in case he does not pay it.

It is a provision to answer for the payment of some debt, or the

performance of some duty in the case of failure of some person who, in the
first instance, is liable for such payment or performance.

Bouviers Law Dictionary gives the meaning of guarantee as a

promise to answer for the debt, default, or miscarriage of another person1.

Guarantee is an. undertaking to be collaterally responsible for the

debt, default or miscarriage of another. In a banking context it is an
undertaking given by the guarantor to the banker accepting responsibility
for the debt of the principal debtor, the customer, should he or she default.
The guarantor may or may not be a customer2.

Vol 2, 1914, p 1386

Dictionary of Banking - F.E. Perry & G.Klein, 3rd Edn, 1988, p.134
 92

A Guarantee is a promise by one person, who is called the

guarantor or surety to answer for the present or future debt of another

person who is called the principal debtor, such promise being made to the
party to whom the principal debtor is, or will become, liable3.

In Lord Halsburys Laws of England a guarantee is defined as "an

accessary contract whereby the promisor undertakes to be answerable to the
promisee for the debt, default or miscarriage of another person whose
primary liability to the promisee must exist or be contemplated.

The words surety and guarantor are used as synonymous terms in

Indian law and English Law.

In American law, guarantee is distinguished from suretyship in being

a secondary, while suretyship is a primary, obligation; or, as sometimes
defined, guarantee is an undertaking that the debtor shall pay; suretyship,
that the debt shall be paid. A surety differs from a guarantor, who is liable
to the creditor only if the debtor does not meet the duties owed to the
creditor; the surety is directly liable. While a suretys liability begins with
that of the principal, a guarantors liability does not begin until the
principal debtor is in default.

In India, Contract of Guarantee is included in the Indian Contract

Act, 1872 and is defined under section 126 as follows :

3 Law of Banking by Lord Chorley - 6th Edn, 1974, p.332

 93

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.

In England, a guarantee to be enforceable at law must be in writing.

By the Statute of Frauds (29 Car. II, c.3) Section 4, it is enacted that "no
action shall be brought whereby to charge the defendant upon any special
promise to answer for the debt, default or miscarriage of another person,
unless the agreement upon which such action shall be brought, or some
memorandum or note thereof shall be in writing and signed by the party to
be charged therewith, or some other person thereunto by him lawfully
authorised".

Though a contract of guarantee may be oral or in writing in India it

must be required to be in writing only in England.

Oral Guarantee

In P.J. Rajappan v Associated Industries (P) Ltd [1990 (1) All

India Bkg Law Judgments 321], the guarantor, having not signed the
contract of guarantee, wanted to wriggle out of the situation. He contended
that he did not stand surety for the performance of the contract. Evidence
showed involvement of the guarantor in the deal, having promised to sign
the instrument later.
 94

The Kerala High Court held that a contract of guarantee is a

tripartite agreement, involving the principal debtor, surety and the creditor.
In a case where there is an evidence of involvement of the guarantor, the
mere failure on his part in not signing the agreement is not sufficient to
demolish otherwise acceptable evidence of his involvement in the
transaction leading to the conclusion that he guaranteed the due
performance of the contract by the principal debtor. When a court has to
decide whether a person has actually guaranteed the due performance of
the contract by the principal debtor all the circumstances concerning the
transactions will have to be necessarily considered. Court cannot adopt a
hypertechnical attitude that the guarantor has not signed the agreement
and so he cannot be saddled with the liability. Due regard has to be given
to the relative position of the contracting parties and to the entire
circumstances which led to the contract.

Under Section 126 of the Contract Act, a contract of guarantee need

not necessarily be in writing; it may be express by words of mouth, or it
may be tacit or implied and may be inferred from the course of the conduct
of the parties concerned. Contracts of guarantee have to be interpreted
taking into account the relative position of the contracting parties in the
backdrop of the contract. The court has to consider all the surrounding
circumstances and evidence to come to a finding when the guarantor refutes
his lability.
 95

In Mathura Das v Secretary of State (AIR 1930 All 848) and in

Nandlal Chanandas v Firm Kishinchand (AIR 1937 Sindh 50), it was

held that contract of guarantee can be created either by parol or by written

instrument and that it may be express or implied and may be inferred from
the course of the conduct of the parties concerned. There is overwhelming
evidence in this case that the second defendant had guaranteed the due
performance of the contract by the first defendant, principal debtor. Hence
the mere omission on his part to sign the agreement cannot absolve him
from his liability as the guarantor.

To be legally effective a guarantee must be given for debt which is

enforceable. If the debt is not enforceable, the guarantee will not be
enforceable. Thus a minor not being answerable for a debt he incurs, a
guarantee for such debt is likewise void4.

Some banks include a clause in their form of guarantee providing

that where the debtor is under a legal disability, such as minor, etc., the
surety shall be liable as principal.

A guarantee is a very convenient form of security, and because of the

ease with which it can be given, a banker should be careful to make clear
to a proposed surety the nature of the document which he has to sign,
although such a party cannot later plead ignorance of the contents of the
guarantee.

4 Coutts & Co v Brown Lecky and others [1946] 2 All E.R. 207
 96

A contract of guarantee should be entered into freely and voluntarily

by the guarantor. Fry J. in Davies v London and Provincial Marine
Insurance Co.5 said "Everything like pressure used by the intending
creditor will have a very serious effect on the validity of the contract".

It is essential that a guarantee form should be most carefully drawn

so as to create an effective security, and bankers have their own printed
forms of guarantees drafted so as to meet, as far as possible, the various
requirements of a good and complete guarantee.

Value of the Guarantee

A guarantee is probably the simplest form of banking security, more

easily obtained than any other and yet frequently most difficult to realise.
It is an intangible security which may or may not be of adequate value
when it is most needed. Few guarantors ever expect to be called upon to
honour their contract and therefore it is imperative that the lending banker
should exercise the greatest care in obtaining the guarantee and thereafter
in ensuring that it is at all times worth what is required from it. The best
advice from experience is, perhaps, not to lend relying solely on a guarantee
unless the bank is completely satisfied that the guarantor is really
undoubted for the amount required and that he is of such unquestionable
standing that no attempt will be made to avoid the liability. The initial
warning concerning such security is given in Chapter XI of Proverbs, verse
15 : "He that is surety for a stranger shall smart for it, and he that hateth
suretyship is sure". These biblical words so often apply in practice and it
behoves the practical banker not to rely too freely upon a popular and
simple form of security so easily obtained but so difficult to realise.

5
(1878) 8 Ch.D 469
 97

The cynical lender from experience may prefer to define a guarantee

as "where one man that cant pay gets another man who cant pay to say he
will". This humorous definition nevertheless serves as a salutary practical
warning to the practical banker.

Guarantees are usually taken to provide a second pocket to pay if the

first should be empty.

The real value of any guarantee depends entirely on the financial

ability or solvency of the guarantor to meet the liability with reasonable
promptitute when called upon to do so. The undoubted standing of the
guarantor must apply not only when the contract is signed, but throughout
the subsistence of the contract of guarantee. Fortunes can still change
overnight, so that a vigilant watch must always be maintained on the
financial position of the guarantor upon whom reliance is placed.

Essentials of a Guarantee

To a layman a guarantee is a baffling document. The main

obligation, namely to pay if the borrower does not pay, is expressed in two
or three lines. Why then does there have to be a long document bristling
with curious legalese?

In fact many of the technical provisions are vital to the protection of

a lender. Some are so fundamental that, if they are not there, the lender
could find himself with a useless guarantee by reason of some seemingly
trivial action on his part. Guarantees are encrusted with law. This is no
doubt attributable to the fact that guarantors have, historically, sought
 98

every available legal means to avoid a liability which, human nature being
what it is, they did not expect to have to meet when they gave the
guarantee. Guarantors have, therefore, become darlings of the courts. As a
result lawyers have drafted provisions into guarantees to counter
vulnerability of the obligation and to redress the balance.

The business side of the contract of guarantee is concerned with

solvency of the surety, the legal side with the provision of an effective
contract which will in conceivable circumstances give the banker a good
legal remedy against the surety.

The best banking approach to the subject of guarantees is to

recognise the following essentials :

1. The value of the guarantee, which must be maintained

throughout the period of the advance to the customer

2. The validity of the guarantee, which means in general that the

guarantors mind must run with his pen at the time he signs
his guarantee and that nothing shall happen to enable the
guarantor later to avoid liability on the grounds of mistake,
duress, or undue influence.

