PPB Unit CChapter Notes6–8 Marks Expected

Contracts of Guarantee & Bank Guarantee

Principles & Practices of Banking | Unit C · Chapter 31

Chapter 30 defined indemnity — a two-party promise. This chapter extends the analysis to the three-party structure: guarantee. A guarantee brings in a third actor, the surety, who stands behind the principal debtor if the debtor fails. Then the chapter takes a sharp practical turn into bank guarantees — the most commercially important form of credit support that banks issue. Both the legal framework (Sec 126–147 ICA) and the banker's operational duty to honour are tested heavily in JAIIB.

By Bankopedia.co.inUpdated 2026JAIIB PPB · Module C

📌 Why This Chapter Matters in JAIIB

Expect 6–8 questions from this chapter — it is one of the highest-yield chapters in Unit C. (1) Section numbers — Sec 126 (definition), Sec 128 (co-extensive liability), Sec 129 (continuing guarantee), Sec 133 (variance), Sec 134 (discharge), Sec 146/147 (co-sureties) are all fair game; (2) Discharge situations — know all the ways a surety is discharged; the examiner loves distinction questions; (3) RBI circular September 9, 2014 — banks can proceed against the guarantor directly without exhausting remedies against the principal debtor (wilful defaulter provision); (4) Bank guarantee types and the duty to honour— the “pay first, litigate later” principle with R.D. Harbottle, Texmaco, and UP Co-op Federation cases; (5) Fraud and special equity— the only two exceptions to the banker's duty to pay.

Key Facts & References — Chapter 31 at a Glance

Sec 126ICA 1872 — definition of contract of guarantee

Sec 127Past consideration valid for guarantee

Sec 128Surety's liability co-extensive with principal debtor

Sec 129Continuing guarantee — extends to series of transactions

Sec 130Revocation of continuing guarantee by notice (future txns only)

Sec 133Variance in terms without surety's consent — discharges surety

Sec 134Release of principal debtor discharges the surety

Sec 145Implied promise by PD to indemnify the surety

Sec 146Co-sureties — share equally in default (unless agreed otherwise)

Sec 147Co-sureties bound in different sums — proportional contribution

Sec 28Standard limitation clauses in bank guarantees declared illegal from 1 Jan 1997

3 partiesSurety · Principal Debtor · Creditor/Beneficiary

RBI 9 Sep 2014Bank can proceed against guarantor without exhausting PD first

15–30 daysMinimum claim period beyond validity date to be stated in BG

Section 1

Definition & Parties — Sec 126, 127, 128 ICA 1872

Sec 126

Statutory Definition — Indian Contract Act, 1872

“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. It must be supported by consideration, but past consideration is valid (Sec 127): anything done or any promise made for the benefit of the principal debtor is sufficient consideration for the surety's promise.

Three Parties & Three Contracts

Surety

The person who gives the guarantee — steps in to pay/perform if the principal debtor defaults. Also called guarantor.

Principal Debtor (PD)

The person whose default triggers the guarantee — the primary obligor who owes the underlying duty to the creditor.

Creditor / Beneficiary

The person to whom the guarantee is given — the bank or entity that has extended credit or contracted with the PD.

At least 3 contracts exist in every guarantee: (1) between PD and creditor (the main contract); (2) between creditor and surety (the guarantee contract); (3) between surety and PD (the implied indemnity under Sec 145).

Sec 128

Co-extensive Liability of the Surety

The liability of the surety is co-extensive with that of the principal debtor unless it is otherwise provided by the contract. This means the surety is liable not just for the principal amount but also for interest, costs, and other charges — to the same extent as the PD.

RBI Circular — September 9, 2014

In cases of wilful defaulters, banks are permitted to proceed against the guarantor/surety directly without first exhausting available remedies against the principal debtor. This was a departure from the conventional practice where banks typically pursued the PD first.

Illustration

A guarantees to B repayment of a loan of ₹1 lakh plus interest @ 10% p.a. that C has taken from B. C defaults after 6 months. A is liable not just for ₹1 lakh but also for ₹5,000 interest accrued — co-extensive with C's full liability including interest.

