A contracting party can seek to reduce its possible exposure for loss caused by breach of contract by requiring the other party or a third party to provide contractual promises in the form of guarantees or indemnities.

While they are common contractual clauses, particularly in commercial bargains, guarantees and indemnities are subject to special rules of interpretation and need to be drafted carefully.

Guarantees and indemnities can be used separately or together, and can also be used with other risk allocation clauses such as liquidated damages, exclusion, warranty and insurance clauses.

What is an indemnity?

As noted above, an indemnity is a promise by one party to protect another party from, or to reimburse that party for, loss or damage suffered on the occurrence of a specified event. The event may, but need not, include a breach of contract or some other legal duty by the indemnifying party.

For example, an indemnity may require a party to compensate another party on the happening of an external event such as a fall in the exchange rate.

What is a guarantee?

A guarantee is a promise by the other contracting party or a third party that certain promises of a party will be performed, failing which the guarantor will be liable for the non-performance or defective performance.

Similarities and differences between guarantees and indemnities

A guarantee is a secondary obligation, in the sense that the guarantor is promising performance by another party. An indemnity is a primary obligation because it is a promise to hold the other party harmless from loss, and the obligation is not triggered by a breach of performance by another party, but instead by the threat or the event of the suffering of loss.

With both guarantees and indemnities the scope of the obligations depends on how they are drafted and their proper construction.

Construction of guarantees and indemnities

Both guarantees and indemnities are subject to special rules of construction. While courts look to the natural and ordinary meaning of words, where there is ambiguity in the possible meaning or operation of a guarantee or indemnity a court will choose a construction that favours the party providing the indemnity or guarantee.

Further, a guarantor will not be bound by a guarantee if the obligations that have been guaranteed have been changed without the guarantor’s knowledge and approval, for example where a guarantee promises loan repayments and then the loan terms are altered. However, guarantees can be drafted as continuing obligations that will not be affected by any changes to the performance obligation that has been guaranteed to ensure that the guarantee remains effective.

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For more information, please contact Gavin McInnes on 07 3367 8681 or gmcinnes@grmlaw.com.au.

 The information contained in this article is general in nature and cannot be regarded as anything more than general comment. Readers of this article should not act on the basis of this comment without consulting one of GRM LAW ‘s legal practitioners who will consider their particular circumstances.

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