Difference between Contract of Indemnity and Contract of Guarantee

Introduction

On one hand, Law may be rigid on certain junctures to maintain its credibility and effectiveness. Nevertheless, on the other hand, it also considers situations wherein the interest of one party is paralyzed, or where a safeguard against losses is necessary. For instance, when it comes to Law of Contract, the provisions are unequivocally and clearly laid down to legally bind the parties, check upon breaches and remedy the aggrieved party.

The terms, Indemnity and Guarantee are almost used synonymously by laymen and at times, also mistaken in the Commercial sphere. It is very crucial to understand the crux and broad differences between the Contract of Indemnity and Contract of Guarantee to carry out our dealings with and borrowings from banks, and claims of protection from Business losses. The terms are examined in the context of India with respect to the content in Indian Contract Act, 1872.

Concept of Indemnity

Longman’s Dictionary outlines indemnity as protection against loss, especially in the form of a promise to pay, or payment for loss of money, goods etc. Likewise, Chambers Dictionary defines indemnity as a security against, or compensation for loss, etc.

Section 124 of the Indian Contract Act, 1872 discusses the contract of indemnity as “A contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself or by conduct of any other person.”

Following inferences may be derived from this definition:

1. A contract of Indemnity is a contract between an “indemnifier” and “indemnified”, i.e., a party promising to compensate in case of loss and a party in whose favour the promise is made respectively.

2. The loss referred to must be caused exclusively by conduct of human agency. In other words, it does not cover any loss caused by an ‘Act of God’ or a natural disaster.

3. Human agency simply refers to the promisor or any other person.

4. This distinguishes indemnity from insurance. Insurance intends to restore the position of a person as before the loss occurred, where the loss may be caused by human or non-human interventions (e.g., lightning, earthquake, tsunami, etc.). Another difference is that while an indemnifier takes the risk voluntarily in contract, insurance plans demand payment of a premium.

5. Contract of indemnity is a contingent contract as it is conditional upon the future conduct of a person, which is likely bring loss. However, in the Indian framework, the indemnified can claim the indemnity well before any actual damage occurs, that is, it can be brought before the breach.

Liability of Indemnifier

In the Indian scenario, there is a confusing stance as to when the indemnifier can be made liable. Two opposing views have been put forward:

1. The first view is of the High Court of Lahore and Nagpur. It holds that the indemnity can be claimed once loss has been already incurred by the indemnity-holder.

2. The second view is widely held by the High Courts of Bombay, Calcutta, Madras, Patna and Allahabad and is akin to the English Law on the matter. According to it, the indemnity can be claimed by the indemnity-holder before incurring loss. This rationale was thought upon equitable principles and focused on freeing the absolute liability of the indemnified.

Rights of Indemnity Holder

Section 125 discusses the rights of the indemnified that can be enforced against the indemnifier. As such, the indemnified is entitled to recover from the indemnifier:

  • Damages which have been promised,
  • Costs of suit, and
  • Sums paid under the terms of compromise of any suit.

Discharge of Liability

An indemnifier can be discharged from the contractual obligation only after its termination.

Kinds of Indemnity

1. Express: A contract of indemnity can be entered into by expressly consenting and stating the terms and conditions in writing or orally.

2. Implied: It can also be assumed impliedly by the circumstances or conduct of the parties. In Secretary of State v. The Bank of India Ltd.[1], the Privy Council recognized implied contract of indemnity.

Concept of Guarantee

Guarantee has been defined under Section 126 of the Indian Contract Act, 1872 as:

“A “contract of guarantee” is a contract to perform the promise, or discharge the liability, of a third person in case of his default.”

Following inferences may be derived from the above definition:

1. A contract of Guarantee must be a valid contract in accordance with the Indian Contract Act. In other words, it must be entered into by free consent of competent parties and for lawful consideration and object.

2. A contract of Guarantee aims at providing extra security against the default of a party in fulfilling their obligations. As such, a third party undertakes the responsibility to do it.

3. It involves three persons, namely “principal debtor”, “surety” and “Creditor.” A Principal debtor is one in respect of whose default the guarantee is given, a surety is one who gives the guarantee on behalf of the principal debtor and a creditor is one to whom the guarantee is given.

