Contract of Indeminity and Guarantee

 Q. 8 Define and  Distinguish between the contract for indemnity and guarantee. What are the differences between Indian and English law?

(b) How far do you agree with the maxim of law that you must be damnified before you can claim to be indemnified? Refer to relevant judicial pronouncements.

(c) "The Liability of a surety is co-extensive with that of the principal debtor". Discuss.

(d) What are the Rights of sureties.

 

 

Ans. In simple words Indemnity" means protection to a person from loss. It contemplates a promise from one person to another that in the eventuality of any loss to the latter either because of the promisor himself or the third person, the promisor will compensate for such loss.

According to Section 124 of the Indian Contract Act

 

"A contract of indemnity means a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself or by the conduct of any other person."

 

Illustration; A contracts to indemnify B against the consequence of any proceedings which C may take against B in respect of a certain sum of Rs. 200. This is a contract of indemnity.

In a contract of indemnity, there are two parties viz.,

 

(1)   The promisor or indemnifier: He is the person who promises to bear the loss.

(2)   The promisee or the indemnified or indemnity-holder: He is the person whose loss is covered or who is compensated.

 

'Indemnifier' means a person who promises to make good the loss caused to another party.

'Indemnity-holder' means a person whose loss is made good by another.

The objective of the Contract of Indemnity

The objective of entering into a contract of indemnity is to protect the promisee against unanticipated losses.

The essential elements of a 'Contract of Indemnity' are as under:

 

1. It is a contract to make good the loss.

2. The loss must be caused to the promisee.

3. The loss may be caused by the promisor or by any other person.

4. Promisor undertakes to make good the loss.

5. The promisor is known as the indemnifier and the promisee is known as the indemnity holder.

 

The definition of the contract of indemnity as given under section 124 of the Act is narrower than its meaning under English Law. Under section 124 of the Act, the loss is supposed to have been caused by the promisor or any other person and it does not include the cases of loss caused by natural reasons beyond human control e.g. accident, fire, flood etc.

 

In English law, the loss is made good either caused by human agency or because of natural factors. In Dudgale v. Lovering, (1975) 10 LRCP 196, the trucks had the plaintiff. The defendant as well as a company claimed them. The plaintiff demanded an indemnity bond, but no reply was received. Yet they delivered the truck to the defendant, it was held that the defendant was liable to indemnify the plaintiff as the indemnity bond led to the creation of an implied promise.

 

A contract of indemnity is a direct engagement between two parties whereby one promises to save another harmless from the result of the conduct of the promisor himself or of any third person. In Texmao Co. Ltd. v. The State Bank of India, AIR 1979 Cal 44, the guarantee was given by the bank to repay the amount on 'first demand' and without contest and protest, it must be deemed that the moment a demand was made without protest and contest, the Bank is bound to pay irrespective of disputes between the parties.

 

The expression "Contract of Indemnity" has been used in a narrow sense. The section deals only with a particular kind of indemnity which arises from a promise by the indemnifier to save the indemnified from the loss caused to him by the conduct of the indemnifier himself or by the conduct of any other person. It does not deal with those classes of cases where the indemnity arises from loss caused by events or accidents which do not or may not depend upon the conduct of the indemnifier or any other person, or because of liability incurred by something done by the indemnified at the request of the indemnifier.

A contract of indemnity is a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor or by the conduct of any other person, as contemplated by section 124 of the Indian Contract Act. But indemnity as applicable to marine insurance must not is by the contract itself and such loss is not caused to the assured by the conduct of the insurer nor by the conduct of any other person; State of Orissa v. United India Insurance Company Ltd., AIR 1997 SC 2671, 2673.

Rights of Promisee/ The Indemnified/Indemnity Holder

As per Section 125 of the Indian Contract Act, 1872 the following rights are available to the promisee/ the indemnified/ indemnity-holder against the promisor/ indemnifier, provided he has acted within the scope of his authority.

Right To Recover Damages Paid In A Suit [Section 125(1)]:

An indemnity-holder has the right to recover from the indemnifier all damages which he may be compelled to pay in any suit in respect of any matter to which the contract of indemnity applies.

Right To Recover Costs Incurred In Defending A Suit [Section 125(2)]

An indemnity-holder has the right to recover from the indemnifier all costs which he may be compelled to pay in any such suit if, in bringing or defending it, he did not contravene the orders of the promisor, and acted as it would have been prudent for him to act in the absence of any contract of indemnity, or if the promisor authorized him to bring or defend the suit.

Right To Recover Sums Paid Under Compromise [Section 125(3)]

An indemnity-holder also has the right to recover from the indemnifier all sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the promisor, and was one which it would have been prudent for the promisee to make in the absence of any contract of indemnity, or if the promisor authorized him to compromise the suit.

