This article provides drafting solutions for lawyers to employ to protect their clients’ interests when drafting contracts for clients receiving personal guarantees from directors of companies or partners of partnerships for payments of the companies or partnerships’ dues.
Keywords: Guarantees, Agreements of Guarantee, Contract Amendments, Guarantor’s Consent, Purchase Contract
Reference: Indian Contract Act, Section 133, illustration a
Section 133 Indian Contract Act:
Section 133 of the Indian Contract Act provides that a guarantor is discharged from his guarantee if the principal contract is amended without his consent.
The principle behind this section is that a guarantor has consented to stand guarantee only for a specific transaction and cannot have his guarantee extended to a different transaction, albeit between the same parties, merely because the new transaction is created by way of an amendment to the original agreement rather than a new agreement.
Section 133, Illustration (a)
A becomes surety to C for B’s conduct as a manager in C’s bank. Afterward, B and C contract, without A’s consent, that B’s salary shall be raised, and that he shall become liable for one-fourth of the losses on overdrafts. B allows a customer to overdraw, and the bank loses a sum of money. A is discharged from his suretyship by the variance made without his consent and is not liable to make good this loss.
It is highly unlikely that someone would guarantee another person’s conduct with an employer in the modern-day. Most companies conduct fairly detailed research on prospective employees. However, it is relatively common to have guarantees for payments due under purchase agreements. Therefore, our example will deal with a guarantee for payment due under a purchase agreement
Company A, a plastic container manufacturer, agreed with Company B of the supply of raw material. Per the agreement, the Company would order a fixed amount of raw material per month and had to pay for it within three weeks of delivery. X, one of the promoters of A, stood as a guarantor for Company A’s payment.
Company A grew rapidly and soon required additional raw material to fulfill its orders. Therefore, it modified the agreement to increase the volume of the monthly order and consequently, the payments to be made to Company B. During this time, however, the promoters of the Company got into disputes, resulting in X selling most of his stake and stepping away from the day to day operations of the Company. However, he remained a Director.
A few months after stepping away from the day-to-day operations of the Company, X received a summons from the court as Company B had sued Company A and X for the recovery of money.
In court, X asked to be dropped from the suit as he was unaware of the change in the contract between Company A and Company B. Hence his guarantee agreement was void.
Interpretation and Scenarios:
In our example, Company B would oppose X’s application to be dropped since, admittedly, he was still a Director of the Company and hence ought to be deemed to know of the Company’s operations. Therefore, X could not avoid his liability on the pretext that he was unaware of the change in the agreement’s terms.
A Judge or Arbitrator would be required to determine two points to decide whether or not X’s guarantee subsisted even after the contract between Companies A and B was amended, namely:
- Whether not being a part of the day to day operations of the Company meant that X had to be separately intimated in the event the agreement was modified, at least by Company A?
- Assuming that X was deemed to be aware of the Company’s day-to-day operations, in the absence of express consent, could he be deemed to have consented to the amendment?
Both parties would have to lead evidence and cite case law to prove their respective cases. However, it is possible to make a dispute over a guarantor’s consent to a change in the main agreement rapid resolution friendly, while at the same time protecting the creditor’s interests, by incorporating a few simple solutions when drafting the agreements:
Solution 1 – Makes It Easy To Determine Whether Or Not The Guarantee Subsists:
In order to rapidly resolve disputes regarding the subsistence of a guarantee, or to avoid them altogether, the circumstances in which the guarantee can either be terminated or would automatically become void must be unambiguously stated in the agreement. This is especially true for agreements where the guarantors are promoters or directors of companies or partners in partnership firms or Limited Liability Partnerships. It is common for Directors and Partners to either resign or step away from the day to day operations without the guarantee being formally terminated. Further, both agreements must be drafted so that the interests of the creditor are protected.
In our example, the guarantee agreement could have had a clause stipulating that X’s guarantee would subsist till such a time that he resigned from the Company. However, to avoid a situation where X could plead ignorance about an amendment to the main agreement, any amendments to the main agreement would mandatorily have to be communicated to him in writing by at least one of the parties.
To further protect Company B’s interests, the main agreement could obligate Company A to ensure that there were always a minimum number of guarantors. Therefore, even if X had resigned from the Company or revoked his guarantee by any other pre-agreed method, Company A would be obligated to bring in a new guarantor.
Solution 2 — accelerates dispute resolution for both parties (Pre-decides contentious elements of the Arbitration process)
Both agreements, i.e., the main agreement and the guarantee agreement, must contain a clause that gives the claimant the right to ask for the arbitrator’s appointment by a named institution or ODR platform; and for such appointment to be made within 35 days of receipt of the defendant receiving notice.
In these cases, it will better serve the parties if the institution or ODR platform promises a process that binds the arbitrator to rapid resolution. Platforms often do this by minimizing oral hearings, not accepting documentation delays, and not allowing adjournments unless in emergencies.
Disputes regarding the subsistence of a guarantee can be made rapid-resolution friendly provided that the conditions under which the guarantee can be terminated by the guarantor, as well as circumstances that would void the guarantee, are stated clearly in the agreement.
Simple Explainer for the Layman:
HQ Containers, a plastic container manufacturer, entered into an agreement with Kumar Plastics for the supply of raw material. Per the agreement, the HQ would order a fixed amount of raw material per month and had to pay for it within three weeks of delivery. Naresh, one of the promoters of HQ Containers, stood as a guarantor for HQ’s payment.
HQ grew rapidly and soon required additional raw material to fulfil it’s orders. Therefore, it modified the agreement to increase the monthly order volume and, consequently, the payments to be made to Kumar Plastics.
During this time, however, the Company’s promoters got into disputes, resulting in Naresh selling most of his stake in the Company and stepping away from its day-to-day operations. However, he remained a Director.
A few months after stepping away from the Company, Naresh received a summons from the court as Kumar Plastics had sued HQ and Naresh for the recovery of money. HQ and Kumar Plastics had gotten into a dispute over one particular shipment’s quality, and HQ had refused to pay for it.
In court, Naresh asked to be dropped from the suit claiming he was unaware of the change in the contract between HQ and Kumar Plastics, and hence his guarantee agreement was void.
On the other hand, Kumar Plastics opposed Naresh’s application, arguing that even if he stepped away from the day-to-day operations of the Company, he was still a Director and hence would be deemed to have been aware of the change in the contract. They further argued that, since he had never opposed the change in terms deposit being aware of them, it ought to be deemed that he had acquiesced.
The entire dispute regarding the guarantee’s subsistence could have been resolved through ODR if the guarantee agreement had been unambiguous about when and how the guarantee could be terminated or would automatically become void.
About the Article
Rapid Contract Enforcement is an essential requirement for the growth and prosperity of India. It will enable more investment, entrepreneurship, and trust for all stakeholders in business and commerce. The community of lawyers in India does not have access to a practical and scholarly manual that gives them a path to deliver rapid contract enforcement to their clients. Such a manual will also help lawyers to draft contracts that enable timely enforcement. Quick enforcement requires the effective use of the Arbitration Act, the institutional framework, and technology-enabled dispute resolution infrastructure. This article belongs to a series where the author analyses each of the Illustrations available in the Contract Act and recommends practical approaches to rapid enforcement.
About the Author:
Dushyant Krishnan is a Mumbai based lawyer and the co-founder of House Court, an online dispute resolution platform.