4. In total, there are three contracts between the parties:

  1. The first contract exists between the Principal Debtor and the Creditor. It must involve a principal debt, e.g., a loan borrowed from a bank.
  2. The second contract exists between the Principal Debtor and the Surety, wherein the Surety accepts to discharge the liability of the principal debtor. It may be an implied contract, i.e., a person may act as surety without the consent and knowledge of the principal debtor.
  3. The third contract exists between the Surety and Creditor, wherein the Surety undertakes to pay the creditor if the Principal Debtor fails to fulfill the promise.

As regards the consent of the surety, it must be free and not have been obtained by misrepresentation or concealment of the material facts of the transactions as elucidated under Sections 142 and 143. Keeping silence on the material facts relating to the principal debtor will amount to discharging the liability of the surety and invalidate the contract.

Further, benefit to the Principal Debtor constitutes a good consideration to the surety for giving the guarantee as mentioned in Section 127 of the Indian Contract Act.

Liability of Surety

According to Section 128, “The liability of the surety is coextensive with that of the principal debtor, unless it is otherwise provided by the contract.” In other words, the liability of surety is equivalent and goes hand in hand with that of the principal debtor.

Simply put,

1. If the Principal debtor defaults on payment, the surety can be asked to pay the sum along with the interest thereon.

2. If the liability of the debtor is reduced or waived, that of the surety also stands reduced or waived.

3. If the contract by the debtor with the creditor is held to be void and unlawful and hereby declared unenforceable, the liability of the surety is also dismissed.

4. If the principal debtor’s agreement is invalidated on grounds of minority, then the liability of the surety for the payment also comes to an end.

5. If any clause in an agreement mentions that the borrower’s collateral security or guarantee is not required and yet the borrower executes a voluntary agreement with the surety for repayment, the surety would be bound to repay the loan in case of default of the debtor. This is because the liability of the debtor and guarantor is joint and coextensive.

6. If the principal debtor makes a default, the creditor can exercise his discretion to sue either the principal debtor or the surety or both. It must be noted that suing the surety wouldn’t exhaust his remedy against the debtor. This again confirms that the liability of the debtor and the surety is joint and several.

7. Ideally, but not necessarily, the Supreme Court in Union Bank of India v. Manku Narayan[2] has held that if there is a decree against the principal debtor, the surety and the ‘mortgaged property’, the creditor should proceed first against the mortgaged property and later on, against the surety.

8. There are also limits upon the liability of the surety, i.e., the surety can be made liable only as regards the part of the amount he promised to pay and in accordance with the terms and conditions of the guarantee bond.

Discharge of Surety from liability

The surety is said to be discharged from his/her obligations once a contract of guarantee has been performed or extinguished. Following are the modes of discharge of surety under the Indian Contract Act:

  1. Revocation by the Surety.[3]
  2. By death of Surety.[4]
  3. By variance in the terms of the contract and Novation of Contract.[5]
  4. By release or discharge of principal debtor.[6]
  5. When the creditor compounds with, gives time to, or agrees not to sue the principal debtor.[7]
  6. By creditor’s act or omission impairing surety’s eventual remedy.[8]
  7. By loss of the security by the creditor.[9]

Rights of the Surety

A surety is vested with definite rights as follows:

1. Rights against the Principal Debtor

a) Right of Subrogation[10]: This means that once the surety has made payment or performance on behalf of the principal debtor’s default, he takes the position of the creditor.

b) Right of Indemnity against the principal debtor[11]-: The surety, after discharging his guarantee can claim rightful indemnity from the principal debtor.

2. Rights against the Creditor

a) Right to securities with the creditor[12]: The surety is entitled to derive benefit from the securities deposited against the creditor at the time of the contract.

3. Rights against the Co-sureties

The co-sureties are liable to pay the part of the debt as guaranteed by them.[13]

Kinds of Guarantee (With illustrations to Section 129)

1. Specific: A specific guarantee holds the surety responsible for a particular transaction or obligation.

Illustration (c)- “A guarantees payment to B of the price of five sacks of flour, to be delivered by B to C and to be paid for in a month. B delivers five sacks to C. C pays for them. Afterwards, B delivers four sacks to C which C did not pay for…” This can be called a specific guarantee, which extended to only the previous delivery.

