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Contracts of Guarantee and Indemnity: Commensurate as Two Sides of the Same Coin

Written by Diksha Dadu 

Fourth Year, BBA.LLB. Amity Law School, Noida




Disclaimer: Please note that the views expressed below represent the opinions of the article's author. The following does not necessarily represent the views of Law & Order.


Introduction

In the current antagonistic commercial world, the contracts of guarantee and indemnity are encompassed as contracts with the same purpose but divergent features. In the purview of commercial contracts, guarantees and indemnities are generally used by the borrowers to defend themselves from the risk of debt delinquency. However, the lender may seek auxiliary security especially if they predetermine any ambiguity regarding the solvency of borrowers. Therefore, to understand the two variant perspectives: one from the perspective of the lender and the other from the side of the borrower. Therefore, this article focuses on the two contingent contracts along with its collusive legal issue, clauses, and practicality in the commercial world.

At the outset, it is crucial to understand the two contracts.


A contract of guarantee is a contract to perform such a promise or discharge the liability of a third person in case of his default.[1] It is a tripartite agreement as the person who gives the guarantee is called ‘surety’, the person in whose default the guarantee is given is called ‘principal debtor’, and the person to whom the guarantee is given is called ‘creditor’. [2]

For a valid contract of guarantee, there must be an existing debt obligation or promise whose performance is guaranteed as against the surety or principal debtor. It pertains to the creation of a secondary obligation as the contractual obligation wherein the issue depends upon the obligations of the third party towards the beneficiary of guarantee. Rationally, a guarantee agreement will come into effect as a guaranteed contract when the cardinal obligations are not fulfilled, for instance where the borrower is delinquent or default.

A contract of indemnity is a contract where one party promises to save the other from loss caused to him by the conduct of the promisor or any other person. [3] It is restrictive in nature since it covers only the losses caused by the conduct of the promiser and strictly prohibits to cover any accidents or mishaps.

However, in the case of Kadiresan Chettiar v Ramaswami Chettiar[4], the court held that “Duty to indemnify can arise out of contractual obligations i.e. express or implied statutory obligations or even relations like principal and agent, employer and employee, etc.” Thus duty to indemnify can also arise from non-contractual relations which are thereto implied in nature. Moreover, there is no single rule for such bifurcation since the extent of liability depends upon case to case.[5]

Both the contracts play a very critical yet similar role in protecting commercial motions from losses by acting as a safety mechanism in case of anyone’s default by providing certain rights and duties to both parties. They guide the creditors in case a third party fails to perform his/her duty.

Legal Issues faced by Contingent Contracts: Practicality in Commercial Transactions and judicial pronouncements

Firstly, in relation to the contract of guarantee, the courts have been very protective of the guarantors and have been sympathetic to their plight when the guarantor has been asked to pay under the guarantee. This has single-handedly resulted in the reformation of various rights and protections in their stance which can cause negative adversities for lenders who require certainty that their money would be paid back through guarantor if required. Whereas, while interpreting indemnity provisions, there must be a conflict with contract act or any judicial decision rendered by the courts in India. At times, the courts have observed miscellaneous acts without any contractual liability.[6]

Secondly, a guarantor has a special right of subrogation wherein he steps into the shoes of the lender against the borrower in as much as a loan agreement which follows payment and other obligations. However, in both cases, the lender tries to ensure that the guarantor doesn’t exercise this right so that there is no such clause as ‘postponement of action by guarantor until all dues are repaid to the lender’. This creates a catastrophic situation and collides with the two agreements. On the other hand, in Fateh Chand v Balkishan Das[7], Hon’ble SC held that “the court has jurisdiction to award a sum only if it considers reasonable, but not exceeding the amount of specified contract.” However, a capped indemnity clause is contradictory to the reasonability approach and is only applicable to the adjudication of an indemnity clause. The two viewpoints are often confused as a single approach.

Thirdly, drafting is the key to both contracts. The courts treat indemnity clauses with extreme strictness as ‘especially exacting standards’.[8] Any ambiguity should be avoided by following a "contra proferentem" approach. It has been observed time and again that the courts are reluctant to rewrite a contract or propose to any opinion which is not already stated in the contract. Therefore, ample time and insight must be given while drafting a particular contract. In indemnity contracts, the effect should be given to the language as to where the responsibility lies, against which the insurance must be obtained.[9]

Fourthly, any party to a contract must not combine guarantee and indemnity as a single contract. It means that no obligation shall be characterized as both ‘guarantee’ and ‘indemnity’, especially in the same contractual clause since both of them are two different legal concepts. Also, an obligation to attempt mitigation of loss should be excluded if possible. It has been observed by the courts and negotiators that at times, the guarantee document is supported by an indemnity clause to recover any damages, if caused.[10] However, in doing so the benefit of indemnity will be lost for the beneficiary which in turn might lead the courts to hold a less onerous decision against the guarantor.

Conclusion


Since both the contracts are subject to general contract law principles, therefore, in the context of a company acquisition, a guarantee or indemnity given to the purchaser should constitute financial assistance and in case it results void, then the directors shall be liable.

There is a longing need to draw a clear line of approach so that the guarantor’s consent shall be taken without any unnecessary clauses. Therefore, careful consideration must be given to all the circumstances whenever the lender is allowing a variation to underlying loan agreement. The parties should not be duped in unnecessary commercial transactions and the courts must follow the concept of equitable relief. There is an urgent need for implementation and formation of uniform contracts so that the lenders and other financial parties are not being put in a hard yet confusing position due to excess paperwork and various similar yet differently executed clauses. Moreover, we all are living amidst the COVID-19 pandemic, and various contracts among different strata of commerce has impacted the traditional atmosphere for working of such contracts. Therefore, there is a substantial need for implementation of a simple yet clearer approach in commercial space with respect to the contract of indemnity and contract of guarantee.


[1] Section 126, The Indian Contract Act, 1872. [2] P.J Rajappan v Associated Industries (1983) [3] Section 124, The Indian Contract Act, 1872. [4] (1947) AIR 1946 Mad 472. [5] Smith v South Wales Switchgear Ltd (1978) 1 ALL ER 18. [6] Gajanan Moreshwar Parelkar v Moreshwar Madan Mantri (1942) 44 Bom LR 704. [7] AIR 1963 SC 1405 [8] Problems with Contractual Indemnities by Peter J.Booth and Victorian Bar, (2017) [9] Samways v Workcover Queensland (2010) QSC 127. [10] The Fanti and the Cadre Islands” Firma C-Trade SA v Newcastle Protection and Indemnity Association [1991] 2 AC 1


Bibliography

  1. Section 126, The Indian Contract Act, 1872

  2. P.J Rajappan v Associated Industries (1983)

  3. Section 124, The Indian Contract Act, 1872.

  4. Kadiresan Chettiar v Ramaswami Chettiar (1947) AIR 1946 Mad 472.

  5. Smith v South Wales Switchgear Ltd (1978) 1 ALL ER 18

  6. Gajanan Moreshwar Parelkar v Moreshwar Madan Mantri (1942) 44 Bom LR 704.

  7. Fateh Chand v Balkishan Das AIR 1963 SC 1405

  8. Samways v Workcover Queensland (2010) QSC 127.

  9. The Fanti and the Cadre Islands” Firma C-Trade SA v Newcastle Protection and Indemnity Association [1991] 2 AC 1

  10. Problems with Contractual Indemnities by Peter J.Booth and Victorian Bar, (2017)

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