Commencement of Liability of Promisor/ Indemnifier

Indian Contract Act, 1872 does not provide the time of the commencement of the indemnifier’s liability under the contract of indemnity. But different High Courts in India have held the following rules in this regard:

Indemnifier is not liable until the indemnified has suffered the loss.

Indemnified can compel the indemnifier to make good his loss although he has not discharged his liability.

In the leading case of Gajanan Moreshwar vs. Moreshwar Madan, an observation was made by the judge that:
If the indemnified has incurred a liability and the liability is absolute, he is entitled to call upon the indemnifier to save him from the liability and pay it off. Thus, a Contract of Indemnity is a special contract in which one party to a contract (i.e. the indemnifier) promises to save the other (i.e. the indemnified) from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person. Sections 124 and 125 of the Indian Contract Act, 1872 apply to these types of contracts.

Contract of Guarantee:- Section 126 of the Indian Contract Act says

 

"Contract of guarantee is a contract to perform the promise or to discharge the liability of a third person in case of his default.

The person who gives the guarantee is called the "Surety" the person in respect of whose default the guarantee is given "principal debtor" and the person to whom the guarantee is given is called the "creditor", A guarantee may be either oral or written."

So the object of the contract of guarantee is to provide additional security for the repayment of the loan to a creditor.

In a contract of guarantee, there are three parties:-

1. the creditor
2. the principal debtor
3. surety

 

A contract of guarantee which is also known as a contract of suretyship is a contract to perform the promise or discharge the liability of a third person in case the third person makes a default. The contract of guarantee may either be oral or in writing. For example, if A says to C "lend money at interest to B and if B be unable to pay I shall pay" then it is known as a contract of guarantee.

Basically “ contract of guarantee” consists of three contracts:-

Firstly, the “principal debtor” himself makes a promise to the “ creditor” to perform the promise.

Secondly, “surety” gives a guarantee to the “creditor” if the principal debtor makes a default or consents to perform his promise.

Thirdly, the principal debtor in the favour of surety if in his default surety discharges the liability he will indemnify him for the same.

 

It is well settled that a bank guarantee is an autonomous contract. It is in common parlance that the issuance of a guarantee is what a guarantor creates to discharge liability when the principal fails in his duty and the guarantee is like the collateral agreement to answer for the debt; Syndicate Bank v. Vijay Kumar, AIR 1992 SC 1066.

 

In United Commercial Bank v. B.M, Mahadev Babu, AIR 1992 Kant 294, it was observed that acknowledgement of the debt by the principal debtor binds the guarantor in all respects as if he had given express consent.

 

Further section 127 of the Contract Act provides

 

"Consideration for guarantee.-Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee."

 

Illustration

 

B requests A to sell and deliver to him goods on credit. A agrees to do so, provided C will guarantee the payment of the price of the goods. C promises to guarantee the payment in consideration of A's promise to deliver the goods. This is sufficient consideration for C's promise. Further section 128 of the Contract Act provides

 

"Surety's liability. The liability of the surety is co-extensive with that of the principal debtor unless it is otherwise provided by the contract."

 

It is settled law that the creditor would be entitled to adjust from the payment of a sum by a debtor towards the time-barred debt from the guarantor's account. Held that the appellants did not act in violation of any law when he cut the amount from the fixed deposit of the respondent i.e. the surety when the principal debtor failed to pay; Punjab National Bank v. Surendra Prasad Sinha, AIR 1992 SC 1815.

Main features of a contract of guarantee

 

1. In India, such a contract may be either oral or written. In England, such a contract must be in writing and signed by the person to be charged therewith.

2. A contract of guarantee pre-supposes a principal debt, or an obligation to be discharged by the principal debtor. The surety undertakes to be liable only if the principal debtor fails to discharge his obligation.

3. Benefit to the principal debtor is sufficient consideration. For the surety's promise, it is not necessary that there should be direct consideration between the creditor and the surety, it is enough that the creditor has done something for the benefit of the principal debtor. (Sec. 127).

4. The consent of the surety should not have been obtained by misrepresentation or concealment. If the guarantee has been obtained that way, the guarantee is invalid. (Secs. 142 & 143). For example, if a cashier has been found guilty of embezzlement, but this fact is not disclosed when a surety has been made to guarantee the future conduct of the cashier, the surety will not be liable as such under these circumstances.