3. The form of guarantee which must cover all possibilities,

limiting the common law rights of the guarantor and
permitting wide freedom to the banker in dealing with the
borrower. Each bank has its own form of guarantee printed for
 99

general use. At first sight it is a verbose (using more words

than are needed) and unduly lengthy document, but every
phrase and condition is essential.

4. The greatest care is necessary when obtaining the signature

_ of the guarantor to the guarantee. The endless legal
phraseology of the document itself will be of little value if the
guarantors mind does not run with his pen. As many
guarantors will seek some loophole to try to wriggle out of the
liability, patience and close attention is always necessary at
the outset to ensure that the guarantee is valid. It is not a
routine task but one demanding skill and knowledge and any
attempt to rush the completion is fraught with danger. The
trouble arises when the security needs to be realised and
carelessness can jeopardise the banks cause of action against
the guarantor.

The law leans in favour of the guarantor, with the result that if the
creditor oversteps in any way the letter of his contract he will usually find
that his security has vanished.

It should be borne in mind that no guarantor ever expects to have to

pay and, when called upon to do so, will inevitably be pained and surprised.
The beautifully worded and printed document is useless unless it is backed
by hard cash, and the ease with which such security can often be
obtained is a quicksand for the unwary. No amount of legal
provision will produce cash from a guarantor who is incapable of
meeting his liability.
 100

Liability

The word liability in Section 126 of the Indian Contract Act, 1872,
means a liability which is enforceable at law, and if that liability does not
exist, there cannot be a contract of guarantee. A surety, therefore, is not
liable on a guarantee for payment of a debt which is statute - barred6. 7

The Supreme Court in Chattanatha Karayalar v Central Bank

of India Ltd7 laid down that if a transaction is contained in more than one
document between the same parties, they must be read and interpreted
together. Although a guarantor may join the principal debtor in executing
the promissory note he will not be a co - obligant where the underlying
transaction and the conduct of the parties show that he is a surety under
Section 126 of the Contract Act.

Guarantor, a Preferred Debtor

Bankers always insist on getting the contracts signed on their printed

guarantee forms with practically no loophole since, to make a guarantor
liable, the terms of the guarantee are to be interpreted strictly. The
Supreme Court in the State ofMaharashtra v Dr. M.N.Kaul8 confirmed
the view that under the law a guarantor cannot be made liable for more
than he has undertaken; a surety is a favoured debtor and he can be bound
"to the letter of his engagement".

6 Manju Mahadev v Shivappa (1918) 42 Bom. 444; 46 IC 122

7 AIR 1965 SC 1856

8
AIR 1967 SC 1634
 101

Consideration for Guarantee

Section 127 of the Contract Act provides that anything done, or any
promise made, for the benefit of the principal debtor may be a sufficient
consideration to the surety for giving the guarantee.

Consideration is the legal detriment incurred by the promisee at the

promisors request and it is immaterial whether there is or is not any
apparent benefit to the promisor9.

A contract of guarantee executed after the contract between the

creditor and principal debtor and without consideration is void. It must be
contemporaneous with the contract of the creditor and principal debtor.
Past benefit to the principal debtor is not a good consideration10. The mere
fact that A lends money to B on the recommendation of C is no
consideration for a subsequent promise by C to pay the money in default of
Bn.

In an interesting case decided by the Kerala High Court, the Branch

Manager of New Bank of India Ltd made irregular advances on the advice
of a clerk. Later on an undertaking was given by the employees namely the
manager and the clerk that the amount of the two advances will be repaid
within a month and also undertook to be personally responsible for such
payment (i.e. if the customers do not pay, they would pay). As the amounts

9 Sonarlinga v Pachai Naicken (1913) 38 Mad 680; 22 IC 1

10 Ram Narain v Lt. Col. Hari Singh AIR 1964 Rajasthan 76

11 Muthukaruppa v Kathappudayan (1914) 27 MLJ 249

 102

were not paid the bank filed suit against those two customers and also
joined the said two employees who were responsible for the two irregular
transactions and as per their undertaking, these employees stated that
their guarantee was without consideration and therefore it could not be
enforced against them. The court however held that the fact of not taking
disciplinary action against the two employees was sufficient consideration
for the undertaking for their misconduct and payment agreement as the
said undertaking amounted to a lawful contract of indemnity. On the
question of limitations the court held that the limitation began to run one
month from the date of the undertaking and as the suit was not brought
within 3 years after the expiry of one month of the undertaking it was time
- barred against the said two employees and as such dismissed12.

Thus it will be clear that it is not necessary that consideration should

imply something done for the benefit of the guarantor but anything done for
the benefit of the principal debtor is considered as ah adequate
consideration for the guarantor to make the contract valid. Even
forbearance on the part of the bank not to sue the debtor will constitute a
good consideration. In State Bank of India v Premco Saw Mill13, the
State Bank gave notice to the debtor - defendant and also threatened legal
action against her, but her husband agreed to become surety and undertook
to pay the liability and also executed promissory note in favour of the State
Bank and the Bank refrained from threatened action. It was held that such
forbearance on the banks part constituted good consideration for guarantor.

12 New Bank of India Ltd v Govinda Prabhu AIR 1964 Kerala 267

13 AIR 1984 Gujarat 93

 103

In Bank of Credit and Commerce International S.A. v

V.KAbdul Rahiman14, the Kerala High Court observed that a guarantee
is a collateral engagement to answer for the debt, default or miscarriage
of another as distinguished from an original and direct engagement for the
partys own act. For the validity of a contract of guarantee it is adequate
consideration if anything is done or any promise made for the benefit of the
principal debtor. The creditor must have done something for the principal
debtor to sustain the validity of the contract of guarantee. Anything done
or any promise made for the benefit of the principal debtor must be
contemporaneous to the suretys contract of guarantee in order to constitute
consideration therefor. A contract of guarantee executed afterwards without
any consideration is void. The word done in the Section 127 of the Indian
Contract Act, 1872 is not indicative of the inference that past benefit to'the
principal debtor can be good consideration.

The consideration for the suretys promise has not to come from
principal debtor, but from the creditor. It need not benefit surety although
it may do so and it may consist wholly of some advantage given to or
conferred on the principal debtor by the creditor at the suretys request. The
consideration may take the form of forbearance by the creditor at the
suretys request, to sue the principal debtor or of the actual suspension of
pending legal proceedings against him. The mere fact of forbearance is not,
however, of itself a consideration for a persons becoming surety for the
payment of a debt. There must be either an undertaking to forbear or an
actual forbearance at suretys express or implied request. An agreement to
forbear for a reasonable time will provide sufficient consideration to
support a suretys promise.

14
(1998) 92 Camp. Cas. 739 (Kerala)
 104

Scope of Guarantee

In determining the scope of guarantee, two important points arise :

Is the guarantee a specific one, that is, one intended to apply to a particular
debt, or a continuing one which extends to a series of transactions between
the banker and his debtor? In case of specific guarantee, the guarantors
liability will cease as soon as the particular advance is repaid. The
guarantor will not be liable if the debtor pays back the amount borrowed
and takes a fresh loan from the bank. On the other hand, if the guarantee
is to be a continuing one the guarantor will be liable for the balance
irrespective of the payments made by the principal debtor, as they would
go towards the repayment of earlier advances. For this reason, bankers
always prefer to have a continuing guarantee so that the guarantors
liability will not be limited to the original advance but should also extend
to all subsequent debts. By Section 38 of the Indian Partnership Act, 1932
which lays down that "a continuing guarantee given to a firm or a third
party in respect of the transactions of the firm is, in the absence of an
agreement to the contrary, revoked as to future transactions from the date
of any change in the constitution of the firm". That is to say, except where
an agreement to the contrary exists, a guarantee extending to a series of
transactions, given by surety to the firm as creditor, or to a third party on
behalf of the firm as principal debtor, is revoked as to future transactions
by a change in the constitution of the firm which may occur by death,
insolvency or retirement of a partner, or by the admittance of a new
partner. A banker has to see that such contingencies are provided for in the
continuing guarantees.
 105

Continuing guarantees may be revoked by giving notice to the

creditor. If the guarantee provides that notice of certain length of time
should be given, the surety should comply with the same15. In the absence
to the contrary, the death of the guarantor operates as revocation of a
continuing guarantee as to future transactions. After the death of the
guarantor the guarantee is revoked for future transactions and guarantors
estate will be liable for all transactions entered into before the death of the
guarantor. Where continuing guarantee is given by two or more persons and
one of them dies, the survivor or survivors remain liable16.

