ICAI Notes- Unit 7: Contract of Indemnity and Guarantee | Business Laws for CA Foundation PDF Download

 Page 1


  BUSINESS LAWS 
2.152 
LEARNING OUTCOMES 
UNIT – 7: CONTRACT OF INDEMNITY AND 
GUARANTEE 
 
After studying this Chapter, you will be able to understand: 
?
Special type of contracts i.e. Indemnity contracts and Guarantee 
contracts and also the nature of obligations and rights of each of 
the parties to the contracts.
 
?
Distinction between contract of indemnity and contract of 
guarantee.
 
?
Mode of discharge of contract of guarantee in various 
circumstances.
 
 
Contract of Indemnity and 
Guarantee
Contract of Indemnity
Contract of Guarantee
Nature of Surety’s Liability
Continuing  Guarantee
Discharge of Surety
Rights of Surety
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
Page 2


  BUSINESS LAWS 
2.152 
LEARNING OUTCOMES 
UNIT – 7: CONTRACT OF INDEMNITY AND 
GUARANTEE 
 
After studying this Chapter, you will be able to understand: 
?
Special type of contracts i.e. Indemnity contracts and Guarantee 
contracts and also the nature of obligations and rights of each of 
the parties to the contracts.
 
?
Distinction between contract of indemnity and contract of 
guarantee.
 
?
Mode of discharge of contract of guarantee in various 
circumstances.
 
 
Contract of Indemnity and 
Guarantee
Contract of Indemnity
Contract of Guarantee
Nature of Surety’s Liability
Continuing  Guarantee
Discharge of Surety
Rights of Surety
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
2.153
THE INDIAN CONTRACT ACT, 1872 
Contract of Indemnity and Guarantee are the specific types of contracts provided under 
sections 124 to 147 of the Indian Contract Act, 1872. In addition to the specific provisions 
(i.e. Section 124 to Section 147 of the Indian Contract Act, 1872), the general principles of 
contracts are also applicable to such contracts. Even though both the contracts are modes of 
compensation based on similar principles, they differ considerably in several aspects. 
In this unit, the law relating to indemnity and guarantee are discussed in detail. 
7.1 CONTRACT OF INDEMNITY 
The term “Indemnity” literally means “Security against loss” or “to make good the loss” or 
“to compensate the party who has suffered some loss”.  
The term “Contract of Indemnity” is defined under Section 124 of the Indian Contract Act, 
1872. It is “a contract by which one party promises to save the other from loss caused to him 
by the conduct of the promisor himself, or by the conduct of any other person.”  
Example 1: Mr. X contracts with the Government to return to India after completing his 
studies (which were funded by the Government) at University of Cambridge and to serve the 
Government for a period of 5 years. If Mr. X fails to return to India, he will have to reimburse 
the Government. It is a contract of indemnity.
Parties:  
a. The party who promises to indemnify/ save the other party from loss- “indemnifier”,  
b. The party who is promised to be saved against the loss- “indemnified” or “indemnity 
holder”. 
Example 2: A may contract to indemnify B against the consequences of any proceedings which 
C may take against B in respect of a sum of 
`
5000/- advanced by C to B.  In consequence, when 
B who is called upon to pay the sum of money to C fails to do so, C would be able to recover 
the amount from A as provided in Section 124. 
Example 3: X may agree to indemnify Y for any loss or damage that may occur if a tree on Y’s 
neighboring property blows over. If the tree then blows over and damages Y’s fence, X will be 
liable for the cost of fixing the fence. 
However, the above definition of indemnity restricts the scope of contracts of indemnity in 
as much as it covers only the loss caused by: 
(i) the conduct of the promisor himself, or  
(ii) the conduct of any other person. 
 
