20 Apr


Guarantees and indemnities are as much part of the business lexicon as butter is to bread in the culinary equivalent, which is not a great analogy, but we hope you get the drift.

It's important to understand what these two, but quite different, legal concepts are and how they operate.

Warranties stand apart from guarantees and indemnities as they are a different type of contractual term, but are often seen and used in conjunction with the other two in commercial agreements.

We explain all three of these very important types of legal terms here.

See the Guarantee and Indemnity templates on our sister legal documents platform LawDocs4All.com.

What is a Guarantee?

A guarantee is perhaps most easily understood in terms of a contractual debt owed by one party (debtor) to another (creditor).

Guarantees can equally apply to the performance of some other obligation (e.g. to perform services or deliver goods).

A guarantee is a contractual promise made by one party ('guarantor') to another party ('creditor') to:

  • Ensure that a third party ('debtor') fulfils his/her/its contractual obligations to the creditor; and/or
  • Ensure that a party pays an amount owed by a third party if that third party fails to do so himself, herself or itself (known as a conditional payment guarantee).

A guarantee is a 'secondary' obligation of the guarantor, because it is one that supports the obligation of the debtor's 'primary' obligation to the creditor and the guarantor's liability to pay is triggered if the debtor fails to do so.

Therefore, if the debtor pays what is owing (to keep the analogy running), the guarantor is effectively no longer liable to the creditor, subject to any terms that may require his continuing responsibility as a guarantor.

What is an On-Demand Guarantee?

An On-Demand Guarantee can be illustrated in terms of the construction trade, where it is frequently used to secure a contractor's 'performance of the works'.

It is sometimes referred to as a Performance Bond or Performance Guarantee.

These types of on-demand security are used in many other businesses and trades as well.

An On-Demand Guarantee imposes a primary obligation on the guarantor (usually the contractor's own bank or finance company, as the issuer of the guarantee) to pay the beneficiary (usually the project owner or employer) on its first demand for payment, which can be made when, for example, the contractor has failed to perform its obligations under the building contract.

There are various other types of demand guarantee used in the building trade, including for tendering and for advance payments.

What is an Indemnity?

An indemnity is a contractual promise made by one party (obligor) to another (beneficiary) to accept liability for the loss to the beneficiary, whether that loss is caused by the obligor or by some other party.

It is a primary obligation of the obligor because it is independent of the obligation to the beneficiary under which the loss arose.

Put another way "An indemnity is a promise, usually made in a contract, to pay money on the happening of a specified event. Indemnities protect one party from a contract from suffering financial loss in relation to certain eventualities – usually those that would arise from the conduct of the other contracting party, or over which the other contracting party has control.

In other words, an indemnity is a contractual mechanism for allocating risk, in a similar way to a warranty in a typical M&A contract, or a guarantee in a finance contract." Osborne Clarke

Advantages of Indemnities

The benefits of indemnities in commercial contracts include:

  • They don't depend on having to prove a breach of a contractual obligation as they can be triggered in their own terms. This is an advantage over bringing a damages claim for a breach of contract.
  • An indemnity will often be set up in a contract so that it is triggered by losses incurred by the beneficiary of the indemnity, without the need to prove any “fault”. This can also help avoid rules around causation and mitigation, which can otherwise make recovery more problematic.
  • An indemnity may be worded so that the beneficiary can claim for losses such as legal and other related expenses.
  • An indemnity can state specific amounts of losses to become payable to the beneficiary in the event it is triggered.
  • Generally speaking, a beneficiary should be in a better position to get paid under an indemnity than having to resort to recovery proceedings in the courts for damages for breach of contract.

The difference between a guarantee and an indemnity

A guarantee, as we have explained, is a secondary promise by a third party to carry out the obligations of one of the parties to the contract should that party fail to do so.

Guarantors are often brought into a contract to give the creditor some additional security, e.g. for payment of rent or a mortgage or to provide other financial support (e.g. an on-demand performance guarantee), but a guarantor can be used for the performance of any terms.

For example, because the shareholders in a limited company have limited liability by definition, anyone contracting with a new company may well ask for the personal assurance in formal writing of a director.

An indemnity, as we have explained, is a primary obligation and may be seen as somewhat similar to insurance, because the indemnifier has a direct and immediate contractual obligation to the beneficiary as and when a specified event happens requiring the loss suffered by the beneficiary of the indemnity to be made good.

What is a Warranty?

A warranty is a contractual promise that a particular statement made is true.

Warranties are frequently used in business sale & purchase agreements for the benefit of the purchasers.

A typical list of topics covered by warranties given by the sellers might include promises relating to;

  • Company formation
  • Legal compliance
  • Court proceedings
  • Debtors and creditors
  • Company structure and operation
  • Accounts
  • Taxation
  • Assets
  • Trading and contracts
  • Employment
  • Insurance
  • Intellectual property
  • Information technology

A breach of a warranty will usually give rise to a claim for damages, unless the warranty is accompanied (as it often will be) by an enforceable indemnity (see above) that allows the purchaser to recover its losses, rather than resorting to the courts to bring its claim.

By the publications team at: Contracts-Direct.com

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