CMPTEB If CONTRACT OF GUARANTEE

Transcription

1 CMPTEB If CONTRACT OF GUARANTEE

2 CHAPTER IV CONTRACT OF GUARANTEE Definition and Meaning Guarantee is an undertaking to answer for another s 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. Bouvier s 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

3 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 Halsbury s 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 surety s liability begins with that of the principal, a guarantor s 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

4 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.

5 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.

6 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

7 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

8 97 The cynical lender from experience may prefer to define a guarantee as "where one man that can t pay gets another man who can t 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

9 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 guarantor s 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

10 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 guarantor s 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 bank s 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.

11 100 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 of Maharashtra 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 AIR 1965 SC AIR 1967 SC 1634

12 101 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 promisor s 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 Muthukaruppa v Kathappudayan (1914) 27 MLJ 249

13 102 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 bank s part constituted good consideration for guarantor. 12 New Bank of India Ltd v Govinda Prabhu AIR 1964 Kerala AIR 1984 Gujarat 93

14 103 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 party s 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 surety s 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 surety s 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 surety s request. The consideration may take the form of forbearance by the creditor at the surety s 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 person s becoming surety for the payment of a debt. There must be either an undertaking to forbear or an actual forbearance at surety s express or implied request. An agreement to forbear for a reasonable time will provide sufficient consideration to support a surety s promise. 14 (1998) 92 Camp. Cas. 739 (Kerala)

15 104 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 guarantor s 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 guarantor s 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.

16 105 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 guarantor s 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, Offord v Davies (1862) 12 CBNS Beeket v Addyman (1882) 8 QBD (1979) 49 Comp. Cas 86; AIR 1979 SC 102

17 106 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 surety s 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 (1988) 64 Comp. Cas 52 (Kerala)

18 107 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 debtor s person in civil prison, as hostage by the court. 20 AIR 1980 SC 470

19 108 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 debtor s 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.

20 109 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 surety s liability to pay the debt is not removed by reason of creditor s 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 debtor Subankhan v Lalkhan AIR 1947 Nag M.S.E.B, Bombay v Official Liquidator H.C. Ernakulam AIR 1982 SC 1497

21 110 If on account of a contract of partnership being illegal, the principal s 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 surety s 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 debtor s liability to pay interest and costs as well as the principal sum awarded by the arbitrators Varadarajulu v Thavasi Nadar AIR 1963 Madras (1925) Ch AIR 1940 Bombay Compania Sudamericana de Fletes SA v African Continental Bank Ltd (1973) 1 Lloyd s Rep 21

22 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 debtor s primary obligation to pay specific instalments of money became translated into secondary obligations to pay damages. The surety s 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 debtor s liability is also the measure of the guarantor s liability. 27 (1973) AC 331

23 112 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 Lloyd s Rep 130 and Hyundai Heavy Industries Co Ltd v Papadopoulos (1980) 1 WLR 1129

24 113 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, 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 (1988) 63 Comp. Cas. 61

25 114 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;

26 115 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 bank s 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

27 116 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.

28 117 State Bank of India v Indexport Registered32 The Supreme held in this case that a surety s liability to pay the debt is not removed by the reason of the creditor s 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". England:34. The court also cited the following passage from Halsbury s Laws of "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 of Bihar Ltd v Damodar Prasad and Another (AIR 1969 SC 297) quoted supra. The Supreme Court also 32 AIR 1992 SC th Edn. Vol, 2, para th Ed, Vol 20 para 159

29 118 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 of India 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 AIR 1998 MP AIR 1998 Madras AIR 1998 Kerala 161

30 119 "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, 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

31 120 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 guarantor s liability is absolute. Surety s 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 creditor s 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

32 121 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 instead Petty v Cooke (1871) LR 6 QB (1817) 3 Mer Atkinson v Grey (1853) 1 Sm & G 577

33 122 Banker s Negligence and Surety s 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 surety s 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

34 123 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 (1989) 65 Comp. Cas. 698

35 124 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 (1999) 95 Comp. Cas. 862