Guarantees and indemnities – the low down

Posted onMarch 12, 2019

Saunders Law is situated nearby to major central London courts, and is experienced in resolving commercial litigation and disputes economically and efficiently. If you have a breach of contract or debt recovery dispute involving a guarantee or indemnity, call us on 0203 553 6318 to see how we can help.

Commercial contracts carry a considerable amount of risk for all involved. Usually there is a lot riding on whether the contract is completed or not and whether it is done on time and within budget. Even slightly veering off course can have disastrous financial results which can quickly spiral and impact other contracts, suppliers, customers and even potentially the liquidity of a company.

Our lawyers regularly deal with commercial contracts which have started off on track and with no issues, but have quickly descended into chaos, turned sour and spiralled into a complex dispute.

Guarantees and indemnities

The good news is that there are mechanisms in law to help protect parties against risks, for example guarantees and indemnities. It is better to put these in place before entering into a commercial contract, although it may be possible to negotiate these part-way through, depending on commercial bargaining power.

This article provides a headline view of guarantees and indemnities, what they are, how they differ, potential pros and cons of using them, and some key practical points.

Limitation issues for bringing claims

It is worth noting that whilst for many types of commercial disputes, parties may have 6 years to bring a claim, there are certain types of disputes involving guarantees, where the limitation period could be much shorter, at 2 years, pursuant to the Civil Liability Act 1978.

The distinction can depend on whether the claim is for a debt or for damages. If it is debt, limitation could be 6 years, if damages, this may be limited in statute to 2 years.

The difference could be as subtle as whether the guarantor promises that it will step into the other party's shoes if it fails to deliver, or whether the guarantor promises that the other party will perform its duties. If the latter, the dispute may be limited to 2 years.

The trigger point when limitation starts running can vary from case to case, and early advice is sensible.

Terminology

In this article, the following terms are used:

Party A - the Beneficiary (i.e. the party getting the benefit of the guarantee). For example, a buyer or "employer" in a construction contract.

Party B - the Principal (i.e. the party with the obligation under the contract required to do something for Party A's benefit). For example, a seller or a construction company tasked with construction work.

Party C - the Guarantor / Surety (i.e. the party who is usually independent from Party A and Party B, but offers the guarantee for either Party B's performance under the contract or loss occasioned by them). This could be for example, the parent company of Party B, or potentially a bank.

A simplified diagram might read:

Party A contracts with Party B, and Party C provides the independent guarantee. A - B / C.

If Party C has to pay out to Party A, Party C may have a claim against Party B.

What is a guarantee?

A guarantee is a contractually binding promise, usually from a third party to a commercial contract (Party C), which either:

1) ensures the party with obligations under a commercial contract (Party B) will perform the contract (and / or if it doesn't will step into Party B's shoes); or
2) promises to pay Party A, if Party B becomes insolvent or otherwise, monies which Party B owes to Party A.

What are some legal implications of guarantees?

A guarantee has to be in writing, signed by the guarantor and follows usual contract rules.
For this reason, if no "consideration", which is broadly a transfer of value, is provided, then the guarantee may be ineffective, and non-binding. To get around this, guarantees are often drawn up by way of a deed, which doesn't require consideration.
The guarantee is tethered to the underlying contract, and if the underlying contract is varied beyond the initial agreement, or is frustrated or falls away, the guarantee may become unenforceable.
The party demanding payment under a guarantee (Party A demanding payment from Party C, following Party B's failure to deliver) has to show that they are entitled to payment under the guarantee and that Party B has failed to deliver, and there are no viable defences. Normal rules of mitigation and remoteness can also apply.
If Party A actively misrepresents a situation to Party C, this may cause a guarantee to fail, but surprisingly there is generally no duty of disclosure by Party A to Party C, unless the information is something unusual which impacts on contractual relations. I.e. if Party C fails to enquire about something which could affect the guarantee, but isn't seen by the court to be "unusual" or if this might otherwise be held to be common knowledge, then Party C may still be bound.
The benefit of guarantees can be assigned to a third party.

What is an indemnity?

Like a guarantee, an indemnity is a contractual agreement for Party C to honour Party A's loss in the event that Party B defaults.

