Indemnity & Guarantee Act
Introduction to Indian Contract Act, 1872
The Indian Contract Act, 1872 was enacted by the Imperial Legislative Council on 25 April 1872 and came into force on 1 September 1872.
The Act here is based on the principle of pacta sunt servanda — meaning “agreements must be kept.”
Section 2(h) of the Act defines a contract as “an agreement enforceable by law.”
According to Section 2(e), every promise and every set of promises forming consideration for each other is called an agreement.
When such an agreement satisfies the conditions of validity, it becomes a contract.
Indemnity
Section 124 of the Indian Contract Act, 1872 states that; a contract by which one party promises to save the other from loss caused to him by the conduct of any other person, is called a “Contract of Indemnity”.
Illustration
“A” contracts to indemnify “B” against the consequences of any proceedings which “C” may take against “B” in respect of certain sum of 200 rupees.
Rights of an Indemnity Holder
Under Section 125 of the Indian Contract Act, 1872, 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 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 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 promise to make in the absence of any contract of indemnity, or if the promisor authorized him to compromise the suit.
Where Does Indemnity Apply
Indemnity applies wherever risk needs to be shifted from one party to another.
It’s essentially a legal safety net, ensuring that if one party suffers a loss because of another’s actions, the loss will be compensated.
Situations Where Indemnity Applies
- Contract & Commercial Transactions:
- Insurance contracts are classic examples of indemnity;
- Business contracts often include indemnity clauses to protect against losses from breach, negligence, or third-party claims.
- Employment & Agency:
- An employer may indemnify an employee for actions taken in good faith while performing duties.
- Litigation & Legal Proceedings:
- Indemnity clauses are common in settlement agreements, where one party agrees to bear liability if future claims arise.
- Court enforces indemnity provisions to ensure fairness when one party suffers due to another’s conduct.
- Property & Lease Agreements:
- Landlords and tenants often use indemnity clauses to cover damages, accidents, or third-party claims arising from property use.
Purpose of Indemnity in Indian Contract Act, 1872
The core purpose of indemnity in the Indian Contract Act, 1872 are:
Risk Protection
Indemnity acts as a bodyguard. If one party incurs a loss due to another’s action, the indemnifier promises to cover that loss.
Encouraging Commercial Confidence
By assuring parties that they will be compensated for potential risks, indemnity promotes trust in business transactions and contracts.
Fairness in Agreements
It prevents one party from being unfairly burdened with losses that arise from circumstances beyond their control.
Legal Certainty
Section 124 of the Act defines indemnity clearly, ensuring that parties know their rights and obligations when entering into contracts.
Case Laws on Indemnity
Gajanan Moreshwar v. Moreshwar Madan (1942, Bombay High Court)
Facts of the Case
- In 1934, the plaintiff, Gajanan Moreshwar Parelkar, entered into a lease agreement with the Bombay Municipal Corporation for a plot of land in the Dadar–Matunga Estate for 999 years.
- At the request of the defendant, Moreshwar Madan Mantri, the plaintiff agreed to transfer the benefit of the lease to him.
- The defendant took possession and began constructing a building on the land.
- However, the plaintiff remained liable to the corporation for ground rent and other obligations under the lease.
- To protect himself, the plaintiff sought indemnity from the defendant for any liabilities arising from the transfer and construction.
- When disputes arose, the plaintiff filed a suit to enforce indemnity against the defendant.
Plaintiff’s Arguments
- The plaintiff argued that since he had transferred possession and the benefit of the lease to the defendant, the defendant should indemnify him against liabilities owed to the corporation.
- He contended that indemnity should apply even before he actually paid damages or suffered loss, as his liability to the corporation was already certain.
Defendant’s Arguments
- The defendant claimed that indemnity could only be enforced after the plaintiff actually suffered loss or paid damages.
- He argued that until the plaintiff had discharged the liability, no indemnity could be claimed under Section 124 of the Contract Act.
Judgment of the Case
Justice Chagla of the Bombay High Court delivered the ruling. The Court held that indemnity is not limited to reimbursement after actual loss.
- If liability has become absolute, the indemnity-holder can compel the indemnifier to discharge it, even before making payment.
- The Court emphasized that the purpose of indemnity is protection, not mere compensation after damage.
- Restricting indemnity to post-loss situations would defeat its purpose.
Thus, the defendant was held liable to indemnify the plaintiff against obligations to the corporation.
Osman Jamal & Sons Ltd. v. Gopal Purshottam (1928, Calcutta High Court)
Facts of the Case
- Osman Jamal & Sons Ltd. entered into a commercial arrangement with Gopal Purshottam involving the supply of goods.
