First-Year Law Notes & Flashcards

Contract of Indemnity

A contract of indemnity is a legal agreement in which one party promises to compensate another for any loss or damage that may arise due to the conduct of the promisor or any other person. The essence of such a contract is the assurance of security against loss. Section 124 of the Indian Contract Act, 1872, defines a contract of indemnity as “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.” This means that the indemnifier undertakes the responsibility of compensating the indemnity holder for losses incurred due to the actions of the promisor or a third party. The English law definition of indemnity is broader, including losses caused not only by human agency but also by accidents, fire, or other natural calamities, thereby encompassing a wider spectrum of risks.

The nature of a contract of indemnity may be either express or implied. An express indemnity arises when the terms are explicitly stated in a contract, while an implied indemnity emerges from the circumstances of the case or from the conduct of the parties. For instance, if a broker in possession of a government promissory note endorses it to a bank, and the endorsement turns out to be forged, the bank may obtain a renewed promissory note in good faith. If the true owner later claims the note, the bank may seek indemnity from the broker who acted at the bank’s request. Similarly, Sections 69, 145, and 222 of the Indian Contract Act provide specific scenarios of implied indemnity. For example, if a tenant pays the electricity bill of a property on behalf of the owner, the tenant is entitled to be reimbursed, or if a surety pays a debt on behalf of a principal debtor, the surety can claim indemnity.

A contract of indemnity is enforceable provided it meets the general requirements of a valid contract, such as free consent, lawful object, and consideration. If the consent is obtained through coercion, fraud, or misrepresentation, the contract becomes voidable. Likewise, an agreement with an unlawful objective is considered void under the law. The liability of the indemnifier typically arises only when the indemnified has suffered a loss, although anticipation of loss can sometimes trigger preventive measures.

The indemnity holder enjoys several rights under Section 125 of the Indian Contract Act. They are entitled to recover all damages suffered, costs incurred in legal proceedings, sums paid under compromise settlements, and, where necessary, can sue for specific performance if the liability arises under the contract. However, these rights are limited by the duty to act in good faith and prudence; compensation cannot be claimed for acts done dishonestly or in contravention of the indemnifier’s directions. For instance, if an auctioneer sells cattle on behalf of a defendant, and it turns out that the cattle belonged to someone else, the auctioneer can claim indemnity from the defendant for any legal liability incurred, provided the auctioneer acted diligently and within the scope of authority.

On the other hand, the indemnifier retains the right to exercise all reasonable measures to protect himself from loss, even after compensating the indemnity holder. For example, if an indemnifier reimburses a third party for a debt paid on their behalf, they may subsequently claim any recoverable amounts from the person responsible for causing the loss.

Contract of Guarantee

A contract of guarantee, under Section 126 of the Indian Contract Act, 1872, involves three parties: the creditor, the principal debtor, and the surety. In this arrangement, the surety promises to fulfill the obligation or discharge the liability of the principal debtor in case the latter fails to perform. Unlike indemnity, where the indemnifier’s liability arises from loss, in a guarantee contract, the surety’s liability is secondary, only arising when the principal debtor defaults. The creditor is the party extending credit or lending money, the principal debtor is the one availing of the credit, and the surety guarantees the debt or performance. For example, if Y requires a loan of Rs. 10,000 from X, and Z provides a guarantee for Y, then X is the creditor, Y is the principal debtor, and Z is the surety. If Y fails to repay the loan, Z becomes liable to pay X.

The essence of a guarantee contract is to facilitate trust in commercial and personal transactions. It allows creditors to extend credit or services with reduced risk, knowing that the surety will be responsible if the debtor defaults. A contract of guarantee requires the consent of all three parties, but this consent can be either express or implied. The principal debtor’s concurrence is essential but does not need to be explicitly documented; an implied acceptance suffices. Consider a situation where an employer requires a surety to secure the performance of an employee tasked with managing company funds. The surety may provide a guarantee that ensures the employer can recover losses if the employee mismanages funds.

A guarantee contract, like any contract, is only valid if supported by lawful consideration. Without consideration, the contract is void. Furthermore, the primary liability always rests with the principal debtor, while the surety’s liability is contingent upon the debtor’s failure. This distinction is critical because it defines the order in which claims may be enforced and protects the surety from premature legal obligations.

In commercial practice, guarantees are widely used, not just for loans, but for securing obligations in contracts, tenders, and employment bonds. They create a legal framework that balances risk and ensures that obligations are met even if the primary party defaults, promoting confidence in commercial dealings.