However, a key distinction between indemnities and guarantees is that an indemnity does not need to be in signed writing, and could potentially be oral. As an indemnity is generally more onerous than a guarantee, this may be surprising, and poses significant potential risk.

Another key distinction is that an indemnity creates an obligation for Party C to pay Party A, independent from the agreement between Party A and B. If the underlying contract between Party A and Party B fails, Party C may still be liable to Party A.

An indemnity can therefore be more secure for Party A as the beneficiary but is conversely likely to be more onerous for Party C than a guarantee.

An indemnity is also less secure than a guarantee for Party C, as a guarantee otherwise can offer Party C more means of redress or repayment, which an indemnity doesn't offer.

Benefits of guarantee

Under a guarantee, Party C has a right of redress and can claim its losses against Party B if Party C has to pay under the guarantee.

Party C can also assume some rights of Party B as against Party A, for example:

If Party B can offset its liabilities to Party A under the contract, then Party C may be able to do so similarly.
If Party C pays the guarantee in full, then Party C can acquire rights of security that Party B may have against Party A, (known as subrogation).
Party C may even be able to obtain the benefit of another creditor's security over Party A's assets under "marshalling" rights in equity.

Is it possible to have a mixed guarantee and indemnity?

The short answer is yes, and banks in particular try to lump them together, but this has to be dealt with carefully.

Quite often in practice a document labelled as either a "guarantee" or an "indemnity" can in fact be a mixture of the two or the polar opposite, and the courts have to interpret what the intention and effect of these documents are.

Someone hoping for an indemnity may regrettably be downgraded to a guarantee, and vice versa.

If someone enters into an indemnity orally, which is actually held to be a guarantee, but as the guarantee is not then in signed writing, then potentially no security exists.

Additional considerations

If an individual is required to provide a guarantee, then Consumer Rights law could potentially apply to guarantees and indemnities; case law in this area is developing.
If the terms of the underlying contract between Party A and B relating to a guarantee are changed without Party C's knowledge or agreement, this could cause the guarantee to fail. This might be the case, for example, even if a relatively minor extension for delivery is agreed.
Whether a guarantee or indemnity is good or bad, or risky or not, depends which party you are in the arrangement.
A guarantee or indemnity is sensible if Party A suspects that Party B may be in financial difficulty or likely to breach the contract.
Pressing for an indemnity is more secure for Party A, but much more onerous for Party C. In particular Party C can assume some of Party B's rights under the contract under a guarantee but not under an indemnity.
The obligations for either guarantees or indemnities (but especially indemnities) are very onerous and if you are being asked to provide one, taking early advice in sensible. Many people enter them without being alive to the risks.
Party C may offer a guarantee or indemnity very willingly on paper, but not actually be good for the money, so Party A should check whether Party C has any money to pay.
A director of a company may offer a guarantee or indemnity on behalf of their company, but not actually have authority to do so, and may not have sought necessary shareholder approval, and this may not be held as being in the company's interests, so requesting confirmation of authority is sensible.
Party C should check whether there are any other guarantors or guarantees already in place, i.e. are there any co-guarantors. In situations where there are several co-guarantors it can become tricky to work out who is liable for what.
If there are other guarantees, do these deal with entirely separate matters, the exact same matters, or is there a partial overlap, and is this intentional or not?
If the wording of a document which purports to be both an indemnity and guarantee is vague or unclear, the courts will likely interpret the document in the favour of the guarantor, and could make obligation less onerous. If the wording is so vague so as be incomprehensible, the instrument could fail in terms of contract law.
There are separate types of instruments known as "on demand guarantees" or "on demand bonds", which are not considered here, but are even more risky than indemnities, as they do not require any proof that the money is payable; it is sufficient simply that a demand is made. These can be useful for parties dealing with foreign companies, as they can lead to a debt becoming due automatically without a legal battle involving several jurisdictions.
Using guarantees and indemnities does not necessarily avoid the need for litigation altogether, as a party's losses may exceed the amount guaranteed or indemnified under the agreement considerably.

Summary

As hinted at above, whilst very common in commercial disputes, guarantees and indemnities can be very complex, and high risk for all parties. However, when used properly, they can offer considerable security if a commercial contract goes wrong.

If you have a dispute involving a guarantee or indemnity, call us on 0203 553 6318 to see how we can help.