In Margaret Lalitha Samuel v Indo Commercial Bank Ltd11,

the Supreme Court held that in continuing guarantee the period of
limitation will commence to run only from the date of breach. In this case
an overdraft was given by the bank to the company and the Director
executed a continuing guarantee bond. The Supreme Court held that so long
as the account is a live account in the sense it is not settled and there is no
refusal on the part of the guarantor - director to carry out the obligation the
period of limitation does not commence to run. Limitation will run only
from the date of the breach under Article 115 of the schedule to the Indian
Limitation Act, 1908.

15 Offord v Davies (1862) 12 CBNS 748

16 Beeket v Addyman (1882) 8 QBD 783

17
(1979) 49 Comp. Cas 86; AIR 1979 SC 102
 106

It was held by the Calcutta High Court in Montosh Kumar

Chatterjee v Central Calcutta Bank Ltd18 that the effect of a

continuing guarantee is not to secure amounts advanced on different

occasions but to secure the floating balance which may be due from time to
time and it is the date of the accrual of that balance which is relevant for
the purposes of limitation when it is sued for. The suretys obligation to pay
would arise immediately on default committed by the principal debtor and
once a cause of action against the surety has arisen the commencement of
the running of time is not further postponed till the making of a demand.

Surety as Trustee

So far as the expression Fiduciary Capacity is concerned it is not

restricted to technical or express trusts, but includes imparting of a
confidence on the basis of which a person acts as a guarantor while giving
an undertaking. It is within the knowledge of the guarantor that the money
is being advanced on the strength of the confidence reposed in the
guarantor and in such cases, the position of the guarantor is very near to
that of a trustee. In the case V.Velayudhan v State Bank of India19, the
bank had obtained a decree for recovery of a loan on the basis of a
guarantee and since the principal debtor died, the bank took execution
proceedings against the guarantor. The guarantor pleaded that he had no
means to pay the debt which was not accepted by the court and it was held
that the surety could be proceeded against tinder Section 51 (c) of the Code

18 (1953) 23 comp. Cas. 491

19
(1988) 64 Comp. Cas 52 (Kerala)
 107

of Civil Procedure, 1908 (for arrest and imprisonment). The court further
held that the surety who guaranteed repayment had an obligation to
account in fiduciary capacity.

The Supreme Court in Jolly George Varghese v The Bank of

Cochin20 observed that the words "or has had since the date of the decree,
the means to pay the amount of the decree" occuring in Section 51, C.P.C.
may imply, if superficially read, that if at any time after the passing of an
old decree the judgment - debtor had come by some resources and had not
discharged the decree, he could be detained in prison even though at the
later point of time he was found to be penniless. This was not a sound
position apart from being inhuman going by the Art. 11 of the International
Covenant on Civil and Political Rights and Art. 21 of the Constitution.

Where the judgment - debtor if once had the means to pay the debt
but subsequently after the date of decree, has no such means or he has
money on which there are some other pressing claims; it is violative of Art.
11 of the Covenant to arrest and confine him in jail so as to coerce him into
payment. Section 51 of the Civil Procedure Code embodies same principle
as that which is embodied in Art. 11 of the Covenant.

The Covenant bans imprisonment merely for not discharging the

decreed debt. Unless there be some other vice or mens rea apart from
failure to foot the decree, international law frowns on holding the debtors
person in civil prison, as hostage by the court.

20
AIR 1980 SC 470
 108

The simple default to discharge the decree is not enough. There must
be some element of bad faith beyond mere indifference to pay, some
deliberate or recusant disposition in the past or alternatively, current
means to pay the decree or a substantial part of it. The provision
emphasises the need to establish not mere omission to pay but an attitude
of refusal as demand verging on dishonest disowning of the obligation under
the decree. Here considerations of the debtors other pressing needs and
straightened circumstances will play prominently.

The Supreme Court further held that it is too obvious to need

eleboration that to cast a person in prison because of his poverty and
consequent inability to meet his contractual liability is appalling. To be
poor, in this land of Daridra Narayana (land of poverty) is no crime and
recover debts by the procedure of putting one in prison is too flagrantly
violative of Art. 21 of the Constitution (protection of life and personal
liberty) unless there is some proof of the minimal fairness of his wilful
failure to pay in spite of his sufficient means and absence of more terribly
pressing claims on his means such as medical bills to treat cancer or other
grave illness.

Article 11 of the International Covenant on Civil and Political Rights

states that no one shall be imprisoned merely on the ground of inability to
fulfil a contractual obligation.

The Supreme Court elaborately discussed the provisions of Section

51 (c) of Civil Procedure Code in comparison with Article 11 of the
International Covenant on Civil and Political Rights.
 109

It is submitted that the Supreme Court decision has laid down the
dictum that the debtor or guarantor cannot be arrested and imprisoned
under Section 51 (c) of CPC for his mere failure or inability to meet his

contractual liability.

Principle of Co - Extensiveness

Section 128 of the Contract Act provides that the liability of the
surety is co - extensive with that of the principal debtor, unless it is
otherwise provided by the contract.

A suretys liability to pay the debt is not removed by reason of

creditors omission to sue the principal debtor. The creditor is not bound to
exhaust his remedy against the principal debtor before suing the surety,
and a suit may be maintained against the surety though the principal
debtor has not been sued. But where the liability arises only upon the
happening of a contingency, the surety is not liable until that contingency
has taken place21.

The liability of the guarantor to pay the amount under the guarantee
is not automatically suspended when the liability of the principal debtor is
suspended under some statutory provision. Thus a contract of guarantee
being an independent contract is not affected by liquidation proceedings
against the principal debtor22.

21 Subankhan v Lalkhan AIR 1947 Nag. 643

22 M.S.E.B, Bombay v Official Liquidator H.C. Ernakulam AIR 1982 SC 1497

 110

If on account of a contract of partnership being illegal, the principals

liability is unenforceable, the surety will also not be liable23.

In Gerrad v James2*, the English Court held that a Company

Director who guaranteed a contract by the company which is ultra vires
that company, remained liable to the creditor.

The Bombay High Court held in E G. Bankruptcy : Jagannath v

Shivnarayan25 that a discharge of the principal debtor by operation of
law does not discharge the surety.

If a contract of suretyship is a guarantee in the true sense, namely

which contains a promise to answer for the debt, default or miscarriage of
another, then there is a strong prima facie rule of construction that the
suretys obligations are to be interpreted as co - extensive with those of the
principal debtor. Accordingly, it has been held that the obligations of a
guarantor of "the due fulfilment of any obligation" of a party to a
charterparty which contained an arbitration clause, covered the debtors
liability to pay interest and costs as well as the principal sum awarded by
the arbitrators26.

23 Varadarajulu v Thavasi Nadar AIR 1963 Madras 942

24 (1925) Ch 616

25 AIR 1940 Bombay 387

26 Compania Sudamericana de Fletes SA v African Continental Bank Ltd

(1973) 1 Lloyds Rep 21
 Ill

When a surety guarantees the performance of a contractual liability

on the part of the principal to make certain payments to the creditor by
instalments, there may now be difficulties in construing the contract of
guarantee in accordance with the principle of co - extensiveness. The
starting point of those difficulties is well explained in Lep Air v Moschi27.
In that case, the debtor defaulted under a contract for payment in
instalments for services already provided by the creditor. The creditor
treated the contract as repudiated. The question which arose was whether
the creditor could sue the surety for the balance monies due under contract
at the time of the repudiation, notwithstanding that when he accepted the
repudiation the debtors primary obligation to pay specific instalments of
money became translated into secondary obligations to pay damages. The
suretys obligation was to see to it that the debtor performed his contractual
obligations, so that when the debtor defaulted, the surety became liable to
pay the creditor a sum of money for the loss he thereby sustained.

However, it was quite clearly envisaged in that case that the liability
of the debtor and guarantor would remain co - extensive and that no rule
of construction would be used to breach this fundamental principle. Thus
Lord Diplock said in that case as under :

"Whenever the debtor has failed voluntarily to perform an obligation

which is the subject of the guarantee the creditor can recover from the
guarantor as breach of his contract of guarantee whatever sum the creditor
could have recovered from the debtor himself as a consequence of that
failure. The debtors liability is also the measure of the guarantors liability.

