Contract of Indemnity (Sections 124-125)

Definition of Indemnity

The Indian Contract Act, 1872, defines certain special types of contracts, including contracts of indemnity and guarantee. A Contract of Indemnity is one where one party promises to protect the other from suffering a loss. Section 124 provides the definition.

Definition under Section 124

"A contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person, is called a 'contract of indemnity'."

Explanation:

Two Parties: There are two parties in a contract of indemnity:
- Indemnifier: The person who promises to make good the loss.
- Indemnity Holder (or Indemnified): The person who is to be protected against the loss.
Promise to Save from Loss: The core of the contract is a promise by the indemnifier to protect the indemnity holder from a loss.
Cause of Loss: The loss must be caused by:
- The conduct of the indemnifier himself, OR
- The conduct of any other person.

Example: A contracts to indemnify B against the consequences of any proceedings which C may take against B in respect of a certain sum of money. This is a contract of indemnity. If C sues B and B has to pay damages/costs, A will have to reimburse B.

Example: A promises to indemnify B if B suffers loss by signing a document based on A's assurance. If B signs and suffers loss due to the document, A must indemnify B.

Promise to save from loss caused by conduct of promisor himself or by conduct of any other person

The definition in Section 124 specifically restricts the source of the loss against which indemnity is provided to the conduct of the promisor (indemnifier) or the conduct of any other person. This means the loss must arise from human agency.

Illustration:

Loss caused by indemnifier's conduct: A asks B to sell certain goods on his (A's) behalf. A promises to indemnify B if B suffers any loss due to acting on A's instructions. If B suffers loss due to following A's specific directions (which were perhaps flawed), A must indemnify B.
Loss caused by conduct of any other person: This covers losses caused by the actions of third parties. The most common example is the illustration given in the Act: indemnity against proceedings by C.

Restriction compared to English Law: The definition in Section 124 is narrower than the concept of indemnity in English Common Law. In English law, a contract of indemnity can cover losses arising from *any* cause, including human conduct, accidents, or natural events (e.g., losses covered by insurance contracts). Section 124's wording limits the cause of loss to 'conduct'.

However, Indian Courts have interpreted 'contract of indemnity' more broadly, often including contracts of insurance within the general concept of indemnity, even if the loss is caused by fire, flood, etc., which are not strictly 'conduct'. The specific provisions of insurance laws also govern insurance contracts.

The essence is that the indemnifier takes on the risk of a specified loss and promises to make it good when it occurs due to the defined events (conduct in the literal sense of Section 124, or broader causes in insurance).

Example 1. Mr. A promises to pay Mr. B Rs. 10,000/- if Mr. C files a baseless lawsuit against Mr. B. Is this a contract of indemnity?

Answer:

Yes, this is a contract of indemnity. Mr. A is the indemnifier and Mr. B is the indemnity holder. Mr. A promises to save Mr. B from loss (having to deal with a baseless lawsuit) caused by the conduct of another person (Mr. C filing the lawsuit). This fits the definition under Section 124. If Mr. C files a baseless lawsuit against Mr. B and Mr. B incurs legal costs or suffers loss, Mr. A is bound to indemnify him up to the agreed amount or the extent of the loss depending on the contract terms.

Example 2. Ms. D takes out a fire insurance policy for her house with Insurer E. Insurer E promises to cover the loss if Ms. D's house catches fire. If the house catches fire due to a short circuit, is this strictly a contract of indemnity under Section 124?

Answer:

Strictly applying the narrow definition of Section 124, which specifies loss caused by 'conduct', loss due to a short circuit (an accident) might not strictly fall under the definition. However, as noted, Indian courts often treat insurance contracts as contracts of indemnity in a broader sense. Also, a short circuit *could* arguably be linked to human conduct in manufacturing or maintenance. The specific provisions of the Insurance Act and the terms of the fire insurance policy would govern the enforceability of the claim, but in practice, fire insurance is considered a form of indemnity.