© The Institute of Chartered Accountants of India
Page 3


  BUSINESS LAWS 
2.152 
LEARNING OUTCOMES 
UNIT – 7: CONTRACT OF INDEMNITY AND 
GUARANTEE 
 
After studying this Chapter, you will be able to understand: 
?
Special type of contracts i.e. Indemnity contracts and Guarantee 
contracts and also the nature of obligations and rights of each of 
the parties to the contracts.
 
?
Distinction between contract of indemnity and contract of 
guarantee.
 
?
Mode of discharge of contract of guarantee in various 
circumstances.
 
 
Contract of Indemnity and 
Guarantee
Contract of Indemnity
Contract of Guarantee
Nature of Surety’s Liability
Continuing  Guarantee
Discharge of Surety
Rights of Surety
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
2.153
THE INDIAN CONTRACT ACT, 1872 
Contract of Indemnity and Guarantee are the specific types of contracts provided under 
sections 124 to 147 of the Indian Contract Act, 1872. In addition to the specific provisions 
(i.e. Section 124 to Section 147 of the Indian Contract Act, 1872), the general principles of 
contracts are also applicable to such contracts. Even though both the contracts are modes of 
compensation based on similar principles, they differ considerably in several aspects. 
In this unit, the law relating to indemnity and guarantee are discussed in detail. 
7.1 CONTRACT OF INDEMNITY 
The term “Indemnity” literally means “Security against loss” or “to make good the loss” or 
“to compensate the party who has suffered some loss”.  
The term “Contract of Indemnity” is defined under Section 124 of the Indian Contract Act, 
1872. It is “a contract by which one party promises to save the other from loss caused to him 
by the conduct of the promisor himself, or by the conduct of any other person.”  
Example 1: Mr. X contracts with the Government to return to India after completing his 
studies (which were funded by the Government) at University of Cambridge and to serve the 
Government for a period of 5 years. If Mr. X fails to return to India, he will have to reimburse 
the Government. It is a contract of indemnity.
Parties:  
a. The party who promises to indemnify/ save the other party from loss- “indemnifier”,  
b. The party who is promised to be saved against the loss- “indemnified” or “indemnity 
holder”. 
Example 2: A may contract to indemnify B against the consequences of any proceedings which 
C may take against B in respect of a sum of 
`
5000/- advanced by C to B.  In consequence, when 
B who is called upon to pay the sum of money to C fails to do so, C would be able to recover 
the amount from A as provided in Section 124. 
Example 3: X may agree to indemnify Y for any loss or damage that may occur if a tree on Y’s 
neighboring property blows over. If the tree then blows over and damages Y’s fence, X will be 
liable for the cost of fixing the fence. 
However, the above definition of indemnity restricts the scope of contracts of indemnity in 
as much as it covers only the loss caused by: 
(i) the conduct of the promisor himself, or  
(ii) the conduct of any other person. 
 
© The Institute of Chartered Accountants of India
  BUSINESS LAWS 
2.154 
Thus, loss occasioned by an accident not caused by any person, or an act of God/ natural 
event, is not covered.  
In case of Gajanan Moreshwar v/s Moreshwar Madan (1942), decision is taken on the 
basis of English Law. As per English Law, Indemnity means promise to save another harmless 
from the loss. Here it covers every loss whether due to negligence of promisee or by natural 
calamity or by accident. 
Mode of contract of indemnity: A contract of indemnity like any other contract may be 
express or implied. 
a. A contract of indemnity is said to be express when a person expressly promises to 
compensate the other from loss. 
b. A contract of indemnity is said to be implied when it is to be inferred from the 
conduct of the parties or from the circumstances of the case. 
A contract of indemnity is like any other contract and must fulfil all the essentials of a valid 
contract. 
Example 4: A asks B to beat C promising to indemnify him against the consequences. The 
promise of A cannot be enforced. Suppose, B beats C and is fined `1000, B cannot claim this 
amount from A because the object of the agreement is unlawful.  
A contract of Fire Insurance or Marine Insurance is always a contract of indemnity. But there 
is no contract of indemnity in case of contract of Life Insurance. 
Rights of Indemnity-holder when sued (Section 125): The promisee in a contract of 
indemnity, acting within the scope of his authority, is entitled to recover from the 
promisor/indemnifier— 
(a) all damages which he may be compelled to pay in any suit 
(b) all costs which he may have been compelled to pay in bringing/ defending the suit 
and 
(c) all sums which he may have paid under the terms of any compromise of suit. 
When does the liability of an indemnifier commence?
Although the Indian Contract Act, 1872, is silent on the time of commencement of liability of 
indemnifier, however, on the basis of judicial pronouncements it can be stated that the 
liability of an indemnifier commences as soon as the liability of the indemnity-holder 
becomes absolute and certain. This principle has been followed by the courts in several 
cases. 
 
