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Contract Of Indemnity And Contract Of Guarantee

An indemnity is a contract by one party to keep the other harmless against loss, but a contract of guarantee is a contract to answer for the debt, default or miscarriage of another who is to be primarily liable to the promisee . Contracts of guarantee and contracts of indemnity perform similar commercial functions, in providing compensation to the creditor for failure of a third party to perform his obligation.

A contract of guarantee always and necessarily involves participation of three parties i.e. creditor, principal-debtor and surety. Without them a contract of guarantee is not possible. It is tripartite agreement, the one between principal-debtor and surety being implied or express. A contract of guarantee includes a contract of indemnity in itself.

The contract between principal-debtor and surety is one being that of indemnity where the principal-debtor indemnifies the surety for any loss occurred to him due to fault of any party. Without this contract, the contract is one of indemnity and not guarantee and it is not possible to work out the liabilities of surety. And hence a contract of guarantee must involve privies of all the three parties. It is not enough to have separate agreements between creditor and principal-debtor and surety and creditor.

Contract Of Indemnity

A contract of indemnity as per section 124 of the Indian contract Act 1872 is defined 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 the conduct of any other person, is called a  contract of indemnity. The key fundamentals of a contract of indemnity are:
  • It is a promise to compensate for or security against damage, loss or injury
  • In wider sense it includes all contracts of insurance, guarantee. It is not a collateral but an independent contract.
  • It is a tool for allocating risks contingent liability.
  • Indemnity clauses, amongst other things, must be clear, specific, where possible stipulate the circumstances under which the indemnity will arise, be considered in light of any exclusion of liability clauses found elsewhere in the agreement and state what damages will be payable in the event of the clause being successfully invoked.

The enforcement of the contract of indemnity also depends on various factors.
The enforcement of contract of indemnity depends upon the following factors:
  • A contract of indemnity can be enforced according to its terms.
  • Claim of Indemnity holder can include: damages, legal costs of adjudication, amount paid under the terms of compromise.
  • The measure of damages is the extent to which the promisee has been indemnified.
  • Indemnifier should ideally be informed of the legal proceedings or should be joined as third party.
  • There is no onus to show breach or actual loss.

Indemnity contract includes two parties namely; Indemnifier and Indemnity holder. The person who is promising to pay compensation is called Indemnifier and the person who`s loss is compensated is called Indemnity holder.

There is a contract between X and Y according to which X has to Sell a tape recorder (which is selected) to Y after three months. On the next day of their contract Z has come to X and has insisted on selling the same tape recorder to him (Z). Here Z is promising to compensate X for any loss faced by X, due to selling the tape recorder to Y. X has agreed. Now the contract which has got formed between X and Z is called indemnity contract, where Z is indemnifier and X is indemnity holder.

Section 125 of Indian Contract Act 1872 defines the damages on the breach of contract of indemnity.

The definition is as follows:
The promisee in a contract of indemnity, acting within the scope of his authority, is entitled to recover from the promisor:
  • all damages which he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies;
  • all costs which he may be compelled to pay in any such suit if, in bringing or defending it, he did not contravene the orders of the promisor, and acted as it would have been prudent for him to act in the absence of any contract of indemnity, or if the promisor authorized him to bring or defend the suit;
  • all sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the promisor, and was one which it would have been prudent for the promisee to make in the absence of any contract of indemnity, or if the promisor authorized him to compromise the suit.
In common law Indemnity was established in the case of Adamson v Jarvis
The plaintiff an auctioneer sold certain cattle on the instruction of the defendant. It subsequently turned out that the livestock didn�t belong to the defendant, but to another person, who made the auctioneer liable and the auctioneer in turn sued the defendant for the loss he had thus suffered by acting on the defendant�s direction. The court laid down that the plaintiff having acted on the request of the defendant was entitled to assume that, if, what he did turned out to be wrongful, he would be indemnified by the defendant.

Thus Indemnity in means a promise to save a person harmless from the consequences of an act. The promise may be express or it may be implied from the circumstances of the case.

In the case of Osman Jamal And Sons Ltd. v. Gopal Purshottam
Plaintiff Company agreed to act as commission agent for the defendant firm for purchase and sale of �Hessian� and �Gunnies� and charge commission on all such purchases and the defendant firm agreed to indemnify the plaintiff against all losses in respect of such transactions. The plaintiff company purchased certain Hessian from one Maliram Ramjidas.

The defendant firm failed to pay for or take delivery of the Hessian. Then Maliram Ramjidas resoled it at lesser price and claimed the difference as damages from the plaintiff company. The plaintiff company went into liquidation and the liquidator filed a suit to recover the amount claimed by Maliram from the defendant firm under the indemnity. The defendant argued that in as much as the plaintiff had not yet paid any amount to Maliram in respect of their liability they were not entitled to maintain the suit under indemnity. It was held negative and decided in plaintiff�s favour with a direction that the amount when recovered from the defendant firm should be paid to Maliram Ramjidas.

The Law Commission of India in its 13th Report, 1958 on the Indian Contract Act, 1872, has recommended the amendment of Section 124. According to its recommendation, �The definition of the �Contract of Indemnity� in Section 124 he expanded to include cases of loss caused by events which may or may not depend upon the conduct of any person. It should also provide clearly that the promise may also be implied.�

Contract Of Guarantee

A contract of guarantee as per section 126 of the Indian contract Act 1872 is defined 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. 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.

