This article provides drafting solutions to ensure that a guarantor is not liable when the creditor does any act that prevents the debtor from performing its obligations under a contract.
The article focuses on solutions to ensure that a guarantor does not have to endure a long and expensive trial to prove that the creditor’s conduct prevented the debtor from performing its obligations, thereby discharging the guarantor.
Keywords: Guarantee Agreement, Guarantor, Debtor,
Reference: Indian Contract Act, Section 134, Illustration (b)
Section 134, Indian Contract Act:
Section 134 of the Indian Contract Act protects the rights of a guarantor. The section states that if either of the following events occurs, a guarantor is discharged from his obligation:
- A contract between the creditor and principal debtor, releasing the debtor from its obligations
- An act or omission by the creditor, the consequence of which is the debtor’s discharge from its obligations.
The second illustration to section 134, which is the basis of this article, deals with the second situation, i.e., an act by the creditor which discharges the principal debtor.
Section 134, Illustration (b):
A contracts with B to grow a crop of indigo on A’s land and to deliver it to B at a fixed rate, and C guarantees A’s performance of this contract. B diverts a stream of water which is necessary for the irrigation of A’s land and thereby prevents him from raising the indigo. C is no longer liable on his guarantee.
In the illustration mentioned above, B actively prevented A from performing his obligations under the agreement. Under Contract Act, if the first party’s act or omission prevents the second party from performing its obligations under a contract, the second party is no longer obligated to perform its obligations. Therefore, the consequence of B’s action is the discharge of A from his obligation. The result is that C is also discharged from his guarantee.
However, in most cases, like our example below, there is a dispute about whether or not the creditor’s act or omission prevented the debtor from fulfilling its obligations.
Modern-day Illustration
Company X took a business loan from Bank Y for a construction project. Mr. A, one of the Directors of the company, stood as a guarantor for the loan.
Under the terms of the agreement, the loan was to be disbursed in two tranches. The first tranche was disbursed at the time of the agreement being signed. The second tranche, which was a much smaller amount, was to be disbursed after six months, after an inspection of the site by the Bank’s Directors.
The Bank disbursed the first tranche of the loan. However, it delayed the disbursal of the second tranche taking advantage of the fact that, while it provided for disbursement after an inspection by the Bank’s directors, the agreement between the company and the Bank did not specify a particular stage of completion that the project had to achieve before the second tranche of the loan had to be disbursed. As a result of the Bank’s failure to disburse the second tranche of the loan, the project failed, and the company was unable to repay the first tranche of the loan
The Bank sued Company X and Mr. A, the guarantor, for recovery of the loan amount that had been disbursed.
Interpretation and Analysis:
In the example given above, the Bank would argue that it was not liable to disburse the second tranche at the project had not reached a satisfactory stage. Further, even if it was liable to do so since the second tranche was a relatively smaller amount, the mere failure by the Bank to disburse it could not be construed as it having prevented the company from fulfilling its obligations. It would also argue that, even otherwise, the debtor and guarantor’s liability to repay the first tranche would remain.
On the other hand, the guarantor would argue that since the loan was taken to finance the project, the Bank’s failure to disburse the second tranche caused the project to fail. Therefore, the company was discharged from its obligation to repay, and consequently, the guarantee automatically stood terminated.
The entire dispute arose due to ambiguity as to when the Bank would be liable to disburse the second tranche of the loan. Removing this ambiguity, by incorporating the clauses discussed below, the dispute could be made suitable for rapid resolution through Online Dispute Resolution, while at the same time protecting the interests of the guarantor.
Solution 1 – Removes Ambiguity:
Any guarantee agreement must incorporate a list of circumstances that would cause the guarantee to be terminated or give the guarantor the right to terminate the guarantee. Doing so protects the guarantor from wrongfully being held liable for defaults by the principal debtor and lengthy and expensive legal proceedings.
In the example in this article, A’s agreement with the Bank ought to have contained a clause stating that, in the event, the Bank failed to disburse the loan amount, or any part of it, the guarantee would automatically stand terminated. It would also have been advisable for A to insist that the agreement between the company and the Bank provided that once the project had reached a particular stage, the Bank would be liable to disburse the second tranche of the loan. Since A was a Director of the company, he was in a position to insist that this clause was incorporated into the agreement between the company and the Bank.
Solution 2 – Accelerates the Dispute Resolution Process:
The agreement should have a dispute resolution clause giving 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 either the dispute resolution clause itself or the institution or ODR platform promises a process that binds the arbitrator to rapid resolution. ODR Platforms often do this by minimizing oral hearings, not accepting documentation delays, and not allowing adjournments unless in emergencies.
Conclusion:
Most guarantee agreements are drafted based on standard templates, which contain many ambiguities. The consequence of the agreements’ ambiguities is that guarantors are forced into long and expensive legal disputes, even when their liability has ended, thereby negating the benefits of the protection accorded to them by provisions like section 134 of the Contract Act.
Guarantors need to ensure that their guarantee agreements protect them from being held liable for defaults that they ought not to be liable for and unnecessary legal proceedings.
Explainer For The Layman:
Agatsya Builders Private Limited took a business loan from Krishna Co-operative Bank for a construction project. Mr. Agatsya, the Managing Director of the company, stood as a guarantor for the loan.
Under the terms of the agreement, the loan was to be disbursed in two tranches. The first tranche was disbursed at the time of the agreement being signed. The second tranche, which was a much smaller amount, was to be disbursed after six months, after an inspection of the site by the Bank’s Directors.
The Bank disbursed the first tranche of the loan. However, it delayed the disbursal of the second tranche taking advantage of the fact that, while it provided for disbursement after an inspection by the Bank’s Directors, the agreement between the company and the Bank did not specify a particular stage of completion that the project had to achieve before the second tranche of the loan had to be disbursed. As a result of the Bank’s failure to disburse the second tranche of the loan, the project failed, and the company was unable to repay the first tranche of the loan.
The Bank sued Agatsya Builders and Mr. Agatsya for the recovery of the first tranche of the loan.
The Bank argued that it was not liable to disburse the second tranche as the project had not reached a satisfactory stage. Further, even if it was liable to do so since the second tranche was a relatively smaller amount, the mere failure by the Bank to disburse it could not be construed as it having prevented the company from fulfilling its obligations. The Bank also argued that, even otherwise, the company and guarantor’s liability to repay the first tranche would be unaffected by the non-disbursal of the second tranche.
On the other hand, Mr. Agatsya argued that the loan was taken to finance the project since the company could not finance construction on its own. Therefore, the Bank’s failure to disburse the second tranche of the loan prevented Agatsya Builders from completing the project and repaying the loan.
In view of this, the legal consequence of the Bank’s failure to disburse the second tranche of the loan was that the company was discharged from its obligation to repay. Consequently, the guarantee automatically stood terminated. However, even though Mr. Agatsya’s argument was legally sound, he was still subjected to a long and expensive court case.
Mr. Agatsya could have saved himself and his company from an expensive court case if he had done the following:
- Ensured that his guarantee agreement contained a clause stating that, in the event, the Bank failed to disburse the loan amount, or any part of it, the guarantee would automatically stand terminated.
- Used his position as Managing Director to insist that the agreement between the company and the Bank provided that once the project had reached a particular stage, the Bank would be liable to disburse the second tranche of the loan.
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.
