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Introduction

In our day-to-day lives, goods are often obtained on loan or credit. Sometimes one may be unable to pay their debt and therefore creditors must find a way to ensure the debt is paid. This is where contracts of guarantee come in. A third party assures payment of the debt if the actual debtor fails to do so. The contract between the third party and the creditor is different from that of the actual debtor and the creditor.

For example:

Wanjiru borrows a loan from Otieno. Kerubo then promises to pay Otieno if Wanjiru fails to pay. In this case, Wanjiru is the principal debtor, Otieno is the creditor and Kerubo is the surety/guarantor.

A contract of guarantee thus has three contracts:

a) The loan agreement between the principal debtor and the creditor.

b) The contract of guarantee which is a secondary contract between the creditor and surety/guarantor.

c) The contract of indemnity which is an implied contract between the surety and the principal debtor.

  1. What is a contract of guarantee?
  • A guarantee refers to the assurance that a legal contract will be duly enforced (Black Laws Dictionary).
  • A contract of guarantee refers to a contract in which one party discharges the liability of another party in case he/she fails to perform his/her contractual obligations.
  • The person promising to pay commits to fulfill the liability when the other party defaults.
  • The main purpose of this contract is to enforce the payment of debt by the person giving the guarantee (surety/guarantor).
  • These contracts also protect the party that is unable to pay from suffering loss.
  • A guarantee may either be oral or written.

Which parties are involved in a contract of guarantee?

a) Principal debtor- this is the person who fails in paying a debt. The guarantee to pay in case the debtor defaults is given by another party (surety).

b) Creditor- this is the person who extends credit to the principal debtor. Guarantee is given to the creditor.

c) Surety- this is the person who promises to pay the creditor in case the principal debtor fails to do so.

What are the outstanding features of a contract of guarantee?

a) The full consent of the parties involved

b) Principal debt- The debt should already be in existence since the purpose of the contract of guarantee is to offer security to a creditor regarding an outstanding debt created by the principal debtor. The surety’s promise is conditional on the principal debtor’s default. If the principal debt is absent, no valid guarantee can take place.

c) A valid consideration- a contract must always be supported by adequate consideration, for without it, it becomes void. However, in a contract of guarantee, no direct consideration exists between the surety and the creditor. This is because the consideration received by the principal debtor is sufficient to the surety to provide a guarantee except when there is past consideration.

d) Free from any misrepresentation- the guarantee should not be obtained using misrepresentation or concealment of a material fact by the creditor. The creditor should reveal all material facts he has knowledge of even though a contract of guarantee is not a contract of uberrimae fidei (a contract of good faith that requires full disclosure of material facts likely to affect the surety’s willingness). If this is not met, the contract becomes invalid.

e) Liability- there must be a promise to perform on the part of the surety. The promise must be capable of being legally enforced. The surety’s liability is not invalidated on grounds that the stipulated time has expired.

f) Co-sureties- if a surety gives a guarantee on the condition that another party must join as a co-surety and no one does then the contract becomes invalid.

g) The principal debtor need not be competent to contract.

 

  1. The legal position of a guarantee in different jurisdictions

India

This is found in the Indian Contract Act, 1872.

The parties involved are also three- the surety, creditor and principal debtor.

Section 126 of the Act provides:

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”.

The following can be concluded from the case of P.J. Rajappan v Associated Industries (1983):

  • A contract of guarantee is a tripartite contract involving three parties.
  • In deciding whether a person has guaranteed the due performance of the contract by the principal debtor, the court will consider all the circumstances of the transaction.
  • Sufficient evidence of a guarantor’s involvement in a transaction automatically implies that he has guaranteed the due performance of the contract by the principal debtor whether or not he has signed the agreement.

The essentials of a contract of guarantee are similar to the outstanding features listed above.

Contracts of guarantee are classified into two types:

  1. Specific/simple guarantee- this is a guarantee for a single debt or specific transaction. It ends when the debt is paid.
  2. Continuing guarantee- section 129 of the Act defines this as: “a guarantee which extends to a series of transactions.” The transactions must be separable and distinct. If a guarantee is given for an entire consideration, it is not a continuing one.