2. Continuing: A continuing guarantee holds the surety responsible for a series of transactions over a duration of time.

Illustration (a)- “A, in consideration that B will employ C in collecting the rent of B’s zamindari promises B to be responsible, to the amount of 5,000 Rupees, for due collection and payment by C of those rents. This is a continuing guarantee.”

A Comparative Chart of Other Key Differences Between the Contract of Indemnity and Contract of Guarantee 

Basis of Differentiation Indemnity Guarantee
Objective The objective of an Indemnity is to compensate and secure a party against future losses, penalties or lawsuit expenses. It tends to shift the burden of damages upon the indemnifier. The objective of a guarantee is to ascertain that the transactions would be honored by the debtor. It acts as a backup by the surety in case the debtor falters in re-payment of debt.
Illustration A contracts to indemnify B against the consequences of any proceedings which C may take against B in respect of a certain sum of 200 rupees. This is a contract of indemnity.[14] A guarantees to B the payment of a loan of Rs. 2,00,000/- (with interest) taken by C if C defaults on payment.
Number of Parties It involves two parties, viz., the indemnified and indemnifier. It involves three parties, viz., the surety, principal debtor and creditor.
Number of Contracts It involves a single contract. It involves three contracts in total.
Remedies for Breach of Contract All the loss can be claimed by the indemnified. The surety can recover all the payments made along with interest from the principal debtor.
Liability The liability of the indemnifier is primary. The liability of the surety is secondary.
Recovery of Reimbursement The loss in case of the considered situation falls upon the shoulders of the indemnifier and he cannot recover the amount. The surety after paying on behalf of the principal debtor, steps into the shoes of the creditor. Thus, he is eligible to recover the amount so paid.

Conclusion

To wrap up, the concepts of indemnity and guarantee are indeed very useful instruments in safeguarding business interests, customers etc. It ensures that common people excel in their endeavors, saving them from pitfalls as they falter in their dealings. Thus, these instruments deal with monetary compensation and play a vital role indirectly in the overall running of the circular flow of the Economy.

References

  1. Dr. R.K. Bangia, Contract-II p.no. 1-51 (Allahabad Law Agency, Haryana, Seventh Edition, 2017).
  2. Dr. Avtar Singh, Contract and Specific Relief p. no. 591-670 (EBC Publishing (P) Ltd., Lucknow, Twelfth Edition, 2017).
  3. Differences between Indemnity, Guarantee and Warranty, available at:https://blog.ipleaders.in/difference-indemnity-guarantee-warranty/(last visited on July 17, 2021).
  4. Contract of Indemnity and Law of Guarantee, available at: https://www.lawteacher.net/free-law-essays/contract-law/contract-of-indemnity-and-law-of-guarantee-contract-law-essay.php (last visited on July 17, 2021).
  5. Rights of Indemnity Holder- Section 125 of Indian Contract Act, available at: https://lawcorner.in/rights-of-indemnity-holder-section-125-of-indian-contract-act/(last visited on July 17, 2021).

[1]A.I.R. 1938 P.C. 191

[2]AIR 1987 SC 1078

[3]See section 130

[4]See section 131

[5] See section 133

[6]See section 134

[7] See section 135

[8]See section 139

[9] See section 141

[10]See section 140

[11]See section 145

[12]See Section 141

[13]See section 146

[14]Illustration to Section 124

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About Tazeen Ahmed

Tazeen Ahmed is a first-year law student at Jamia Millia Islamia, New Delhi, inquisitive about Constitutional Law, Family Law, Corporate Law, Human Rights Law, and Criminal Law. She is a proficient writer, skilled in conducting legal research and organizing her articulations on social-legal and political issues. She holds a sound academic record, having scored 93.80 % in AISSE and 95% in both Political Science and English Language in AISSCE. She has held prestigious positions in the Student Council and been adjudged the ‘Student of the Year 2016, Gurgaon’ by UnivQuest. She has formerly served as a legal intern at ubadvocate, where her performance was marked “outstanding” by the team and is an Editor at The Wall of Justice blog. She is also an avid reader, a poet, and a political enthusiast. Above all, she is a dedicated and dynamic soul, ever-prepared to undertake challenging roles in the legal battlefield, and treats constructive criticisms as stepping stones towards progress.

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