Rights of Indemnity Holder

Section 125 of the Indian Contract Act, 1872, specifies the rights of the indemnity holder (the person indemnified) when sued in respect of the matter covered by the indemnity contract.

Rule under Section 125

"The promisee in a contract of indemnity, acting within the scope of his authority, is entitled to recover from the promisor—

(1) all damages which he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies;

(2) all costs which he may be compelled to pay in any such suit if, in bringing or defending it, he did not contravene the orders of the promisor, and acted as it would have been prudent for him to act in the absence of any contract of indemnity, or if the promisor authorized him to bring or defend the suit;

(3) all sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the promisor, and was one which it would have been prudent for the promisee to make in the absence of any contract of indemnity, or if the promisor authorized him to compromise the suit."

Explanation: This section outlines what the indemnity holder can claim from the indemnifier when they have incurred liability or expenses in a lawsuit related to the subject matter of the indemnity.

When loss is incurred

The rights of the indemnity holder typically arise when the loss is incurred, meaning when they have suffered actual damage or have become absolutely liable to pay a sum of money in a lawsuit. While Section 125 describes rights when 'compelled to pay' in a suit, there is debate and judicial interpretation on whether the indemnity holder must wait until they have actually paid the money out of their pocket, or if becoming liable is sufficient to claim indemnity.

Judicial interpretation: Indian courts have generally taken a liberal view, holding that the indemnity holder can claim indemnity from the indemnifier as soon as their liability to a third party has become clear and absolute, even if they have not yet actually paid the money. The indemnity holder can compel the indemnifier to pay the third party directly or to place the indemnity holder in a position to pay. This prevents the indemnity holder from having to suffer financial hardship by paying first and then seeking reimbursement.

Specific Rights (under Section 125, when sued):

Damages: The indemnity holder can recover all damages they are compelled to pay in a lawsuit related to the indemnity.
Costs: They can recover all litigation costs, provided they acted prudently or with the indemnifier's authorization in bringing or defending the suit.
Compromise Amounts: They can recover sums paid to compromise a suit, provided the compromise was prudent or authorized by the indemnifier.

These rights are available provided the indemnity holder was acting within the scope of their authority conferred by the indemnity contract.

Example 1. Mr. F promises to indemnify Mr. G against any loss arising from Mr. G selling certain goods that Mr. F claims belong to him. Mr. G sells the goods. A third party, Mr. H, sues Mr. G, claiming the goods belonged to him and demanding Rs. 50,000/- as damages. The court orders Mr. G to pay Rs. 40,000/- in damages to Mr. H and also awards Mr. H Rs. 10,000/- as litigation costs. Mr. G also incurs Rs. 5,000/- in his own legal costs to defend the suit prudently. What can Mr. G recover from Mr. F?

Answer:

Mr. G is the indemnity holder and Mr. F is the indemnifier. Mr. G was sued in respect of the matter covered by the indemnity (selling the goods). According to Section 125, Mr. G can recover from Mr. F:

All damages he is compelled to pay: Rs. 40,000/- (Section 125(1)).
All costs he is compelled to pay: Rs. 10,000/- (awarded to Mr. H) + Rs. 5,000/- (his own prudent costs to defend) = Rs. 15,000/- (Section 125(2)).

Therefore, Mr. G can recover a total of Rs. 55,000/- (Rs. 40,000 + Rs. 15,000) from Mr. F, provided he acted within the scope of his authority and defended the suit prudently.

Furthermore, based on judicial interpretation, Mr. G can claim this amount from Mr. F as soon as the court decree is passed making him liable, even if he hasn't paid Mr. H yet.

Contract of Guarantee (Sections 126-147)

Definition of Guarantee

A Contract of Guarantee is another special type of contract defined in the Indian Contract Act, 1872. It involves a promise to perform the promise or discharge the liability of a third person in case of their default. Section 126 provides the definition.