Indemnity vs Guarantee: A Comparative Discussion

While both indemnity and guarantee are contracts designed to provide protection against loss or risk, they differ fundamentally in their structure, parties involved, and the nature of liability. Understanding these differences in a practical context helps in grasping the concepts clearly.

A contract of indemnity is essentially a promise to compensate for any loss incurred. It involves two parties : the indemnifier and the indemnity holder. The indemnifier undertakes the responsibility to make good any loss suffered by the indemnity holder due to the conduct of the indemnifier or a third party. For example, suppose X agrees to sell a tape recorder to Y. Meanwhile, Z approaches X and requests to purchase the same tape recorder, promising to compensate X for any loss caused due to selling it to Z. Here, Z acts as the indemnifier, and X is the indemnity holder. If X suffers a loss because of this transaction, Z is legally bound to compensate X. The liability in indemnity is primary , meaning it arises as soon as the loss occurs. The indemnity holder can claim damages, costs, or any sums paid under compromise settlements, provided he acts in good faith and prudence.

In contrast, a contract of guarantee is a tripartite arrangement involving three parties : the creditor, the principal debtor, and the surety. The purpose of a guarantee is to secure the performance of the principal debtor’s obligations or repayment of a debt. Unlike indemnity, the liability of the surety is secondary ; it arises only if the principal debtor fails to fulfill their obligation. For instance, if Y borrows Rs. 10,000 from X, and Z guarantees repayment, X is the creditor, Y the principal debtor, and Z the surety. If Y defaults, only then does Z become liable to pay X. A contract of guarantee is often used in loans, contracts, or employment arrangements where additional assurance is required. The guarantee ensures that the creditor has a fallback if the principal debtor fails to meet obligations, while the surety’s liability is contingent, not automatic.

The distinction between indemnity and guarantee also extends to the nature of risk covered. In indemnity, the indemnifier is liable for losses caused by an act, either of his own or of a third party. This means indemnity covers actual loss suffered by the indemnity holder. Guarantee, however, does not compensate for loss per se; it ensures the performance of an obligation or repayment of a debt. The creditor is primarily interested in fulfillment rather than compensation for loss. For example, if an employee fails to complete a contract task, a surety under a guarantee may need to fulfill the obligation, whereas in indemnity, the indemnifier pays for the monetary loss incurred due to that failure.

Another important difference lies in rights and remedies . In indemnity, the indemnity holder can directly recover losses from the indemnifier. The indemnifier cannot avoid liability by pointing to the conduct of a third party if the loss is covered under the contract. In a guarantee, the surety has specific legal remedies against the principal debtor after paying the creditor. For instance, if Z pays X on behalf of defaulting Y, Z can subsequently recover the amount from Y. This “right of subrogation” is unique to guarantees and underscores the secondary nature of suretyship liability.

Finally, the formation of these contracts differs. A contract of indemnity is valid as long as there is lawful consent and consideration between the two parties. A guarantee contract, however, requires the consent of all three parties: the creditor, the principal debtor, and the surety. The surety’s consent can be express or implied, but it is essential. Without this concurrence, the contract of guarantee is void.

In summary, indemnity is about compensation for loss , involves two parties , and liability is primary , while guarantee is about performance or repayment , involves three parties , and liability is secondary . Both contracts serve to mitigate risk, but they operate differently in terms of responsibility, rights, and remedies. Understanding these distinctions with practical examples makes it easier to apply the concepts in real-life legal and commercial situations.

DIFFERENCES BETWEEN INDEMINTY AND GUARANTEE 

Feature	Contract of Indemnity	Contract of Guarantee
Definition	As per Section 124, “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.”	As per Section 126, “A contract to perform the promise or discharge the liability of a third person in case of default.”
Number of Parties	Two parties – Indemnifier and Indemnity Holder	Three parties – Creditor, Principal Debtor, and Surety
Nature of Liability	Primary – the indemnifier is liable directly on occurrence of loss	Secondary – the surety is liable only if the principal debtor defaults
Purpose	To compensate for loss or damage	To secure performance of obligation or repayment of debt
Consideration	Can arise even without prior transaction; the indemnifier promises to bear future loss	Must be supported by lawful consideration; guarantee without consideration is void
Right of Recovery	Indemnity holder can directly recover damages, costs, and sums paid under compromise from the indemnifier	Surety has the right to recover from the principal debtor after paying the creditor (subrogation)
Consent Requirement	Only two parties’ consent required	Consent of all three parties is necessary (creditor, principal debtor, and surety)
Trigger of Liability	Loss suffered by indemnity holder triggers liability	Default of principal debtor triggers liability
Examples	X sells a tape recorder; Z promises to compensate X for any loss caused by selling it to Z. Here, Z is indemnifier and X is indemnity holder.	Y borrows Rs. 10,000 from X; Z guarantees repayment. X is creditor, Y is principal debtor, Z is surety. If Y defaults, Z pays X.
Sections of Indian Contract Act	Section 124–125	Section 126–128

2.1 The Essentials of a Contract of Guarantee are:

Tripartite Agreement: A contract of guarantee entails three parties, principal creditor, creditor and surety. In a successful contract of guarantee, there must be three separate contracts between the three parties and each and every contract must be consenting.