© The Institute of Chartered Accountants of India
Page 4


  BUSINESS LAWS 
2.152 
LEARNING OUTCOMES 
UNIT – 7: CONTRACT OF INDEMNITY AND 
GUARANTEE 
 
After studying this Chapter, you will be able to understand: 
?
Special type of contracts i.e. Indemnity contracts and Guarantee 
contracts and also the nature of obligations and rights of each of 
the parties to the contracts.
 
?
Distinction between contract of indemnity and contract of 
guarantee.
 
?
Mode of discharge of contract of guarantee in various 
circumstances.
 
 
Contract of Indemnity and 
Guarantee
Contract of Indemnity
Contract of Guarantee
Nature of Surety’s Liability
Continuing  Guarantee
Discharge of Surety
Rights of Surety
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
2.153
THE INDIAN CONTRACT ACT, 1872 
Contract of Indemnity and Guarantee are the specific types of contracts provided under 
sections 124 to 147 of the Indian Contract Act, 1872. In addition to the specific provisions 
(i.e. Section 124 to Section 147 of the Indian Contract Act, 1872), the general principles of 
contracts are also applicable to such contracts. Even though both the contracts are modes of 
compensation based on similar principles, they differ considerably in several aspects. 
In this unit, the law relating to indemnity and guarantee are discussed in detail. 
7.1 CONTRACT OF INDEMNITY 
The term “Indemnity” literally means “Security against loss” or “to make good the loss” or 
“to compensate the party who has suffered some loss”.  
The term “Contract of Indemnity” is defined under Section 124 of the Indian Contract Act, 
1872. It is “a contract by which one party promises to save the other from loss caused to him 
by the conduct of the promisor himself, or by the conduct of any other person.”  
Example 1: Mr. X contracts with the Government to return to India after completing his 
studies (which were funded by the Government) at University of Cambridge and to serve the 
Government for a period of 5 years. If Mr. X fails to return to India, he will have to reimburse 
the Government. It is a contract of indemnity.
Parties:  
a. The party who promises to indemnify/ save the other party from loss- “indemnifier”,  
b. The party who is promised to be saved against the loss- “indemnified” or “indemnity 
holder”. 
Example 2: A may contract to indemnify B against the consequences of any proceedings which 
C may take against B in respect of a sum of 
`
5000/- advanced by C to B.  In consequence, when 
B who is called upon to pay the sum of money to C fails to do so, C would be able to recover 
the amount from A as provided in Section 124. 
Example 3: X may agree to indemnify Y for any loss or damage that may occur if a tree on Y’s 
neighboring property blows over. If the tree then blows over and damages Y’s fence, X will be 
liable for the cost of fixing the fence. 
However, the above definition of indemnity restricts the scope of contracts of indemnity in 
as much as it covers only the loss caused by: 
(i) the conduct of the promisor himself, or  
(ii) the conduct of any other person. 
 
