Guarantee and Indemnity in Bank Lending under the Indian Contract Act

A guarantee is a bank's cheapest security. It costs nothing to take, requires no registration, and reaches assets the bank could never have charged. It is also the security most often lost, because the Contract Act discharges a surety for a long list of reasons, most of them things a careless lender does without thinking. The law of guarantee is therefore, from a bank's point of view, mainly a law about what not to do after the guarantee has been taken.

1. Indemnity and Guarantee Distinguished

Indemnity (Section 124): a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person.
Rights of the indemnity holder (Section 125): when sued, he is entitled to recover from the indemnifier all damages he may be compelled to pay, all costs he may be compelled to pay in bringing or defending a suit where he acted prudently or with the indemnifier's authority, and all sums paid under a compromise that was not contrary to the indemnifier's orders and was prudent.
Guarantee (Section 126): 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 the surety, the person in respect of whose default it is given is the principal debtor, and the person to whom it is given is the creditor. A guarantee may be either oral or written.
The practical difference: an indemnity is a primary obligation arising on the indemnifier's own promise; a guarantee is secondary, arising only on the principal debtor's default. The surety who pays may recover from the principal debtor; the indemnifier who pays has no equivalent right.

Indemnity and guarantee side by side

Figure 1: Indemnity and guarantee side by side

Consideration (Section 127): anything done, or any promise made, for the benefit of the principal debtor is sufficient consideration for the surety's promise. The surety need receive nothing himself, which is why a guarantee given for an advance made to a company by its director is enforceable.
Past advances: a guarantee given in respect of an advance already made, without any fresh forbearance or further advance, may fail for want of consideration. Bank forms therefore recite the fresh or continued facility.

2. The Extent of the Surety's Liability

Section 128, Indian Contract Act, 1872

The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract.

Co-extensive means the same, not more: the surety is liable for whatever the principal debtor is liable for, including interest and costs, but no more. If the principal debt is unenforceable for a reason going to its existence, the guarantee of it ordinarily fails too. Discharge of the principal debtor by operation of law, as by limitation or insolvency, does not by itself release the surety.
Unless otherwise provided: the words permit the parties to limit the liability, by amount, by period or by transaction, and bank guarantees commonly state a maximum amount.
Not a condition precedent to sue the debtor first: the creditor need not exhaust his remedies against the principal debtor, or realise his securities, before calling on the surety. He may proceed directly against the surety (Bank of Bihar Ltd. v. Damodar Prasad, AIR 1969 SC 297), and may execute a decree against the surety alone (State Bank of India v. Indexport Registered, (1992) 3 SCC 159).
Joint and several: a guarantee is ordinarily expressed to be joint and several, so the bank may sue any one of several guarantors for the whole.
A minor as principal debtor: a minor's agreement is void, so the minor is not liable. Whether the surety is then bound has divided opinion, Indian courts having generally treated the surety as liable as a principal debtor on his own promise. A bank should not rely on the point either way.

3. Continuing Guarantees

Definition (Section 129): a guarantee which extends to a series of transactions is a continuing guarantee. A bank's guarantee for a running cash credit account is the standard example, because the balance rises and falls with every transaction.
Revocation by notice (Section 130): a continuing guarantee may at any time be revoked by the surety, as to future transactions, by notice to the creditor. It does not affect liability for transactions already entered into.
Revocation by death (Section 131): the death of the surety operates, in the absence of any contract to the contrary, as a revocation so far as regards future transactions. The section does not make the revocation depend on notice of the death, which is why bank guarantee forms commonly provide that the guarantee continues until notice is received.
Breaking the account: on revocation or death the bank must rule off the account and open a new one, or the rule in Clayton's case will apply later credits to the guaranteed balance while fresh advances take its place, leaving the surety discharged on the old debt and not liable for the new.

