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This article is authored by Nidhi Bajaj, of Guru Nanak Dev University, Punjab. This article will take through the various aspects that distinguish a contract of indemnity from a contract of guarantee. 

This article has been published by Sneha Mahawar.

Introduction

Contract of guarantee and contract of indemnity perform similar commercial functions in providing compensation to the creditor for failure of a third party to perform their obligation. However, there are some major differences between the two. In this article, the author will talk about the differences between the contract of indemnity and contract of guarantee along with relevant legal provisions of the Indian Contract Act, 1872.

Meaning

Indemnity

The dictionary meaning of the term ‘indemnity’ is protection against future loss. Indemnity is the protection against loss in the form of a promise to pay for loss of money, goods, etc. It is security against or compensation for loss incurred.

According to Halsbury, indemnity refers to an express or implied contract that protects a person who has entered or is going to enter into a contract or incur any other duty from loss, irrespective of the default incurred by a third person.

As per the Oxford Dictionary of Law, indemnity is an agreement by one person to pay to another, a sum that is owed or which may be owed, to him by a third person. It is not conditional on the third person defaulting on the payment.

Guarantee

Guarantee enables a person to get a loan, to get goods on credit, etc. Guarantee means to give surety or assume responsibility. It is an agreement to answer for the debt of another in case he makes default. 

The Oxford Dictionary of Law defines guarantee as a secondary agreement in which a person (guarantor) is liable for a debt or default of another (principal debtor) who is the party primarily liable for the debt. A guarantor who has paid out on his guarantee has a right to be indemnified by the principal debtor.

Contract of Indemnity

Chapter VIII of the Indian Contract Act, 1872 contains the legal provisions governing a contract of indemnity and a contract of guarantee in India.

Section 124 : Contract of indemnity

Section 124 of the Act defines a contract of indemnity as a contract wherein 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. 

A contract of indemnity can provide protection against loss caused—

  1. By the conduct of promisor, or
  2. By the conduct of any other person.

Under Indian law, a contract of indemnity can only provide for losses caused by human agency whereas in England, it includes a promise to save the other person from loss caused whether by acts of promisor or of any other person or any other event like fire, accident, etc. 

Indemnifier

The person who makes a promise to indemnify against the loss or to make good the loss (promisor) is called an indemnifier.

Indemnity-holder

The person in whose favour such a promise to indemnify is made (promisee) is called indemnity-holder.

For example, Anil enters into a contract with Swapnil to indemnify him against the consequences of any proceedings which Mrinal may initiate against Swapnil in respect of a certain sum of Rs. 2000/-. In this contract, Anil is the indemnifier and Swapnil is the indemnity-holder.

Main features

  1. It involves two parties i.e. promisor being the indemnifier and promisee being the indemnity holder.
  2. Object of the contract of indemnity is to protect from a loss.
  3. As per the Indian Contract Act, the contract of indemnity must be to indemnify against a loss caused by any act or conduct of the promisor himself or by the conduct of any other person.
  4. It is not contingent on the default of some third person.

What are the rights of an indemnity holder

Section 125 of the Act covers ‘Rights of indemnity-holder when sued’. This Section provides for the right of the indemnity holder to recover the damages and costs that he may have been compelled to pay in a suit filed against him, in a case where the indemnity-holder has promised such indemnity, i.e., where a contract of indemnity to that effect exists. The rights of the indemnity holder are-

  1. Right to recover from the promisor, the damages that he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies.
  2. Right to recover from the promisor all the costs that he may be compelled to pay in any suit, provided—
  1. that he did not contravene any of the orders of the promisor in filing or defending such suit, and
  2. that he acted in a manner as would have been prudent for him to act in the absence of any such contract of indemnity, or 
  3. that the promisor had authorised him to file or defend such a suit.
  4. Right to recover from the promisor all such sums that he paid under the terms of any compromise of any such suit, provided-
  1. the compromise was not contrary to orders of the promisor, and
  2. such compromise is one as the promisee would have made while acting in a prudent manner even if such contract of indemnity did not exist, or
  3. that the promisor had authorised the promisee to compromise the suit.

When liability commences

A pertinent question that arises with regard to a contract of indemnity is, ‘when does the liability to indemnify commence/arise’. Originally, under English law, the rule was that the indemnity holder cannot recover the amount unless he had suffered actual loss i.e. ‘you must be damnified before you can claim to be indemnified’. However, this position of the law changed. In Richardson Re, Ex parte the Governors of St. Thomas’s Hospital (1911), it was held that indemnity is not necessarily given by repayment after payment, but it requires that the party to be indemnified shall never have to pay. This principle was followed by the Calcutta High Court in Osman Jamal & Sons Ltd. v. Gopal Purshottam (1928). 

As far as Indian position is concerned, the Bombay High Court in Gajanan Moreshwar v. Moreshwar Madan (1942), held that the equitable principle applicable in England shall be applicable in India too and therefore, where the indemnity holder has incurred a liability and that liability is absolute, he is entitled to call upon the indemnifier to save him from that liability and pay it off. 

Contract of guarantee

Section 126 of the Indian Contract Act defines the term contract of guarantee, surety, principal debtor and creditor. The purpose behind a contract of guarantee is to give additional security to the creditor that his money will be paid back by the surety if the debtor makes a default.

Contract of guarantee : Section 126

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 contract of guarantee has three parties involved, namely, the principal debtor, the creditor, and the surety.

Surety

The person who gives the guarantee is called the Surety. The liability of the surety is secondary, i.e., he has to pay only if the principal debtor fails to discharge his obligation to pay.