- During the course of the transaction, disputes arose regarding losses suffered by Osman Jamal & Sons due to the conduct of third parties.
- The plaintiff sought to enforce indemnity against the defendants, arguing that the defendants had promised to protect them from such losses.
- The central issue was whether indemnity under Section 124 of the Indian Contract Act, 1872 was limited only to losses caused directly by the promisor, or whether it extended to losses caused by third parties as well.
Plaintiff’s Arguments
- The plaintiffs argued that indemnity should cover losses caused not only by the promisor’s conduct but also by third parties.
- They contended that the purpose of indemnity is protection, and restricting it to the promisor’s own acts would defeat its commercial utility.
- They relied on equitable principles recognised in English law, where indemnity is interpreted broadly to include third-party actions.
Defendant’s Arguments
- The defendants argued that Section 124 of the Contract Act defines indemnity narrowly, covering only losses caused by the promisor or by another person at the promisor’s instance.
- They claimed that losses caused by independent third parties were outside the scope of indemnity under the Act.
- Therefore, they were not liable to compensate the plaintiffs for such losses.
Judgment of the Case
The Calcutta High Court took a broader view of indemnity.
- It held that indemnity contracts are meant to protect the indemnity-holder against losses, whether caused by the promisor or by third parties.
- The Court emphasized that the Indian Contract Act should be interpreted in line with equitable principles, ensuring that indemnity serves its protective purpose.
Thus, the defendants were held liable to indemnify the plaintiffs for losses suffered due to third-party actions.
What Is Guarantee?
Under Section 126 of the Indian Contract Act, 1872, a contract of guarantee defined as;
“A contract to perform the promise, or discharge the liability, of a third person in case of his default”.
So, it’s essentially a promise to stand surety for someone else.
Parties to a Contract of Guarantee
There are always three parties involved:
| Party | Description |
|---|---|
| Principal Debtor | The person who has taken a loan or obligation. |
| Creditor | The person to whom the obligation is owed. |
| Surety | The person who gives the guarantee, promising to discharge the debtor’s liability if they default. |
Example: If A borrows money from B, and C promises to pay B, if A defaults, C is the surety.
Essentials of a Valid Guarantee
- Agreement of all Three Parties:
(Debtor, creditor, surety). - Consideration:
Anything done for the benefit of the principal debtor is sufficient consideration for the surety. - Consent:
Must be free (no coercion, fraud or misrepresentation). - Written or Oral:
A guarantee may be oral or written.
Rights of the Surety
There are multiple rights of a surety, which are;
- Right of Subrogation:
After paying the creditor, the surety steps into the shoes of the creditors and can recover from the principal debtor. - Right to Indemnity:
The surety can claim indemnity from the debtor for any amount paid under the guarantee. - Right to Benefit of Securities:
If the creditor holds securities against the debtor, the surety is entitled to them once he pays off the debt.
Discharge of Surety
A surety can be discharged in several ways:
- By revocation of guarantee.
- By variance in contract terms without surety’s consent.
- By release or discharge of the principal debtor.
- By creditor’s act impairing surety’s eventual remedy.
Where Does Guarantee Apply?
Guarantee applies in situations such as;
Banking & Loans
When a person takes a loan, bank often require a guarantor. If the borrower defaults, the guarantor (surety) must repay the loan.
Business Contracts
In supply contracts, a guarantor may promise to pay if the buyer fails to pay the seller. Guarantees are common in construction projects, where contractors provide performance guarantees.
Employment Bonds
Employers sometimes require a surety for employees who handle sensitive roles. The surety guarantees compensation if the employee commits fraud or negligence.
Lease & Property Agreements
Landlords may ask for a guarantor to ensure rent payment if the tenant defaults. Guarantees also apply in property sales where payment is staggered.
Government Contracts
Contractors bidding for government projects often provide a guarantee to ensure performance and compliance.
Purpose of Guarantee in Indian Contract Act, 1872
Core purposes of guarantee are;
- Risk Management for Creditors:
Guarantees reduce the risk of default by giving creditors an additional party to rely on. This makes creditors more willing to extend loans, credits, or enter into contracts. - Facilitating Commerce and Credit:
Guarantees encourage trade and business by providing confidence that obligations will be met. Banks, landlords, and businesses often rely on guarantees to secure repayment or performance. - Ensuring Performance of Contracts:
In performance guarantees, the surety assures that the contractor will complete the work. If the contractor defaults, the surety compensates the creditor. - Legal Protection for Creditors:
The Act gives creditors enforceable rights against the surety, ensuring they are not left uncompensated if the debtor defaults. - Trust Building in Transactions:
Guarantees build trust between parties, especially in high-value or long-term contracts, by providing a legal safety net.