27
(1973) AC 331
 112

Despite this clear affirmation of the principle of co - extensiveness,

the Court of Appeal and the House of Lords subsequently construed two
similar guarantees in a way which, at least prima facie, appears to derogate
from the principle of co - extensiveness. In two cases concerning guarantees
of instalments due from purchasers of ships under shipbuilding contracts,
the surety was held liable for certain accrued instalments rather than the
damages which the debtor was liable to pay for breach of his obligation to
pay those instalments28.

The courts purportedly relied on what was said in Lep Air case in
order to reach this result. It may be that the cases turned on their special
facts and that when construed against the factual matrix the "guarantees"
were in truth indemnities, though the reasoning is hard to reconcile with
that explanation. It also appears that the principle of co - extensiveness
may not have played a very substantial part in the argument. Until the
matter is resolved, particular care will have to be used when drafting or
advising on the construction of such contracts of guarantee.

Co - extensiveness of liability is one of the essential characteristics

of a guarantee that distinguishes it from contract of indemnity. Where,
therefore, the liability of a promisor under an agreement exceeds that of the
primary debtor, in that, for example, he may be liable, when the primary
debtor is not, or for an amount for which he is not, then the agreement is
not a guarantee, and the promisor undertakes primary liability himself. In
such circumstances, the contract in question can be viewed as an indemnity.

28 Hyundai Shipbuilding & Heavy Industries Co. Ltd v Pournaras (1979) 1

Lloyds Rep 130 and Hyundai Heavy Industries Co Ltd v Papadopoulos
(1980) 1 WLR 1129
 113

However, the principle of co - extensiveness is not an immutable rule.

The precise extent of the liability of the surety will always be governed by
the provisions of guarantee on their true construction of the document, and
the parties remain free to provide for limitations of the liabilities of the
surety without detracting from the nature of the contract as guarantee. For
example, the surety guarantees only the future transactions, and not the
past indebtedness. Furthermore, the court has not always regarded itself
as bound to treat the surety as co - extensively liable with the principal,
and there are circumstances where the surety will remain liable
notwithstanding the fact that the principal is not, or is no longer, liable for
the principal obligations29.

An interesting case entitled Radha Thiagarajan v South Indian

Bank Ltd30 was decided by the Kerala High Court. In that case, the
appellant and her husband executed a continuing guarantee in favour of the
respondent bank for grant of an over draft account to a textile company, the
terms of which provided that the liabilities of the sureties would remain
unaffected, notwithstanding any indulgence or release granted to the
company. The bank instituted a suit against the company and the sureties
for recovery of money under the overdraft account. The company was,
meanwhile, taken over under section 18A of the Industries (Development
and Regulation) Act, 1951 and subsequently nationalised under the Sick
Textile Undertakings (Nationalisation) Act, 1974. The suit was dismissed
as against the company on the ground of availability of alternative remedy

29 Moschi v Lep Air Services Ltd (1973) AC 331

30
(1988) 63 Comp. Cas. 61
 114

under the Nationalisation Act, but decreed as against the appellant. The
appellant contended that since the liability of the principal debtor was
extinguished under the Nationalisation Act, the liability of the sureties was
also extinguished.

It was held that under Section 5 of the Nationalisation Act, every

liability of the textile undertaking, other than a liability arising from loans
advanced by Government after it had been taken over under the Industries
(Development and Regulation)Act, 1951 was the exclusive liability of the
owner and enforceable against him only. Under Section 24 of the
Nationalisation Act, the liability of the owner stood discharged in respect
of a claim only to the extent the claim was admitted in terms of Section
23(4) of the Act. The discharge under the section had, therefore, no effect
upon any claim which had been rejected in part or whole, and in regard to
any such claim, the remedy against the owner had to be pursued outside
the statute. The liability of the surety remained unimpaired in respect of
the undischarged debt.

This case clearly points out that the discharge of the principal debtor
is not discharge of the surety where it is not brought about by the voluntary
act of the creditor, but by operation of law.

The principle of co - extensiveness is farther reinforced by the

decision of the Supreme Court in the following two leading cases;
 115

Bank of Bihar Ltd v Damodar Prasad and Another31

The palnitiff - bank had lent moneys to Demodar Prasad (Defendant

No.l) on the guarantee of P.N. Sinha (Defendant No. 2). In terms of his
guarantee bond, Sinha had agreed to pay and satisfy the liability of the
principal debtor upto Rs.12,000/- and interest thereon two days after
demand by the bank. The bond also provided that the bank would be at
liberty to enforce and recover upon the guarantee, notwithstanding any
other guarantee, security or remedy which the bank might hold or be
entitled to in respect of the amount secured. As, despite its demands, the
bank could not recover the dues from either the borrower or the surety it
filed a suit against both of them. The trial court decreed against them, but
ordered that the hank could enforce its dues in question against the
surety, only after having exhausted its remedies against the
borrower. The banks appeal to the Patna High Court against this order
was dismissed. The bank successfully appealed to the Supreme Court.

The Supreme Court held that the demand for payment of the liability
of the principal debtor was the only condition for the enforcement of the
bond. The condition was fulfilled. Neither the principal debtor nor the
surety discharged the admitted liability of the principal debtor in spite of
demands. Under Section 128 of the Indian Contract Act, save as provided
in the contract, the liability of the surety is co - extensive with that of the
principal debtor. The surety became thus liable to pay the entire amount.
His liability was immediate. It was not deferred until the creditor
exhausted his remedies against the principal debtor

31
AIR 1969 SC 297
 116

Before payment the surety has no right to dictate terms to the

creditor and ask him to pursue his remedies against the principal debtor in
the first instance. Lord Eldon observed in Wright v Simpson (1802) 6 Ves.
Jr. 714, 734, "But the surety is a guarantor, and it is his business to see
whether the principal pays, and not that of the creditor". In the absence of
some special equity the surety has no right to restrain an action against
him by the creditor on the ground that the principal is solvent or that the
creditor may have relief against the principal debtor in some other
proceedings.

Likewise, where the creditor obtained a decree against the surety and
the principal, the surety has no right to restrain execution against him until
the creditor has exhausted his remedies against the principal debtor.

The solvency of the principal is not a sufficient ground to restrain

execution of the decree against the surety. It is the duty of the surety to pay
the decretal amount. On such payment, he will be subrogated to the rights
of the creditor under section 140 of the Indian Contract Act, and he may
then recover the amount from the principal. The veiy object of the
guarantee will be defeated if the creditor is asked to postpone his remedies
against the surety. In the present case, the creditor is a banking company.
A guarantee is a collateral security usually taken by the banker. The
security will become useless if his rights against the surety can be so easily
cut down.
 117

State Bank of India v Indexport Registered32

The Supreme held in this case that a suretys liability to pay the debt
is not removed by the reason of the creditors omission to sue the principal
debtor. The creditor is not bound to exhaust his remedies against the
principal before suing the surety, and a suit is maintainable against the
surety though the principle has not been sued. The Supreme Court cited the
following passage from Chitty on Contracts33:

"Prima facie the surety may be proceeded against without demand

against him and without first proceeding against the principal debtor".

The court also cited the following passage from Halsburys Laws of
England:34.

"It is not necessary for the creditor, before proceeding against the
surety, to request the principal debtor to pay, or to sue him, although
solvent, unless this is expressly stipulated for".

The Supreme Court emphasized the principle of Section 128 of the

Contract Act and referred to Bank ofBihar Ltd v Damodar Prasad and
Another (AIR 1969 SC 297) quoted supra. The Supreme Court also

32 AIR 1992 SC 1740

33 24th Edn. Vol, 2, para 4831

34 4th Ed, Vol 20 para 159

 118

approved the Karnataka High Court decision in the case of Hukumchand

Insurance Co Ltd v Bank of Baroda35, Venkatachellich J (as His

Lordship then was) speaking for the Division Bench observed as follows :

"The question as to the liability of the surety, its extent and the
manner of its enforcement have to be decided on first principles as to the
nature and incidents of suretyship. The liability of a principal debtor and
the liability of a surety which is co - extensive with that of the former are
really separate liabilities, although arising out of the same transaction.
Notwithstanding the fact that they may stem from the same transaction,
the two liabilities are distinct".

The aforesaid principles laid down by the Supreme Court were later
followed by Madhya Pradesh High Court in State Bank of India v M.P.
Iron and Steel (P) Ltd?6 and Madras High Court in Balakrishnan v
Chunnilal Bagmar37.

