Contracts often include indemnities and guarantees – two distinct legal obligations. As a business owner, understanding the different obligations you agree to is crucial when entering a contract.
This article will provide clarity on:
- what indemnities and guarantees are; and
- highlight the key differences between these two obligations.
Understanding the implications of each obligation is essential to avoid exposing your business to unintended risks.
What is an Indemnity?
An indemnity is a contractual promise where one party (the indemnifier) agrees to compensate the other party (the indemnified party) for any losses or damages they may suffer in certain circumstances.
In this scenario, Company A is indemnifying (protecting) Company B from bearing losses caused by Company A’s actions. If Company A causes an accident, it must provide financial compensation to Company B rather than Company B covering those costs itself.
Indemnities in contracts allocate and manage risk between the parties involved. Drafting an indemnity clause can increase a party’s liability beyond their legal responsibility. When you agree to an indemnity in a contract, it is crucial to treat it cautiously.
Insurance policies generally cover a party’s legal liabilities. However, if you agree to an indemnity that exceeds your normal legal responsibilities, your insurance may not fully cover claims made under that indemnity. Therefore, your insurance might not pay out for all or part of a claim related to that extended liability.
When signing a contract with an indemnity clause, careful review is essential. A broad indemnity could potentially leave you uninsured for some of the risks you’re taking on.
What is a Guarantee?
A guarantee is a contractual obligation where one party (the guarantor) agrees to be responsible for another party’s existing obligations or debts if they fail to meet their obligations (i.e. if they default).
A common example is a loan agreement where the guarantor promises to repay the loan if the borrower defaults on payments to the lender.
A guarantee acts as a backup plan. If the primary party cannot fulfil their contractual duties, the guarantor becomes responsible for fulfilling those duties instead.
For instance, if someone is saving to purchase a property but cannot meet the full deposit required by the bank to obtain a loan, they may ask a family member or friend to act as a guarantor on their home loan. In this circumstance, two contracts are created:
- the mortgage between the home buyer and the lender/bank (the actual home loan); and
- the guarantee between the guarantor and the lender/bank.
Within the guarantee contract, the guarantor agrees that if the home buyer fails to make the scheduled mortgage payments to the lender, the guarantor will repay the loan instead.
In this situation, the guarantor promises the lender that the loan will be fully repaid. If the home buyer makes the payments, the guarantor does not need to act. However, if the home buyer defaults, the guarantor must make the payments.
Continue reading this article below the formGuarantee Relationship
The diagram below outlines the relationships in a guarantee.
Guarantees often apply to loan agreements and financial obligations, but they can also cover non-monetary commitments, like delivering a service. If a service provider fails to fulfil their contractual duties, the guarantor may be liable to compensate the other party for any losses suffered due to the non-performance.
Another example is a parent company guaranteeing the obligations of its subsidiary under a contract.
The purpose of a guarantee is to protect one party from losses if the other party fails to uphold their end of the agreement. The guarantee becomes enforceable if the primary party (borrower, service provider, etc.) does not perform their obligations.
Key Differences
| Guarantee | Indemnity: |
| + involves a third party who agrees to be liable for the primary obligor’s debt/duty; + the guarantor’s liability is limited to the amount of the initial agreement; + a guarantor is discharged from their obligations if the principal contract is void or unenforceable; and + depending on the state or territory, guarantees may not have to be enforceable in writing. | + exists between the two parties to the contract, where one party indemnifies (protects) the other from potential losses; + one party to an agreement indemnifies another party to the agreement for any loss they may suffer; + the indemnifying party’s liability depends on the drafting of the indemnity clause; + an indemnity can remain valid even after the contract expires or is terminated; and + indemnities may be implied into an agreement by law, even if not expressly stated. |
When you are ready to sell your business and begin the next chapter, it is important to understand the moving parts that will impact a successful sale.
This How to Sell Your Business Guide covers all the essential topics you need to know about selling your business.
Key Takeaways
Indemnities and guarantees can be complex to understand. Indemnities impose a liability on the person giving the indemnity. In contrast, a third party provides guarantees if the primary party to the agreement fails to uphold their obligations.
Understanding these obligations is crucial when entering contracts to avoid exposing your business to unintended risks.
If you need assistance before entering into an agreement where you are required to provide an indemnity or a guarantee, our experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
It is a contractual promise to compensate another party for loss suffered or incurred by the other party.
It is a contractual obligation where one party (the guarantor) agrees to be responsible for the obligations of another party in case the other party fails to comply with its obligations under the legal contract.
No, they do not have to be over money owing. Instead, parties can guarantee the performance of an obligation, including the performance of a service.
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