Laws On Guarantee: An Overview

Anshika Agarwal And Sakshi Madan    |   

INTRODUCTION

Guarantee is an undertaking to answer for another’s liability. It is a promise to make payment of certain debt or performance of certain duty, when the principal debtor fails to make payment or perform the duty, as the case maybe. In other words, it is a collateral undertaking to pay the debt of another in case he does not pay it. A guarantee is a promise by one person, who is called the ‘guarantor’ or ‘surety’ to answer for the present and future debts of another person who is called the ‘principal debtor’ such promise being made to the party to whom the principal debtor is, or will become, liable.

LEGAL PROVISIONS RELATING TO GUARANTEE

A. WHEN GUARANTEE CAN BE GIVEN WITHIN INDIA:

  • Indian Contract Act,1872

"Contract of Guarantee" is defined as follows-

"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."1

A guarantee is usually used in the instance of person taking loan, goods on credit. For a valid contract of guarantee, there must be an existing debt or promise whose performance is guaranteed. In the absence of an existing debt or promise, the guarantee shall not be valid.

The liability of the surety with the principal debtor is co-extensive. The expression “co-extensive with that of the principal debtor” means that the surety is liable for the whole of the amount for which the principal debtor is liable and he is liable for no more.2 Thus, in the absence of a contract to the contrary, the liability of surety is co-extensive with that of the liability of the principal debtor.it means that surety is liable to the same extent to which the principle debtor is liable.

  • Companies Act, 2013

A public or a private company may advance any loan (including a loan represented by a book debt) or give any guarantee or security in connection with a loan taken by the directors of such company or any other person in whom such directors are interested only if the same has been agreed upon in a general meeting by a special majority of the shareholders and the loans so granted must be used by the borrowing company for its principle business activities.3

However, the above provision shall not apply in case of a holding company making any loan to its wholly owned subsidiary company or giving any guarantee or security in respect of any loan made to its wholly owned subsidiary.4

1Section 126 of the Indian Contract Act, 1872
2Section 128 of the Indian Contract Act, 1872
3Section 185(2) of Companies Act 2013
4Section 185(3) of Companies Act 2013

B. WHEN GUARANTEE GIVEN TO OR ON BEHALF OF FOREIGN ENTITY:

When an Indian company extends guarantee to or on behalf of a foreign entity, it must comply with the Foreign Exchange Management Act (FEMA), 1999 along with the Indian Contract Act,1872 and the Companies Act, 2013. The FEMA guidelines on guarantees issued by the Reserve Bank of India (RBI) come into play especially when there is a case of extending guarantee outside India.

Following are the FEMA regulations on guarantee-

  • Foreign Exchange Management (Guarantees) Regulations, 2000
    Foreign Exchange Management (Guarantees) Regulation 2000 provides the necessary provisions in respect of providing of guarantee by person resident in India to person resident outside India. The Regulation provides that, as otherwise provided in these regulations, no person resident in India shall give a guarantee or surety in respect of a person resident outside India without general or special permission of the Reserve Bank:
    • Guarantees which may be given by authorised dealer-
      An authorised dealer may give a guarantee in respect of any debt, obligation or other liability incurred by a person resident in or outside India and in the ordinary course of business.
    • Guarantees which may be given by persons other than Authorised dealer-
      A person resident in India being an exporting company may give a guarantee for performance of a project outside India, or for availing of credit facilities, whether fund-based or non-fund based, from a bank or a financial institution outside India in connection with the execution of such project.
  • Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2013
    An Indian party may extend a loan or a guarantee to or on behalf of the Joint Venture Company (JV) or Wholly Owned Subsidiary (WOS) abroad within the permissible financial commitment.5 The financial commitment allowed to a holding company in its JV/WOS is upto a limit of 400 percent of the net worth as on the date of the last audited balance sheet.
    Financial commitment means the amount of direct investment done by an Indian party to or on behalf of its overseas JV/WOS by way of contribution to equity, loan and 100 per cent of the amount of guarantees and 50 per cent of the performance guarantees.6 This financial commitment can be in various forms like:
    • capital contribution and loan to the JV / WOS;
    • corporate guarantee (only 50 percent value in case of performance guarantee) and / or bank guarantee (which is backed by a counter guarantee / collateral by the Indian party) on behalf of the JV / WOS and
    • charge on immovable / movable property and other financial assets of the Indian party (including group company) on behalf of JV WOS.

C. DRAFTING A GUARANTEE DEED – IMPORTANT POINTS

  • Consents and Approvals

While entering into a contract of guarantee, it must be ensured that all consents, approvals, licenses and authorizations of, and filings and registrations with, any governmental authority required under applicable law and regulations for the making and performance of the guarantee have been obtained or made and are in full force and effect.

5Regulation 6(4) of Foreign Exchange Management (Transfer or Issue of any Foreign Security) (Fourth Amendment) Regulations, 2013
6Refer A.3 (f) of Master Direction – RBI/FED/2015-16/10 FED Master Direction No. 15/2015-16: FEMA 120-Direct Investment by Residents in Joint Venture (JV) / Wholly Owned Subsidiary (WOS) Abroad

For e.g. – "All consents, approvals, licenses and authorizations of, and filings and registrations with, any governmental authority required under any applicable law and regulations for making and performance of this guarantee have been obtained or made and are in full force and effect."

  • Liability

Careful consideration needs to be given to the wording used in the clause defining the scope of the liabilities covered by the guarantee. Problems frequently arise when the clause is not drafted in sufficiently wide terms or with sufficient clarity to cover a particular liability.

For e.g. – "Guarantor unconditionally guarantees the full and timely payment of all dues on behalf of the Subsidiary, and the liability of Guarantor under this Guarantee shall not be affected or discharged in whole or in part by any modification, change, extension, or waiver of any of the terms of the Sub-contract by Subsidiary."

  • Principle Debtor Clause

A principal debtor clause may keep the guarantor liable if events occur after the guarantee has been given which put an end to the liability of the principal debtor, or which might otherwise discharge the guarantor from liability. This shall prevent the guarantor from being discharged even if there had been a departure from the terms of the contract between the creditor and the principal debtor.

For e.g. – "This Guarantee shall not be discharged nor shall the Guarantor’s liability under it be affected by anything which would not have discharged or affected the Guarantor’s liability if the Guarantor had been a principal debtor to the creditor instead of a guarantor."

  • Continuing Security Clause

A continuing security clause provides that the guarantee shall continue for the principal debtor’s obligations to the creditor at any time and that it shall not be satisfied or otherwise affected by any repayment from time to time of the whole or part of the sums due and owing by the principal debtor to the creditor.

For e.g. – "This Guarantee shall remain in full force and effect and shall be binding on the Guarantor, its successors and assigns until all amounts payable under this Guarantee have been indefeasibly paid or satisfied in full."

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