The Kerala High Court in State Bank ofIndia v G.J.Herman and

others38 following the Supreme Court decision made the following
observations while dwelling on the liabilities of the co - surety :

35 AIR 1977 Kant 204

36 AIR 1998 MP 93

37 AIR 1998 Madras 175

38 AIR 1998 Kerala 161

 119

"The Principle laid down by the Supreme Court is that the liability
of the sureties is co - extensive with that of the principle debtor.
Consequently creditor can proceed against the principal debtor or against
the sureties, unless it is otherwise provided in the contract. The same
should be principle with regard to the rights and liabilities between the
co - sureties as well. A co - surety cannot insist that the creditor should
proceed either against principal debtor or against other sureties before
proceeding against him, since the liability of a surety is joint and several.
To the extent to which they stood guarantee, they are liable to be proceeded
against by the creditor. The option is entirely that of the creditor to decide
against whom he could proceed either against principal debtor or against
any of the sureties. Court for that matter, or a co - surety cannot insist that
creditor should proceed against other sureties before proceeding against
him. Such a direction is directly against the principle of co - extensiveness.

It is heartening to note that Indian Courts have thoroughly

recognised the principle of co - extensiveness even before the enactment of
the Indian Contract Act, 1872.

In the year 1869, the Bombay High Court in the case Lachman
Joharimal v Bapu Khandu and another39 stated as under.

"This Court is of the opinion that a creditor is not bound to exhaust

his remedy against the principal debtor before suing the surety and when
a decree is obtained against a surety, it may be enforced in the same
manner as a decree for any other debt".

39
(1869) 4 Bom HC Rep 241
 120

Thus it is clear that the contract of guarantee is an independent

contract making the liability of the surety co - extensive with that of the
principal debtor, unless otherwise agreed upon. The creditor can opt to
proceed to recover debt against the surety independently of the principal
debtor. Even though the contract of surety may originate from the same
transaction it creates rights and liabilities "separate and distinct" from the
rights and liabilities created by contract between the principal debtor and
the creditor. The two cannot be mixed up. It is, therefore, clear that subject
to contract to the contrary, liability of surety remains intact so long as the
debt of the principal debtor is not discharged. This is what the word "co -
extensive" in Section 128 of the Indian Contract Act, 1872 means. Since the
contract of surety is an independent contract, the surety cannot require the
creditor to recover the debt from the principal debtor personally or from the
securities furnished by the principal debtor. It is submitted that Section 128
of the Contract Act indicates the liability of the surety and not the manner
of discharge of the debt of the principal debtor.

Thus the guarantors liability is absolute.

Suretys Liability when Principal is Insolvent

Usually if the principal is known to be insolvent, the creditor will

bring his action against the surety instead. He may prove in the bankruptcy
or liquidation of the principal. However the question may arise as to the
creditors right to claim against the surety if a payment made by the
principal to the creditor is set aside as wrongful preference, and he has to
repay the money to the liquidator or trustee in bankruptcy. The position
 121

appears to be that if the creditor was not a party to the preference, he

probably can recover the money from the surety, on the grounds that there
was no valid payment to him and he has not done anything to discharge the
surety on equitable grounds40.

Claims Against The Estate of the Surety

If the liability of the surety has not accrued by the time he dies, the
general rule is that his personal representatives cannot be forced to set
aside a sum out of his estate to meet the potential future liability on the
guarantee. In Antrobus v Davidson41, an application made by the
executor of the deceased creditor against the representatives of the deceased
surety for an order that the latter should set aside a sufficient sum of the
estate to answer future contingent demands, was dismissed.

However, if the liability of the surety has already accrued, or if the

terms of the guarantee are worded in such a way that he appears to be a
principal debtor with a liability to make payment on a fixed future date,
albeit he is really a surety, a sufficient sum must be set aside out of his
estate to meet that liability, even if there is a prospect that the principal
debtor might pay the debt instead42.

40 Petty v Cooke (1871) LR 6 QB 790

41 (1817) 3 Mer 569

42 Atkinson v Grey (1853) 1 Sm & G 577

 122

Bankers Negligence and Suretys Liability

Section 139 of the Indian Contract Act, 1872 provides that 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.

Under this section, the negligence of the banker in handling the

security will discharge the suretys liability to the extent of the impairment
of such security.

Any negligent or improper handling by banker of the securities

belonging to the debtor which reduces their value will diminish the liability
of the guarantor to the extent to which the securities depreciate, unless
there is a clause in the contract of guarantee allowing the banker to deal
with the securities as he may think fit. Similarly, if the banker holds some
securities belonging to the principal debtor, he should not return them
wholly or partially to the principal debtor, as thereby he will prejudice the
interests of the surety.

In State Bank ofSaurashtra v Chitranjan Rangnath Raja and

another,43 the bank granted a cash credit facility to the customer against
pledge of goods by the principal debtor and the personal guarantee of the
surety. Goods pledged under the custody of the bank were lost by the
negligence of the bank. The Supreme Court held that the surety is

43
AIR 1980 SC 1528
 123

discharged to the extent of the security of the goods lost. The Court
observed that even if the surety of the personal guarantee is not aware of
the security offered by the principal debtor, yet once the right of the surety
against the principal debtor is impaired by any action or inaction, which
implies negligence appearing from lack of supervision undertaken in the
contract, the surety would be discharged to the extent of the value of the
securities so impaired.

In State Bank of India v Quality Bread Factory44, cash credit

was given by the bank on open cash credit system. Hypothecated goods
were lost by the negligence of the bank. Based on the aforesaid decision of
the Supreme Court, Punjab and Haryana High Court held that it has not
been laid down in the Contract Act that this principle applies only to
pledges and not the hypothecation. Therefore the law applies equally to
open credit system. The bank should, as a pledgee, keep requisite vigilance
on the debtor both in the "lock and key" system and "Open Credit System"
in order to protect himself and the security against the illegal actions of the
debtor. Any negligence or inaction on the part of the bank by which he loses
the security absolves the surety from his liability.

In Jose Inacio Lourence v Syndicate Bank,45 the bank had given

a loan for purchase of a vehicle and since the loan was not paid by the
principal debtor the bank filed a suit both against the principal debtor and
surety which was decreed. The case of the surety in appeal was that the
principal debtor had transferred the vehicle which was now registered in

44 AIR 1983 Punjab & Haryana 244

45
(1989) 65 Comp. Cas. 698
 124

another State and the Bank had failed to register the charge (Hire Purchase
or H.P. Clause) with the Regional Transport Authority and it was unable
to produce the vehicle for the benefit of the surety. In such circumstances,
the Bombay High Court held that this amounted to parting with security
and the surety stood discharged to the extent of the value of the security.
The failure to register the charge was an act which was inconsistent with
the rights of the surety within the meaning of Section 139 of the Indian
Contract Act, 1872, as the eventual remedy of the surety had been
impaired.

In Amrit Lai Goverdhan Lalan v State Bank of Travancore46,

the bank lost goods of Rs.35,690/- with it due to its negligence. The
Supreme Court held that the surety was discharged of the liability to the
bank to the extent of Rs.35,690/-.

In M.R. Chakrapani Iyengar v Canara Bank47, the surety

informed the bank that an electric oven hypothecated by the principal
debtor to the bank was sold to a particular party and gave details. The bank
did not take steps to seize the property to sell it and recover its dues which
could easily have been done. The surety prayed for discharge since the bank
was negligent in realising the security. The trial court negatived his
contention and passed a decree against the principal debtor and the surety.
The surety filed a Civil Revision Petition before the Karnataka High Court.
The amount due was Rs.4000/- to be paid to the bank to liquidate the debt.
The court held that the bank was grossly negligent in not seizing and

46 AIR 1968 SC 1432

47 (1999) 95 Comp. Cas. 862

 125

selling the hypothecated goods though the surety had intimated the factual
position to the bank. The bank could have filed even a police complaint for
tracing of the asset, which was not done. The court heavily came down on
the bank stating the bank had been guilty of negligence or gross inaction
and the surety had been wrongly foisted with the liability which would
have otherwise been discharged through the seizure and sale of the
property. The court allowed the appeal of the surety and set aside the trial
courts order as far as the surety was concerned.

