Both guarantees and indemnities play important, yet distinct roles in commercial and other agreements. Both are designed to satisfy a liability owed by someone (other than the guarantor or indemnifier) to a third person. It is therefore important that parties have a clear understanding of the difference between them.
Under a guarantee, the guarantor contractually agrees to ensure that a third party (one of the principal parties to the contract, who we will call X) fulfils his obligations under that contract. In the event that X does not adhere to the terms of the contract, the guarantor agrees to ‘make good’ X’s default.
Guarantees are usually referred to as secondary obligations because the guaranteed obligations are secondary to the principal obligations of X under the contract.
Guarantees are generally considered to be more advantageous to the guarantor because they confer certain rights, including the ability of the guarantor to recover any payments that the guarantor has made to the beneficiary of the guarantee as a consequence of X’s default. Until the principal party, X, commits a breach of the contract in respect of which the guarantee is given, the guarantor has no legal liability as guarantor.
Under an indemnity, a promise is made by one party to accept liability for another party’s loss. The indemnity obligation is therefore contingent on the loss of the indemnified person. A common example is an indemnity given by a company to its directors in respect of personal liability if the director suffers a loss as a result of this so acting, in certain circumstances.
Unlike a guarantee an indemnity is a ‘primary’ contractual obligation: as the indemnifier (the company in this example above) assumes a liability that does not depend on default by a third party. For this reason, an indemnity is considered by some as being a more favourable option than a guarantee from the perspective of the person seeking protection against loss.
The main distinction between a guarantee and indemnity is therefore that the guarantor makes himself secondarily liable for an obligation in the case of a guarantee, whereas the indemnifier makes himself primarily liable in the case of an indemnity, as his obligation is wholly independent of the liability of the principal obligor. In the case of the guarantee there must first be a failure or default by the principal obligator to perform these contractual obligations.
In each case, the Courts will interpret the words of the specific contract in determining whether a document or particular provision is a guarantee or an indemnity. In doing so, matters a Court may consider include the following:
- The natural and ordinary meaning of the particular provision
- Any other relevant provisions of the contract
- The overall purpose of the provision; and
- The specific facts and circumstances surrounding known by the parties at the time of the contract
The Court’s central concern will be the interpretation of the substance of the Agreement as opposed to its form or description.
In the case of both the guarantee and the indemnity it may be possible for the party giving the guarantee or indemnity to limit his liability under the guarantee or indemnity. Therefore, a guarantee/indemnity agreement may provide that the guarantor/indemnifier is only liable for loss that does not exceed a stated dollar limit. In these circumstances, the guarantor/ indemnifier will only be liable for loss up to the stated limit, even where the loss suffered by the other party exceeds the limit.
The general principle is that if the principal contract is void, the guarantee (of the obligations under the void contract) is also void and is therefore unenforceable. However, this is not the same in the case of an indemnity and the void status of the principal transaction will not affect the principal liability or the indemnifier. Additionally, the general rule is that a guarantor is discharged from his liability as guarantor in certain circumstances. One such circumstance is where there is a material variation of the principal contract without the guarantor’s consent. On the other hand, in the case of an indemnity the liability of the indemnifier will continue notwithstanding variation of the principal contract.
In order to have the desired effect documents containing guarantees or indemnities must be well drafted and unambiguously express the intention of the parties as to whether a guarantee (a secondary obligation) or indemnity (a primary obligation) is intended. This will take on added importance where it becomes necessary to take steps to enforce a guarantee or indemnity where well drafted, clear and unambiguous language will assist a Court in discerning and giving effect to those intentions.
Gina Phillips Black is a Partner at Myers, Fletcher & Gordon in its Commercial Department. She may be contacted via email@example.com or www.myersfletcher.com. This article is for general information purposes only and does not constitute legal advice