Contracts of Guarantee & Bank Guarantee | PAPER II – PRINCIPLES & PRACTICES OF BANKING | MODULE B: FUNCTIONS OF BANKS

Contracts of Guarantee & Bank Guarantee

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1. Parties to the Contract

A Contract of Guarantee involves three parties:

• Creditor – The party to whom the guarantee is given.
• Principal Debtor – The party on whose behalf the guarantee is given.
• Surety – The party who gives the guarantee.

2. Basic Principles of Contract

A contract of guarantee must satisfy basic principles of a valid contract: offer, acceptance, consideration, capacity, free consent, lawful object.

3. Consideration

There must be a lawful consideration between the parties, even if the surety does not directly receive a benefit.

Example: If A lends Rs.10,000 to B and C guarantees repayment, the loan itself serves as consideration.

4. Liability of the Surety

The surety’s liability is co-extensive with the principal debtor, unless otherwise provided by the contract.

If B owes Rs.50,000 to A and C is the surety,
Then: Liability of C = Rs.50,000

5. Continuing Guarantee

A continuing guarantee applies to a series of transactions until revoked.

6. Revocation of Continuing Guarantee

It can be revoked by:

• Notice by the surety
• Death of the surety

7. Death of Surety

It automatically revokes a continuing guarantee for future transactions unless stated otherwise.

8. Variance in Terms of the Contract

Any change without surety’s consent discharges the surety.

9. Discharge of Principal Debtor

If the principal debtor is discharged, the surety is also discharged unless agreed otherwise.

10. Forbearance to Sue

A creditor's mere forbearance to sue does not discharge the surety.

11. Surety’s Rights

• Right to Claim: Surety can recover the amount paid from the principal debtor.
• Right to Security: Surety is entitled to benefit of any security held by the creditor.

12. Implied Promise by Principal Debtor

The principal debtor is bound to indemnify the surety for payments made.

13. Misrepresentation or Concealment

Misrepresentation or concealment by the creditor invalidates the guarantee.

14. Co-sureties for the Same Debt

When multiple sureties exist, liability is shared equally unless stated otherwise.

Debt = Rs.90,000; 3 Co-sureties (X, Y, Z)
Each Surety’s Liability = Rs.90,000 ÷ 3 = Rs.30,000

15. Release of One Co-surety

Does not discharge the others; remaining co-sureties continue to be liable.

16. Bank Guarantees

A Bank Guarantee is a promise by a bank to cover a loss if a party fails to fulfill contractual obligations.

Types of Bank Guarantees:

• Financial Guarantee
• Performance Guarantee
• Advance Payment Guarantee
• Bid Bond Guarantee

17. Banker’s Duty to Honour Guarantee

The bank must honour guarantees as per terms, provided claim is within validity and conditions are met.

18. Precautions for Issuance

• Proper documentation
• Verification of applicant’s financials
• Obtaining adequate security or margin

19. Precautions for Payment

• Check validity and invocation clauses
• Verify the claim’s genuineness

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Multiple Choice Questions (MCQs)

1. Who is the principal debtor in a contract of guarantee?
   A. Person giving guarantee
   B. Person receiving guarantee
   C. Person on whose behalf guarantee is given
   D. Bank
   Answer: C
2. Which of the following discharges a continuing guarantee?
   A. Default by principal debtor
   B. Death of surety
   C. Loan repayment
   D. Court order
   Answer: B
3. Which of these is NOT a type of bank guarantee?
   A. Performance Guarantee
   B. Demand Draft Guarantee
   C. Bid Bond Guarantee
   D. Financial Guarantee
   Answer: B
4. What happens if a co-surety is released by the creditor?
   A. All sureties are discharged
   B. Only that co-surety is discharged
   C. Principal debtor is discharged
   D. Contract becomes void
   Answer: B
5. Liability of the surety is:
   A. More than principal debtor
   B. Less than principal debtor
   C. Co-extensive unless otherwise agreed
   D. Not legally enforceable
   Answer: C
6. Which act governs the Contract of Guarantee in India?
   A. Banking Regulation Act
   B. RBI Act
   C. Indian Contract Act
   D. Companies Act
   Answer: C
7. Misrepresentation by the creditor:
   A. Strengthens the guarantee
   B. Makes no difference
   C. Invalidates the guarantee
   D. Increases the surety’s liability
   Answer: C
8. In a bank guarantee, the bank acts as:
   A. Principal Debtor
   B. Surety
   C. Creditor
   D. Beneficiary
   Answer: B
9. What does a performance guarantee ensure?
   A. Loan repayment
   B. Bid submission
   C. Execution of contract work
   D. Payment of taxes
   Answer: C
10. Which of the following is a precaution before making payment under bank guarantee?
    A. Consult principal debtor
    B. Check claim validity
    C. Wait for court order
    D. Ask for extra interest
    Answer: B