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How to Protect Yourself: Understanding Indemnity and Guarantee Contracts

Contracts of indemnity and guarantee are a part of special contracts designed to offer security or compensation against potential losses. However, some distinct differences exist between the two which we will understand as we continue our discussion.

Chapter VIII of The Indian Contract Act, 1872 lays down the provisions related to contracts of indemnity and guarantee.

Contract of Indemnity
According to the dictionary meaning, indemnity is protection against loss, especially in the form of a promise to pay.

According to Section 124 of the Indian Contract Act, 1872, a contract by which one party promises to save the other from loss caused to him by the contract of the promisor himself or by the conduct of any other person, is called a "contract of indemnity".

For instance, A contracts to indemnify B against the consequences of any proceedings that C may take against B in respect of a certain sum of Rs.200. This is a contract of indemnity.

Based on this provision, a fundamental aspect of the contract of indemnity is that one party promises to save the other from losses solely under the following situations:
  1. when the loss is caused by the conduct of the promisor himself; or
  2. when the loss is caused by the conduct of any other person.
Therefore, the definition covers those cases where the losses are caused by human agency only and not the ones which do not or may not depend upon the conduct of the indemnifier or any other person.

Thus, a contract of insurance does not come within the purview of section 124.

In United India Insurance Company v. M/s. Aman Singh Munshilal[1], the cover note stipulated delivery to the consigner. Moreover, on its way to the destination, the goods were to be stored in a godown and thereafter to be carried to the destination. While the goods were in the godown, the goods were destroyed by fire. It was held that the goods were destroyed during transit, and the insurer was liable as per the insurance contract.

Contract of Guarantee
According to Section 126 of the Indian Contract Act, 1872, 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".

The section further provides that a guarantee may be either oral or written.

For instance, A takes a loan from a bank with a commitment to repay the borrowed amount. Additionally, B makes a promise to the bank ensuring that if A defaults on the payment of the loan then B will assume the responsibility for repayment.

In this case, A is a principal debtor, who undertakes to repay the loan, B is the surety who undertakes to perform the same duty in case there is a default on the part of A and the bank is the creditor in whose favor the promise has been made.

Hence it is clear that in every contract of guarantee, there are the following three contracts between the three parties:
  1. the principal debtor himself makes a promise in favor of the creditor to perform a promise.
  2. the surety undertakes to be liable to the creditor if the principal debtor makes a default.
  3. an implied promise by the principal debtor to indemnify the surety if the surety has to discharge the liability in case of default on the part of the principal debtor.
The main object of a contract of guarantee is to provide additional security to the creditor and the surety's liability is secondary.

'In the event of a decree in favor of the creditor against the principal borrower, the wings of the decree can also be extended against the sureties as their liability is coextensive with the principal debtor'[2].

Main features of Contract of Guarantee:
The contract may be either oral or in writing: Section 126 of the act specifically provides that a contract of guarantee may be either oral or in writing. Thus, such a contract is valid even if it is not written. However, it should be expressed (not implied) and must be entered into in the presence of all three parties.

There should be a principal debt: A contract of guarantee pre-supposes a principal debt or an obligation to be discharged by the principal debtor. The surety undertakes to be liable only if the principal debtor fails to discharge his obligation.

Benefit to the principal debtor is sufficient consideration: Section 127 of the act provides that 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.

For instance, B requests A to sell and deliver to him the goods on credit. A agrees to do so, provided C will guarantee the payment of the price of the goods. C promises to guarantee the payment in consideration of A's promise to deliver the goods. Here, the basis of promise by the surety is a sale of goods on credit to the principal debtor. This is a sufficient consideration for C's promise.

Consent of the surety should not have been obtained by misrepresentation or concealment: Sections 142 & 143 provide that any guarantee which has been obtained by means of misrepresentation made by the creditor, or with his knowledge and assent, concerning a material part of the transaction; or by means of keeping silence as to material circumstance is invalid.

For instance:
  1. A engages B as a clerk to collect money from him. B fails to account for some of his receipts and A in consequence calls upon him to furnish security for his duly accounting. C gives his guarantee for B's duly accounting. A does not acquaint C with B's previous conduct. B afterward makes default. The guarantee is invalid.
  2. A guarantees to C payment for iron to be supplied by him to B to the amount of 2,000 tons. B & C have privately agreed that B should pay five rupees per ton beyond the market price, such excess to be applied in liquidation of an old debt. This agreement is concealed from A. A is not liable as a surety.

Therefore, it is clear from the above provisions that if a cashier has been found guilty of embezzlement, but this fact is not disclosed when a surety has been made to guarantee the future conduct of the cashier, the surety will not be liable as such, under these circumstances. Similarly, if a surety is made to guarantee an employee's existing and future liabilities, without being informed that the said employee is already indebted to an extent more than that of the guarantee, the guarantee is invalid.

Having established a foundational understanding of the concept of contracts of indemnity and guarantee, let us now analyse the differences between the two:

There are two parties in a contract of indemnity, the indemnifier and the indemnified; whereas there are three parties in a contract of guarantee, the creditor, the principal debtor, and the surety.

A contract of indemnity consists of only one contract under which the indemnifier promises to indemnify the indemnified in the event of a certain loss; whereas there are three contracts under the contract of guarantee. One is between the principal debtor and the creditor, the second is between the creditor and the surety, and the third contract is an implied one which is between the principal debtor and the surety.

The object of the contract of guarantee is the security of the creditor; whereas the contract of indemnity is made to protect the promisee against some

  1. A.I.R. 1994 P. & H. 206.
  2. State Bank of India v. Messrs Indexport Registered, A.I.R. 1992 S.C. 1740

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