The key fundamentals of a contract of guarantee are

  • A guarantee is a contract to answer for the payment of some debt, or the performance of some duty by a third person who is primarily liable for that payment or performance.
  • It is a collateral contract, which does not extinguish the original obligation for payment or performance. It is rendered null and void if the original obligation fails.
  • The liabilities of a guarantor in law depend upon those of the principal debtor, and when the principal's obligations cease the guarantor's do too; except in certain cases where the discharge of the principal debtor is by the operation of the law.

In some guarantees the consideration is entire. For example, in consideration for a lease being granted, the surety becomes answerable for the performance of the covenants of the lease. In other cases it is fragmentary or supplied from time to time, as where a guarantee is given to secure the balance of a running account at a bank, for goods supplied. When the consideration is entire, the guarantee runs on through the duration of the lease and is irrevocable. When the consideration is fragmentary, unless the guarantee stipulates to the contrary, the surety may at any time terminate his liability under the guarantee.

Guarantee contract includes three parties namely; Creditor, Principal Debtor and Surety. The person who is granting the loan, the person who is utilizing the amount of loan is principal debtor and the person who is giving guarantee is called surety or guarantor or favored debtor. In case of guarantee contract there will be two types of liabilities namely; Primary liability and secondary liability. Primary liability will be with principal debtor and Secondary liability goes to surety.

Example: Y is in need of Rs. 10000/-. Upon guarantee by Z, Y has got the amount from X. Here X, Y and Z are creditor, principal debtor and surety respectively.

The liability arises right from the beginning. The surety becomes liable when the principle debtor commits default in meeting the liability. Surety has the right to sue the third party (Principle Debtor) directly. The Law puts him in the position of Creditor. Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee.

The guarantor need not personally derive any benefit from the guarantee. The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract. The creditor can straightway proceed against the guarantor without first proceeding against the principal debtor. The liability of the surety can never be greater than that of the principal debtor. The surety can however may restrict his liability to part of the Principal debtor's liability by contract. Surety's liability is distinct and separate.

In P.J Rajappan v Associate Industries (P) Ltd, it was held by the Kerala High Court that since an oral guarantee is also valid, a person who otherwise appeared to be a guarantor was held liable though his signature did not appeared on the guarantee papers.

In Punjab National Bank Limited vs Bikram Cotton Mills & Anr it was held that though, the bond, it is true, did not expressly recite that the Company was the principal debtor; it is also true and the Company did not execute the bond. But a contract of guarantee may be wholly written, may be wholly oral, or may be partly written and partly oral.

The following are the major differences between indemnity and guarantee:
  • In the contract of indemnity, one party makes a promise to the other that he will compensate for any loss occurred to the other party because of the act of the promisor or any other person. In the contract of guarantee, one party makes a promise to the other party that he will perform the obligation or pay for the liability, in the case of default by a third party
  • Indemnity is defined in Section 124 of Indian Contract Act, 1872, while in Section 126 Guarantee is defined.
  • In indemnity, there are two parties, indemnifier and indemnified but in the contract of guarantee, there are three parties i.e. debtor, creditor, and surety.
  • The liability of the indemnifier in the contract of indemnity is primary whereas if we talk about guarantee the liability of the surety is secondary because the primary liability is of the debtor.
  • The purpose of the contract of indemnity is to save the other party from suffering loss. However, in the case of a contract of guarantee, the aim is to assure the creditor that either the contract will be performed, or liability will be discharged.
  • In the contract of indemnity, the liability arises when the contingency occurs while in the contract of guarantee, the liability already exists.

  • Contracts of guarantee and contracts of indemnity perform the similar role of providing security to creditors in case a third party fails to perform his duty in a contract. Thus they play a very vital role in protecting commercial activities from losses by acting as safeguards in case of anyone�s default, which promotes risk taking and entrepreneurship in businesses. They are protective security covers in both the instances wherein parties have certain rights and duties they are supposed to perform in order to reap the benefits of the provisions of the agreement.
  • Neither contract of indemnity nor contract of guarantee is dependent upon the Latin principle of uberrima fidei. The term is used for describing bona fide disclosure of all associated facts and circumstances, primarily in insurance laws. However in the context of indemnity and guarantee it is perfectly fine if parties do or do not reveal all the events as they are not obligated by law to do so. This has been explained in the cases of British India General Insurance Co. Ltd., (for contracts of indemnity) and Hukumchand Insurance Co. Ltd. V. Bank of Baroda, (for contracts of guarantee).

Thus, contracts of indemnity and contracts of guarantee can be termed as an instance of being objects with same purpose but different features. In their technical differences we can observe two separate provisions within the same act. However on closer observation they are meant for the same purpose of ensuring parties are not duped in commercial transactions.
Though the preference of either of the options is very individualistic and depends on the needs and conditions of the parties. Overall these are provisions of law that help business activities take place and bring parties to the same level of bargaining power.

In a Contract of Indemnity indemnifier's liability is primary. In a Contract of Guarantee liability of a surety is secondary, in a Contract of Indemnity indemnifier has no rights against a third party after performing obligations. His rights against a third party can arise only if such a right is assigned to him by the Indemnified in his favour. In a Contract of Guarantee once the surety discharges the liability of the principal debtor he steps into the shoe of the creditor and can sue the principal debtor.

To study about guarantee & indemnity, study about some cases based on this, enquire the essential elements of it, evaluate the differences between both of them and look into similarities if any.

Research Methodology
Doctrinal Research:
In this we go through literature available on the subject matter and thereon propound conclusion based on our study.

Written By: Rohit Raman - Kiit School Of Law

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