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If you are preparing for settlement and your lender has asked you to obtain independent legal advice before you sign a deed of guarantee and indemnity, you may have wondered what these terms actually mean. While they often appear together, they are not the same, and understanding their differences is important as they create different legal obligations.
This article explains the concepts of guarantee and indemnity to help you understand the risks and responsibilities involved.
What is a Guarantee?
A guarantee is a promise by one party (the guarantor) to ensure another party (the obligor) complies with its obligations under a contract. The guarantor only becomes responsible if the obligor fails to perform. If the obligor's obligations are reduced, released, or voided, the guarantor's liability is reduced, released, or voided as well.
In most cases, a guarantee involves three parties:
- The guarantor (the party providing the guarantee);
- The obligor (the party with the original obligations); and
- The beneficiary (the party who receives the benefit of the guarantee).
Example:
A company (the obligor) wishes to borrow money from ABC Bank (the beneficiary) and agrees to enter a loan agreement. The company has certain obligations in the loan agreement, such as repaying the loan plus interest and compensating ABC Bank for any losses incurred as a result of the company breaching the loan agreement. Because the company does not own any assets of significant value, ABC Bank will have little prospect of recovering any losses from the company if the company breaches the loan agreement even through legal action. However, ABC Bank discovers that the company's director has $50,000 in a bank account, a house and a car. To mitigate this risk, ABC Bank requires the company's director to provide a personal guarantee as additional security.
The director agrees to be the guarantor and signs a guarantee. Under the guarantee, the director will only become legally obliged to perform the company's obligations under the loan agreement if the company fails to meet them. In that case, the landlord can recover the unpaid rent from the director, instead of the company.
Secondary liability can be thought of as being "second in line"-the guarantor is only liable if the obligor fails to meet its obligations.
However, a guarantee from the guarantor may not adequately protect the beneficiary, such as the lender. The guarantor's liability is limited to:-
- the obligations expressly set out in the contract; and
- compensating the beneficiary for damages that only arise naturally from the breach of contract or were reasonably contemplated by the parties at the time the contract was formed (Hadley v Baxendale (1854) 9 Exch 341).
What is an Indemnity?
An indemnity is a promise to compensate someone for losses, which can include losses that may not otherwise be reasonably foreseeable, arising from a breach of contract. In Zaccardi v Caunt [2012] NSWSC 285, the court held that an indemnifier could recover losses even if they were not of a kind reasonably contemplated at the time the contract was entered into.
A beneficiary may also benefit from an indemnity by not being required to limit or manage its losses, or by not being bound to cap the limitation period for making a claim against the indemnifier. The limitation period often begins when the loss is suffered or when a demand is not met. This can give the beneficiary more time to make a claim against the indemnifier than would be available under ordinary contractual damages (see Hawkins v Clayton (1988) 164 CLR 539).
Generally, an indemnity involves two parties:
- The indemnifier (the party promising to cover the beneficiary's loss); and
- The beneficiary (the party receiving protection).
Example:
A company (the indemnifier) enters a loan agreement with ABC Bank (the beneficiary) to borrow $1 million and agrees to indemnify ABC Bank for any loss it incurs as a result of the company breaching the loan agreement. The company is required to repay the loan in 10 years and the loan agreement provides that failure to repay on time incurs $50,000 in late interest. ABC Bank also relies on the company to repay on time, as a delay could cause it to miss the opportunity to earn profit from lending to other customers. The company fails to repay the loan on time, triggering the following series of events:
- The company becomes liable to pay $50,000 in late interest.
- ABC Bank is unable to lend $1 million to another customer purchasing a home, suffering a loss of $500,000 in potential profit.
- The home seller sues the other customer for $1 million for failing to pay the purchase price, and the customer in turn sues ABC Bank for failing to provide the loan.
Under the indemnity, the company would be liable to compensate ABC Bank not only for the original loan amount and interest, but also for $50,000 in late interest, $500,000 for the lost profit and $1 million for settling the home seller's claim.
However, in some cases, a third party may provide the indemnity in respect of someone else's obligations under a contract. In that arrangement, three parties are involved:
- The indemnifier (the party promising to cover the beneficiary's loss);
- The obligor (the party with the original obligations); and
- The beneficiary (the party receiving protection).
This demonstrates the severity of an indemnity. Unlike a guarantee, which is limited to covering the obligor's failure to perform its contractual obligations, an indemnity can extend to consequential losses, such as loss of profit from the lender.
Essentially, an indemnity provides a direct and enforceable remedy for any losses suffered by the beneficiary, offering broader protection than a guarantee.
The Importance of Reviewing Guarantees and Indemnities
Reviewing guarantees and indemnities is crucial because unclear wording may prevent enforcement.
A well-drafted guarantee should extend beyond the payment of money and expressly require the guarantor to perform the obligor's obligations. In Toma v Taylor Square TT Pty Ltd [2007] NSWSC 680, the guarantee stated that the guarantor would ensure "prompt performance" of obligations. The court found this wording insufficient to require specific performance, highlighting the need for precise drafting.
On the other hand, for an indemnity, ambiguous or unclear wording may unintentionally reduce the scope of the indemnifier's obligations, limiting the beneficiary's ability to rely on the indemnity in certain situations. For example, in a loan arrangement, if a borrower provides an indemnity but the wording is vague, the lender might find that certain consequential losses - such as lost profits, reputational damage, or costs arising from the lender being unable to finance other projects - are not clearly covered, leaving the lender exposed to risks the indemnity was intended to address.
It is therefore essential to review the wording of a guarantee or an indemnity carefully, ensuring it is tailored to the specific circumstances of the parties and their contract.
Combining a Guarantee and an Indemnity
Requiring the guarantor to provide an indemnity, instead of the obligor, can be particularly beneficial for the beneficiary especially if the obligor does not have sufficient assets to give an indemnity. This is because:
- A guarantee is generally limited to the obligations and damages specified in the contract and may not cover all losses suffered.
- An indemnity from the obligor may not be adequate if it has insufficient assets.
In loan transactions, lenders often require borrowers or third parties to sign a deed of guarantee and indemnity as a condition of finance. This ensures the lender is protected and able to proceed smoothly to settlement.
Commercial Applications of Guarantees and Indemnities
Guarantees and indemnities are often used in a variety of commercial settings, such as:
- leases;
- property and business sale and purchase transactions;
- loan agreements;
- supply agreements;
- franchise agreements;
- property development projects; and
- joint ventures.
Conclusion
In summary, guarantees and indemnities differ primarily in terms of liability. Under a guarantee, the guarantor is only responsible if the obligor fails to comply with its obligations under a contract. Under an indemnity, the indemnifier is directly responsible for losses, including consequential losses beyond the contract.
Many contracts use a guarantee and an indemnity to provide two layers of protection: the guarantor promises to step in if the obligor does not meet its obligations, while the indemnity covers broader losses even if the guarantee does not apply.
If you have been asked to sign a deed of guarantee and indemnity and require independent legal advice, our team can assist on an urgent basis to ensure your lender is ready for settlement.
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.
