Contract of Indemnity and Guarantee | Business Laws for CA Foundation PDF Download

Contract of indemnity

An indemnity contract is a legal arrangement between two parties in which one party agrees to pay another party for a loss or harm that meets certain requirements and conditions unless other circumstances are specified. It is a form of contingent contract which is characterized by all the essential elements of a valid contract.

In an indemnity contract, there are only two parties, as stated in:

• The indemnifier: The promisor, who agrees to make up the damage caused to the other group, is called the Indemnifier.
•  The Indemnified: The person who is assured of compensation for the damage incurred (if any) is referred to as the indemnity holder or the indemnified.

The mode of the compensation contract can be express or implied, i.e. if a person expressly agrees to save the other from damages, the mode of the contract will be stated, while if the contract is signified by the terms of the case, the mode of the contract will be implied.

Examples of the indemnity contract are given below:

Suppose John had sold Paul a house at Peter's direction. Afterwards it is revealed that Alex is the house's registered owner. Alex got back John's sum for selling his house. John will now recoup Peter's fee. This is an implicit form of an indemnity contract.

 Beta Insurance Company entered into a deal with Alpha Ltd. to reimburse the company's stock of products up to Rs. 50,00,000 for a premium of Rs.1,00,000 for damages incurred by accidental fire. That is an explicit type of an indemnity contract.

Rights of indemnity holder

Section 125 of the Indian contracts act states:
Rights of indemnity-holder when sued.
The promisee in a contract of indemnity, acting within the scope of his authority, is entitled to recover from the promisor:

• All damages which he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies.
• all costs which he may be compelled to pay in any such suit if, in bringing or defending it, he did not contravene the orders of the promisor, and acted as it would have been prudent for him to act in the absence of any contract of indemnity, or if the promisor authorized him to bring or defend the suit;
• all sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the promisor, and was one which it would have been prudent for the promisee to make in the absence of any contract of indemnity, or if the promisor authorized him to compromise the suit.

Rights of the Indemnifier

• After the indemnity holder is paid for the damage incurred, the compensator shall have all the rights to all the methods and services which can save the compensator from the damage.

The essence of the indemnity contract is the loss to the party, i.e. Indemnification can only be done if the loss to the other party is incurred, or if it is certain that the loss will incur.

The Indian Contract Act of 1872 does not provide for the time to commence the liability of the indemnifier under the contract.

But in this respect different high courts in India held the following rules:

The Indemnifier shall not be liable until the loss has been suffered by the indemnified person.
If the indemnified person has not discharged his liability, he may compel the indemnifier to make good his loss. In the leading case of Gajanan Moreshwar vs. Moreshwar Madan (1942), the judge made the observation that If the indemnified has incurred a liability and the liability is absolute, he is entitled to call upon the indemnifier to save him from the liability and pay it off.

Indemnity and insurance

Stand in India

section-124 acknowledges only such a contract as an indemnity contract where there is a guarantee to save another person from harm that may be incurred by the actions of the promiser himself or by some other person's conduct. It does not cover a commitment to compensate for the loss due to human activity not occurring. Therefore, the scope of section-124 does not extend to an insurance plan. Therefore, if an insurer agrees to pay compensation in the case of damage by fire under an insurance policy, such a policy does not fall under the purview of section-124. Such contracts are contracts that are valid as contingent contracts as described in section 31.

In United India Insurance Co. vs. M/s. Aman Singh Munshilal. 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.

Stand in Europe

Under English law the term "indemnity" has a far wider sense than the Indian Contract Act gives it. It requires a guarantee to save the pledge from failure, be it caused by human intervention or some other incident such as an accident and fire. By English law an insurance contract (other than life insurance) is an indemnity contract. Nevertheless, the Life Insurance plan is not an indemnity plan, since specific factors apply in such a contract. For example, a life insurance policy may include payment of a certain sum of money either upon a person's death or upon the expiry of a defined period of time (even if the insured person is still alive).

For such a case, there does not arise the issue of the amount of damage incurred by the insured, or compensation for the same. However, even though a certain sum is due in the event of death, because a person's life can not be measured unlike property, the entirety of the guaranteed amount is due. Even for that reason it is not an indemnity deal.

Recommendations of the law commission of India

The Indian Law Commission prepared and published its Thirteenth Report in 1958, under the chairmanship of Shri MC Setalvad, proposing changes to the various provisions of this act.

The most important of this commission's recommendations are:

• Modification of the privity doctrine to require a third party to sue in such conditions in respect of a contract made for his benefit.
• Change of consideration doctrine to make contracts enforceable without consideration, an obligation to hold a bid open for an indefinite period of time.
• The recognition of principle of promissory estoppels
• wagering contracts and contingent deals to be made unlawful
• To require fair restriction of the right to carry on trade
• Include the rules relating to substantive modifications to papers.
• The concept of coercion in the Indian contract act isn't exhaustive.