Principal debtor

The person in respect of whose default the guarantee is given is the Principal debtor. The principal debtor has the primary liability to pay.

Creditor

The person to whom the guarantee is given is called the creditor.

For example, Anil orders certain goods of the value of Rs. 2000/- from Swapnil on credit. Mrinal guarantees that, if Anil will not pay for the goods, she will. This is a contract of guarantee. Here, Rs. 2000 is the principal debt, Anil is the principal debtor, Mrinal is surety and Swapnil is the creditor.

Main features 

  1. A contract of guarantee may be oral or written: According to Section 126, a contract of guarantee may be oral or in writing. However, under English law, for a contract of guarantee to be valid, it has to be in writing and signed. 
  2. There must be a principal debt: The existence of a principal debt is necessary for a contract of guarantee. If there is no principal debt, then there is no existing obligation to pay. As a result of the absence of such obligation to pay, there cannot be any promise/guarantee. If there is a promise to pay for compensating some loss without there being any principal debt, such a contract will become a contract of indemnity. 
  3. Contract of guarantee is tripartite in nature: There being three parties involved in a contract of guarantee, three contracts take place in a contract of guarantee-
  • The principal debtor promises to make payment to the creditor.
  • Surety undertakes to pay the creditor in event of default of payment by the principal debtor.
  • An implied promise by the principal debtor in favour of surety to indemnify him in case he discharges the liability of the principal debtor.
  1. There is a promise to pay upon default of payment by the debtor: In a contract of guarantee, the surety’s promise to pay is dependent on the default of the debtor i.e. surety pays only when the debtor defaults. 
  2. The consideration is the benefit to the debtor: As per Section 127, anything done or promise made for the benefit of the principal debtor may be a sufficient consideration to the surety for giving the guarantee. For example, Anil sells and delivers certain goods worth Rs. 5000 to Swapnil. Mrinal afterward requests Anil to refrain from suing Swapnil for a year and promises that if he does so, she will pay for the goods in default of payment by Swapnil. Anil agrees. The forbearance by Anil to sue is of benefit to Swapnil (the debtor) and that constitutes sufficient consideration for Mrinal (surety) for giving the guarantee.
  3. The consent of the surety should not have been obtained by misrepresentation or concealment of material facts: Section 142 of the ICA, 1872 provides that a guarantee obtained using misrepresentation made by the creditor or with his knowledge or assent, concerning a material part of the transaction is invalid.

Section 143 provides that a guarantee obtained by the creditor by keeping silent as to some material circumstance is also invalid.

Difference between contract of indemnity and contract of guarantee

BASIS OF DISTINCTIONCONTRACT OF INDEMNITYCONTRACT OF GUARANTEE
Parties There are two parties in a contract of indemnity, namely the indemnifier and the indemnity holder.There are three parties in a contract of guarantee, namely the principal debtor, the creditor, and the surety. 
No. of contractsIt consists of only one contract between the indemnifier and the indemnity holder. The indemnifier promises to indemnify the indemnified/indemnity holder in event of a certain loss.It consists of three contracts-A contract between principal debtor and creditor wherein the debtor promises to perform his obligation/make payment. The contract between surety and creditor wherein the surety promises to perform the aforesaid obligation/make the payment if the principal debtor makes a default. An implied contract between the surety and the principal debtor. The principal debtor bounds himself to indemnify the surety for the sum that he has paid under the guarantee undertaken by him.
3. Nature of liabilityThe liability of the indemnifier is primary. The liability in a contract of indemnity is contingent in the sense that it may or may not arise.The liability of the surety is a secondary one, i.e., his obligation to pay arises only when the principal debtor defaults. Liability in a contract of guarantee is continuing in the sense that once the guarantee has been acted upon, the liability of the surety automatically arises. However, the said liability remains in suspended animation until the debtor makes default.
Default of third personThe liability of an indemnifier is not conditional on the default of somebody else. For example, Mrinal promises the shopkeeper to pay, by telling him that, “Let Anil have the goods, I will be your paymaster”. This is a contract of indemnity as the promise to pay by Mrinal is not conditional on default by Anil.Liability of surety is conditional on the default of the principal debtor. For example, Anil buys goods from a seller and Mrinal tells the seller that if Anil doesn’t pay you, I will. This is a contract of guarantee. Thus, the liability of Mrinal is conditional on non-payment by Anil.
Principal debtNo requirement of the principal debt.Principal debt is necessary. (refer to the previous example)
Whether subsequent recovery is possibleOnce the indemnifier indemnifies the indemnity holder, he cannot recover that amount from anybody else.After the surety has made the payment, he steps into the shoes of the creditor and can recover the sums paid by him from the principal debtor.
Whether a contract has to be in writing or can be oral as well In India, contracts of indemnity may be either oral or written. In India, a contract of guarantee may be either oral or written. 

Conclusion

Both the contract of indemnity and contract of guarantee are similar in the sense that they provide protection against loss. However, as mentioned above, there is an important distinction between the two. Whether a contract is a contract of indemnity or a contract of guarantee is a question of construction in each case. One of the ways to identify such a contract might be the description of the agreement as to whether it is named as a contract of guarantee or indemnity and if those terms are mentioned in the contract a few times or more. However, that cannot be considered conclusive enough. Another way might be to see if under the contract, the liability of a person exists irrespective of the default of the principal debtor or where such liability is for a greater amount than the amount payable by principal debtor. In that case, the contract may be construed as a contract of indemnity. Thus, it will depend on a case to case basis and while analysing the facts/agreement, one must keep in mind the relevant points of distinction between the two concepts.

References


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