Case Law on Guarantee under Indian Contract Act, 1872
Cases have clarified the scope of Guarantee under the Indian Contract Act, 1872, such as;
Bank of Bihar v. Damodar Prasad (1969, Supreme Court)
Facts of the Case
- The Bank of Bihar advanced a loan to Damodar Prasad (principal debtor).
- To secure repayment, Dr. Paras Nath Sinha acted as a surety, executing a guarantee in favor of the bank.
- The debtor defaulted, and the bank sued both the debtor and the surety for recovery.
- The trial court decreed repayment but directed the bank to first exhaust remedies against the debtor before proceeding against the surety.
- The bank appealed, arguing that such a condition was contrary to the law of guarantee.
Arguments
Appellant’s Argument (Bank of Bihar)
- Under Section 128, the liability of the surety is co-extensive with that of the principal debtor.
- The creditor has the right to sue the surety directly without first suing the debtor.
- The trial court’s direction was inconsistent with the Contract Act.
Respondents’ Argument (Damodar Prasad & Surety)
- The surety argued that his liability was secondary and conditional.
- He claimed the bank must first attempt recovery from the debtor before enforcing the guarantee against him.
- He relied on equitable principles that the debtor should be pursued first.
Judgement of the Case
The Supreme Court overturned the lower court’s direction; it held that the surety’s liability is immediate and co-extensive with that of the principal debtor unless the contract specifies otherwise.
The creditor is not bound to exhaust remedies against the debtor before suing the surety; any condition requiring the creditor to proceed against the debtor first is invalid.
Difference Between Indemnity and Guarantee in Indian Contract Act, 1872
| Aspect | Indemnity | Guarantee |
|---|---|---|
| Definition | A contract where one party promises to save the other from loss caused by the promisor or a third party (Sec. 124). | A contract to perform the promise or discharge the liability of a third person in case of default (Sec. 126). |
| Parties Involved | Two parties: Indemnifier and Indemnity-holder. | Three parties: Principal Debtor, Creditor, and Surety. |
| Nature of Liability | Primary liability rests on the indemnifier. | Surety’s liability is secondary; arises only if the principal debtor defaults. |
| Purpose | To protect against losses and shift risk. | To provide security to the creditor for repayment or performance. |
| Consideration | Consideration flows between indemnifier and indemnity-holder. | Consideration flows from creditor to principal debtor; sufficient for surety. |
| Scope | Covers losses due to promisor’s conduct or third-party actions. | Covers liability of debtor only; surety steps in if debtor fails. |
| Example | Insurance contracts, agency indemnity, commercial indemnity clauses. | Loan guarantees, performance bonds, bank guarantees. |
| Legal Principle | Indemnity is about protection before or after loss. | Guarantee is about assurance of performance or payment. |
Conclusion
Indemnity (Sec. 124)
- Purpose: To protect a party against losses caused by the promisor or third parties.
- Nature: A two-party contract (indemnifier and indemnity-holder).
- Principle: Liability is primary and arises once loss or liability becomes certain (Gajanan Moreshwar v. Moreshwar Madan).
- Application: Insurance contracts, agency relationships, commercial indemnity clauses.
Guarantee (Sec. 126)
- Purpose: To secure performance or repayment by providing a surety if the debtor defaults.
- Nature: A three-party contract (principal debtor, creditor, surety).
- Principle: Liability of the surety is co-extensive with the debtor (Bank of Bihar v. Damodar Prasad).
- Application: Loans, bank guarantees, performance bonds, employment bonds.
Together, they form the backbone of Commercial Confidence and Contractual Fairness in Indian Law, ensuring that parties are safeguarded against risks and defaults.
Bibliography
- Indian Contract Act, 1872. Bare Act with latest amendments. Government of India.
- Gajanan Moreshwar v. Moreshwar Madan, AIR 1942 Bom 302 (Bombay High Court).
- Osman Jamal & Sons Ltd. v. Gopal Purshottam, AIR 1928 Cal 362 (Calcutta High Court).
- Bank of Bihar v. Damodar Prasad, AIR 1969 SC 297 (Supreme Court of India).
- Indian Kanoon. (n.d.). Case law database. Retrieved from https://indiankanoon.org
- Lawful Legal. (n.d.). Case summaries and legal analysis. Retrieved from https://lawfullegal.in
- Legal Bites. (n.d.). Indian Contract Act notes and case law. Retrieved from https://www.legalbites.in
- iPleaders. (n.d.). Indemnity and Guarantee under the Contract Act. Retrieved from https://blog.ipleaders.in
