Guarantees and indemnities: a quick guide

A quick guide to guarantees and indemnities, including their respective advantages, legal and drafting issues to bear in mind, and links to further materials.

Contents

Why are guarantees and indemnities important?

Guarantees and indemnities are a common way in which creditors protect themselves from the risk of debt default. Lenders will often seek a guarantee and indemnity if they have doubts about a borrower's ability to fulfil its obligations under a loan agreement. Guarantors and indemnifiers take on a serious financial risk in entering into such transactions, and it is important that they are aware of all the implications.

 

What is a guarantee?

A guarantee is a contractual promise to:

  • Ensure that a third party fulfils its obligations (pure guarantee); and/or

  • Pay an amount owed by a third party if it fails to do so itself (conditional payment guarantee).

A guarantee is a secondary obligation because it is contingent on the obligation of the third party (principal) to the beneficiary of the guarantee (beneficiary).

A guarantee is distinct from a demand guarantee ( www.practicallaw.com/6-502-0561) (also called an on demand bond). The latter is a guarantee that imposes a primary obligation on the guarantor to pay the beneficiary on its first demand for payment, where the principal fails to perform the contract. For more on demand guarantees and how they differ from true guarantees, see Practice note, Bonds, guarantees and standby credits: overview: The guarantor's obligation ( www.practicallaw.com/4-107-3649) .

 

What is an indemnity?

An indemnity is a contractual promise to accept liability for another's loss. It is a primary obligation because it is independent of the obligation of a third party (principal) to the beneficiary of the indemnity (beneficiary) under which the loss arose. For more information on indemnities, see Practice note, Contracts: indemnities ( www.practicallaw.com/w-004-0860) .

 

Advantages of a guarantee

Guarantees tend to be more advantageous to the guarantor because they confer certain rights including:

  • Right to indemnity. Once the guarantor pays the beneficiary under the terms of the guarantee, it has a right to claim indemnity from the principal provided that the guarantee was given at the principal's request.

  • Right of set-off. Where the principal satisfies its obligations by way of set-off against the beneficiary's liabilities to the principal, the guarantor is also entitled to that right of set-off and will be discharged from its obligations under the guarantee.

  • Subrogation. A guarantor who fulfils the principal's obligations under the terms of the guarantee is entitled to all the rights of the beneficiary against the principal under the primary agreement, including any rights of set-off and any security that the beneficiary had taken from the principal.

  • Marshalling. The equitable doctrine of marshalling ( www.practicallaw.com/6-503-8622) applies to guarantees so that a guarantor may be able to obtain the benefit of another creditor's security over the principal's assets that it would otherwise not have security over.

For more on guarantor rights, see Practice note, Enforcing guarantees: guarantor's rights ( www.practicallaw.com/5-562-6805) .

 

Advantages of an indemnity

Indemnities tend to be more advantageous to the beneficiary.

  • No specific formal requirements. Unlike a guarantee, an indemnity need not be in writing or signed by the indemnifier in order to be effective.

  • More robust. Being a primary obligation, an indemnity will be valid even if the underlying transaction is set aside; unlike a guarantee, which is dependent on the underlying transaction. Furthermore, any variation to the underlying transaction will discharge a guarantor's (but not an indemnifier's) liability, unless the guarantor consents to the variation, or the variation is insubstantial or incapable of adversely affecting the guarantor. For more information on the variation of guaranteed obligations, see Practice note, Variation of guaranteed obligations ( www.practicallaw.com/7-228-2952) .

 

Drafting issues

For a list of standard form deeds of guarantee and indemnity, see Accessing Practical Law Finance's guarantees resources: Key standard documents and clauses ( www.practicallaw.com/5-523-7995) .

 

Other legal issues

 

Key reading

Practice note, Guarantees and indemnities ( www.practicallaw.com/9-200-1437) provides a fuller analysis of the issues touched upon in this guide.

For a guide to Practical Law Finance's resources on guarantees, including key practice notes and a list of standard form guarantees and indemnities relating to different types of transactions, see Accessing Practical Law Finance's guarantees resources ( www.practicallaw.com/5-523-7995) .


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