4. Discharge of the Surety

The ways a surety escapes liability

Figure 2: The ways a surety escapes liability

Variance (Section 133): any variance made without the surety's consent in the terms of the contract between the principal debtor and the creditor discharges the surety as to transactions subsequent to the variance. A change in the rate of interest, the limit or the repayment schedule, agreed with the borrower alone, is the usual instance.
Release of the principal debtor (Section 134): the surety is discharged by any contract between the creditor and the principal debtor by which the principal debtor is released, or by any act or omission of the creditor the legal consequence of which is the discharge of the principal debtor.
Composition, extension of time, promise not to sue (Section 135): a contract by which the creditor makes a composition with, or promises to give time to, or not to sue the principal debtor, discharges the surety, unless the surety assents to it.
Agreement with a third person (Section 136): where the contract to give time is made with a third person and not with the principal debtor, the surety is not discharged.
Mere forbearance (Section 137): mere forbearance on the part of the creditor to sue the principal debtor, or to enforce any other remedy, does not discharge the surety in the absence of a contract to that effect.
Impairing the remedy (Section 139): if the creditor does any act inconsistent with the rights of the surety, or omits to do any act which his duty to the surety requires, and the eventual remedy of the surety against the principal debtor is thereby impaired, the surety is discharged.
Loss of security (Section 141): the surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time the contract of suretyship is entered into, whether or not the surety knows of it; and if the creditor loses or parts with such security without the surety's consent, the surety is discharged to the extent of its value.
Misrepresentation and concealment (Sections 142 and 143): a guarantee obtained by misrepresentation of a material part of the transaction, or by keeping silence as to material circumstances, is invalid.
Failure of a co-surety to join (Section 144): where a person gives a guarantee on a contract that the creditor shall not act on it until another person has joined as co-surety, the guarantee is invalid if that other does not join.

⚠ Note

Almost every one of these discharges can be excluded by contract, and a bank's standard guarantee form does exactly that. The surety consents in advance to variations, to time being given, to the release of securities and to compositions, which neutralises Sections 133 to 141. What cannot be contracted away is the requirement that the guarantee be free of misrepresentation and concealment under Sections 142 and 143, and the proposition in Section 128 that the liability cannot exceed that of the principal debtor.

5. The Rights of the Surety

Subrogation (Section 140): where a guaranteed debt has become due and the surety has paid it, he is invested with all the rights which the creditor had against the principal debtor. He steps into the creditor's shoes, including as to any security.
Benefit of securities (Section 141): the surety is entitled to the benefit of every security the creditor had at the time the guarantee was given, and is discharged to the extent of its value if the creditor parts with it.
Implied indemnity (Section 145): in every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety, and the surety is entitled to recover from him whatever sum he has rightfully paid under the guarantee, but no sums he has paid wrongfully.
Contribution between co-sureties (Sections 146 and 147): co-sureties for the same debt are liable, as between themselves, to pay each an equal share of the whole debt, or of that part of it which remains unpaid; where they are bound in different sums, they are liable to pay equally as far as the limits of their respective obligations permit.
Rights against the bank: the surety may require the bank to account for securities it held, and may complain where its act or omission has impaired his remedy. A bank that releases the primary security without the guarantor's consent reduces the guarantee by that value.

6. The Guarantor in Insolvency

The moratorium does not protect the guarantor: the moratorium under Section 14 of the Insolvency and Bankruptcy Code, 2016 applies to the corporate debtor and its assets. It does not bar proceedings against a personal guarantor (State Bank of India v. V. Ramakrishnan, (2018) 17 SCC 394), and the Code was amended in 2018 by Section 14(3)(b) to put the point beyond doubt.
A resolution plan does not automatically release the guarantor: approval of a plan binds the corporate debtor and its creditors, but the personal guarantor's liability survives, because the liability is a separate contract between the surety and the creditor (Lalit Kumar Jain v. Union of India, (2021) 9 SCC 321).
Insolvency of personal guarantors: Part III of the Code, applied to personal guarantors to corporate debtors, allows the creditor or the guarantor to initiate insolvency against the guarantor before the same tribunal that is dealing with the corporate debtor.
Double recovery: the creditor may proceed against both the corporate debtor and the guarantor, but may not recover more than the debt, and the guarantor who pays is subrogated to the creditor's claim against the corporate debtor to the extent of his payment, subject to the terms of any approved resolution plan.
Why this matters in practice: the survival of the guarantee is what makes promoters' personal guarantees the most effective discipline in Indian lending, since a resolution that writes down the company's debt does not write down theirs.

7. Questions Arising

Must a bank sue the borrower before calling on the guarantor?

No. The liability under Section 128 is co-extensive, and it arises on the principal debtor's default, not on the exhaustion of remedies against him. The creditor need not first sue the borrower, realise the security or even make a demand on him unless the contract requires it, and a decree against both may be executed against the guarantor alone. A guarantor who wishes to be protected must bargain for a term making the bank's recourse conditional, and bank forms do not grant it.

If a bank's standard form waives the discharge provisions, is anything left of them?