In Chistovan Vaz and another v Indian Overseas Bank and

others48, the first respondent bank advanced a loan of Rs.96,000/- for
purchase of a mini - bus against hypothecation of the mini bus. The
appellants stood guarantee. The principal borrower defaulted in repayment.
The bank attached the vehicle and with the help of the police the said
vehicle was detained for five months. Thereafter the branch manager took
possession of the said vehicle which was auctioned fetching a value of
Rs. 10000/- only. The trial court decreed the suit against the principal debtor
and sureties who filed an appeal before the Bombay High Court Panaji
Bench. The High Court held that the bank took possession of the
hypothecated vehicle without informing the surety and allowed the vehicle
to deteriorate due to exposure to rain and sun and it had to be sold as
scrap. The court further held following the Supreme Courts decision in
State Bank of Saurashtra v Chitranjan Rangnath Raja49 that in
maintaining the mini bus, the bank was absolutely negligent and their

48 (2000) 100 Comp. Cas. 16

49
AIR 1980 SC 1528
 126

negligence contributed to the deterioration of the mini bus. Therefore, any

reduction in the value of the security is to be accounted for by the bank and
the sureties stand discharged to that extent under the combined operations
of Sections 139 and 141 of the Indian Contract Act, 1872.

Suretys Right of Subrogation

According to Bouviers Law Dictionary50, "Subrogation is the

substitution of another person in the place of the creditor, to whose rights
he succeeds in relation to the debt. That change which puts another person
in the place of the creditor, and which makes the right, the mortgage, or the
security which the creditor has pass to the person who is subrogated to him
- that is to say, who enters into his right".

It is the substitution of another person in place of the creditor, so

that the person substituted will succeed to all the rights of the creditor,
having reference to a debt due him. It is independent of any mere
contractual relations between the parties to be affected by it, and is broad
enough to cover every instance in which one party is required to pay a debt
for which another is primarily answerable, and which in equity, and
conscience ought to be discharged by the latter.

The suretys right to be placed in the creditors position on the

discharge of the principal debtors obligation, to the extent that the suretys
property has been used to satisfy the creditors claim and to effect such
discharge, is called the suretys "right of subrogation".

50
3rd Edn, 1914, Vol 3, p.3166
 127

The suretys right of subrogation should be distinguished carefully

from the creditors right of equitable subrogation. On the principal

debtors default the creditor has the right to resort to any security which
has been deposited by the debtor with the surety. The creditor is subrogated
to the suretys right against the property of the principal debtor. This right
of the creditor to reach such security is called "the right of equitable
subrogation". Until the principal debtors default the surety has the
obligation to preserve the security.

The origion and nature of the right of subrogation, was laid down in
Morgan v Seymore51 where it was held that a surety who has performed
the obligations of the principal which are the subject of his guarantee is
entitled to stand in the shoes of the creditor and to enjoy all the rights that
the creditor had against the principal. This is an equitable right. It is a
right that arises out of the relationship of surety and creditor itself. Equity
intervenes to assist the surety because, he having paid off the principal
debt, it would be unconscionable for the principal then to recover the
securities from the creditor while remaining under an obligation to
indemnify the surety for the payment. The right of subrogation can be
expressly excluded by clear words in the contract of guarantee. It seems
that the statutory right of subrogation is also excluded by sufficient words
or conduct. The surety cannot be deprived of his rights of subrogation by an
agreement between the creditor and the principal to that effect52.

51 (1638) 1 Rep Ch 120

52
Steel v Dixon (1881) 17 Ch D 825
 128

The right extends to all securities which the bank has received from
its customer before, contemporaneously with, or after the execution of the
guarantee, and it is immaterial whether or not the guarantor knew of their
existence at the time when he signed the guarantee53.

A guarantor who pays off the whole debt is entitled, not only to
securities deposited by the customer, but also to those deposited by third
parties. This is what right of subrogation is under English Law.

In India, the right of subrogation has been enunciated in Sections 140

and 141 of the Indian Contract Act, 1872. Section 140 provides for the right
of subrogation as under :

"Rights of surety on payment or performance Where a guaranteed

debt has become due, or default of the principal debtor to perform a
guaranteed duty has taken place, the surety upon payment or performance
of all that he is liable for, is invested with all the rights which the creditor
had against the principal debtor".

When the surety has paid all that he is liable for he is invested with
all the rights which the creditor had against the principal debtor. The
surety steps into the shoes of the creditor. The creditor had the right to
sue the principal debtor. The surety may, therefore, sue the principal debtor
in the rights of the creditor.

53 Forbes v Jackson (1882) 19 Ch. D 615

 129

The Supreme Court has laid down in Amrit Lai Goverdhan Lalan

v State Bank of Travancore54 that the surety will be entitled to every

remedy which the creditor had against the principal debtor; to enforce every
security and all means of payment; to stand in the place of the creditor; to
have the securities transferred to him, though there was no stipulation for
that; and to avail himself of all those securities against the debtor. This
right of surety stands not merely upon contract, but also upon natural
justice. The language of Section 140 which employs the words "is invested
with all the rights which the creditor had against the principal debtor"
makes it plain that even "without the necessity of transfer, the law vests
those rights in the surety".

In Kadamba Sugar Industries (P) Ltd v Devro Ganapathi

Hegde55, the Corporation Bank advanced a loan to Appellant No.l and a
mortgage was created by depositing the title deeds towards security for the
loan. The loan was not paid and a suit had to be filed. During the pendency
of the suit, the Respondents 1 to 5 paid the amount as they were sureties
to the loan. It was held by the court that the sureties had the right of
subrogation provided under Section 140 of the Indian Contract Act, 1872.

A question arose as to whether the surety, impleaded as defendant

in the suit can apply for attachment before judgment and temporary
injunction in respect of the property of the principal debtor. It was held by

54 AIR 1968 SC 1432

55 (1993) Vol II Bank Cas. 507

 130

Bombay High Court in Jugalkishore Ram Pratap and Rathi v

Brijmohan Ram Pratap and Rathi and Another56 that a surety is so

entitled to protect his interests.

It was decided by the Bombay High Court in State Bank of India

v Fravina Dyes Intermediate57 that the guarantor by invoking the
doctrine of subrogation can apply for a temporary injunction against the
debtor even before making payment to the creditor if he apprehends that
the debtor threatens or is about to remove or dispose of his property with
intent to defraud the creditor. That is, the guarantor is entitled to a grant
of Quia Timet injunction against the principal debtor under certain
circumstances.

Section 141 of the Indian Contract Act, 1872 reads as under:

"Suretys right to benefit of creditors security 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 entired into, whether
the surely 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".

It was held by the Supreme Court in State of M.P. v Kaluram58

that the term "Security" in Sec 141 is not used in any technical sense; it

56 (1993) ISJ (Banking) 266

57 AIR 1989 Bombay 95
58 AIR 1967 SC 1105
 131

includes all rights which the creditor had against the property of the
principal at the date of the contract.

The difference between the English Law and the principle laid down
in Sec 141 was explained by the Supreme Court in Amrit Lai Goverdhan
Lalan v State Bank of Travancore59 as under:

"It is true that Section 141 has limited the suretys right to securities
held by the creditor at the date of his becoming his surety and has modified
the English rule that the surety is entitled to the securities given to the
creditor both before and after the contract of guarantee. But subject to this
variation, Section 141 incorporates the rule of English Law relating to
discharge from liability of a surety when the creditor parts with or loses the
security held by him".

In Bank of India v Yogeshwar Kant Wadhera60, the Punjab and

Haryana High Court held that where the delivery of goods is not given to
the creditors as in the case of hypothecatee (bank), the surety was not
entitled to claim protection of Section 141 of the Indian Contract Act, 1872.
As in hypothecation the possession of the goods is with the borrower, it will
be wrong to say that the goods are in constructive possession of the creditor
- bank because it has no effective control over them. By hypothecation, only
an equitable charge is created and nothing more and therefore the Section
141 is not applicable to hypothecation.

59 AIR 1968 SC 1432

60 AIR 1987 P & H 176

 132

The Punjab and Haryana High court has, by this decision, overruled
its earlier decision in State Bank of India v Quality Bread Factory
(page 123 supra).

Surety for Minors Contract

The obligation of sureties is an obligation accessory to that of a

principal debtor. If the principal debtor is not obliged, neither is the surety,
as there can be no accessory without a principal obligation according to the
rule of law.