It can't refer to modern-day circumstances where violence can be caused in many ways. The Indian Contract Act defines coercion as:
the committing or threatening to commit, any act forbidden by the Indian Penal Code or the unlawful detaining or threatening to detain, any property, to the prejudice of any person whatever, with the intention of causing any person to enter into an agreement.

The report suggested the phrase  forbidden by the Indian Penal Code should be replaced with a wider expression of the offences forbidden by law in India be included in the Section. The report suggested the following phrase instead:

Coercion is the committing or threatening to commit any act, when the committing, or threatening to commit such act is punishable by any law for the time being in force, or the unlawful detaining, or threatening to detain, any property, to the prejudice of any person whatever, with the intention to causing any person to enter into a contract.

Contract of Guarantee

Section 126 of the Indian Contracts Act defines a contract of guarantee as A contract of guarantee is a contract to perform the promise or discharge the liability, of a third person in case of his default.

Furthermore, the section adds:

The person who gives the guarantee is called the surety, the person in respect of those defaults the guarantee is given called principal debtor, and the person to whom guarantee is given is called the creditor.

There are three parties in each guarantee contract, the principal creditor, the surety and the principal debtor.

A guarantee contract consists 3 contracts:

• First, the principal debtor himself makes a commitment to fulfill a contract in favor of the creditor.
• Second, if the principal debtor makes a default, the surety undertakes to be liable to the creditor.
• Thirdly, the principal debtor's implicit promise in support of the assurance that, in the event that the protection is obliged to discharge the responsibility of the principal debtor's default, the principal debtor shall indemnify the protection for it.

Main features of contract of guarantee

• The contract can be either oral or in writing. Nevertheless, the assurance contract can only be in writing in English law.
• The guarantee contract presumes a principal liability or a discharge duty on the part of the principal debtor. Even if there is no such principal liability, one party agrees to pay another under such situations, and the enforcement of this obligation is not contingent on anyone else's default, it is an indemnity contract.
• Sufficient consideration is to support the principal debtor. It is not necessary to have clear consideration between the creditor and the assurance that it is appropriate that the creditor has done anything for the good of the principle debtor.
• Assurance consent cannot be obtained by misrepresentation or cover of any material information relating to the transaction.

Liability of surety

Section 128 of the Indian contracts act states the liability of the surety is co-extensive with that of principal debtor, unless it is otherwise provided by the contract

Surety's liability is the same as that of the principal debtor. A creditor can move directly against the surety. Without suing the principal debtor, a creditor may sue the surety directly. Surety is liable to make payment immediately after the default of any payment by the principal debtor.

Primary responsibility for making payment, however, is from the principal debtor, and the responsibility of the surety is secondary. In fact, if the principal debtor can not be held liable for any payment due to any document error, then surety is not responsible for such payment as well.[5]

Rights of surety

Broadly, the rights of the surety are classified into 3 types:

• Rights against the principle debtor
  • Right to give Notice
  • Rights of Sub-rogation
  • Right of Indemnity
  • Right to get Securities
  • Right to ask for Relief
•  Rights against the creditor
  • Right to get Securities
  • Right to ask for Set-off
  • Rights of Sub-rogation
  • Right to advice to Sue Principal Debtor
  • Right to insist on Termination of Services
•  Rights against co-sureties
  • Right to ask for contribution: Surety can ask its co surety to add the sum when the principal debtor defaults. If they have issued commitments for equal quantities, they would have to make equivalent contributions. In the event that guarantee is given in equal quantities, the contribution style varies from England law to Indian law. According to England law payment in the ratio of assured sums is to be made. Nevertheless, according to Indian law, the sum of the deficit is to be allocated equally to all guarantees, and each promise must contribute a share of the deficit or pledge that is ever lower.
  • Right to claim share in securities

Continuing Guarantee

One form of guarantee that extends to a series of transactions is a continuing guarantee. A continuing guarantee extends to all transactions that the principal debtor enters into before the surety revokes it. A continuing guarantee for future transactions may be withdrawn at any time by notice to the creditors. However, the responsibility of a surety for transactions completed prior to such revocation of guarantee is not diminished.

Discharge of a surety

• By providing a revocation notice for future transactions (section 130).
• the guarantee is revoked for all the future transactions under the circumstances of the death of the surety (section 131).
• When there is a non-consensual change in terms and condition of the contract between the creditor and principal debtor.
• In case the creditor releases the debtor or makes any omission due to which results in the discharge of principal debtor's liability (section 134).
• When the complete payment is made by the principle debtor
• The surety is also discharged when the creditor enters into an arrangement with the principal debtor for not to sue him or to provide extra time for payment of debt, (section 135).
• when the creditor does any act, which is inconsistent with the rights of the surety.

