UNIT 07 CONTRACT OF INDEMNITY & GUARANTEE
A contract of indemnity and a contract of guarantee are both special types of contracts under the Indian Contract Act, 1872. While they both provide protection against loss or liability, they differ in their nature, the number of parties involved, and the primary purpose.
- Contract of Indemnity
A contract of indemnity is a contract by which one party promises to save the other from loss caused by the conduct of the promisor or by the conduct of any other person. It’s about protection against a potential loss.
Parties: There are two parties:
- Indemnifier: The person who promises to make good the loss.
- Indemnified (or Indemnity-holder): The person who is to be protected from loss.
Liability: The indemnifier’s liability is primary and independent. It arises when the indemnified person suffers a loss due to the specified event.
Nature of the contract: There is only one contract between the indemnifier and the indemnified.
Legal Provision: It is defined under Section 124 of the Indian Contract Act, 1872.
Example: An insurance contract is a classic example. When you buy fire insurance for your house, the insurance company (indemnifier) promises to compensate you (indemnified) for any loss suffered due to a fire.
- Contract of Guarantee
A contract of guarantee is a contract to perform the promise, or discharge the liability, of a third person in case of their default. It’s a form of security for a debt or obligation.
Parties: There are three parties:
Creditor: The person to whom the guarantee is given.
Principal Debtor: The person in respect of whose default the guarantee is given.
Surety: The person who gives the guarantee.
Liability: The surety’s liability is secondary. It arises only when the principal debtor fails to perform their obligation.
Nature of the contract: There are three contracts that form a guarantee:
- A principal contract between the creditor and the principal debtor.
- A secondary contract between the creditor and the surety.
- An implied contract of indemnity between the surety and the principal debtor.
Legal Provision: It is defined under Section 126 of the Indian Contract Act, 1872.
Example: If person A takes a loan from a bank and person B guarantees that if A fails to repay, B will. Here, the bank is the creditor, A is the principal debtor, and B is the surety.
- Difference between-
| Feature | Contract of Indemnity | Contract of Guarantee |
| Number of Parties | Two (Indemnifier, Indemnified) | Three (Creditor, Principal Debtor, Surety) |
| Number of Contracts | One | Three |
| Nature of Liability | Primary and independent | Secondary and conditional on the default of the principal debtor |
| Purpose | To protect against a potential loss | To secure a debt or obligation |
| Occurrence | May or may not involve a third party | Always involves a third party (the principal debtor) |
Ø Types of Guarantees
Guarantees can be classified in several ways, but the most common types are based on the nature of the transaction:
Specific Guarantee: This is a guarantee given for a single debt or a specific transaction. The surety’s liability ends once that particular debt is paid or the promise is fulfilled.
For example, if a person guarantees a one-time loan for a friend, that’s a specific guarantee.
Continuing Guarantee: This type of guarantee extends to a series of transactions over a period of time. The surety’s liability continues until the guarantee is revoked.
For instance, a person might guarantee a line of credit for a business for an indefinite period. A continuing guarantee can be revoked by giving notice to the creditor for future transactions, but the surety remains liable for transactions that have already occurred.
- Nature and Extent of Surety’s Liability (Section 128)
Section 128 of the Indian Contract Act, 1872, deals with the nature and extent of a surety’s liability. It states: “The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract.”
- If the principal debtor’s debt includes the principal amount, interest, and charges, the surety is also liable for all of these, unless the contract specifies otherwise.
- The surety’s liability is triggered only upon the principal debtor’s default. The creditor does not have to sue the principal debtor first; they can proceed directly against the surety upon default.
- The phrase “unless it is otherwise provided by the contract” is crucial. It means the surety can limit their liability through a specific agreement.
For example, a surety can agree to be liable for only a portion of the debt or for a specific, fixed amount, regardless of the total debt of the principal debtor.
(d) If the principal debtor’s liability is reduced or extinguished the surety’s liability is also reduced or extinguished to the same extent.
Ø Discharge of a Surety
A surety can be discharged from their liability under a contract of guarantee in several ways, primarily by the revocation of the guarantee, the conduct of the creditor, or by the invalidation of the contract.
1. By Revocation
- By notice (Section 130): A continuing guarantee can be revoked by the surety for future transactions by giving notice to the creditor. The surety remains liable for transactions that have already occurred.
- By death of surety (Section 131): The death of a surety automatically revokes a continuing guarantee for all future transactions unless the contract states otherwise.
2. By Conduct of the Creditor
- Variance in contract terms (Section 133): Any material change in the terms of the contract between the creditor and the principal debtor without the surety’s consent discharges the surety from liability. The surety is not bound by a contract they did not agree to.
- Release or discharge of principal debtor (Section 134): If the creditor releases the principal debtor from their liability, the surety is also discharged.
- Composition, giving time, or promise not to sue (Section 135): If the creditor, without the surety’s consent, makes a settlement with the principal debtor, promises to give them more time for payment, or agrees not to sue them, the surety is discharged.
- Creditor’s act or omission impairing surety’s remedy (Section 139): If the creditor does an act that is inconsistent with the surety’s rights, or fails to do something that their duty requires, which ultimately impairs the surety’s ability to recover from the principal debtor, the surety is discharged.
- Loss of security (Section 141): If the creditor loses or parts with any security provided by the principal debtor without the surety’s consent, the surety is discharged to the extent of the value of that security.
- By Invalidation of the Contract
A surety can also be discharged if the contract of guarantee is found to be invalid from the start due to:
- Misrepresentation (Section 142): If the guarantee was obtained by the creditor through a misrepresentation of a material fact.
- Concealment (Section 143): If the creditor obtains the guarantee by concealing material facts.
Ø Rights of a Surety
A surety has several rights to protect their interests, which can be categorized into three groups.
Rights against the Principal Debtor
Right of Subrogation: After a surety has paid the guaranteed debt, they step into the shoes of the creditor. This means the surety acquires all the rights that the creditor had against the principal debtor.
For example, if the creditor had any securities for the debt, the surety can claim them.
Right to Indemnity: There’s an implied promise in every contract of guarantee that the principal debtor will indemnify the surety. The surety has the right to recover any amount they’ve rightfully paid under the guarantee from the principal debtor, including any costs incurred.
Rights against the Creditor
Right to Securities: A surety is entitled to the benefit of all the securities that the creditor holds against the principal debtor at the time the contract of suretyship is entered into, whether the surety was aware of them or not.
Right to Set-off: If the principal debtor has any counterclaims against the creditor, the surety can also claim a set-off for that amount against the creditor’s claim.
Rights against Co-sureties
- Right to Contribution: When a debt is guaranteed by two or more sureties, they are called co-sureties. If one co-surety pays the entire debt or more than their share, they have the right to claim a contribution from the other co-sureties. This contribution is typically in equal shares unless the contract specifies otherwise