Memory Hook — “SPC” (Surety–Principal–Creditor)

Surety → gives the guarantee (secondary liability)
Principal Debtor → owes the primary obligation
Creditor → receives the guarantee; can invoke on PD's default

Sec 128: Surety's liability = PD's full liability (principal + interest + costs). RBI 2014: proceed against S even without exhausting PD first.

Section 2

Continuing Guarantee — Sec 129, 130 & Death of Surety

Sec 129

Continuing Guarantee — Defined

A continuing guarantee extends to a series of transactions. It is not exhausted by a single transaction — the surety remains on the hook for each transaction in the series until the guarantee is revoked.

Illustrations

A guarantees payment to B, a tea dealer, for any tea B may from time to time supply to C up to ₹ 10,000. This is a continuing guarantee.
A guarantees to B, up to ₹ 10,000, that C shall pay all bills drawn on him. This is a continuing guarantee.
A guarantees to B payment for five sacks of flour to be delivered to C. B delivers 5 sacks and C pays. B then delivers more — A is NOT liable for these additional deliveries. This is NOT a continuing guarantee (specific transaction only).

Sec 130

Revocation of Continuing Guarantee

By Notice

A continuing guarantee may, at any time, be revoked by the surety as to future transactions — by notice to the creditor. The surety remains liable for transactions already entered into before notice.

By Death of Surety

In the absence of any contract to the contrary, the death of the surety automatically operates as a revocation of a continuing guarantee with regard to future transactions. The surety's estate remains liable for past transactions but NOT for transactions entered into after the surety's death.

Memory Hook — Revocation: “Notice or Death — Future Only”

Revocation (whether by notice or death) always operates prospectively — for futuretransactions only. Transactions already entered into remain covered by the continuing guarantee. The surety's estate is still liable for past dues even after death.

Section 3

Discharge of Surety — Sec 133, 134 & Forbearance

A surety is discharged (i.e., released from liability) in several situations. These are among the most-tested concepts in the chapter — know each trigger, its section, and whether the discharge is total or partial.

Section	Trigger	Effect on Surety
Sec 133	Variance in terms of contract without surety's consent	Discharged as to transactions subsequent to the variance
Sec 134	Creditor releases the principal debtor (or acts/omission results in PD being released)	Surety is fully discharged
Sec 135	Creditor compounds with, gives time to, or agrees not to sue the PD — without surety's consent	Surety discharged
Sec 139	Creditor acts inconsistent with surety's rights; or impairs surety's eventual remedy against PD	Surety discharged to extent of impairment
Sec 141	Creditor loses or parts with security held at the time of the guarantee	Surety discharged to the extent of the value of security lost

Mere Forbearance to Sue — Does NOT Discharge Surety

A frequent exam trap: mere forbearance by the creditor to sue the principal debtor does NOT discharge the surety (unlike an agreement not to sue, which does discharge under Sec 135).

Illustration

B owes C money on a note guaranteed by A. C does not sue B at the maturity of the note. A is still liable as surety. Merely choosing not to sue (without any agreement or consideration to that effect) does not release the surety.

Sec 133 — Variance: Exam-Favourite Scenario

A becomes surety to C for B's conduct as a manager in C's bank for two years. B and C agree — without A's knowledge — that B shall be paid ₹200 instead of ₹100 per month. B subsequently embezzles. A is discharged from liability for the embezzlement — because the agreed change in salary was a variance in the contract made without the surety's consent.

Section 4

Surety's Rights, Co-Sureties & Misrepresentation

Surety's Rights on Paying Up

Subrogation (steps into creditor's shoes)

On paying the debt, the surety is invested with all the rights that the creditor had against the PD — i.e., the surety can sue the PD for recovery and can use any security the creditor held.

Implied promise by PD to indemnify (Sec 145)

The surety is entitled to recover from the PD all sums rightfully paid under the guarantee. This is an implied promise in every guarantee contract — the PD must save harmless the surety for amounts the surety is compelled to pay on the PD's behalf.