© The Institute of Chartered Accountants of India
  BUSINESS LAWS 
2.154 
Thus, loss occasioned by an accident not caused by any person, or an act of God/ natural 
event, is not covered.  
In case of Gajanan Moreshwar v/s Moreshwar Madan (1942), decision is taken on the 
basis of English Law. As per English Law, Indemnity means promise to save another harmless 
from the loss. Here it covers every loss whether due to negligence of promisee or by natural 
calamity or by accident. 
Mode of contract of indemnity: A contract of indemnity like any other contract may be 
express or implied. 
a. A contract of indemnity is said to be express when a person expressly promises to 
compensate the other from loss. 
b. A contract of indemnity is said to be implied when it is to be inferred from the 
conduct of the parties or from the circumstances of the case. 
A contract of indemnity is like any other contract and must fulfil all the essentials of a valid 
contract. 
Example 4: A asks B to beat C promising to indemnify him against the consequences. The 
promise of A cannot be enforced. Suppose, B beats C and is fined `1000, B cannot claim this 
amount from A because the object of the agreement is unlawful.  
A contract of Fire Insurance or Marine Insurance is always a contract of indemnity. But there 
is no contract of indemnity in case of contract of Life Insurance. 
Rights of Indemnity-holder when sued (Section 125): The promisee in a contract of 
indemnity, acting within the scope of his authority, is entitled to recover from the 
promisor/indemnifier— 
(a) all damages which he may be compelled to pay in any suit 
(b) all costs which he may have been compelled to pay in bringing/ defending the suit 
and 
(c) all sums which he may have paid under the terms of any compromise of suit. 
When does the liability of an indemnifier commence?
Although the Indian Contract Act, 1872, is silent on the time of commencement of liability of 
indemnifier, however, on the basis of judicial pronouncements it can be stated that the 
liability of an indemnifier commences as soon as the liability of the indemnity-holder 
becomes absolute and certain. This principle has been followed by the courts in several 
cases. 
 
© The Institute of Chartered Accountants of India
2.155
THE INDIAN CONTRACT ACT, 1872 
Example 5:  A promises to compensate X for any loss that he may suffer by filling a suit 
against Y. The court orders X to pay Y damages of `  10000. As the loss has become certain, 
X may claim the amount of loss from A and pass it to Y.
7.2 CONTRACT OF GUARANTEE 
“Contract of guarantee”, “surety”, “principal debtor” and 
“creditor” [Section 126] 
Contract of guarantee: A contract of guarantee is a contract to perform the promise made 
or discharge the liability, of a third person in case of his default.  
  
Example 6: When A requests B to lend ` 10,000 to C and guarantees that C will repay the 
amount within the agreed time and that on C falling to do so, he (A) will himself pay to B, 
there is a contract of guarantee.  
Here, B is the creditor, C the principal debtor and A the surety. 
Example 7: X and Y go into a car showroom where X says to the dealer to supply latest 
model of Wagon R to Y, and agrees that if Y fails to pay he will. In case of Y’s failure to pay, 
the car showroom will recover its money from X.  
This is a contract of guarantee because X promises to discharge the liability of Y in case of 
his defaults. 
A contract of guarantee is a tripartite agreement between principal debtor, creditor and 
surety. There are, in effect three contracts 
(i) A principal contract between the principal debtor and the creditor. 
(ii) A secondary contract between the creditor and the surety.  
(iii) An implied contract between the surety and the principal debtor whereby principal 
debtor is under an obligation to indemnify the surety; if the surety is made to pay or 
perform.  
 
Three 
parties are 
involved in a 
contract of 
guarantee
Surety- person who gives the guarantee 
Principal debtor- person in respect of whose default the 
guarantee is given
Creditor- person to whom the gurantee is given
© The Institute of Chartered Accountants of India
Page 5


  BUSINESS LAWS 
2.152 
LEARNING OUTCOMES 
UNIT – 7: CONTRACT OF INDEMNITY AND 
GUARANTEE 
 
After studying this Chapter, you will be able to understand: 
?
Special type of contracts i.e. Indemnity contracts and Guarantee 
contracts and also the nature of obligations and rights of each of 
the parties to the contracts.
 
?
Distinction between contract of indemnity and contract of 
guarantee.
 