Yes, three things. First, the waiver must itself be part of a guarantee that is valid, so Sections 142 and 143 on misrepresentation and concealment still apply. Second, Section 128 limits liability to that of the principal debtor, which cannot be enlarged by waiver. Third, a waiver is construed strictly against the bank that drafted it, so a general consent to variations may not cover a variation that fundamentally alters the character of the facility guaranteed.

⚠ Key point

An indemnity (Sections 124 and 125) is a two party, primary obligation; a guarantee (Section 126) is a three party, secondary one, performable on the principal debtor's default, and may be oral or written. Section 127 makes anything done for the benefit of the principal debtor sufficient consideration. Section 128 makes the surety's liability co-extensive with the principal debtor's unless otherwise provided, so the creditor need not sue the debtor first. A continuing guarantee (Section 129) covers a series of transactions and is revocable as to future transactions by notice (Section 130) or by the surety's death (Section 131), after which the bank must break the account. The surety is discharged by variance (133), release of the debtor (134), composition, time or a promise not to sue (135), an act or omission impairing his remedy (139), and loss of a security to the extent of its value (141); but mere forbearance does not discharge him (137). On payment he is subrogated (140), takes the benefit of securities (141), has an implied indemnity from the debtor (145) and shares equally with co-sureties (146 and 147). The moratorium under the Insolvency and Bankruptcy Code does not protect a personal guarantor, and a resolution plan does not automatically discharge him.

8. Quick Revision

✦ Points worth fixing

Indemnity is two parties and primary; guarantee is three and secondary.

Consideration may move to the principal debtor alone. Section 127.

Co-extensive, unless otherwise provided. The whole of Section 128.

The bank need not sue the borrower first.

Notice revokes, death revokes, but only as to the future.

Variance, release, composition, impairment, loss of security. Five routes to discharge.

Mere forbearance is not discharge. Section 137.

Section 140 subrogates, 141 gives the securities, 145 indemnifies.

Co-sureties share equally, within their respective limits.

The moratorium does not reach the personal guarantor.

Break the account when a guarantee is revoked.

9. Frequently Asked Questions

What is the difference between a contract of indemnity and a contract of guarantee?

An indemnity under Section 124 involves two parties and a primary obligation to save the other from loss. A guarantee under Section 126 involves three parties, the surety, the principal debtor and the creditor, and creates a secondary liability that arises only on the principal debtor's default. A surety who pays is subrogated under Section 140; an indemnifier has no equivalent right.

What does co-extensive liability mean?

That under Section 128 the surety is liable for whatever the principal debtor is liable for, including interest and costs, and for no more, unless otherwise provided by the contract. The creditor may therefore proceed directly against the surety without first suing the borrower or realising his security, and may execute a decree against the surety alone.

How is a continuing guarantee revoked?

By notice to the creditor under Section 130, or by the death of the surety under Section 131, in each case only as to future transactions. Liability for transactions already entered into remains. The bank must then break the account, or the rule in Clayton's case will apply later credits to the guaranteed balance and discharge the surety on it.

When is a surety discharged?

By a variance in the terms without his consent (Section 133); by release or discharge of the principal debtor (Section 134); by the creditor's composition with, giving of time to, or promise not to sue the debtor (Section 135); by an act or omission of the creditor impairing the surety's eventual remedy (Section 139); and to the extent of its value by the loss of a security the creditor held (Section 141). Mere forbearance does not discharge him.

Does a company's insolvency release its personal guarantor?

No. The moratorium under Section 14 of the Insolvency and Bankruptcy Code, 2016 protects the corporate debtor and its assets, not the guarantor, and approval of a resolution plan does not automatically discharge him, because his liability rests on a separate contract with the creditor (Lalit Kumar Jain v. Union of India, (2021) 9 SCC 321). A guarantor who pays is subrogated to the creditor's claim to the extent of his payment, subject to the terms of any approved resolution plan.

Why does a bank take a guarantee when it already holds security?

Because the two reach different assets and fail for different reasons. A charge reaches one identified asset, whose value falls precisely when the borrower is in difficulty. A guarantee reaches everything the guarantor owns, present and future, including assets the bank could never have identified or charged, and it survives the corporate insolvency of the borrower. It also changes behaviour: a promoter whose personal estate stands behind the company's debt manages the company differently from one who risks only the shareholding.

10. Related Topics and Provisions

Principles of bank lending and credit facilities
Securities for advances: lien and pledge
Hypothecation and mortgage
Documentary credits and bank guarantees
Non-performing assets and the recovery statutes