Benefit of all securities (Sec 141)

A surety is entitled to the benefit of every security which the creditor has against the PD — even if the surety was unaware of the security at the time of the guarantee. If the creditor loses or parts with the security, the surety is discharged to the extent of the security's value.

Misrepresentation & Concealment — Guarantee Becomes Invalid

If a creditor obtains a guarantee by misrepresentation of a material fact, the guarantee is invalid.
If the creditor conceals a material circumstance that the surety would have considered relevant, and the surety would not have given the guarantee had the circumstances been disclosed — the guarantee is invalid as to the suppressed circumstances.
Example: Bank does not disclose that the PD has already overdrawn his account by ₹5 lakh before the surety signs. If the surety would not have guaranteed had he known, the guarantee is void for that concealment.

Co-Sureties — Sec 146 & Sec 147

Sec 146

Equal Liability — Same Guarantee, No Limit Specified

Co-sureties who are bound in the same guarantee (jointly) for the same principal debt are liable to contribute equally to a default by the PD. If one surety pays more than their equal share, they can recover the excess from the other co-sureties.

Illustration:A, B, and C jointly guarantee X's debt of ₹ 3,000 to Y. X defaults. A, B, and C must contribute ₹ 1,000 each.

Sec 147

Proportional Liability — Different Bonds / Limits

Where co-sureties guarantee different maximum amounts, their liability is proportional to their respective bond limits — up to the limit each has agreed to, not beyond.

Illustration: A (bond of ₹10,000), B (₹20,000), C (₹40,000) are co-sureties for D's debt to E. D defaults by ₹40,000.

Total bond = ₹70,000. Ratios: A = 10/70, B = 20/70, C = 40/70.

A pays ₹ 5,714; B pays ₹ 11,429; C pays ₹ 22,857 — up to ₹ 40,000 total.

If default were ₹ 70,000 or more — A's max = ₹ 10,000; B's = ₹ 20,000; C's = ₹ 40,000.

Release of One Co-Surety — Does NOT Discharge Others

If the creditor releases one co-surety, the other co-sureties are not discharged. Nor is the released co-surety freed from their responsibility to the remaining co-sureties for contribution (if the others end up paying more than their proportionate share).

Section 5

Bank Guarantees — Types & Banker's Duty to Honour

A bank guarantee is a trilateral contract between the bank (guarantor), the applicant (principal debtor), and the beneficiary (creditor). It is an independent instrument— the bank's obligation to pay arises on demand, regardless of the underlying contract between the applicant and the beneficiary. This autonomy principle is the cornerstone of bank guarantee law.

Three Types of Bank Guarantees

Financial Guarantee

Issued in lieu of cash security or earnest money deposit. Assures the beneficiary of the bank's financial support if the applicant fails to fulfil a financial obligation (e.g., deposit earnest money, pay a fee). Concern here is the applicant's creditworthiness.

Performance Guarantee

Issued to secure performance of a contract (e.g., execution of a civil works project, supply of goods). The bank guarantees that the applicant will perform the contract satisfactorily. The BG is independent of the underlying contract — bank must pay on a valid claim without examining whether the contractor actually defaulted.

Deferred Payment Guarantee

Guarantees payment of instalments for machinery or capital goods purchased on deferred payment terms. The bank undertakes to pay on behalf of the buyer if the buyer fails to pay each instalment on its due date.

Banker's Duty to Honour — Key Cases

R.D. Harbottle Ltd vs National Westminster Bank Ltd (1978 QB 146)

Banks deal in documents, not in goods or underlying disputes. A bank that has issued a guarantee must honour it strictly in accordance with its terms. The only exception the court would consider was clear fraud of which the bank had notice at the time of demand.

UP Co-operative Federation vs Singh Consultants (1988 (1) SCC 174)

International trade cannot function if commitments of banks are not honoured promptly. Courts should not interfere with payment under bank guarantees except in cases of clear fraud.

Texmaco Ltd vs State Bank of India (AIR 1979 Cal 44)

Once a bank guarantee is invoked, the bank must pay on demand. The bank cannot raise objections based on disputes between the principal debtor and the beneficiary.