?
Mode of discharge of contract of guarantee in various 
circumstances.
 
 
Contract of Indemnity and 
Guarantee
Contract of Indemnity
Contract of Guarantee
Nature of Surety’s Liability
Continuing  Guarantee
Discharge of Surety
Rights of Surety
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
2.153
THE INDIAN CONTRACT ACT, 1872 
Contract of Indemnity and Guarantee are the specific types of contracts provided under 
sections 124 to 147 of the Indian Contract Act, 1872. In addition to the specific provisions 
(i.e. Section 124 to Section 147 of the Indian Contract Act, 1872), the general principles of 
contracts are also applicable to such contracts. Even though both the contracts are modes of 
compensation based on similar principles, they differ considerably in several aspects. 
In this unit, the law relating to indemnity and guarantee are discussed in detail. 
7.1 CONTRACT OF INDEMNITY 
The term “Indemnity” literally means “Security against loss” or “to make good the loss” or 
“to compensate the party who has suffered some loss”.  
The term “Contract of Indemnity” is defined under Section 124 of the Indian Contract Act, 
1872. It is “a contract by which one party promises to save the other from loss caused to him 
by the conduct of the promisor himself, or by the conduct of any other person.”  
Example 1: Mr. X contracts with the Government to return to India after completing his 
studies (which were funded by the Government) at University of Cambridge and to serve the 
Government for a period of 5 years. If Mr. X fails to return to India, he will have to reimburse 
the Government. It is a contract of indemnity.
Parties:  
a. The party who promises to indemnify/ save the other party from loss- “indemnifier”,  
b. The party who is promised to be saved against the loss- “indemnified” or “indemnity 
holder”. 
Example 2: A may contract to indemnify B against the consequences of any proceedings which 
C may take against B in respect of a sum of 
`
5000/- advanced by C to B.  In consequence, when 
B who is called upon to pay the sum of money to C fails to do so, C would be able to recover 
the amount from A as provided in Section 124. 
Example 3: X may agree to indemnify Y for any loss or damage that may occur if a tree on Y’s 
neighboring property blows over. If the tree then blows over and damages Y’s fence, X will be 
liable for the cost of fixing the fence. 
However, the above definition of indemnity restricts the scope of contracts of indemnity in 
as much as it covers only the loss caused by: 
(i) the conduct of the promisor himself, or  
(ii) the conduct of any other person. 
 
© The Institute of Chartered Accountants of India
  BUSINESS LAWS 
2.154 
Thus, loss occasioned by an accident not caused by any person, or an act of God/ natural 
event, is not covered.  
In case of Gajanan Moreshwar v/s Moreshwar Madan (1942), decision is taken on the 
basis of English Law. As per English Law, Indemnity means promise to save another harmless 
from the loss. Here it covers every loss whether due to negligence of promisee or by natural 
calamity or by accident. 
Mode of contract of indemnity: A contract of indemnity like any other contract may be 
express or implied. 
a. A contract of indemnity is said to be express when a person expressly promises to 
compensate the other from loss. 
b. A contract of indemnity is said to be implied when it is to be inferred from the 
conduct of the parties or from the circumstances of the case. 
A contract of indemnity is like any other contract and must fulfil all the essentials of a valid 
contract. 
Example 4: A asks B to beat C promising to indemnify him against the consequences. The 
promise of A cannot be enforced. Suppose, B beats C and is fined `1000, B cannot claim this 
amount from A because the object of the agreement is unlawful.  
A contract of Fire Insurance or Marine Insurance is always a contract of indemnity. But there 
is no contract of indemnity in case of contract of Life Insurance. 
Rights of Indemnity-holder when sued (Section 125): The promisee in a contract of 
indemnity, acting within the scope of his authority, is entitled to recover from the 
promisor/indemnifier— 
(a) all damages which he may be compelled to pay in any suit 
(b) all costs which he may have been compelled to pay in bringing/ defending the suit 
and 
(c) all sums which he may have paid under the terms of any compromise of suit. 
When does the liability of an indemnifier commence?
Although the Indian Contract Act, 1872, is silent on the time of commencement of liability of 
indemnifier, however, on the basis of judicial pronouncements it can be stated that the 
liability of an indemnifier commences as soon as the liability of the indemnity-holder 
becomes absolute and certain. This principle has been followed by the courts in several 
cases. 
 
