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The Difference Between a Guarantee and an Indemnity
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The Difference Between a Guarantee and an Indemnity
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The Difference Between aGuarantee and an Indemnity
Sarah Sinclair
Introduction
Proverbs 11:15 reads:
He is in a bad way who becomes surety for another, but he who hates giving pledges is safe.
Despite this early warning the law of guarantee as part of the law of
contract has developed and maintained an important commercial status as a
form of security.
Because New Zealand, together with the rest of the Western World, has a
credit based economy, the law relating to creditors is extremely important.
One of its most important developments has been the use of guarantees and
indemnities by creditors attempting to pierce the corporate veil in order to
reduce risk of non-payment and to ensure personal commitment from the
directors of a fictitious company personality. New Zealand has experienced a
significant increase in litigation in this area.
The undertaking of liability for a debt of a third person is a well developed
and complex area of contract law. One significant yet often misunderstood
distinction is that between guarantees and indemnities. This confusion was
highlighted in Nathan Finance Ltd v Martin Simmons Air Conditioning
Services Ltd:t
1 High Court, Auckland, 17 December 1986 (A 1019/85). Wylie J.
, Difference Between a Guarantee and an Indemnity
[the confusion] is not to be wondered at. I suspect that not only are there many responsible
senior executives of finance companies who are not aware of the distinction, but also that
there are many lawyers to whom such a distinction is somewhat of a mystery.
In its broadest meaning an indemnity is an undertaking to perform an
obligation or pay a debt of another, and therefore encompasses all contracts
of guarantee and many contracts of insurance. For the purposes of this article
it is therefore necessary to define indemnity more narrowly. The term
"contract of indemnity" will be used to denote an independent promise by a
third party to indemnify a creditor against any loss that may be suffered in the
course of a transaction with a principal debtor. Primary liability is assumed by
the indemnifier by way of security given for the performance of an obligation
or the payment of a debt. The liability is therefore wholly independent of any
obligation of the principal debtor.
"Contract of guarantee" will refer to the obligation of a third party either to
ensure that the principal debtor performs his obligations or to repay the debt
herself. The liability of the guarantor may therefore be described as secondary
as it will arise only upon the default of the principal debtor on his primary
obligation to the creditor:2
In ever case of guaranty there are at least two obligations, a primary and a secondary. The
secondary - the guaranty - is based upon the primary, and is enforceable only if the
primary default.
The obligation assumed by the guarantor is to answer for the default of
3
another.
"Surety" will be used as a general term to cover both guarantors and
indemnifiers.
Both a contract of guarantee and a contract of indemnity must be valid
contracts: there must be offer and acceptance, intention to create legal
relations, and good consideration. There is, however, a difference in the obli-
4
gation undertaken:
An indemnity is a contract by one party to keep the other harmless against loss, but a
contract of guarantee is a contract to answer5
for the debt, default or miscarriage of another
who is to be primarily liable to the promise.
There are no hard and fast rules for determining whether a contract is an
indemnity or a guarantee. In each case the courts will look at the specific
terms of the agreement and in some cases the surrounding circumstances.
Thus the central concern is construction, and the courts will base their
decision on the substance of the agreement as opposed to its form or
description. The fact that a document is described as either a "guarantee" or
an "indemnity" is taken as a guide by the courts, but is by no means conclu-
2 Western Dominion Investment Co Ltd v Macmillan [1925] 2 DLR 442, 444 per Dysart J.
3 Ibid.
4 Yeoman Credit Ltd v Latter [1961] 1 WLR 828, 831 per Holroyd Pearce L.
5 Ibid.
, Auckland University Law Review
sive. Each case is a question of fact.
Factors
Cases in this area point to several broad principles which the courts will
consider when determining classification.
Ultimate Object
A document will be construed by the courts in accordance with what is
seen to be the "ultimate object"6 of the agreement. The intention of the
parties will be central to interpretation. Therefore, in commercial
agreements, for example, the courts will have regard to such factors as how
the parties intended to regulate their dealings by way of the agreement, and
the commercial benefits arising out of the agreement.
In Direct Acceptance Finance Ltd v Cumberland Furnishing Pty Ltd7
construction was held to be the key to interpretation. Although the ultimate
object of the document must govern its interpretation, "[ilt is the method by
which that object is attained which decides the class to which the document
belongs".8
Terms of the Agreement
The court must start by looking at the terms of the agreement. A guaran-
tor's liability is generally taken to be co-extensive with that of the principal
debtor, and therefore if the principal debtor defaults on his primary obliga-
tion to the creditor, the creditor may recover from the guarantor whatever
sum she could have recovered from the principal debtor.9 The liability of a
guarantor must not be different in kind or extent from that of the principal
debtor. If it is potentially greater then the contract will be one of indemnity.
The courts must therefore ascertain whether the document was intended to
be a mere contract of guarantee by asking what is the extent of the protection
that the creditor has been promised by the surety. The courts will consider
some of the following factors.
THE EXTENT OF THE PROMISE
What did the surety undertake to pay? For a guarantee there must
generally be no liability imposed upon the guarantor by the agreement other
than the promise for the debt due from the principal debtor." A contract will
6 Ibid.
7 [1965] NSWR 1504,1507 per Walsh J.
8 Yeoman Credit Ltd v Latter, supra at note 4, at 831 per Holroyd Pearce U.
9 DirectAcceptance Financev CumberlandFurnishing,supra at note 7, at 1510.
10 Coady v J Lewis & Sons Ltd [1951] 3 DLR 845.
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