 

Distinction Between Contracts of Indemnity and Guarantee

 

(1) There are two parties in the contract of indemnity i.e. indemnifier and indemnity holder. In a contract of guarantee, there are three parties i.e. surety, principal debtor and creditor

 

(2) Contract of indemnity consists of one contract whereby the indemnifier promises to indemnify the indemnity-holder for certain loss, whereas in the contract of guarantee there are three contracts between parties inter-se. One between principal debtor and creditor in respect of debt or obligation to be discharged by the principal debtor. The second contract whereby surety undertakes to perform same obligation if the principal debtor fails to perform and the third contract, which is the implied one, is between the principal debtor and surety whereby the principal debtor is bound to indemnify the surety for payment of debt or discharge of obligation made by surety under the contract of guarantee.

 

(3) The object of the contract of guarantee is to provide additional security to creditors for debt or liability. A contract of indemnity is to protect the promisee against some likely loss.

 

(4) In a contract of guarantee, the liability of the surety is only a secondary one and arises only when the principal debtor fails to discharge is an obligation under the contract, but once surety had discharged his liability on behalf of the principal debtor surety steps into the shoes of creditor and can realise the payment made by him. from principal debtor, whereas in the contract of indemnity, the liability of indemnifier is the primary one and he can not recover the amount paid by him from anyone.

 

Ans. (b) Damnum Sine Injuria It may happen that a person may suffer loss without any legal injury. In the law of torts this rule means damages which is not coupled with an unauthorized interference in the plaintiff's lawful right. Causing of damage, however substantial to another person is not an action at in law unless there is also a violation of a legal right of the plaintiff. It means that the plaintiff may suffer actual or substantial loss without any violation or infringement of a legal right and therefore no action lies in such cases. This is generally so when the exercise of legal right by one results in consequential harm to the other, even though the injury is intentional.

 

There are many forms of harm of which the law takes no account:

 

(i)                 Loss inflicted on individual traders by completion in trade,

 

(ii) Where the damage is done by a man acting under the necessity to prevent a greater evil,

 

(iii) Damage caused by defamatory statements made on a privileged occa

 

(iv) Where the harm is too trivial, too indefinite or too difficult of proof,

 

(v) Where the harm done may be of such a nature that a criminal prosecution is more appropriate e.g. in case of public nuisance or causing of death,

(vi) There is no right of action for damages for contempt of court.

 

The following cases explain the maxim:

Gloucester Grammar School case (1410) Y B. Hill, 11 Hen- The defendant, a schoolmaster, set up a rival school to that of the plaintiffs. Because of the competition the plaintiffs had to reduce their fees. Held that the plaintiffs had no remedy for the loss thus suffered by them.  Handkford J., said: "Damnum may be absque injuria (without infringement of a right) as if I have a mill and my neighbour builds another mill whereby the profit of my mill is diminished, I shall have no action against him, although I am damaged....but if a miller disturbs the water from going to my mill, or does any nuisance of the like sort, I shall have such action as the law gives."

 

In Action v. Blundell 1843 12 MandWV 324 the defendants by digging a coalpit intercepted the water which affected the plaintiff's well, less than 20 years old at a distance of about one mile. It was held that they were not liable. It was observed :

 

"The person who owns the surface may dig therein and apply all that is there found to his own purposes, at his free will and pleasure and that if in the exercise of such rights he intercepts or drain off the water collected from underground springs in the neighbour's well this inconvenience to his neighbour falls within the description "damnum: abseque injuria" which cannot become the ground of action."

 

in Bradford Corporation (Mayor of) v. Pickles, 1895 A.C. 587, the House of Lords went a step further and held that even if the motive of the adjoining owner was malicious no action could lie against him for the harm caused by him by the lawful exercise of his rights over his own land. In this case the plaintiffs had been deriving water from the adjoining land of the defendant which was at a higher level. The defendant sank a shaft over his own land which diminished and discoloured the water flowing to the land of the plaintiffs. The plaintiffs claimed an injunction to restrain the defendants from sinking the shaft alleging that the sole purpose of the same was to injure the plaintiffs if they did not pur chase his land. The House of Lords held that since the defendant was exercising his lawful right, he could not be made liable even though the act, which injured the plaintiff, was done maliciously.

Ans (c )"The Liability of a surety is co-extensive with that of the principal debtor".

 

Section 128 of the Contract Act provides

"The liability of a surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract."

 

Illustration

A guarantees to B the payment of a bill of exchange by C, the acceptor. The bill is dishonoured by C. A is liable, not only for the amount of bill but also for any interest and charges which may have become due on it.