Definition under Section 126

"A 'contract of guarantee' is a contract to perform the promise, or discharge the liability, of a third person in case of his default."

Explanation:

Specific Purpose: The purpose of a guarantee is to provide security to the creditor that the promise or liability will be fulfilled, even if the primary obligor (the third person) fails to do so.
Contractual Obligation: It is a contract, meaning it requires agreement, consideration, lawful object, etc.

A contract of guarantee is a tripartite agreement involving three parties:

Principal Debtor, Surety, Creditor

Section 126 also defines the three parties involved:

"The person who gives the guarantee is called the 'surety';"

"the person in respect of whose default the guarantee is given is called the 'principal debtor';"

"and the person to whom the guarantee is given is called the 'creditor'."

Principal Debtor: This is the person who is primarily liable to the creditor. The guarantee is given in respect of their debt or promise.
Creditor: This is the person to whom the guarantee is given. They are the recipient of the promise of guarantee.
Surety: This is the person who gives the guarantee. They promise to perform the principal debtor's obligation if the principal debtor defaults. The liability of the surety is secondary, arising only upon the default of the principal debtor.

Example: A borrows money from a bank. B promises the bank that if A fails to repay the loan, B will repay it. Here, A is the Principal Debtor, the Bank is the Creditor, and B is the Surety.

A contract of guarantee can be oral or written (Section 126, Proviso). However, in practice, banks and financial institutions always require guarantees to be in writing.

Consideration for Guarantee

A contract of guarantee, being a contract, must be supported by consideration. However, Section 127 makes a special provision for the consideration in a contract of guarantee:

Section 127:

"Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee."

Explanation:

The consideration for the surety's promise is usually something done or promised for the benefit of the principal debtor. It is not necessary that the surety receives any direct benefit.
The loan or advance made by the creditor to the principal debtor, or the promise to forebear from suing the principal debtor, can be sufficient consideration for the surety's guarantee, even if the guarantee is given after the loan/advance is made, provided it is part of the same transaction.

Example: A requests B to sell and deliver to him goods on credit. C promises B that if A does not pay for the goods, C will pay. B delivers the goods to A. The delivery of the goods to A is sufficient consideration for C's promise.

Discharge of Surety

The surety's liability is secondary, dependent on the principal debtor's default. However, the surety's obligation can be discharged in various ways, even if the principal debtor's liability continues. Sections 130 to 147 of the Act deal with the rights and discharge of a surety. Some ways a surety is discharged include:

By Revocation (Section 130): A specific guarantee may be revoked by the surety by giving notice to the creditor as to future transactions. For a continuing guarantee (guarantee covering a series of transactions), the surety can revoke it as to future transactions by notice to the creditor.
By Death of Surety (Section 131): In the absence of any contract to the contrary, the death of the surety is a revocation of a continuing guarantee, so far as regards future transactions.
By Variance in terms of contract (Section 133): Any variance (change) made in the terms of the contract between the principal debtor and the creditor, without the surety's consent, discharges the surety as to transactions subsequent to the variance. The surety is liable only for the contract they guaranteed, not a materially altered one.
By Release or Discharge of Principal Debtor (Section 134): The surety is discharged by any contract between the creditor and the principal debtor, by which the principal debtor is released, or by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor. If the principal debtor is discharged, the surety's secondary liability automatically ends.
By Compounding with, or Giving Time to, or Agreeing not to Sue, Principal Debtor (Section 135): If the creditor, without the surety's consent, enters into a composition agreement with the principal debtor, or promises to give the principal debtor more time for payment, or promises not to sue the principal debtor, the surety is discharged. This protects the surety from the creditor unilaterally changing the terms of the primary obligation or delaying recovery.
By Creditor's Act or Omission Impairing Surety's Remedy (Section 139): If the creditor does any act inconsistent with the rights of the surety, or omits to do any act which his duty to the surety requires him to do, and the eventual remedy of the surety himself against the principal debtor is thereby impaired, the surety is discharged. This includes losing or parting with any security held against the principal debtor without the surety's consent.

