06/07/2020
LAW OF GUARANTEE – A LEGAL TRAP!
In today’s business environment the word ‘guarantee’ is very common to be used and heard by most of us. Literal meaning of this word is ‘to promise something with certainty or to agree to be legally responsible for something’. Meaning thereby that in simple words guarantee is a promise to do something on behalf of other.
In Legal parlance, the term ‘guarantee’ is understood as a collateral engagement to answer for the debt, default or miscarriage, of another person. The India Contract Act defines ‘contract of guarantee’ is a contract to perform the promise, or discharge the liability, of a third party in case of his default. The person who gives the guarantee is called as ‘surety’ or ‘guarantor’ and the person in respect of whose default the guarantee is given is called the ‘principal debtor’. There are different kinds of guarantees such as personal guarantee, corporate guarantee, Bank guarantee etc. which are presently prevailing in the commercial market.
There is no ambiguity in the mind of common person about the meaning of terms ‘guarantee’ or ‘guarantor’. However, the problem comes in understanding the consequence of giving a commercial guarantee or being a guarantor. Common impression is that if someone gives guarantee for somebody i.e. principal debtor then in the event that somebody fails to perform or commits default, the person giving guarantee has to correct the default. This impression about the consequence of the guarantee is perfectly right except the understanding of the event when a principal debtor is being treated as in default. The general impression is that obligation of guarantor to pay arises when principal debtor fails to pay debt even after exhorting all its assets or perform obligations despite all efforts. However, legal definition of default varies according to the provisions enumerated in the guarantee agreement or the principal agreement for which guarantee was given. This variation in definition is actually the epicenter which completely changes the meaning of default as understood by common person and legal person. For a common man in commercial sense, the liability of guarantor arises only when creditor fails to recover its loan amount from principal debtor despite disposing off the entire assets of the principal debtor. Thus, as per understanding of a common person, the liability of guarantor to pay arises only after the principal debtor technically declared as an Insolvent. However, legally the position is not the same, in legal sense principal debtor commits default either if it fails to pay any installment of loan or breaches any provision of the agreement. Now here is the catch. In law, the liabilities of principal debtor and guarantor have been kept as co-extensive unless otherwise provided in the agreement. Meaning thereby that in the event of default, the creditor is not under any legal compulsion to first recover outstanding debt from the principal debtor and then only to approach guarantor. Law makes the creditor entitle for the option to recover the loan amount or to compel the performance either from the principal debtor or the guarantor. The consequence of this entitlement is that creditor is free to initiate a legal proceeding to recover the loan amount or to fulfill the promises against the guarantor without exhausting all means to recover the loan amount or to perform the promises against the principal debtor. So, in legal sense, the liability of guarantor may arise without the principal debtor is being declared as insolvent.
Now the next issue which common people does not understand correctly is when a guarantor is legally discharged from the liabilities as guarantor. Generally people assume or understood that guarantee can be revoked in the same manner in which one gives guarantee and shall be discharged from liabilities. Again here is the catch. Once you gives guarantee and on the basis of your guarantee if something has been done like some loan amount has been released to principal debtor or some performances have been done in favor of principal debtor then it becomes difficult for guarantor to revoke the guarantee. Although the law provides that guarantee may be revoked, as to future transactions, by notice to the creditor. However, generally in guarantee agreements, the right to revoke the guarantees is taken away by the specific waiver of this right. The Apex Court while dealing with the issue that whether a provision of non-revocation of continuing guarantee in the agreement will prevail over specific legal provisions that continuing guarantee may be revoked at any time by notice to creditor held that provisions of agreement will prevail and the guarantor cannot revoke the guarantee by serving notice to creditor. Thus, once you have given guarantee then you cannot revoke it without the consent of the creditor.
Therefore, before signing the guarantee agreement or being a guarantor please understand the legal complexity involves into it otherwise you may be in a serious financial trap.
© Anand Shankar
Advocate-on-Record of Supreme Court of India