The surety’s liability continues until all the transactions are completed or until the surety rescinds the guarantee for future transactions. A continuing guarantee can be revoked through:

  • Giving a notice- section 130 of the Act provides: “A continuing guarantee may at any time be revoked by the surety, as to future transactions, by notice to the creditor.” This only applies to future transactions. The surety will still be liable for all the transactions done before he gave the notice.
  • Death of surety- section 131 of the Act provides: “The death of the surety operates, in the absence of any contract to the contrary, as a revocation of a continuing guarantee, so far as regards future transactions.” The estate of the deceased surety through his legal representatives will be liable for the transactions made before his death.

The period of limitation of enforcing a guarantee is three years from the date on which the letter of guarantee was executed.

The rights of a surety under Indian Law

On paying the debt and discharging the liability of the principal debtor, the surety acquires several rights. These rights are against;

a) The principal debtors

b) The creditor

c) The co-sureties

Discharge of surety from liability

A surety is discharged from liability through;

a) Revocation of the contract

b) Invalidation of the contract

c) The conduct of the creditor

 

a) Revocation of the contract

This is discussed above under continuing guarantees

b) Invalidation of the contract

A contract of guarantee may be avoided if it becomes void or voidable. A surety is discharged from liability if;

  • The guarantee is obtained by concealment- provided for in Section 143 of the Act.
  • The co-surety fails to join the surety- provided in Section 144 of the Act.
  • The guarantee is obtained through misrepresentation- provided for In Section 142 of the Act.

 

c) The conduct of the creditor

A guarantor will be discharged if;

  • The creditor alters the terms of the agreement between him and the principal debtor- Section 133.
  • The creditor releases the principal debtor from liability- Section 134.
  • There is an agreement between the creditor and principal debtor where the creditor agrees to give more time to pay the debt or not sue the debtor- Section 135.
  • The creditor loses any security given to him at the time of the guarantee without the surety’s consent- Section 141.

Kenya

The Kenyan position of the law is as set out in statutory provisions.

The position of the law in respect to guarantees is found in:

a) The Constitution of Kenya, 2010

b) The Law of Contract Act

c) Case law

The Law of Contract Act provides that contracts of guarantee must be:

a) In writing for liability to be imposed on the surety.

b) Signed by the surety or someone else who the surety has lawfully authorized to sign.

Section 3(1) of the Act provides:

No suit shall be brought whereby to charge the defendant upon any special promise to answer for the debt, default or miscarriages of another person unless the agreement upon which such suit is brought, or some memorandum or note thereof, is in writing and signed by the party to be charged therewith or some other person thereunto by him lawfully authorized.

Courts and Tribunals have also pronounced themselves immensely on this subject of guarantee agreements. For instance, in the case of John Chege & 6 others v Stima Sacco Co-operative Society Ltd [2019] eKLR, the Court stated as follows:

“As well understood in law, a guaranty is a promise to a lender to perform the obligations of another party. A guarantor can assume responsibility for the debt of a Borrower in a number of transactions, including mortgages, leases, and business loans. Thus the guarantor’s responsibility is to make loan payments if the borrower doesn’t. Therefore the relationship of the parties is contractually based on the guarantee contract.”

  1. The position under Shariah Law

The contract of guarantee is also present under Shariah Law as provided in the Quran, Sunnah and Ijma. The law of contract in Shariah emphasizes on the importance of the declaration of intention and consent. Consent is central for without it a contract will not have a binding force.

The contract of guarantee in Western and Pakistani Law is overwhelmingly similar to the general provisions outlined above on the same. A comparison of the contract as interpreted both in Western law and Islamic law shows that the contract is almost exactly the same for both legal systems.

The provisions on the contract of guarantee in Shariah law are found in the Shariah Standard No. 5 issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

The Standard includes a large number of contracts under it that are not guarantees. They are independent contracts whose purpose is the provision of security. Contracts included in the Standard under the headline of guarantees are:

a) Personal guarantees (kafalah)

b) Guarantees in contracts of trust (Amanah)

c) Pledges (rahn)

d) Guarantees for existing leased properties

e) Documentary credits

f) Letters of guarantee

The Rules of the Contract of Guarantee (Daman) in Islamic Law

The Shariah Standard provides the following rules on the contract of guarantee:

a) Kafalah is of two types:

  • Kafalah that is with the consent of the principal debtor
  • Kafalah that is without the consent of the principal debtor

