18 Feb Alternatives to Securities: Guarantees and Indemnities
Typically, there are two methods in which a creditor can protect itself against non-performance or insolvency of its debtor. The first which is commonly utilized is by taking security i.e. obtaining an interest over a specific asset through which a creditor can be paid in the event the debtor defaults. The other way is for the creditor to engage someone else to assume responsibility for the debtor’s obligations. This allows the creditor an alternative option for recovery in case the debtor becomes bankrupt or insolvent.
This paper seeks to examine structures whereby there is a liability owed by a person (debtor) to another person (creditor) and that a third person (guarantor) assumes an obligation to discharge it.
This is the most obvious method as an alternative to security whereby a creditor obtains a guarantee to the effect that a third party guarantees the performance of a debtor’s obligation to the creditor. A guarantee is typically described as a “contract of suretyship”, the guarantor as a “surety” and the debtor as the “principal”.
Another option is for the creditor to take an indemnity by which a third party agrees to indemnify the creditor against any loss suffered (direct/indirect) by the creditor as a result of entering into the said transaction with the debtor.
The Nature of Guarantees and Indemnities
If a creditor wants to make a third party personally liable for the debtor’s obligations, he has a choice of taking a guarantee or an indemnity. We will discuss below the nature of a contract of guarantee and then how it differs to that of a contract of indemnity.
Under a guarantee, the nature of the guarantor’s obligation to procure that the debtor performs his obligation to the creditor. Since the guarantor’s obligation is not to pay money to the creditor but to ensure the debtor performs a covenant, the creditor’s remedy against the guarantor is damages for breach of contract notwithstanding the debtor’s obligation to the creditor was to pay money. Therefore, where the debtor fails to observe a promise, the creditor can recover from the guarantor as damages as a result of that failure. The measure of the debtor’s liability to the creditor being also the measure of the guarantor’s liability to the creditor.
Based on the above, the principal features of a guarantee are as follows:
- It is a contract and as such is subject to normal rules for creating, interpreting and enforcing contracts;
- The key feature of a contract of guarantee is that one person assumes liability for the failure of another to perform an obligation. The guarantor’s liability does not replace the debtor’s liability. It is secondary to that of the debtor.
The distinction between Guarantees and Indemnities
The distinction between a guarantee and an indemnity is that an indemnity creates a different type of liability than a guarantee. An indemnity is an undertaking or representation to make good a loss suffered to another. The result may occur as a result of a transaction with the indemnifier or as a result of a transaction with a third party. Essentially, the indemnifier agrees to indemnify the creditor in respect of loss suffered by him as a result of a transaction with the debtor.
When looking at it from a commercial perspective, there is no real distinction between:
- A person guaranteeing to a creditor the obligations of the debtor under a particular contract; and
- A person agreeing to indemnify the creditor against loss suffered by him as a result of entering into a contract with the debtor.
In essence, the creditor is protecting the same in interest in both cases. However, it is germane to look at the intricacies of both in the sense that a guarantee imposes on the guarantor a secondary liability while an indemnity creates a primary obligation. It is not secondary to or dependent on an obligation being performed by anyone else.
A guarantor is given various rights against a debtor, the creditor and co-guarantors (if any). The effect of such rights is to enable the guarantor to recover payments which he has made under the guarantee. This can be done in three different ways:
- The guarantor has rights of indemnity against the debtor in respect of amounts paid under the guarantee – the guarantor has a right to be indemnified by the debtor against payments made by him under the guarantee if the guarantee is entered into at the express or implied request of the debtor.
- The guarantor has a right of contribution against co-guarantors in order to ensure that he does not pay more than his fair share – this is to enable the guarantor recover that part of the amount which he has paid which is in excess of his fair share. Fair share will be dependent on the arrangement between the parties.
- The guarantor has the right to be subrogated to the creditor’s rights (including its security) against the debtor and co-guarantors in order to give effect to those rights of indemnity and contribution – the importance of this right is that the guarantor is subrogated not only to the creditor’s personal right of repayment but also to all security and preferential rights held by the creditor in relation to the guaranteed debt, whether they are available against the debtor or against the co-guarantors.
As stated earlier in this paper, the obligation of a guarantor is to procure that the debtor performs his obligations. It is for this reason that the creditor is generally entitled to bring proceedings against the guarantor without enforcing his rights against the debtor. The guarantor’s liability is secondary to that of the principal debtor. Unless there is a contrary provision stipulated in the guarantee agreement, the creditor is precluded from proceeding against the guarantor until the principal debt becomes outstanding. Therefore, if the debt only becomes payable if demand is made on the debtor, then the creditor must do so first before proceeding on the guarantor. Guarantees typically are only payable “on demand” against the guarantor.
Limits on the guarantor’s liability are common and some of the main types of limit are:
- Limits in time;
- Limits as to amount; and
- Limits as to particular types of transaction.
Discharge by the conduct of the Creditor
There are various instances whereby the actions of the creditor will release the guarantor from all or part of his liability. Some of the actions are as follows:
- The release of the debtor by the creditor;
- The debtor being given time to pay the creditor;
- Variations to the contract between the creditor and the debtor;
- The release of co-guarantors by the creditor;
- The loss of security held by the creditor; and
- Breach of contract by the creditor.
It can be seen from the above that there are indeed options to taking security in financial transactions as well as other forms of transaction however it is also pertinent to note that financial institutions preferred method is to take security on any of the borrowers’ assets as this provides added comfort in the event of any default.
Berkeley Legal is able to advise on all areas pertaining to finance documents, guarantees, indemnities and also what structure best suits the needs and intricacies of our client’s transactions.
The information provided in this article is for general informational purposes only and does not constitute legal advice. If you require specific legal advice on any of the matters covered in this article please contact firstname.lastname@example.org