Liability: Here the main liability lies with the principal debtor. Secondary liability lies with the surety which can only be invoked once the principal debtor defaults on its payment.

Essentials of a Valid Contract: Like any other general contract, it maintains free consent, consideration, lawful object and competency of contracting parties as the essentials of a valid contract.

Medium of Contract: The Indian Contract Act, 1872, does not strictly mention the need for any written form of contract of guarantee. Both oral and written form will suffice.

2.2 Rights of a surety:

As against the Creditor:

1. Right to securities.

 As per section 141, a surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of surety ship is entered into whether the surety knows about the existence of such security or not; and if the creditor loses or without the consent of the surety parts with such security, the surety is discharged to the extent of the value of the security.

Illustrations –

C advances to B, his tenant, 2000/- on the guarantee of A. C also has a further security for 2000/- by a mortgage of B's furniture. C cancels the mortgage. B becomes insolvent and C sues A on his guarantee.

A is discharged of his liability to the amount of the value of the furniture.

 C, a creditor, whose advance to B is secured by a decree, also receives a guarantee from A. C

Afterwards takes B's goods in execution under the decree and then without the knowledge of A,

Withdraws the execution. A is discharged.

 A as surety for B makes a bond jointly with B to C to secure a loan from C to B. Afterwards, C obtains from B a further security for the same debt. Subsequently, C gives up the further security. A is not discharged.

This section recognizes and incorporates the general rule of equity as expounded in the case of Craythorne vs Swinburne 1807 that the surety is entitled to every remedy which the creditor has against the principal debtor including enforcement of every security.

The expression "security" in section 141 means all rights which the creditor had against property at the date of the contract. This was held by the SC in the case of State of MP vs Kaluram AIR 1967. In this case, the state had sold a lot of felled trees for a fixed price in four equal installments, the payment of which was guaranteed by the defendant. The contract further provided that if a default was made in the payment of an installment, the State would get the right to prevent further removal of timber and the sell the timber for th e  realization of the price. The buyer defaulted but the State still did not stop him from removing further timber. The surety was then sued for the loss but he was not held liable.

It is important to note that the right to securities arises only after the creditor is paid in full. If the surety has guaranteed only part of the debt, he cannot claim a proportional part of the securities after paying part of the debt. This was held in the case of Goverdhan Das vs Bank of Bengal 1891.

2. Right of set-off

If the creditor sues the surety, the surety may have the benefit of the set off, if any, that the principal debtor had against the creditor. He is entitled to use the defenses that the principal debtor has against the creditor. For example, if the creditor owes the principal debtor something, for which the principal debtor could have counter claimed, then the surety can also put up that counter claim.

According to the Indian Contract Act, 1872 the following rights Sec. 133 – The creditor ought not fluctuate terms of the agreement between the creditor and the principal debtor without the surety’s assent. Any such fluctuation releases the surety as to transactions ensuing to the difference.

However in the event that the change is for the profit of the surety or does not prefer him or is of an irrelevant character, it might not have the impact of releasing the surety.

Sec. 134 – The creditor ought not discharge the principal debtor from his liability under the agreement. The impact of the release of the principal debtor is to release the surety too. Any enactment or exclusion from the creditor which in law has the impact of releasing the principal debtor puts a close to the liability of the surety.

Sec. 135 -In the event that an agreement is made between the Creditor and Principal debtor for intensifying the last’s liability or making a guarantee to him growth of time for doing the commitments or swearing up and down to not to beyond any doubt, releases the surety unless he consents to such an agreement.

As Against the Principal Debtor

1. Right of subrogation – The surety on making good of the debt obtains a right of subrogation.

 Sec. 140 – the surety can’t assert the right of subrogation to the creditor’s securities in the event that he has agreed as a security for a part of the contract and security has been procured by the creditor for the complete debt.

As per section 140, where a guaranteed debt has become due or default of the principal debtor to perform a duty has taken place, the surety, upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the princpal debtor. This means that the surety steps into the shoes of the creditor. Whatever rights the creditor had, are now available to the surety after paying the debt.