Example 1. Mr. P gives a guarantee to a bank for a loan given to Mr. Q. The loan is for Rs. 5 Lakhs, to be repaid in 10 equal monthly instalments. After 5 instalments are paid, the bank and Mr. Q agree to reschedule the loan, reducing the monthly instalment amount and increasing the repayment period, without informing Mr. P. What happens to Mr. P's guarantee?

Answer:

Mr. P's guarantee is discharged as to future transactions (remaining instalments). The bank and Mr. Q made a variance in the terms of the contract (rescheduling the loan) without Mr. P's consent. According to Section 133, any variance made in the terms of the contract between the principal debtor and the creditor, without the surety's consent, discharges the surety as to transactions subsequent to the variance. Mr. P remains liable for any default on the first 5 instalments but is discharged from liability for the rescheduled remaining instalments.

Rights of Surety

The law provides certain rights to the surety to protect their interests, given that they are undertaking liability for another person's debt. These rights arise primarily after the surety has paid the creditor upon the principal debtor's default.

Against the creditor

The surety has certain rights against the creditor, which largely aim at ensuring that the surety's position is not worsened by the creditor's actions or inactions:

Right to Securities (Section 141): A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship is entered into, whether the surety knows of the existence of such security or not. If the creditor loses or parts with such security without the consent of the surety, the surety is discharged to the extent of the value of the security. This right arises when the surety pays the debt or discharges the liability of the principal debtor. Upon paying, the surety steps into the shoes of the creditor regarding these securities.
Right to Set-off: If the creditor sues the surety, the surety can plead any set-off or counterclaim that the principal debtor has against the creditor, arising out of the same transaction.

Against the principal debtor

The surety has recourse against the principal debtor, particularly after the surety has been called upon to pay the creditor.

Right of Subrogation (Implied in Section 140): When the surety has paid the guaranteed debt or discharged the liability of the principal debtor, he is invested with all the rights which the creditor had against the principal debtor. This means the surety steps into the shoes of the creditor and can sue the principal debtor for the amount paid, just as the creditor could have. This is known as the right of subrogation.
Right to Indemnity (Section 145): In every contract of guarantee, there is an implied promise by the principal debtor to indemnify the surety. The surety is entitled to recover from the principal debtor whatever sum he has rightfully paid under the guarantee, but not sums paid wrongfully. This implied contract of indemnity is separate from the contract of guarantee itself.

Example: A is surety for B for a loan from C. B defaults, and A pays the loan amount to C. A is subrogated to C's rights against B (e.g., regarding any security C held). A also has an implied right to be indemnified by B for the amount he paid to C. A can sue B to recover the amount.

Co-sureties

When two or more persons are sureties for the same debt or duty, they are called co-sureties. The Act provides rules regarding their rights and liabilities among themselves (Sections 146, 147).

Liability of Co-sureties to Contribute (Section 146): Where two or more persons are co-sureties for the same debt or duty, either jointly or severally, and whether under the same or different contracts, and whether with or without the knowledge of each other, they are liable, as between themselves, to pay each an equal share of the whole debt, or of that part of it which remains unpaid by the principal debtor.
Contribution based on Different Amounts (Section 147): If co-sureties have bound themselves in different sums, they are liable to contribute equally up to the limits of the sums for which they have respectively bound themselves.

Example: A, B, and C are co-sureties for a loan of Rs. 9 Lakhs given to P. P defaults. A, B, and C are liable to contribute equally, i.e., Rs. 3 Lakhs each to the creditor (assuming the whole amount is due). If A pays the whole Rs. 9 Lakhs, he can claim Rs. 3 Lakhs each from B and C.