Maharashtra Electricity Board vs Official Liquidator (AIR 1982 SC 1497)

The winding up of the applicant company does not absolve the bank of its obligation to honour the guarantee. The bank's obligation is primary and independent.

SCIL (India) Ltd vs Indian Bank (AIR 1992 Bom 121)

Statutory suspension or moratorium on the applicant's obligations does not affect the bank's liability under the guarantee.

M/s Escorts Ltd vs Modern Insulators Ltd (AIR 1988 Delhi 345)

In cases of doubt about fraud, banks should seek directions from the court rather than unilaterally refusing payment. Unilateral refusal without clear fraud can itself expose the bank to liability.

Memory Hook — BG Types: “FPD”

Financial — in lieu of cash security / earnest money; creditworthiness-driven
Performance — secures contract performance; independent of outcome
Deferred Payment — secures instalment payments for deferred-payment machinery

All three: pay on demand, irrespective of underlying disputes (except fraud / special equity).

Section 6

Exceptions to Paying & Precautions on Issuance / Payment

Two Exceptions to the Banker's Duty to Pay

1. Fraud — Egregious & Known to the Bank

A bank may refuse payment if the beneficiary is making a fraudulent claim and the bank has clear notice of the fraud at the time of demand. The fraud must be egregious in nature — vitiating the entire underlying transaction — not merely a commercial dispute between the parties.

United Commercial Bank vs Bank of India (AIR 1981 SC 1426):The Supreme Court recognised fraud as the only clear exception — the fraud must be of a clear and obvious nature that has come to the bank's knowledge before payment is made.

2. Special Equity — Irretrievable Injustice

In exceptional circumstances, where payment would cause irretrievable injusticeor where the claim is unconscionable (and not merely unjust), a court may grant an injunction. The Itek Corporation case established this narrow “special equity” exception in the USA; Indian courts have occasionally applied a similar principle.

M/s G.S. Atwal Co. vs Hindustan Works Construction (AIR 1989 Cal 184): The Calcutta HC granted relief where the bank had itself issued the guarantee in error — special equity applied where irretrievable injustice would otherwise result.

Delhi HC vs Calcutta HC — Divergent Views on Invocation

Delhi High Court (stricter view)

In M/s Harprashad & Co vs Sudarshan Steel (AIR 1980 Delhi 174), the Delhi HC held that the invocation must explicitly state the facts constituting the default — a bare demand without stating reasons is insufficient.

Calcutta High Court (pragmatic view)

In Road Machines (India) vs Project & Equipment Corp (AIR 1983 Cal 91), the Calcutta HC held that invocation in a commercial manneris sufficient — a detailed statement of reasons is not required. The bank should pay if the invocation complies with the guarantee's terms.

Precautions — On Issuance of a Bank Guarantee

Amount: State the guaranteed amount both in figures and words; specify whether it is inclusive of interest and charges. Any ambiguity weakens the bank's position.
Period: State the exact validity period clearly. Include a claim period — minimum 15–30 days beyond the validity date — within which claims must be lodged.
Sec 28 Amendment (from 1 Jan 1997): Standard limitation clauses (that extinguish the bank's liability if the beneficiary does not sue within a certain period from invocation) were declared illegal. Courts can now admit claims even after the stated limitation period.
Counter Guarantee-cum-Indemnity: Before issuing the BG, the bank must obtain a counter guarantee and an indemnity from the applicant. The value of this counter guarantee depends on the applicant's financial strength.
Wrong Authority: In State of Bihar (1999) 8 SCC 436, the SC held that invocation by a party not competent/authorised to invoke the guarantee is invalid — bank need not pay on such defective invocation.

Precautions — On Payment Under a Bank Guarantee

Proper invocation: Verify the demand is made by the correct party (the named beneficiary or their authorised representative). Any doubt about identity or authority must be resolved before paying.
Within validity: Ensure the demand is made within the validity period (or the claim period stated in the guarantee).
No injunction ordinarily: Banks should generally not pay if a court injunction is in force — but a court should not grant an injunction merely because the applicant alleges a dispute with the beneficiary.
In cases of doubt on fraud: As held in M/s Escorts vs Modern Insulators (AIR 1988 Delhi 345), banks that are genuinely uncertain whether fraud exists should seek court directions rather than unilaterally refusing payment.

