Guarantees and indemnities are common ways in which creditors protect themselves from serious financial risks by entering into financial transactions. However, the nature and legal jargon surrounding guarantees and indemnities can be confusing, especially if you have been asked to be a party for either concept. If you wish to know more, keeping reading this Business Kitz blog and contact Legal Kitz for any assistance you may require.
What is a guarantee?
A guarantee is a contractual promise to ensure that the borrower fulfils their obligations, or promises to pay the amount owed by the borrower if they fail to do so themselves. This guarantee is normally between the lender of the money (beneficiary), and the party who advocates and guarantees themselves against debt default on behalf of the borrower (known as the guarantor).
- Guarantor = person who has promised to pay a borrower’s debt in the event that the borrower defaults on their loan
- Beneficiary = lender of the money, eg. a bank
- Borrower = the third party
What is an indemnity?
An indemnity can be defined as a contractual obligation to accept liability for another person’s loss or damage.
What is the difference between guarantees and indemnities?
An indemnity is a direct liability for a party to compensate for loss or damage occurring from another party. A guarantee involves a party answering for debt or default of another party. The difference is that a guarantee is a secondary liability, in that another party is primarily liable for the obligation. An indemnity is a primary liability, thus the party contractually obliged is solely responsible for another person’s loss.
Advantages of a guarantee
Guarantees have many advantages, including a right to indemnity once the guarantor pays the beneficiary under the terms of the guarantee. Further, a guarantee can assist both the beneficiary and the borrower as it serves to be additional protection in a loan. The beneficiary is more willing to provide a loan to third parties, even with a poor credit profile, as the presence of a guarantor reduces the likelihood of a beneficiary not being paid.
Advantages of an indemnity
One of the many advantages of an indemnity is that there are no specific formal requirements, and parties can decide upon terms and conditions to their preferences. For the party relying on the indemnity, they do not need to prove causation, instead they must only prove that the event occurred and loss or damage was suffered. Further, there is no obligation under an indemnity for a party to mitigate loss resulting from a breach of the contract.
Disadvantages of a guarantee
There are disadvantages with a guarantee, including the rigidness of a bank when assessing the financial position of a person or entity. A financial institution is less likely to offer a guarantee with loss-making entities. Regarding personal guarantees, if the borrower is unable to pay the debt, they become personally liable for it and therefore forfeit their own assets. Regarding the guarantor, the main disadvantage and risk they face is becoming financially liable for paying the loan if the person they have guaranteed for cannot keep up their repayments.
Disadvantages of an indemnity
The main disadvantage of an indemnity is the way in which it is contracted. Indemnities do not need to be in writing and can be very vague, thus, broad and versatile nature can become a problem for parties to the contract. To prevent this, indemnities should be written and simple, to include all the potential losses that the party wishes to cover. Once signed, the contract should be kept somewhere safe, as under a contract, the statute of limitation on an indemnity lasts 6 years. A statute of limitations is a period of limitation that a party can bring for actions of a certain kind.
What is a demand guarantee?
Demand guarantees are an agreement entered into by the beneficiary and guarantor which imposes a primary obligation on the guarantor to pay a specified amount on the beneficiary’s demand. This is used as protection against the risk of the borrower defaulting on the contract. This differs from a normal guarantee, as a demand guarantee requires a party to pay money to another party, whereas a guarantee is normally used as insurance for the guarantor against the beneficiary and the borrower in the event that a default occurs. A normal guarantee does not require money to be paid until there is a default, whereas a demand guarantee requires money to be paid prior to a default.
What do I need to know if I have been asked to be a guarantor?
If you have been asked to be a guarantor for someone, it is important that you understand what exactly will mean for your financial stability. The risks of being a guarantor which should be considered are:
- that you may have to pay back the entire debt of the borrower; and
- it could stop you getting a loan in the future and may impact your credit score.
Further, you should understand the details of the loan contract, and check whether you will be able to pay the loan amount and whether you wish to use your house or another asset as loan security. You should also enquire as to what might occur if you were wishing to sell the property that was being used as loan security. The loan should clearly state the term and interest payments required.
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What does an indemnity clause contain?
An indemnity clause, generally, is drafted to include two key elements:
- a description of the specific event or set of circumstances triggering the indemnity; and
- a description of the loss which the indemnifying party will be liable for.
What are the different types of guarantees?
The three main types of guarantees are:
- Personal guarantee
This guarantee is generally used as an individual’s legal promise to repay credit issued to a business where they are employed as an executive or partner. In the case of default, the individual will repay the outstanding amount of the loan with his or her assets.
- Bank guarantee
A bank guarantee is where the bank will act as the guarantor on behalf of the borrower, and if in the case of default, the bank will cover the outstanding amount. It is generally used as an alternative to providing a deposit or bond directly to a supplier.
- Financial guarantee
A financial guarantee is similar to a bank guarantee, in which a specialised insurance company will repay the amount and interest payments in the case of the borrower’s default.
What are the different types of indemnities?
There are many different types of indemnities, the main indemnities being express and implied. Express indemnities are usually contracted in a written agreement, and involve the parties abiding by certain terms and conditions. Common examples include indemnity, construction and agency contracts.
Implied indemnities often arise from circumstances or via the conduct of the parties. This is generally not written, and an example is an agent-principal relationship; in which if the principal refuses the goods that the agent supplies, the agent is able to sell the goods to others and claim the loss sustained whilst selling from the principal, who is obligated to pay for it.
If you have any queries, or are entering into a guarantee or indemnity, you should seek legal advice. Legal Kitz can direct you with your next step, in determining whether your guarantee or indemnity will protect you sufficiently, or for any legal issues that may arise. Our Legal Kitz business specialists can assist with ensuring that your concerns are addressed, and can provide you with advice that is tailored to your situation. You can book a free 30-minute consultation via our website now.