#10299 - Guarantee V Indemnity - Finance and Capital Markets

Why are guarantees and indemnities important? They are a common way in which creditors protect themselves from the risk of debt default. Lenders will often seek guarantees and indemnities 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.

	Guarantee	Indemnity
What is it?	A promise to ensure that a third party fulfils its obligations and/or promise to fulfil those obligations if a third party fails to do so.	A promise to be responsible for another’s loss.
Primary or Secondary Obligation	It is a contractual agreement that creates a Secondary Obligation to support a primary obligation of one party to another	It is a contractual agreement that creates a Primary Obligation given by the indemnifier to the person to be indemnified.
Contingent	The guarantor’s obligation is contingent on the borrower’s primary obligation. It will never be greater than that of the borrower under the primary agreement.	It is independent to, and not contingent on the obligation of the borrower.
What’s the obligation	The obligation is usually a payment obligation, but it can also be a performance obligation (such as a guarantee to take over building works under a construction contract.)	If the underplaying transaction is set aside for any reason, the indemnity will remain valid.
Courts	The courts are protective of guarantors and guarantors have a number of important rights both against the underlying obligor and against the lender.	The Lender will want any guarantee to be supported by an indemnity in order for the lender to be properly protected.
Distinguishing Test = connection with the transaction + the extent of the promise + Actual words	A promisor unconnected with the underlying transaction, except by means of a promise to pay has been held to be a guarantor + It is a guarantee if the promise can be construed as being the main purpose of the transaction, + The true construction of the actual words in which the promise is expressed	A promise made by someone that will derive some benefit for the transaction gives an indemnity (Courtier v Hastie) + It is an indemnity if the promise can be construed as being incidental to the main purpose of the transaction. + The true construction of the actual words in which the promise is expressed
Proving, Onus	On the beneficiary (the lender or Bank) to prove that the document is a guarantee (secondary obligation)	On the beneficiary (the lender) to prove that the document is an indemnity (primary obligation)
Advantages	By s.4 of Statute of Frauds 1677 A guarantee must be in writing and signed by the guarantor or a person authorised by it. If the primary obligation ceases to exist for any reason, the guarantor cannot be liable for it because the guarantee is dependent on the primary obligation. This means that the beneficiary can be prevented from claiming repayment form the guarantor when it most needs to relay on the guarantee. Guarantees are vulnerable if any changes are made to the underlying contract. Amendments to the contract after the giving of the guarantee, will discharge the guarantor’s liability under the guarantee unless: The guarantor consents the variation The variation is patently insubstantial or incapable of adversely affecting the guarantor	Formalities s.4 of Statute of Frauds 1677 do not apply to indemnities i.e. flexibility. Thus it does not need be in writing to be enforceable. An indemnity is a primary obligation from the promisor to the beneficiary. This is more robust than a guarantee which is a secondary obligation as it creates a “stand alone” (or primary) obligation which is independent of the liability or default or the other party. If a primary obligation is set aside as illegal, and the beneficiary has an indemnity, then the indemnity would survive the setting aside of the loan between the borrower and the beneficiary.
Rights	Guarantee automatically provides the following rights to guarantor: 1. Indemnity form the underlying obligor: Principal contractually obliged to indemnify guarantor Guarantor can claim indemnity from the obligor without waiting for a demand for the amount in debt, Guarantor has right of set-off against the obligor 2. Subrogation Once the guarantor has fulfilled all the borrower’s obligations (i.e. repaid the beneficiary (i.e. the Bank)) the guarantor is entitled to step into the shoes of the beneficiary (the Bank) and take the benefit of any rights of set-off and any security that the beneficiary has taken from the borrower. 3. Marshalling (PLC article in WS 4) An equitable remedy available to a creditor when: Creditors A&B take security over debtor’s asset X A has also taken security over debtor’s asset Y. A enforced its security over asset X but not Y B entitled to use asset Y to repay its secured debt. 4.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.	INDEMNITY Rights are NOT automatically provided by an indemnity.

Challenging a Guarantee

The main grounds upon which a Guarantee may be challenged.

Contractual formalities: Guarantees & Indemnities Follow basic contract requirements:

(offer+acceptance+intention to create legal relations +consideration+Certainty). Consideration for both can be problematic and deemed as insufficient (unless it is a bank guarantee). Therefore guarantees are usually executed as deed to overcome any argument about whether good consideration was given. Execution of a guarantee as a deed extends the period during which the beneficiary of the guarantee may claim under the guarantee.

Formalities:

Not in writing or signed by the guarantor = not enforceable under s.4 Statute of Frauds 1677

Primary Obligation Fails/void:

because a guarantee is usually a dependent contract, not a stand-alone one
if the primary debt is discharged or the primary contract declared void the guarantee falls away (but not an indemnity)
But the lender wants to ensure the guarantee survives avoidance of the main contract. They therefore include a provision to this effect in the guarantee, expressing it to be payable on demand as if was a principal debt (see McGuiness v Norwich Building Society)

The primary obligation is varied:

if 1ry obligation is varied without Guarantor’s consent (knowledge is insufficient), the guarantee falls away. Other acts whichare directly prejudicial to the guarantor can void the secondary contract (e.g. a bank fails to register its security for the debt)
The ruling in Triodos indicates that even if the contract allows for variation and amendments, these must be within the “general purview of the original guarantee”. e.g. if the facility is now to be increase and used for a different purpose (as in Triodos) this would cause the guarantee to fall away.

Capacity i.e. giving the guarantee is ultra vires:

outside the powers of the company or the authority of Directors Co.’s and Directors of Co.’s giving a guarantee must have capacity/authority to give the guarantee or indemnity (act in the best interest/success of the CAss. 171 &172) and not be acting against the constitution of the Co.

In Insolvency of Borrower (Preference and Reinstatement wording):

Where the repayment constitutes a transaction at undervalue or a preferenceand is avoided by the liquidator of the principal obligor by ss.238 or s.239 IA 1986 if it was given for no consideration or below market value. However, to cover the risk that a repayment by the principal obligor of the guaranteed debt may be set aside as a preference, most guarantees include reinstatementwording. This wording says that, if there is a repayment by the principal obligor that later must be repaid following its administration or liquidation, the guarantor's liability will continue as if the principal obligor had not made the repayment and any discharge of the guarantee had not occurred (in other words, the guarantee will be reinstated). The beneficiary can then recover from the guarantor an amount equal to the repayment it would have received had the repayment not been set aside as a preference or a transaction at undervalue.

No corporate benefit:(See YourLPC WS3 Corp Benefit p.9)

The Parent Co or the Shareholders can challenge a guarantee by demonstrating that there was no Corporate benefit as it did not satisfy s.172 of the CA (promote the success of the Co.).

Financial Assistance (FA): (See YourLPC WS3 Corp Benefit p.12)

it’s unlawful for a public Co. to give FA directly or indirectly for the purpose of an acquisition unless one of the exceptions applies. Includes guarantees & indemnities = void and/or D’s fined and imprisoned.
Where the guarantee is in a standard form and/or the guarantor is an individual (but not a Co. Dir or a partner in a Ltd Partnership), it will be subject to the test of reasonableness under s.3 UCTA and the UTCCR respectively.

Duress:

where a party to a contract is induced by duress (actual or threatened violence or unlawful restraint) it is voidable by the injured party. Threat can be: to person, to property, of economic nature

Undue influence and misrepresentation:

a guarantee can be set aside if it was procured by misrepresentation or undue...

#10299 - Guarantee V Indemnity - Finance and Capital Markets

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