Shariah Standard No. 5, item 3/1/2 states that banks only accept Kafalah in which the principal debtor has given consent.

b) The Standard is permitted to make the contract conditional and associate it with a future obligation.

c) It is permitted to guarantee a debt that has not yet been determined or one that is not due as yet.

d) The creditor is permitted to demand the debt from the principal debtor or guarantor whenever he wishes.

e) It is permitted to fix a period of the guarantee and to determine the amount to be paid.

f) It is not permitted to charge an amount for providing a guarantee, but the guarantor is entitled to the costs incurred.

g) The contract of Kafalah may be part of a loan agreement or be independent of it.

h) There can be more than one guarantor.

i) The guarantor is allowed to set an order on how the demand will be made. Normally, the creditor demands it from the principal debtor then he proceeds to demand it from the guarantor upon default. However, the guarantor has an option to consent to primary liability.

j) When the creditor frees the guarantor from liability, the liability of the principal debtor remains. However, when the creditor absolves the principal debtor of the debt liability, the guarantor’s liability comes to an end.

k) For future obligations, the guarantor may determine the guarantee by giving notice to the creditor but this must be done before debt liability arises.

Rights of guarantors before satisfying the debt owed by the principal debtor

  1. Right to ownership of property- Article 40(2)(a) of the Constitution provides that no one should be arbitrarily deprived of property of any description or right over, property of any description.
  2. Liability of a guarantor is dependent on whether the guarantee is an “on-demand guarantee” or “conditional guarantee”. An “on-demand” guarantee specifies that the guarantee is payable once the first demand has been made. A “conditional guarantee” is payable when particular conditions have been met. Therefore, liability only attaches when the principal debtor has defaulted.
  3. Right to receive timely and accurate updates from the creditor regarding the loan- Article 35 of the Constitution on ‘access to information’ stipulates that “Every citizen has the right of access information held by another person and required for the exercise or protection of any right or fundamental freedom.
  4. Right to call on the principal debtor to pay the amount of the debt guaranteed- a guarantor has the right to ask the principal debtor to pay the debt, even though the creditor has not yet demanded payment from him or the principal debtor, in the case where he has entered himself as the first to be contacted by the creditor if the principal debtor defaults.

Effects of variation of terms of guarantee

A variation of terms refers to the amendment made to a contract, whether adding, deleting or changing parts of the contract. The original guarantee still remains but some terms are changed.

In Kenya, the position is that alteration of the terms of the principal contract to an extent that fundamentally changes the terms of the agreement may discharge the guarantors from liability. The same applies in cases of novation. Novation is basically the substitution of a party in a contract.

The position in England and Wales as provided in “Halsbury’s Laws of England” is similar to the Kenyan position:

  1. A surety will be discharged if the creditor, without the consent of the surety, modifies the contract made with the principal debtor. The surety cannot be held liable for default in the performance of a contract he has not guaranteed.

The position under case law is:

  1. The law as illustrated in Reid-Vs- National Bank of Commerce (1971) E.A.525 shows that the law seeks to protect the surety who mostly seems to be under the control of the creditor.
  2. A guarantor will be discharged if he has not consented to a variation to the original contract. This was the position in Holme-vs- Brunskil (1878) 3QBD.

Effects of a creditor not acting in good faith

If a creditor acts in bad faith towards the guarantor, the guarantor will be freed from his obligations. In a situation where both the creditor and the principal debtor conspire to ask for payment from the guarantor so as to extort him, then the guarantor is discharged.

Remedies available to the guarantor

When the guarantor is sued for failing to fulfill his guarantee obligations, the following defenses are available to him:

  1. A variation to the contract- if there is a change to the agreement without the guarantor’s consent and the change does not favor the guarantor, then the guarantor is discharged from his obligation.
  2. The creditor releases the debtor’s security.

 

Recommendations

The position of the law in Kenya favors the creditor as opposed to the guarantor. The recommendations to probable clients would therefore be:

  1. Endeavor to acquire legal advice before getting into this kind of contract.
  2. Carry out adequate due diligence on persons you wish to guarantee.

 

 

This bulletin is not intended to offer professional advice and you should not act upon the matters referred to in it without taking specific advice. It is not intended to create, and receipt of it does not constitute, a lawyer-client relationship.

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