© The Institute of Chartered Accountants of India
2.155
THE INDIAN CONTRACT ACT, 1872 
Example 5:  A promises to compensate X for any loss that he may suffer by filling a suit 
against Y. The court orders X to pay Y damages of `  10000. As the loss has become certain, 
X may claim the amount of loss from A and pass it to Y.
7.2 CONTRACT OF GUARANTEE 
“Contract of guarantee”, “surety”, “principal debtor” and 
“creditor” [Section 126] 
Contract of guarantee: A contract of guarantee is a contract to perform the promise made 
or discharge the liability, of a third person in case of his default.  
  
Example 6: When A requests B to lend ` 10,000 to C and guarantees that C will repay the 
amount within the agreed time and that on C falling to do so, he (A) will himself pay to B, 
there is a contract of guarantee.  
Here, B is the creditor, C the principal debtor and A the surety. 
Example 7: X and Y go into a car showroom where X says to the dealer to supply latest 
model of Wagon R to Y, and agrees that if Y fails to pay he will. In case of Y’s failure to pay, 
the car showroom will recover its money from X.  
This is a contract of guarantee because X promises to discharge the liability of Y in case of 
his defaults. 
A contract of guarantee is a tripartite agreement between principal debtor, creditor and 
surety. There are, in effect three contracts 
(i) A principal contract between the principal debtor and the creditor. 
(ii) A secondary contract between the creditor and the surety.  
(iii) An implied contract between the surety and the principal debtor whereby principal 
debtor is under an obligation to indemnify the surety; if the surety is made to pay or 
perform.  
 
Three 
parties are 
involved in a 
contract of 
guarantee
Surety- person who gives the guarantee 
Principal debtor- person in respect of whose default the 
guarantee is given
Creditor- person to whom the gurantee is given
© The Institute of Chartered Accountants of India
  BUSINESS LAWS 
2.156 
The right of surety is not affected by the fact that the creditor has refused to sue the 
principal debtor or that he has not demanded the sum due from him. 
 
ESSENTIAL FEATURES OF A GUARANTEE
The following are the requisites of a valid guarantee:- 
1. Purpose: The purpose of a guarantee being to secure the payment of a debt, the 
existence of recoverable debt is necessary. If there is no principal debt, there can be 
no valid guarantee. 
2. Consideration: Like every other contract, a contract of guarantee should also be 
supported by some consideration. A guarantee without consideration is void, but 
there is no need for a direct consideration between the surety and the creditor.  
As per Section 127 consideration received by the principal debtor is sufficient 
consideration to the surety for giving the guarantee, but past consideration is no 
consideration for the contract of guarantee. Even if the principal debtor is 
incompetent to contract, the guarantee is valid. But, if surety is incompetent to 
contract, the guarantee is void. 
Example 8: B requests A to sell and deliver to him 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. As per 
Section 127, there is a sufficient consideration for C’s promise. Therefore, the 
guarantee is valid.  
Example 9: A sells and delivers goods to B. C afterwards, without consideration, 
agrees to pay for them in default of B. The agreement is void.  
3. Existence of a liability: There must be an existing liability or a promise whose 
performance is guaranteed. Such liability or promise must be enforceable by law. The 
liability must be legally enforceable and not time barred. 
Contract of Guarantee
(Tripartite Agreement) 
Principal 
Contract
Principal 
Debtor
Creditor
Secondary 
Contract
Creditor Surety
Implied 
Contract
Surety
Principal 
Debtor
© The Institute of Chartered Accountants of India