The guiding principle applicable to contracts of guarantee is that the

liability of the surety is co - extensive with that of the principal debtor. This
is because a contract of guarantee is an undertaking to the creditor that the
principal debtor will perform his principal obligation. Accordingly, as Lord
Selbome said in Lakeman v Mountstephen61 :

".... until there is a principal debtor, there can be no suretyship. Nor

can a man guarantee anyone elses debt unless there is a debt of some other
person to be guaranteed".

However the fact that the principal obligation is void or

unenforceable will not necessarily release the surety from his liability under
the guarantee. The surety may find himself liable to the creditor where the
principal debtor is not, or under a liability to the creditor different from
that of the principal debtor.

61
(1894) LR 7 HL 17
 133

In accordance with the principle of co - extensiveness, the fact that

the principal obligation is void will mean that as a general rule the surety
will not be liable under his guarantee of the principals obligations
thereunder, for example where the principal obligation is void for minority
of the debtor. However, there are a number of different situations in which
the general rule does not apply, and the surety will be liable
notwithstanding the voidness of the principal obligation.

In Wauthier v Wilson82, the creditor had lent money to a minor,

whose father had given a promissory note to the creditor as a surety.
Although the debt was void under the provisions of the Infants Relief Act,
1874 (England), the court held that the father was not released from
liability under the note. At the trial Pickford J. held the father liable
though he was treated as a guarantor. The Court of Appeal affirmed this
decision on another ground. It treated the father as having entered into a
joint obligation with his son. The fact that the son was not bound did not
exonerate the father from his separate and distinct liability treating the
fathers contract as one of indemnity.

In Coutts & Co v Brown Lecky63, where an overdraft to a minor

was guaranteed by an adult, Oliver J. held that since the overdraft was
absolutely void under the provisions of the Infants Relief Act 1874, the
guarantee was unenforceable by the bank. As a guarantee is a secondary or
ancillary undertaking, it cannot be more effective than the primary
obligation which it aims to secure.

62(1911) 27 TLR 582

63(1947) KB 104
 134

The decision in Coutts & Co case has been criticised in particular on

the ground that the provisions of the Infants Relief Act 1874 afforded a
personal privilege to the minor that was open to him and to no body else.
This privilege should not be granted to an adult who has guaranteed the
debt of a minor.

In Stadium Finance Co Ltd v Helm64, where a finance company

had hired a car to a minor under a hire - purchase agreement which had
been co - signed by his mother, the Court of Appeal held that she was a
surety for the minor, and not an indemnifier, and that because the minor
was not liable under the principal contract she could not be liable under the
guarantee. It appears from the judgment of Denning MR in the transcript
that in fact it was conceded by the finance company that a guarantee of a
minors void debt is unenforceable, and so it may be said to be authority for
the proposition that the surety is not liable even where he or she knew of
the principals incapacity.

In Yeoman Credit v Latter65, a finance company released a car to

a minor under a hire - purchase agreement. To back the minors
undertaking, an adult executed a document entitled an Indemnity, in which
he undertook to "make good" to the finance company any loss incurred
under the hire - purchase agreement. The minor defaulted, whereupon the
finance company brought an action to enforce its rights against the adult.
It was argued, as a preliminary point, that the document in question

64(1965) 109 SJ 447

65(1961) 1 WLR 828

 135

constituted a guarantee and it fell together with the hire - purchase

contract. The Court of Appeal held that the adults undertaking constituted
an indemnity, which was unaffected by the avoidance of the hire - purchase
agreement.

A guarantee constitutes a promise to compensate a creditor against

loss incurred by the main debtors default. An indemnity is a promise to
reimburse to the beneficiary thereof any loss incurred in a given venture.
In practice, it is not always easy to distinguish between a guarantee and an
indemnity. A guarantor is usually granted the right of subrogation, which
enables him to recover from the debtor any amount paid under the
guarantee to the creditor. No such right is conferred by the indemnity. An
indemnity is a separate and distinct undertaking to pay money, and the
person giving it is a principal and independent debtor, not, as is a
guarantor, merely a secondary debtor. This would seem to leave available
to lenders the security offered by adults in support of advances to minors
provided it is in the form of indemnity rather than of guarantee.

The law in England was changed by the enactment of Minors

Contracts Act 1987. Section 1 of that Act repealed the Infants Relief Act
1874. Section 2 of the Act provides that where a guarantee is given in
respect of an obligation of a party to a contract made after the
commencement of the Act and the obligation is unenforceable against him
(or he repudiates the contract) because he was a minor when the contract
was made, the guarantee shall not for that reason alone be unenforceable
against the surety. It is not clear whether the surety who has paid the
creditor has a right of indemnity against the minor principal. The Law
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Commission Report on Minors Contracts (Law Com 134) in England

suggested that there was a right of recovery only where the minor could,
under the common law rules, have been sued by the original creditor.

It is now well settled in English Law after the enactment of Minors

Contracts Act 1987 that the surety for a minors contracts is liable as a
principal debtor or indemnifier, despite earlier conflicting judicial decisions
in respect of such suretys liability.

It is well known that most of the commercial enactments in India

follow the principles of English Law. Section 11 of the Indian Contract Act,
1872 provides that a minor is not competent to contract.

In Mohiribibi v Dharmodas66, the Privy Council held in respect

of section 11 of the Contract Act as under :

"Looking at Section 11 their Lordships are satisfied that the Act

makes it essential that all contracting parties should be competent to
contract and especially provides that a person who by reason of infancy is
incompetent to contract cannot make a contract within the meaning of the
Act. The question whether a contract is void or voidable presupposes the
existence of a contract within the meaning of the Act, and cannot arise in
the case of an infant".

66
(1903) 30 IA 114
 137

Ever since this decision it has not been doubted that a minors
agreement is absolutely void. The ruling of the Privy Council in the
Mohiribibi Case has been generally followed by courts in India and
applied both to the advantage and disadvantage of minors.

Section 128 of the Indian Contract Act, 1872 provides that the
liability of the surety is co - extensive with that of the principal debtor.
When Section 128 is read with section 11, the minors obligation under the
contract is void and hence the surety for the minors obligation is not liable.
The principle of co - extensiveness does not make the surety for a minor
liable due to the principal obligation of the minor being void. The dictum is
that guarantee being a collateral or secondary obligation cannot be enforced
when the principal obligation is void.

Bombay High Court in Kashiba v Shripat67 held that the surety

to a bond passed (executed) by a minor was liable. When the original
agreement is void e.g. a contract by minor, the surety is liable as a principal
debtor. This case laid down the principle that the surety for a minors
contract is liable while the minor being principal debtor is not liable.

Kashibas case was considered by a Bench of the Madras High

Court in Kelappan Nambiar v Kunhiraman68. The Bench held that in
the absence of special circumstances like fraudulent representation, or in
the absence of other features from which a court can infer a contract to be

67 (1895) 19 Bom 697

68 (1956) 2 MU 544; AIR 1957 Madras 164

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one of indemnity the liability of the surety is only ancillary and rests only
on a valid obligation on the part of the party whose debt or obligation is
guaranteed. Where the liability of the principal is held unenforceable, there
is no question of the surety being made liable. This case establishes that a
surety for a minors contract is not liable since the principal obligation of
the minor is void. Minors contract is the foundation for the surety to
guarantee the obligation. When the foundation is itself a nullity the suretys
ancillary contract of guarantee is also a nullity. The case also laid down
that the contract of guarantee is collateral to the main contract of the
principal debtor with the creditor. When the main contract is void the
collateral contract is also void. Since the liability of the surety is secondary,
not primary, it does not arise at all when no liability can ever be fastened
on the principal debtor because of his minority at the time of entering into
the contract.

It is apparent that the decisions of Bombay High Court and Madras

High Court are in conflict with each other. Bombay High Court decision is
more relevant to Indian commercial law.

The legal provisions relating to personal disabilities are intended for

the protection of the person affected by that disability. It follows that others
cannot share in this protection. To this extent the rule that the contract of
guarantee is accessory to the main contract is inoperative. The guarantee
is given for the purpose of protecting the creditor just against the possibility
of the debtor pleading his incapacity, like minority.
 139

One can be surety not only for obligations which are enforced by civil
law, but also for obligations which are based on natural law. Thus it may
happen that a surety may be legally compellable and the principal debtor
not (as in the case of minor principal). If the main contract is invalid merely
because of personal qualities. On the part of the debtor, the guarantor is
liable as a joint debtor.