The section only explains the quantum of a surety's obligation when the terms of the contract do not limit it, as they often do. It does not follow conversely, that a surety can never be liable when the principal debtor cannot be held liable. Thus a surety is not discharged from liability by the mere fact that the contract between the principal debtor and creditor was voidable at the option of the former, and was avoided by the former. However, if a surety guarantees a debt by a minor, he incurs no liability as his liability is co-extensive with that of the principal debtor, whose contract is void; Kelappan Nambiar v. Kunhi Raman, AIR 1957 Mad 164.

In Bank of Bihar Ltd. v. Dr. Damodar Prasad, AIR 1969 SC 217, the Supreme Court held that the liability of the surety is immediate and cannot be defended on the ground that until the creditor has exhausted all his remedies against the principal debtor the surety can not be sued.

 

A surety's liability to pay the debt is not removed by reason of creditor's omission to sue the principal debtor. The creditor is not bound to exhaust his remedy against the principal debtor before suing the surety, and a suit may be maintained against the surety though the principal has not been sued; State Bank of India v. Indexport Registered, AIR 1992 SC 1740 (1743). But where the liability arises only upon the happening of a contingency, the surety is not liable until that contingency has taken place; Subankhan v. Lalkhan, (1947) Nag 643: 1948 AN 123

Ans (d)   The Contract Act provides the following rights of sureties:

 

(1) Right of Subrogation Section 140 provides:

 

"Where a guaranteed debt has become due, or default of the principal debtor to perform a guaranteed duty has taken place, the surety upon payment or performance of all that he is liable for, is invested with all the rights which the creditor has against the principal debtor."

 

Thus, after a surety performs his liability or makes the payment, he steps into the shoes of the creditor and gets all the rights which he had against the principal debtor. The surety's right does not depend upon any contract. It rests on the equitable principle that he should be indemnified; Duncan Fox and Co. v. North and South Wales Bank, (1980) 6 AC 1).

It has been aptly pointed out "In India the entire law is condensed in the provision in section 140 and so the surety can claim a legal right for payment. The surety gets into the shoes of the creditor as regards all securities given by the debtor whenever they were given. It matters not if the securities existed at the time when the surety executed the guarantee or if they were required subsequently." V.G. Ram Chandran: The Law of Contract in India, Vol. II, 1968). Section 140 applies where a guarantor has paid the whole or part of the liability which is guaranteed and, in that case, the guarantor protanto will be subrogated to the position of the creditor and as subrogee he will be entitled to all the rights which the creditor has against the principal debtor. In other words, this section, by reason of payment by the guarantor, entitles him to enforce the securities in his own right, which were originally available to the creditor; J. Harigopal Agarwal v. State Bank of India, Madras, AIR 1976 Mad 211 (213).

 

(2) Right to Indemnity

 

The surety's right to indemnity is contained in section 145 of the Act which provides:

 "In every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety, and the surety is entitled to recover from the principal debtor whatever sum he has rightfully paid under the guarantee, but no sums which he has paid wrongfully".

Section 145 contains the following illustrations:

(a)    B is indebted to C, and A is surety for the debt. C demands payment from A, and on his refusal sues him for the amount. A defends the suit, having reasonable grounds for doing so, but he is compelled to pay the amount of the debt with costs. He can recover from B the amount paid by him for costs as well as the principal debt.

(b) Clends B a sum of money, and A at the request of B, accepts a bill of exchange drawn by B upon A to secure the amount. C, the holder of bill, demands payment of it from A, and on A's refusal to pay, sues him upon the bill. A, not having reasonable ground for so doing, defends the suit, and has to pay the amount of the bill and costs. He can recover from B the amount of the bill, but not the sum paid for costs, as there was no real ground for defending the action.

 

(c) A guarantees to C, to the extent of 2,000 rupees, payment for rice to be supplied by C to B. C supplied to B rice to a less amount than 2,000 rupees but obtains from A payment of the sum of 2,000 rupees in respect of the rice supplied. A cannot recover from B more than the price of the rice actually supplied.

 

Thus according to section 145, a surety is entitled to recover from the principal debtor whatever he has rightfully paid under the guarantee and is not entitled to recover the sum which he has paid wrongfully. The connotation of the words "rightfully" and "wrongfully" was explained by the Law Commission (in its 13th Report, 1958) in the following words: 'Rightfully' was intended to convey that the sums paid were such as the creditor was legally entitled to recover and therefore, the surety had the right to and likewise the expression 'wrongfully' was intended to convey that the sums paid were such as the creditor was legally not entitled to recover and therefore the surety was wrong in paying the same." As regards the question of whether payment of a time-barred debt by surety comes within the meaning of section 145 and is 'rightfully' paid, the Law Commission expressed its opinion in the affirmative and recommended that an explanation should be added to make the position clear in this connection.

