In brief - Ask your lawyer to draft and review all guarantee and indemnity documentation
Both guarantees and indemnities are commonly used to protect lenders from risk of default by a borrower under a loan agreement. However, their obligations differ fundamentally in nature and scope. It is important to know what guarantees and indemnities are and the key differences between them, as guarantors and indemnifiers often take on a substantial financial risk.
What is a guarantee and what is an indemnity?
A guarantee is a contractual promise by one party (the guarantor) to another party (the beneficiary) to fulfil the obligations owed by a third party (the primary obligor) to the beneficiary, in case the primary obligor fails to fulfil the obligation. These obligations are not limited to pecuniary obligations - they can also include obligations to perform.
The primary obligor has an ultimate or primary liability for the obligations guaranteed by the guarantor. The guarantor, on the other hand, has an ancillary or secondary liability which is only triggered when the primary obligor fails to perform the guaranteed obligations. This liability of the guarantor cannot be greater than the liability of the primary obligor (this is known as the principle of co-extensivity) and will be extinguished or reduced if there is a defect in the primary obligation (such as if the primary obligation is void, unenforceable or illegal).
An indemnity is a contractual promise by one party (the indemnifier) to compensate for loss suffered by another party (the beneficiary). It is a primary liability because it is not dependent on the primary obligor's failure to perform.
Guarantors and indemnifiers can be third parties, related entities of the borrower (such as a parent company) and can include individuals or corporations.
Courts will consider the contract terms' construction to determine whether it is a guarantee or an indemnity
Sometimes in financing transactions, lenders prefer for a guarantee document to include both a guarantee and indemnity which allows the beneficiary to rely on the protection of the indemnity in the event that the guarantee is discharged.
So, how do we know if a contract is a guarantee or an indemnity? The name of the contract ("guarantee" or "indemnity") might indicate the intentions of the relevant parties, however, it is not conclusive that the contract is a guarantee or indemnity. The courts have said that they will look at the construction of the terms of the relevant contract and consider the instrument as a whole (i.e. substance over form).
Primary and secondary liabilities among differences in nature and scope of obligations
In financing transactions, a guarantee and indemnity share the same objective of protecting the lender from default by the borrower under the loan agreement. However, the nature and scope of the obligations in a guarantee is fundamentally different to those contained in the indemnity.
As discussed above, a guarantee is a secondary liability that is dependent on the existence of the primary liability, such that if the primary liability is extinguished or satisfied, the guarantee will no longer be required. A guarantor's liability can also be extinguished by any transaction between the beneficiary and the primary obligor which has the effect of expanding the guarantor's liability (this includes any transaction between the beneficiary and the primary obligor which was not approved by the guarantor).
By contrast, an indemnity is a primary liability.
Even when not required by law, guarantees should be in writing
Section 4 of the Statute of Frauds 1677 (UK) requires a guarantee to be made in writing, or to be evidenced in writing. Equivalent legislation has been enacted in a number of states in Australia; however, it is not in force in South Australia or the ACT. The Statute of Frauds was repealed in NSW by section 8 of the Usury, Bills of Lading and Written Memoranda Act 1902 (NSW). However, it was retained by local legislation but was repealed by the Usury, Bills of Lading and Written Memoranda (Repeal) Act 1990 (NSW). Although guarantees do not have to be in writing in some states, it is recommended that a guarantee be executed in writing.
No requirement to have an indemnity in writing
An indemnity does not have to be in writing and may be implied (based on a common law principle that when party A acts on the instructions of party B and such act injures the rights of party C, party A may request an indemnity from party B), subject to certain statutes, including consumer credit legislation.
|Does a primary obligation need to exist?||Primary obligation needs to exist for the guarantee to be enforceable.||Primary obligation does not need to exist for indemnity to be enforceable. Indemnity is enforceable as long as loss has occurred.|
|Scope of liability||Liability is limited by the extent of the principal obligor's liability.||Liability is determined by terms of the indemnity.|
|Does it have to be in writing?||A guarantee does not have to be in writing in NSW, SA and ACT. It does have to be in writing in some other states, such as VIC.||An indemnity does not have be in writing - it may be oral or may arise by implication.|
|Rights of subrogation and contribution||A guarantee carries the right of subrogation and contribution.||An indemnity does not carry the right of subrogation and contribution.|
|Defects or variations of primary obligation||Defects/variation in the primary obligation may (absent special protections) void a guarantee.||Defects/variation in the primary obligation are unlikely to void an indemnity.|
Revised Code of Banking Practice contains some guarantor protections
The revised Code of Banking Practice 2013 is a voluntary code of conduct which sets standards of good banking practice for banks to follow when dealing with persons who are a bank's individual and small business customers and their guarantors. It is important to note that the Code only applies to certain guarantees, that is, to each guarantee and indemnity received from an individual guarantor for securing a facility provided by a bank to another individual or a small business.
The Code contains certain guarantor protection provisions, such as a stipulation that a bank must notify a potential guarantor that it needs to obtain independent legal and financial advice on the guarantee before the bank receives the guarantee from the guarantor.
Tips for beneficiaries
The following are some simple tips for a beneficiary of a guarantee:
- Check the capacity of the guarantor
- Execute the guarantee as a deed because this extends the time to proceed on a breach.
- Make sure the guarantor receives independent legal and financial advice before executing any guarantee document.
- If the relationship with the borrower changes in a material way (e.g. if a substantial amount of further funds are advanced), new guarantees should be executed.
- Make sure the guarantee document is clear on what is being guaranteed and when the beneficiary will be indemnified.
- Secure the guarantee via a mortgage or a charge over the guarantor's property.
- Make sure there are solid guarantor representations and warranties in place in the guarantee document.
Finally, it is always a good idea to ask your lawyer to draft (or review) all guarantee and indemnity documentation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.