In the case of Lampleigh Iron Ore Co Ltd, Re 1927, the court has laid down that the surety will be entitled, to every remedy which the creditor has against the principal debtor; to enforce every security and all means of payment; to stand in place of the creditor to have the securities transferred in his name, though there was no stipulation for that; and to avail himself of all those securities against the debtor. This right of surety stands not merely upon contract but also upon natural justice.

In the case of Kadamba Sugar Industries Pvt Ltd vs Devru Ganapathi AIR 1993, Kar HC held that surety is entitled to the benefits of the securities even if he is not aware of theire existence.

In the case of Mamata Ghose vs United Industrial Bank AIR 1987, Cal HC held that under the right of subrogation, the surety may get certain rights even before payment. In this case, the principal debtor was disposing off his personal properties one after another lest the surety , after paying the debt, seize them. The surety sought for temporary injunction, which was granted.

2. Right to Indemnity

 As per section 145, in every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety; and the surety is entitled to recover from the the principal debtor whatever sum he has rightfully paid under the guarantee but no sums which he has paid wrong fully.

Illustrations –

B is indebted to C and A is surety for the debt. Upon default, C sues A. A defends the suit on reasonable grounds but is compelled to pay the amount. A is entitled to recover from B the cost as well as the principal debt.

In the same case above, if A did not have reasonable grounds for defence , A would still be entitled to recover principal debt from B but not any other costs.

A guarantees to C, to the extent of 2000 Rs, payment of rice to be supplied by C to B. C supplies rice to a less amount than 2000/- but obtains from A a payment of 2000/- for the rice. A cannot recover from B more than the price of the rice actually supplied.

This right enables the surety to recover from the principal debtor any amount that he has paid rightfully. The concept of rightfully is illustrated in the case of Chekkara Ponnamma vs A S Thammayya AIR 1983. In this case, the principal debtor died after hire-purchasing four motor vehicles. The surety was sued and he paid over.

The surety then sued the legal representatives of the principal debtor. The court required the surety to show how much amount was realized by selling the vehicles, which he could not show. Thus, it was held that the payment made by the surety was not proper.

Rights against co-sureties.

1. Effect of releasing a surety

As per section 138, Where there are co-sureties, a release by the creditor of one of them does not discharge the others; neither does it free the surety so released from his responsibility to the other sureties.

A creditor can release a co-surety at his will. However, as held in the case of Sri Chand vs Jagdish Prashad 1966, the released co-surety is still liable to the others for contribution upon default.

2. Right to contribution

As per section 146, where two or more persons are co- sureties for the same debt jointly or severally, with or without the knowledge of each other, under same or different contract , in the absence of any contract to the contrary, they are liable to pay an equal share of the debt or any part of it that is unpaid by the principal debtor.

Illustrations -

 A, B, and C are surities to D for a sum of 3000Rs lent to E. E fails to pay. A, B, and C are liable to pay 1000Rs each. A, B, and C are surities to D for a sum of 1000Rs lent to E and there is a contract among A B and C that A and B will be liable for a quarter and C will be liable for half the amount upon E's default. E fails to pay. A and B are liable for 250Rs each and C is liable for 500Rs.

As per section 147, co-sureties who are bound in different sums are liable to pay equally as fas as the limits of their respective obligations permit.

Illustrations -

 A, B and C as surities to D, enter into three several bonds, each in different penalty, namely A for 10000Rs, B for 20000 Rs, and C for 30000Rs with E. D makes a default on 30000Rs. All of them are liable for 10000Rs each.

 A, B and C as surities to D, enter into three several bonds, each in different penalty, namely A for 10000Rs, B for 20000 Rs, and C for 40000Rs with E. D makes a default on 40000Rs. A is liable for 10000Rs while B and C are liable for 15000Rs each.

 A, B and C as surities to D, enter into three several bonds, each in different penalty, namely A for 10000Rs, B for 20000 Rs, and C for 40000Rs with E. D makes a default on 70000Rs. A, B and C are liable for the full amount of their bonds

Conclusion

A contract of indemnity primarily aims to compensate the indemnity holder for any loss suffered and involves only two parties, the indemnifier and the indemnity holder, with liability arising immediately upon the occurrence of loss. In contrast, a contract of guarantee is intended to secure the performance of an obligation or repayment of a debt, involves three parties—the creditor, the principal debtor, and the surety—and the liability of the surety arises only upon default by the principal debtor. While both contracts serve to mitigate risk, indemnity focuses on covering actual losses, whereas guarantee ensures that obligations are fulfilled, with the surety having the right to recover from the principal debtor after payment (subrogation). Understanding these distinctions, supported by case laws, helps in applying these concepts effectively in both commercial and legal contexts.

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