Allocating Risk in Large Transactions: Guarantees and Indemnities

Allocating Risk in Large Transactions: Guarantees and Indemnities

Newsflash

In significant commercial transactions, Guarantees and Indemnities are vital tools for managing risk. They are especially important when contracting with a company with only a very small amount of share capital (eg, a $2 company) given that such a company may have no assets sufficient to meet any liability for negligence, breach of contract or other civil wrong. Guarantees and Indemnities are agreements that make one party liable to answer for a certain liability, debt or other expense of another party. For example, the parent company of a $2 subsidiary company might agree to meet a liability for the subsidiary. Depending on the terms of the promise, this could take the form of a Guarantee (in which case the parent company would be a ‘guarantor’) or an Indemnity (in which case the parent company would be an ‘indemnifier’). Two important distinctions exist between Guarantees and Indemnities. First, a Guarantee must be in writing and signed by the guarantor; an Indemnity need not be[1]. Second, a Guarantee only creates a ‘secondary obligation’ on the part of the guarantor. This means that if the person whose liability is being guaranteed stops being liable, eg if the person ‘escapes’ the contract giving rise to the liability or the transaction is voided under bankruptcy law[2], the guarantor also stops being liable. By contrast, an Indemnity creates a ‘primary obligation’. Thus, even if the primary liability is voided, the indemnifier remains liable. This difference is illustrated by the case of Yeoman Credit Pty Ltd v Latter [1961] 1 WLR 828. An indemnifier promised to answer for the default of a minor under a contract. The minor defaulted. The contract with the minor was found to be void because of minority, but the indemnifier’s obligation to pay continued to exist. If the indemnifier had instead been a guarantor, the obligation would have been extinguished due to the minor’s obligation being extinguished. Guarantees and Indemnities involve numerous legal complexities. The scope of a Guarantee or Indemnity depends heavily on how it is drafted, making precision essential. Further, if the person making the Guarantee or Indemnity receives nothing in return for it – as will often be the case where a parent company executes a Guarantee or Indemnity – the document must be executed as a Deed to ensure that it is enforceable. Legal advice is highly recommended for anyone seeking a Guarantee or Indemnity. Freeman Zhong 22 September 2017 [1] Instruments Act 1958 (Vic) s 126 (also known as the ‘Statute of Frauds’). [2] Eg under Corporations Act 2001 (Cth) s 588FF or Bankruptcy Act 1966 (Cth) s 122. Copyright © Kellehers Australia 2017 Liability limited by a scheme approved under Professional Standards Legislation This fact sheet is intended only to provide a summary and general overview on matters of interest. It does not constitute legal advice. You should always seek legal and other professional advice which takes account of your individual circumstances.