Example: A, B, and C are co-sureties for Rs. 9 Lakhs loan to P. A's guarantee is for Rs. 5 Lakhs, B's for Rs. 3 Lakhs, and C's for Rs. 1 Lakh. P defaults. Creditor can recover up to their guaranteed limits from any of them. Among themselves, they are liable equally up to their respective limits. If Rs. 6 Lakhs is due and paid by A, A can claim Rs. 3 Lakhs from B and Rs. 1 Lakh from C (equal up to C's limit), leaving A to bear Rs. 2 Lakhs (total Rs. $3+1+2=6$ Lakhs). If total debt is less than the lowest guarantee, they contribute equally.

Example 1. Mr. S is surety for a loan taken by Mr. T from a bank. The bank holds securities (like shares or property documents) belonging to Mr. T as collateral for the loan. Mr. T defaults, and Mr. S pays the entire outstanding loan amount to the bank. What rights does Mr. S have against the bank and against Mr. T?

Answer:

Against the Bank (Creditor): Mr. S is entitled to the benefit of all securities which the bank had against Mr. T at the time the guarantee was given (Section 141). Upon paying the debt, Mr. S steps into the shoes of the bank regarding these securities. The bank must hand over the securities to Mr. S.

Against Mr. T (Principal Debtor): Mr. S has the right of subrogation and the right to indemnity. He is subrogated to all the rights of the bank against Mr. T and can enforce the securities against Mr. T. He also has an implied right to be indemnified by Mr. T and can sue Mr. T to recover the entire amount he has rightfully paid to the bank under the guarantee (Section 145).

Example 2. A and B are co-sureties for a debt of Rs. 60,000/- owed by P to C. A gives a guarantee for the full amount, and B gives a guarantee for Rs. 40,000/-. P defaults, and A is compelled to pay the entire Rs. 60,000/- to C. How much can A recover from B?

Answer:

A and B are co-sureties. According to Section 146, they are liable to contribute equally to the debt (Rs. 60,000/-). However, their liability to contribute among themselves is limited by the amounts for which they respectively bound themselves (Section 147). Here, B's guarantee is limited to Rs. 40,000/-. They are liable to contribute equally up to the limit of the lowest guarantee, and then for the rest up to their limits. For Rs. 60,000/-, each would ideally contribute Rs. 30,000/-. However, if B's guarantee was only Rs. 40,000/-, A can recover Rs. 30,000/- from B (as they are liable equally). No, let me recheck Section 147. It says "equally up to the limits". The limits are A=60k, B=40k. The total debt is 60k. If they contribute equally, it's 30k each. Both limits (60k and 40k) are above 30k. So they should contribute equally? The illustrations to Section 147 clarify this. Illustration (a) shows equal contribution. Illustration (b) shows contribution up to the limits. If A guarantees 10k and B guarantees 20k, and debt is 10k, A pays 10k, recovers 5k from B. If debt is 15k, A pays 15k, recovers 7.5k from B. If debt is 30k, A pays 30k, recovers 10k from B. The wording is "liable... to pay each an equal share of the whole debt... but if they are bound in different sums, they are liable to contribute equally up to the limits of the sums for which they have respectively bound themselves." In this example, debt is Rs. 60,000. A's limit is Rs. 60,000, B's limit is Rs. 40,000. The total debt is Rs. 60,000. Their equal share would be Rs. 30,000 each. Both limits (60k and 40k) are above 30k. So, B should contribute Rs. 30,000/-. Therefore, A, who paid Rs. 60,000/-, can recover Rs. 30,000/- from B. This leaves A having borne Rs. 30,000/- and B Rs. 30,000/- out of the total Rs. 60,000/- debt borne by the co-sureties. Yes, this seems consistent with equal contribution within limits.

Therefore, A can recover Rs. 30,000/- from B. Both A and B are liable to contribute equally ($60,000 / 2 = 30,000$), provided this equal share does not exceed the limit of their respective guarantees. Since B's limit is Rs. 40,000/-, which is more than his equal share of Rs. 30,000/-, he must contribute his equal share. A, who paid the full amount, can recover B's share from him.