Exceptions to the discharge of surety

• The surety cannot be discharged, if the contract to provide time to the principle debtor is not made by the creditor with the principle debtor but with a third party.
• In case of co-surety, if one is released by the creditor, the others do not stand discharged.

Difference between contract of indemnity and contract of guarantee 

• There are two parties in a contract of indemnity whereas a contract of guarantee has three parties.
• Three contracts exist in contracts of guarantee whereas in contracts of indemnity, there is just one contract
• The liability of the indemnifier in the contract of indemnity is primary whereas for a contract of guarantee the liability of the surety is secondary and the primary liability is of the debtor.
• A contract of indemnity serves the purpose of saving the other party from suffering loss. However, in a contract of guarantee, the purpose is to assure the creditor that either the contract will be performed, or liability will be discharged.
• the liability in a contract of indemnity only arises when the contingency occurs while in the contract of guarantee, the liability already exists
• the promisor cannot file the suit against third person, in a contract of indemnity, until the promisee relinquishes his right in favour of the promisor whereas the surety does not require any relinquishment for filing of suit in a contract of guarantee.

Bank Guarantee

A bank guarantee is a tripartite arrangement between the bank, the receiver and the individual or client, whereby the bank gives an undertaking to pay the receiver a definite amount of money or arranges the fulfilment of the customer's obligations in the event of his default. Banks are usually approached for having the financial resources to meet these obligations. It is simply a kind of absolute obligation to pay the balance if the guarantee holder requests it.

A bank guarantee arrangement between the beneficiary and the creditor is distinct and separate from the underlying contract that subsists. It is particularly relevant when assessing the banks' responsibility in the event of debtor default. It is simply for the free flow of trade as a guarantee provided by the bank, it protects the borrower from the loss and also gives the borrower the right to claim debt in the event of a default without going through the tiresome and prolonged process of litigation.

There are two types of bank guarantee:

• Advance payment guarantee: Buyers of goods and commodities generally use this type of guarantee to secure and protect the advance payment that they make in exchange of the goods. Advance guarantee paid can be recovered as it is the primary obligation of the bank which is giving the guarantee.
•  Payment guarantee: it is a more secure form of guarantee that makes it compulsory for the debtor to pay.

Case Laws

• Adamson vs. Jarvis: The plaintiff, who was an auctioneer sold certain cattle on the instruction of the defendant. It was subsequently found out that the livestock sold was not owned by the defendant but belonged to another person who made the auctioneer (plaintiff) liable for the conversion. The auctioneer in turn sued the defendant for indemnity for the loss and damage suffered by him while acting on the defendant's instructions. The court laid down that the plaintiff had acted upon the request of the defendant and was entitled to presume that he would be indemnified in case things went wrong. Hence, the defendant was ordered to indemnify the loss and damage to the plaintiff.
• Osman Jamal and Sons Ltd. vs. Gopal Purshottam: In this case the plaintiff's company was in the process of liquidation and was being represented by the official liquidator. The plaintiff's company was acting as the commission agent for the defendant firm for the purchase and sale of certain goods. Further the defendant firm was to indemnify the plaintiff company against all loss and damage in respect of such transaction. The defendant firm failed to receive the delivery because of which the goods were resold by the vendor at less than the contract price. The plaintiff consequently sued for the recovery of the sum. The judge decided in the favour of the plaintiff.
• Gajanan Moreshwar Parelkar v Moreshwar Madan Mantri: the plaintiff executed two mortgages in favour of Mohandas at the command of the defendant. Defendant promised to indemnify the plaintiff against any suits by the mortgagee, along with executing a third mortgage in place of the previous two(by the means of a letter). Plaintiff requested to release of liability.
  The issues raised were whether the indemnified could ask for performance of the contract of indemnity without suffering any actual loss and whether the obligation of the plaintiff was absolute. It was held that the sections 124 and 125 do not apply, as said sections do not cover the transaction
• Lala Shanti Swarup vs Munshi Singh & Others: The plaintiff sold an encumbered land to defendant, who promised to make required payment against a mortgage to the mortgagee; but failed to do so because of which the plaintiff incurred loss in the form of their property being sold. The plaintiff sued under implied contract of guarantee. The Issues that arose were: was there a contract of guarantee? Was the suit barred by limitation?

It was held:
A conveyance which contains a covenant whereby the purchaser promises to pay off encumbrances on the sold property is nothing but an implied contract of indemnity, whose cause of action arises when actually indemnified. (Mortgage decree being passed does not amount to actual indemnification)