What are Contracts Of Indemnity and Guarantee?

Contracts of indemnity and guarantee are special agreements covered by the Indian Contract Act of 1872. In a contract of indemnity, one person promises to compensate another for losses. In a contract of guarantee, three people are involved: a third person steps in to pay the debt if the debtor fails. Both types of contracts help protect creditors when a third party does not fulfil its obligations. Chapter VIII of the Act provides the rules for these contracts in India.

Contract of Indemnity

"Indemnity" comes from a Latin word meaning "without loss." It's an agreement where one person promises to protect another from losses caused by the actions of the promisor or someone else. According to Section 124 of the Indian Contract Act, a contract of indemnity involves:

Key Parties:

• Indemnifier: The person who promises to pay for the losses.

• Indemnified: The person who is protected from loss.

Essentials of a Contract of Indemnity:

• Valid Contract: Must meet all the requirements of a valid contract.

• Protection Against Loss: It is specifically meant to cover losses.

• Two Parties: Only the indemnifier and the indemnified are involved.

• Single Agreement: There's only one contract between the parties.

• Express or Implied: Can be oral, written, or understood from actions.

Types of Indemnity:

• Express Indemnity: A written contract that clearly outlines all terms. Common in insurance, construction, and agency contracts.

• Implied Indemnity: Not written but understood from the actions of the parties, like a boss compensating an employee for losses while following instructions.

Who is an Indemnity Holder?

An indemnity holder is a party in a contract of indemnity who is entitled to compensation or protection from losses or damages caused by a specific event or circumstance. The indemnifier is the party who agrees to compensate the indemnity holder for any losses they may incur. 

Rights of an Indemnity Holder: Section 125 says an indemnity holder can recover:

• Damages they were required to pay in legal cases.

• Legal costs if they acted within the promisor's approval or reasonably.

• Any sums paid in settlements if made reasonably or with the promisor's consent.

The promisee in a contract of indemnity, acting within the scope of his authority, is entitled to recover from the promisor—

1. all damages which he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies;

2. 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;

3. 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.

Rights of the Indemnifier: After paying the indemnified, the indemnifier can use any methods available to minimize their losses. They are liable only when a loss occurs or is certain to happen.

Key Cases:

• Gajanan Moreshwar vs Moreshwar Madan (1942): The Indemnifier must act once the indemnified has absolute liability.

• Lala Shanti Swarup vs Munshi Singh & Others (1967): Implied indemnity happens when the indemnity is actually given.

Contract of Guarantee 

A contract of guarantee is an agreement where a third party (the surety) assures a creditor that they will pay if the debtor defaults. Defined in Section 126, this contract involves:

Parties Involved:

• Surety: The person who guarantees the debt.

• Principal Debtor: The person whose debt is guaranteed.

• Creditor: The person to whom the guarantee is given.

Essentials of a Contract of Guarantee:

• It can be oral or written.

• Includes three contracts: debtor to the creditor, the creditor to the surety, and debtor to the surety.

• Requires some consideration for the debtor's benefit.

• There must be a principal debtor

• Consent of the surety must not be obtained by misrepresentation/ concealment (sec 142 & 143)

Liability of Surety: Section 128 states that the surety's liability is the same as the principal debtor's and can be enforced immediately if the debtor defaults. However, the surety's obligation is secondary. 

Rights of the Surety:

• Against Debtor: Rights include recovery, notice, and indemnity.

• Against Creditor: Rights include demand for securities and set-off.

• Against Co-sureties: Rights to contribution and shared security.

The two main types of guarantees are specific and continuing guarantees:

Specific Guarantee: A guarantee for a single debt or transaction that ends when the debt is paid or the promise is fulfilled.

Continuing Guarantee: A continuing guarantee covers multiple transactions until it is revoked. Even after revocation, the surety is liable for transactions that occurred before.

Continuing guarantees can be further classified into two types: prospective and retrospective:

Prospective guarantee: A guarantee for future debts

Retrospective guarantee: A guarantee for existing debts 

A surety can revoke a continuing guarantee for future transactions by giving notice to the creditors. However, the surety's liability for transactions entered into before the revocation is not reduced. 

Examples

Specific Guarantee: A bookseller supplies books to a customer on the condition that the customer's friend will pay if the customer doesn't. The friend's liability ends when the customer pays for the books.

Continuing Guarantee: A landlord employs an estate manager to collect rent from tenants and pay it to the landlord. A guarantor promises to make up for any defaults the estate manager makes. 

A continuing guarantee can be revoked by the surety at any time for future transactions. However, the surety's liability for transactions that happened before the revocation remains the same. 

The Extent of Surety's Liability

Section 128 of the Indian Contract Act of 1872 states that a surety's liability is the same as the principal debtor's unless the contract states otherwise. This means that the surety is liable to pay the debt as soon as the principal debtor defaults, and a creditor can sue the surety directly without first suing the principal debtor. However, the surety's liability is secondary, and the principal debtor's liability is primary. 

The surety's liability is limited to the express terms of the contract. If the contract specifies a penalty for breach, the surety is not liable for more than the penalty. 

Discharge of Surety from Liability

A surety can be released from its obligation when its responsibility to fulfil the promise in case of the principal debtor's default ceases. The main scenarios of discharge include revocation, conduct of parties, and invalidation of the contract.

1. Discharge by Revocation

• Revocation by Notice (Section 130): Surety can revoke a continuing guarantee for future transactions by giving notice to the creditor.

• Revocation by Death (Section 131): Upon a surety's death, their liability ceases for future transactions.

2. Discharge by Conduct of Parties

• Variance in Contract Terms (Section 133): A material change in the contract without the surety's consent discharges the surety.

• Release of Principal Debtor (Section 134): Discharge of the principal debtor's liability also discharges the surety.

• Compounding with Debtor (Section 135): New agreements or promises between creditor and debtor, without surety's consent, discharge the surety.

• Impairing Surety's Remedies (Section 139): Creditor's actions that impair the surety's rights against the debtor discharge the surety.

• Loss of Security (Section 141): If the creditor loses the security that was meant to protect the surety, the surety's liability is discharged to that extent.

3. Discharge by Invalidation of the Contract

• Misrepresentation (Section 142): Guarantees obtained through false information release the surety from liability.

• Concealment (Section 143): Non-disclosure of essential facts by the creditor discharges the surety.

• Failure of Co-Surety (Section 144): If a required co-surety fails to join, the guarantee is invalid, releasing the other sureties.

Differences Between Contract of Indemnity and Contract of Guarantee

Additional Considerations

Is an Insurance Contract a Contract of Indemnity?
Insurance contracts are generally considered contracts of indemnity, as the insurer promises to compensate the insured for specific losses or damages. However, life insurance is not considered a contract of indemnity since it involves a fixed sum paid on the occurrence of an event rather than compensation for loss.

When Can an Indemnifier Be Made Liable?
An indemnifier can be asked to indemnify even before the indemnity-holder has actually suffered a loss, depending on the terms of the contract. This issue was discussed in State Bank of India v. Mula Sahakari Sakhar Karkhana Ltd. (2007), where the court allowed indemnification before actual loss based on the terms agreed upon.

Conclusion

Though contracts of indemnity and guarantee both provide protection against loss, they function differently. Understanding these distinctions is key to determining the appropriate contract for any given situation. Each case must be reviewed carefully to decide whether it is a contract of indemnity or guarantee.