 

(3) Rights Against Co-sureties to Contribute Equally

 

As against co-sureties, every surety has a right to ask the other sureties to pay off the principal debt. Section 146 provides:

 

"Where two or more persons are co-sureties for the same debt or duty, either jointly or severally and whether under the same or different contracts, and whether with or without the knowledge of each other, the co-sureties, in the absence of any contract to the contrary, are liable, as between themselves, to pay each as an equal share of the whole debt or of that part of it which remains unpaid by the principal debtor."

 

The right of a surety to benefit of creditor's security is founded, on the principle that as between the principal debtor and surety, the principal debtor is under an obligation to indemnify the surety. Moreover, equity requires that the creditor must not do anything as may deprive the surety of his right.

 

A leading case on section 141 is the Supreme Court case.-State of M.P. v. Kaluram, 1967 SCR 266: AIR 1967 SC 1105. In this case, a huge quantity of felled timber was sold by the State to a person at a certain price which was payable at four equal instalments. The defendant guaranteed the payment of the said instalments. One of the clauses in the contract provided that in case of default in payment of an instalment, the State would be entitled to prevent the removal of timber and would have the right to sell the remaining timber to realize the price. Even on the default of the buyer to pay an instalment state allowed the removal of the timber. In an action brought against the surety, the surety was held not liable.

Discharge of a surety from liability

 

A surety may be discharged from his liability in the following ways

 

1. Revocation by the surety. According to section 130, a continuing guarantee may be revoked by the surety, as to future transactions, by notice to the creditor.

 

2. By surety's death.-According to section 131. the death of a surety operates, in the absence of any contract to the contrary. as a revocation of a continuing guarantee, so far as regards future transactions.

 

3. By variance in the terms of the contract. When the surety has undertaken liability on certain terms, it is expected that they will remain unchanged during the whole period of the guarantee. If there is any variance in the terms of the contract between the principal debtor and the creditor, without the consent of the surety. the surety gets discharged as regards transactions subsequent to the change. (Sec. 133) For example, C contracts to lend B Rs. 5,000 on 1st March. A guarantees repayment. C pays Rs. 5,000 to B on 1st January. A is discharged from his liability, as the contract has been varied, inasmuch as C might sue B for the money before 1st March.

 

4. By release or discharge of the principal debtor.-It has already been noted that according to section 128, the liability of the surety is co-extensive with that of the principal debtor. Therefore, if by any contract between the creditor and the principal debtor, the principal debtor is released, or by any act or omission of the creditor, the principal debtor is discharged, the surety will also be discharged from his liability accordingly. (Sec. 134). The position becomes different after a decree has been obtained, jointly against the principal debtor and the surety. In such a case, the creditor may recover only a part of the sum from the principal debtor and release him for the balance and then sue the surety for the balance.

 

5. When the creditor compounds with, gives time to, or agrees not to sue the principal debtor.-According to section 135 when the creditor makes a composition with the principal debtor, or the creditor promises to give time to the principal debtor, or the creditor promises not to sue the principal debtor, the surety is discharged thereby. In the above-stated circumstances, the surety is discharged if the creditor and the principal debtor make such a contract without the consent of the surety.

 

Although a promise by a creditor not to sue the principal debtor discharges the surety, yet a mere forbearance to sue on his part does not discharge the surety. The reason is that a promise by the creditor not to sue results at the end of the right of the creditor to sue, whereas by mere forbearance to sue, the right to sue is not extinguished, and that can still be exercised.

 

6. By creditor's act or omission impairing surety's eventual remedy.-Section 139 incorporates the rule that when the act or omission on the part of the creditor is inconsistent with the interest of the surety, and the same results in impairing surety's eventual remedy against the principal debtor, the surety is discharged thereby. For instance. A puts M as an apprentice to B, and gives a guarantee to B for Ms fidelity. B promises on his part that he will, at least once a month, see M make up the cash. B omits to see this done as promised, and M embezzles. A is not liable to B on this guarantee.

 

In M.R. Chakrapani v. Canara Bank (1997-Kant.), the property hypothecated to the bank was sold by the principal debtor. After the bank came to know of this, he did not take any steps either to trace and seize that property or to bring any kind of action against the principal debtor. The surety was discharged by such inaction of the bank. Similar was also the decision of the Gujarat High Court in Union Bank of India v. S.B. Mehta. (1997).

 

7. By loss of security by the creditor.-Section 141 casts a duty on the creditor to preserve the securities which the creditor has against the principal debtor when the contract of suretyship is entered into. The surety is entitled to such securities. If the creditor loses such securities or parts with them, the surety will be discharged to that extent. If, however, the securities are lost without any fault of the creditor, then the surety would not be discharged in such cases.