Section 7

Chapter Summary & Revision Flashcards

Chapter 31 in 6 Lines

A contract of guarantee (Sec 126) has three parties — surety, principal debtor, creditor — and is supported by consideration (past consideration valid, Sec 127).
Surety's liability is co-extensive with the PD (Sec 128); RBI circular Sept 9, 2014 allows banks to proceed against guarantors directly without exhausting PD first.
Continuing guarantee (Sec 129) covers a series of transactions; revocation by notice (Sec 130) or death of surety operates prospectively — future transactions only.
Surety is discharged by variance (Sec 133), release of PD (Sec 134), and loss of security (Sec 141); mere forbearance to sue does NOT discharge the surety.
Co-sureties share equally (Sec 146) or proportionally to their bonds (Sec 147); release of one co-surety does not discharge the others.
Bank guarantees are independent/autonomous instruments — banks must honour on demand (R.D. Harbottle, Texmaco, UP Co-op); exceptions are clear fraud (United Commercial Bank case) and special equity (Itek Corp / G.S. Atwal).

Which section defines contract of guarantee?

Sec 126 ICA 1872

Can a contract of guarantee be oral?

Yes — Sec 126 explicitly says it may be oral or written

What is consideration for a guarantee?

Sec 127 — anything done or promised for the benefit of the PD; past consideration is valid

What does co-extensive liability mean (Sec 128)?

Surety is liable to the same extent as the PD — principal + interest + costs

RBI circular Sept 9, 2014 on guarantors?

Banks may proceed against guarantors (wilful defaulters) without first exhausting remedies against PD

Define a continuing guarantee (Sec 129).

A guarantee that extends to a series of transactions — not exhausted by a single transaction

How can a continuing guarantee be revoked?

Sec 130 — by notice to creditor; also automatically on death of surety (future transactions only)

Does death of surety discharge liability for past transactions?

No — estate remains liable for past transactions; only future transactions are discharged

Effect of variance in contract without surety's consent (Sec 133)?

Surety is discharged as to transactions subsequent to the variance

Effect of release of principal debtor on surety (Sec 134)?

Surety is fully discharged

Does mere forbearance to sue discharge the surety?

No — only an agreement not to sue (with consideration) discharges the surety

What right does a surety acquire on paying up?

Subrogation — steps into creditor's shoes and can enforce all creditor's rights against PD

What is the implied promise by PD in a guarantee (Sec 145)?

An implied undertaking to indemnify the surety for all sums the surety rightfully pays on PD's behalf

How do co-sureties share default under Sec 146?

Equally — regardless of who among them is sued first

How do co-sureties contribute under Sec 147?

Proportionately to their respective bond limits, up to each party's maximum

Does releasing one co-surety discharge the others?

No — other co-sureties remain liable; released co-surety still has contribution obligation to others

Name the three types of bank guarantees.

Financial Guarantee · Performance Guarantee · Deferred Payment Guarantee

What is the autonomy/independence principle of bank guarantees?

A bank guarantee is an independent contract — bank must pay on demand regardless of underlying disputes

Key case for banker's duty to honour a guarantee?

R.D. Harbottle vs National Westminster Bank (1978 QB 146)

Two exceptions to the banker's duty to pay on invocation?

1. Clear fraud (known to bank at time of demand). 2. Special equity (irretrievable injustice)

Effect of Sec 28 amendment from 1 Jan 1997 on bank guarantees?

Standard limitation clauses extinguishing bank's liability after invocation were declared illegal

What is the minimum claim period that should be stated in a BG?

15–30 days beyond the validity date

Case where wrong-authority invocation was held invalid?

State of Bihar (1999) 8 SCC 436 — invocation by incompetent/unauthorised party is invalid

Does winding up of the applicant discharge the bank's BG liability?

No — Maharashtra Electricity Board vs Official Liquidator (AIR 1982 SC 1497)

What document must a bank obtain from the applicant before issuing a BG?

Counter guarantee-cum-indemnity — its value depends on the applicant's financial strength