A Contract of Guarantee as defined under Section 126 of the Indian Contract Act, 1872 deals with discharging the liability of the third person (principle debtor) in case he fails to keep his promise. The reason a contract of such nature exists is due to the probability of loss that creditor can suffer due to failure of abiding by the promise by the principle debtor. For such non-abidance, the surety will have to indemnify the creditor.

Contract of Guarantee is contingent in nature and depends upon the collateral undertaking. The liability or the burden on the surety is not primary but secondary in nature. The primary liability still lies on the principal debtor.

A contract of guarantee has a three-way contract. It involves three actors: creditor, the one to whom the principal debt is owed, the principal debtor who owes the debt to creditor and surety who takes guarantee on behalf of the principal debtor. Once the debt is paid to the creditor, the contract between the creditor, principal debtor and surety end there. A new contract between surety and principal debtor begins. The surety has complete right to ask the principal debtor pay him/her the money which is owed. So a contract of a principal debtor with a creditor, surety with creditor and debtor with surety sums it up to three contracts.

The essentials of Contract of Guarantee are:

1. Default: As mentioned in Section 126, a default needs to occur for this contract to come in force. Default, in simple words, means fault or mistake on part of the principal debtor. When the principal debtor fails to perform the contractual obligations, the surety has to.
2. Principal Debt: Past, present or future liability of the surety will be secured only then this contract will arise. Principal debt means the amount due to discharge the contractual liabilities. Such debt has to be in place for the liability on the surety to arise.

Exception: In case of a minor, when the guarantee has been taken on behalf of the minor, the surety will be treated as the one having primary burden as a principal debtor. This is done for the convenience of serving justice since minors cannot enter into agreements. In case of a company, the Board of Directors is held liable in case they enter into a contract which is ultra-vires to the Memorandum of Association(MoA). They can be held liable and not the official person of the company.

1. Consideration: As mentioned in Section 127, there has to be a consideration. Consideration in simple words as defined under Section 2(d) refers to doing or abstaining from doing something in place of a promise. It is the general rule under the law of contracts that no promise can be legal until it has some consideration (there some exceptions).
2. Liability: Section 128, states that the principal debtor’s and surety’s liability is co-extensive in nature meaning that scope of their liability is not more than the contract itself. The creditor can ask the surety pay if the principal debtor fails to do so.