Guarantees for the debts of minors perform a useful function, because

they enable minors to obtain credits which they may require and which they
may not be able to obtain without such valid guarantees. The interests of
the minor which the law wants to protect are not endangered by
enforcement of the guarantors lability.

It is pertinent to note that in the U.S.A, guarantees for the debts of

minors are considered as fully valid and binding on the ground that
contracts of minors are merely voidable, not void69.

Mistaken Belief about Guarantees

The proverbial litigation attendant upon the guarantees is perhaps

due to the popular belief that the signing of contract of guarantee is nothing
more than a "mere formality". Even in the face of religious warnings in the
Holy Bible against the risks of suretyship, persons do enter into contract of
suretyship without taking thought for the morrow and the possibility of
their being called upon to discharge the liability.

69 Williston, On Contracts (1920 Edn) S 484

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Jesus, the son of Sirach advises "Guaranteeing loans has ruined

many prosperous men and caused them unsettling storms of trouble"70.

It is easy to put ones pen to paper and complacently append ones

signature to a contract of guarantee, but to be compelled to put ones hands
into ones pockets or loosen the strings of ones purse when the fruit of the
friendly act is demanded, is usually an unexpected and painful experience.
Even when the eventual liability falls on him the surety generally imagines
that he will be called upon to pay, only when all means of compelling the
debtor to pay have been exhausted. It is a fallacy because many judicial
decisions fasten absolute liability on the surety.

Letters of Comfort

The situation sometimes arises in which a third party is unable or

unwilling to provide a guarantee for a loan made to a borrower71, but is
prepared to give a written assurance to the lender of its continued support
for, interest in, or dealings with, the borrower. These written assurances
are known as letters of comfort because they are intended to afford
"Comfort" to the lender by indicating to him that the borrower is likely to
be able to repay the loan. Although the use of letters of comfort is not
confined to banking transactions, they are perhaps most prevalent in this
area, and are often given by parent companies in respect of prospective
loans to their less affluent subsidiaries.

70 Good News Bible, Sirach (Ecclesiasticus) Chapter 29 verse 17

71 Eg : if it would be ultra vires for a company to give a guarantee for its

subsidiary; or if it would be undesirable to give a guarantee because its
contingent liability would have to appear in its balance sheet.
 141

The contents of a letter of comfort may range from a statement that

the parent company intends to continue to hold a controlling interest in the
subsidiary, and to use that controlling interest so as to procure that the
subsidiary conducts its affairs in a particular way, to an assurance that it
will ensure that the subsidiary keeps sufficient reserves to enable it to meet
its obligations to repay the loan. A bank which is offered a letter of comfort
in place of a guarantee would be well advised to study the proposed wording
very carefully before accepting it. It should be borne in mind that the
question whether the letter of comfort gives rise to a binding legal
obligation is often difficult to resolve72.

Statements of Promise or Present Intention

There is a clear distinction between a statement which involves a

promise to ensure that a particular state of affairs exists or continues to
exist and a statement of present intention. The former may give rise to a
binding contractual obligation (in an appropriate case, it may even amount
to a guarantee or indemnity) whereas, provided the latter is an honest
statement of the writers intention at the time when it is made, there is
nothing legally to prevent the giver of the letter of comfort from changing
his mind at any time in the future. The distinction is illustrated by the case
of Kleinwort Benson Ltd v Malaysian Mining Corporation Bhd12, in
which the Court of Appeal had to construe the following statement in a

72 In business matters there is usually a presumption that an agreement is

intended to create legal relations unless the opposite intention is clearly
shown : Rose & Frank Co v JR Crompton & Bros Ltd (1923) 2 KB 261

73 [1988] 1 WLR 799

 142

letter written by a parent company to a bank : "It is our policy to ensure

that the business of (the subsidiary) is at all times in a position to meet its
liabilities to you under the above arrangement". The subsidiary became

insolvent and the loan was not repaid.

Although the bank had relied on the letter when advancing money to
the subsidiary, and there was evidence that both the bank and the parent
company had treated it as a matter of commercial importance, it was held,
reversing the decision of Hirst J74, that the letter of comfort merely stated
the parent companys present intention. Since the statement was honestly
made, the only obligation on the parent company to maintain that policy
was a moral one, and therefore a subsequent change in its intention did not
entitle the bank to claim damages75. The statement had to be construed'
in the context of the rest of the letter, and against the factual matrix, which
included a refusal by the parent company throughout the negotiations to
assume any legal liability for repayment of the loan. In the light of all these
factors, there was no binding promise76.

74 Kleinwort Benson Ltd v Malaysian Mining Corporation Bhd [1988] 1 WLR

799
75 Of course, if the person making the statement "changed his mind" veiy
shortly after the loan was advanced, a court might be persuaded that the
statement was not made honestly in the first place. The person who gives
the letter of comfort must therefore be prepared to justify any change in his
position
76 This approach is to be contrasted with that of HIRST J, who had pointed
out that even if a formal guarantee has been rejected, that does not mean
that the parties are not willing to enter into some other contractual
obligation
 143

This case can be contrasted with Chemco Leasing SPA v

Rediffusion pic11, in which the parent company had given a letter of

comfort in these terms :

"We assure you that we are not contemplating the disposal of our
interests in [the subsidiary] and undertake to give Chemco prior notification
should we dispose of our interest during the life of the leases. If we dispose
of our interest we undertake to take over the remaining liabilities to
Chemco of [the subsidiary] should the new shareholders be unacceptable to
Chemco".

The Court of Appeal held that the parent company was not liable,
because Chemco had failed to give it reasonable notice that the new
shareholders were unacceptable to it [and thus an implied condition
precedent to the undertaking in the second sentence had not been fulfilled].
However, it appears that the decision of Staughton J that the parent
company was liable as guarantor would have been upheld but for the failure
of issuance of the notice.

Of course, it is rarely the subjective intention of the person giving the

letter of comfort to make a binding legal commitment to the person
receiving it. For the avoidance of any doubt, therefore, the company which
gives the letter may insist that it includes an express statement that the
contents are not intended to give rise to any enforceable legal obligation on
the part of the writer. In order to strengthen its position further, it may
also insist that the bank signs and returns a copy of the letter accepting

77
[1987] 1 FTLR 201
 144

that it does not give rise to any binding contract. Such disclaimers are now
common. A bank may be prepared to accept such a letter of comfort from a
business whose financial standing is well - known to it, on the basis that
failure to adhere to its promise would cause it such a commercial damage
that the risk of default would be minimal. On the other hand, if the bank
has had no prior dealings with the companies involved, it is more likely to
insist that there should be some form of binding legal obligation even if it
falls short of a guarantee, such as a letter in the terms of the first sentence
of the relevant paragraph in the Chemco case.

Even if the letter of comfort does not give rise to a binding contract,
it will not afford the bank the same degree of protection as a guarantee or
indemnity. The subsidiary may become insolvent and fail to repay the loan,
but that will not necessarily involve any breach of its obligations by the
parent company. Further more, even if a parent company does renege on its
promise by withdrawing support from the subsidiary or selling its
shareholding, the bank will have to establish a sufficient causal connection
between that default and any loss which it suffers.

In determining whether a letter of comfort is acceptable where it

might otherwise have required a guarantee, a bank must understand the
nature and extent of the commitment which is being given. While it might
be thought that the considerations which generally give rise to the use of
a comfort letter rather than a guarantee are such that the giver would
necessarily wish to ensure that the comfort letter did not in itself constitute
a legally binding commitment, it appears that courts will in fact treat such
letters as being capable of constituting binding obligations unless the
contrary intention is clearly expressed.
 145

The taking of proceedings on a letter of comfort may be more complex

than the making of a claim for a debt under a guarantee since, depending
on the precise nature of the "Comfort" given, it may be necessary for the
bank to establish a causal link between its loss and the breach by the
writer of the obligations that it undertook.

A further danger may occur if in fact the subsidiary does go into

liquidation, and the parent company does then repay the bank. The
liquidator may attack the bank on the grounds that this repayment
constitutes a fraudulent preference.

The letter of comfort is intended to be taken in rare cases from

companies of high - credit rating and good reputation, keeping in mind that
the obligations undertaken by the author of the letter of comfort are mostly
moral obligations.

Though banks in India are accepting letters of comfort the

enforceability and binding nature of such letters does not appear to have
been tested before the courts of law so far. Therefore the principles of
English Law are the guiding light for the banks in India while dealing with
comfort letters.