Introduction
It is common for a contractor to provide an indemnity and/or a guarantee to a principal under a construction contract. However, contractors must know that the two are fundamentally different. They should not take on additional obligations/risks than what is agreed between the parties under the construction contract.
For ease of understanding, we shall use a typical scenario where a construction contract requires the directors of a contractor to provide a personal guarantee for the performance of the contractor. We will also use the following terms:
- the primary obligor who is required to perform its obligations under the construction contract (the Contractor);
- the guarantor/indemnifier of the Contractor (the Directors); and
- the beneficiary of the guarantee/indemnity (the Principal).
Guarantee vs Indemnity
The key distinctions between an indemnity and a guarantee are:
Type of Obligation
…any reduction in liability of the Contractor under the construction contract may not affect the liability of the Director to the Principal.
Under a guarantee, the Directors’ liability is a secondary obligation to that of the Contractor.[1] This means that the Directors’ obligations shadows the Contractor’s liability and the guarantee is enforceable against the Directors to the extent that the Contractor’s obligation is enforceable under the construction contract.
By contrast, under an indemnity, the Directors’ liability is a primary obligation and separate from that of the Contractor.[2] This means that the Directors’ obligation is not necessarily co-extensive/the same with that of the Contractor. It follows that any reduction in liability of the Contractor under the construction contract may not affect the liability of the Director to the Principal. Accordingly, the Directors could find themselves being sued under an indemnity for losses that are not recoverable by the Principal under the construction contract with the Contractor.
Nature and Quantum of Claim
As a guarantee is a secondary obligation, the Principal may only recover from the Directors that part of the Contractor’s debt under the construction contract which is owing but unpaid, and which has been guaranteed.
By contrast, an indemnity may be drafted such that the liability of the Directors to keep the Principal harmless against all loss or expense. This may be wider than the Contractor’s liability under the construction contract and may include consequential losses (such as economic loss and indirect loss) of the Principal.
Conclusion
Under a guarantee, a Directors’ liability is limited to that of the Contractor under the construction contract and, under an indemnity, the Directors’ liability may not be limited to the Contractor’s liability under the construction contract and is not affected by any nullity, reduction or extinguishment of the Contractor’s liability to the Principal.
What does this mean for contractors?
It is preferable for contractors to provide a guarantee rather than an indemnity to the principal under a construction contract. Any obligations under a guarantee are subject to the contractor’s obligations under the construction contract and not an independent obligation (i.e. indemnity).
Also, if only required to provide a guarantee under the construction contract, contractors should ensure that the clauses in the guarantee does not (in effect) operate as an indemnity.
[1] See Sunbird Plaza Pty Ltd v Maloney [1998] HCA 11; (1988) 166 CLR 245.
[2] Ibid.