This article concerns two surety related issues that are the subject of long running debate and recent decisions of the Court of Appeal. Factors determining whether a surety’s obligations are characterised as a guarantee or an indemnity, and the effect that amending obligations, which are the subject of a guarantee, has on the surety’s obligations.
Key Distinctions between a Guarantee and an Indemnity
Guarantors receive preferential treatment from the courts: guarantees are strictly construed, guarantors are only liable to the extent they have agreed to be liable in writing and any ambiguity in that writing will be interpreted in the guarantor's favour. Indemnifiers receive less sympathetic treatment and, as a result of this and the nature of an indemnity, the recipient of a guarantee should look to include a conversion to indemnity in its guarantees.
The obligations under a guarantee are coterminous with, and dependent upon the continued validity of, the primary obligor's obligations; the guarantor's liability only extends to cover that of the primary obligor. If the principal obligor's liability is reduced or extinguished, the guarantor's liability is correspondingly reduced or extinguished. Equally, if the primary obligation is amended, the guarantee may be extinguished.
Under a contract of indemnity, the indemnifier is assuming a primary obligation. This is not dependent on the validity, extent or nature of any underlying obligation or whether any other party defaults. The indemnifier's liability is independent of, and not an accessory to, the liability of anyone else.
Guarantee or Indemnity?
In Marubeni Hong Kong & South China Limited v. Mongolian Government [2005] All ER (Comm) 289 the Court of Appeal considered a claim from a machinery supplier whose purchaser had secured a letter of undertaking from the Mongolian state (the “Surety”). Prior to the claimant making demand on the Surety, the purchaser’s payment obligations had been rescheduled and it had then failed to pay.
The undertaking was expressed to be unconditional, waived the requirement to first claim on any other person and referred to the Surety indemnifying the claimant, who argued that this was a “demand bond” (an indemnity) and not a guarantee (as it had been described by the parties in other documents).
If the undertaking were a guarantee, any material amendment to the underlying obligations being guaranteed (which the rescheduling was found to be) – without the consent of the Surety or an express provision in the undertaking giving prior consent – would discharge the Surety. If, the undertaking were a primary obligation to pay all amounts payable under the contract of sale, it would survive the rescheduling.
It was found that:
- each authority on which the claimant relied related to demand bonds issued by banks;
- such instruments are a bank specific form of document creating irrevocable and unconditional primary obligations;
- outside that banking context and without clear wording, there is a strong presumption against construing a document as creating a primary obligation where it imposes obligations on a party which relate directly to obligations created in an extrinsic agreement between other parties;
- prior authority describing a document as a “guarantee” is not conclusive and was explained and distinguished on the basis that there must be other features sufficient to displace the use of this term;
- the “unconditional” and “demand” wording in the undertaking was qualified;
- inclusion of a waiver of recourse to third parties does not change the nature of the obligation from secondary to primary, it indicates that the parties intended the obligation to be secondary – necessitating an explicit waiver; and
- the amendment to the underlying obligation had released the Surety.
Amendments to the underlying obligation
In Triodos Bank NV v. Ashley Charles Dobbs [2005] All ER (D) 364 the Court of Appeal considered whether a guarantee, which permitted the beneficiary, a lender, to: “agree to any amendment, variation, waiver or release in respect of an obligation of the [borrower] under the [underlying loan agreement]”, covered three additional agreements subsequently entered into between the lender and the borrower which “replaced” the agreement between the lender, the borrower and the guarantor. The loan was made to refinance an existing loan and to finance part of a construction project.
It was found that:
- execution of a new document incorporating an amendment did not indicate a new and different agreement (which would not be covered and would release the guarantee);
- a guarantor will only be held to have agreed that its liability can be increased or made more onerous if there are clear words (that is, this is contemplated in the document creating the guarantee);
- other types of amendments might be covered even if not expressly contemplated and will be considered on a case by case basis;
- rescheduling was permissible – it was contemplated in the document;
- making substantial new money available and making money available for a different purpose (a new construction contract) were not permissible – they were not contemplated;
- increasing sums payable to the bank and including sums payable to the construction contractors constituted a new agreement, not a genuine amendment and the terms of the document in which these changes were contained was substantially different to the original document;
- even if the guarantor’s liability is not changed, an increase in the risk that the guarantee will be called (because, for example, the loan is increased) may discharge the guarantee in the absence of the guarantor’s agreement; and
- the agreement should state whether more than one amendment or variation is permitted.
These cases indicate first the continuing care that needs to be taken, when taking an obligation from a third party, to ensure that it will be sufficiently flexible to enable future variations and dealings and second the need to be mindful of defences that might become available to a surety to release it from its obligations as a result of such variations or dealings.
This article first appeared in our Construction and development legal update Spring 2006. To view this publication, please click here to open it as a pdf in a new window
