Your Guarantees and Indemnities May Not Be as Effective as You Think

“Guarantee and Indemnity” is a familiar phrase in commercial contracts. The two words often appear together, almost as though they are interchangeable. But they are not.

A creditor may believe it has the benefit of both, only to discover that the wording does not provide the protection expected. A guarantee may have been created, but no effective indemnity. Alternatively, an indemnity may exist, but its scope may be too narrow to provide the intended protection.

The document’s title does not determine the obligations it creates. The operative wording does.

What is a Gurantee? 

A guarantee is a contractual promise by one party (the guarantor) to answer for the debt, default or failure to perform of another party (the principal debtor). It is a secondary obligation, generally dependent on the existence and extent of the principal debtor’s liability.

Example

ABC Limited enters into a hire purchase agreement with Finance Limited to acquire a Ferrari, with monthly instalments of £5,000. Adam provides a personal guarantee of ABC Limited’s payment obligations.

ABC Limited fails to pay an instalment. Assuming the guarantee covers the missed payment and the relevant enforcement requirements are satisfied, Finance Limited may pursue Adam A.

But what happens if ABC Limited successfully argues that the underlying hire purchase agreement is unenforceable? A conventional guarantee may not provide the protection Finance Limited would expect, because the guarantor’s liability is ordinarily tied to the liability guaranteed.

What is an Indemnity? 

An indemnity is a contractual promise to compensate another party for specified losses or liabilities. Properly drafted, it can create a primary obligation independent of the principal debtor’s liability under the underlying contract.

Example

Returning to our example, Adam also provides Finance Limited with an indemnity expressly covering losses arising from ABC Limited’s failure to perform its obligations, including where the relevant payment obligation is invalid or unenforceable.

If ABC Limited successfully challenges the enforceability of the agreement, Finance Limited may still have a claim against Adam under the indemnity, provided its wording covers the loss and the indemnity is valid and enforceable.

An indemnity is not, however, a guarantee of recovery in every circumstance. Its wording matters.

Common Drafting Issues

1.The Document is headed “Guarantee and Indemnity”, but only creates a gurantee 

Consider a document supporting the hire purchase agreement that is headed “Guarantee and Indemnity”, but contains this operative clause:

“Adam guarantees the due payment and performance by ABC Limited of all its obligations under the Hire Purchase Agreement.”

Where is the separate promise to indemnify Finance Limited?

The heading does not, by itself, establish an indemnity. Although a court will interpret the document as a whole, the creditor should not assume that the title compensates for missing operative provisions.

2. The indemnity merely repeats the guarantee

Consider the following clause:

“Adam indemnifies Finance Limited against ABC Limited’s failure to pay any sums due under the Hire Purchase Agreement.”

Although this uses the word “indemnifies”, questions remain. Does it cover losses where the underlying debt is invalid or unenforceable? Does the wider document establish a genuinely independent obligation?

The wording must be considered in context. Using the word “indemnity” does not automatically achieve the intended legal effect.

3. The indemnity does not address invalidity or unenforceability

An indemnity may be required precisely because the underlying agreement might not be enforceable.

A clause limited to unpaid instalments “due under the Hire Purchase Agreement” may leave room for argument where no enforceable contractual debt exists.

Consider expressly addressing losses arising from invalidity, illegality or unenforceability, where appropriate. The drafting should reflect the particular risks the indemnity is intended to cover.

4. The indemnity is too narrow

An indemnity covering unpaid instalments may not clearly extend to other losses associated with default, such as recovery costs, legal expenses or liabilities arising from the recovery of a vehicle.

If these losses are intended to be covered, address them expressly, subject to appropriate limitations and exclusions.

5. Conditions are overlooked

An indemnity may impose requirements concerning written notice, formal demands or the handling of third-party claims. Failure to comply may complicate enforcement, even where an indemnity exists.

If you intend to rely on a guarantee or indemnity, ensure that you as creditor are confident that you will comply with any conditions you set yourself. 

The Takeaway 

Guarantees and indemnities serve related but distinct purposes. A guarantee provides secondary recourse for another party’s obligations; an indemnity can create an independent obligation to compensate for specified losses.

The distinction may appear technical but can become critical when a customer defaults.

 Can we Help?

Our highly skilled team know exactly what you need in your Guarantee and Indemnity to ensure that it works for you when it counts, during litigation. If you would like any help with your Guarantee and Indemnity, please reach out to our Banking and Finance team for advice.

The contents of this article are a general guide only at the date of publication. It is not comprehensive, and it does not constitute legal advice. Specific legal advice should be sought in relation to the particular facts of a given situation.