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Security Devices (part A)
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Charles Lamson
The next couple posts discuss two types of security devices: (1) guarantee and suretyship contracts and (2) secured credit sales.
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Guarantee and Suretyship
A contract of guarantee or suretyship is an agreement whereby one party promises to be responsible for the debt, default, or obligation of another. Such contracts generally arise when one person assumes responsibility for the extension of credit to another, as in buying merchandise on credit or in borrowing money from the bank.
A person entrusted with the money of another, such as a cashier, a bank teller, or a county treasurer, may be required to have someone guarantee the faithful performance of the duties. This contract of suretyship is commonly referred to as a fidelity bond.
In recent years bonding companies have taken over most of the business of guaranteeing the employer against losses caused by dishonest employees. These bonding companies are paid sureties, which means they receive money for entering into the suretyship. The bonding companies obligation arises from its written contract with the employer. This contract of indemnity details the conditions under which the surety will be liable.
Parties
A contract of guarantee or a suretyship involves three parties. The party who undertakes to be responsible for another is the guarantor, or the surety; the party to whom the guarantee is given is the creditor; and the party who has primary liability is the principal debtor, or simply the principal. Because these three parties are distinct and have differing rights and obligations, it is important to identify exactly what role a party has in a guarantee or suretyship arrangement.
Distinctions
The words surety and guarantor are often used interchangeably, and they have many similarities. Some states have abolished any distinction between them. However, in other states their legal usages differ. In a contract of suretyship, the shurety has liability coextensive with that of the principal debtor. The surety has direct and primary responsibility for the debt or obligation just like the primary debtor. the surety's obligation, then, is identical with the debtors.
A guarantor's obligation is secondary to that of the principal debtor. As a secondary obligation, the guarantee agreement may not even be executed at the same time or in the same instrument as the principal obligation. The guarantor's promise to pay comes into effect only in the event the principal defaults. The guarantor's obligation does not arise simultaneously with the principal's. The obligation depends upon the happening of another event, namely, the failure of the principal to pay.
For the most part, the law of suretyship applies with equal force to both paid sureties and accommodation sureties. A bail bondsman is a paid surety. An accommodation surety agrees to be a surety as a favor to the principal. A parent who cosigns a note for a teenager constitutes an accommodation surety. In some instances the contract of a paid surety will be interpreted strictly. Thus, in the case of acts claimed to discharge the surety, courts sometimes require paid sureties to prove that they have actually been harmed by the conduct of the principal before allowing recovery.
Importance of Making a Decision Distinction
In states that recognize a difference between guarantors and sureties, the distinctions involve three aspects:
Form. All the essential elements of a contract must be present in both contracts of guarantee and contracts of suretyship. However, a contract of guarantee must be in writing (see Illustration 1), whereas most contracts of suretyship may normally be oral.
ILLUSTRATION 1 A Letter of Guarantee
The Uniform Commercial Code (UCC) provides: "The promise to answer for the debt, default, or obligation of another must be in writing and be signed by the party to be charged or by his authorized agent." This provision should apply to a promise that creates a secondary obligation, which means an obligation of guarantee, not to a promise that creates a primary obligation or suretyship.
Notice of Default. A creditor need not notify sureties---parties primarily liable for the debt---if the principal defaults. On the other hand, the creditor must notify guarantors. In some states, failure to give notice does not of itself discharge the guarantyship. A guarantor damaged by the failure to receive notice may offset the amount of the damage against the claim of the creditor.
Remedy. In the case of suretyship, the surety assumes an original obligation. The surety must pay. Sureties have liability as fully and under the same conditions as if the debt where theirs from the beginning. The rule is different in many contracts of guarantee. In a conditional guarantee the guarantor has liability only if the other party cannot pay.
For example, Arnold writes, "Let Brewer have a suit; if he cannot pay you, I will." This guarantee depends upon Brewer's ability to pay. Therefore, the seller must make all reasonable efforts to collect from Brewer before collecting from Arnold. If Arnold had written, "Let Brewer have this suit, and I will pay you," an original obligation would have been created for which Arnold would have been personally liable. Therefore, Arnold would be deemed a surety if the understanding was that Arnold was to pay for the suit.
Rights of the Surety and the Guarantor
A guarantor and a surety have the following rights:
Indemnity. A guarantor or surety who pays the debt or the obligation of the principal has the right to be reimbursed by the principal, known as the right of indemnity. The guarantor or the surety may be induced to pay the debt when it becomes due to avoid the accumulation of interest and other costs on the Debt.
Subrogation. When the guarantor or the surety pays the debt of the principal, the law automatically assigns the claim of the creditor to the guarantor or surety. The payment also entitles the guarantor or surety to all property, liens, or securities that were held by the creditor to secure the payment of the debt. This right of subrogation does not arise until the creditor has been paid in full but it does arise if the surety of the guarantor has paid a part of the debt and the principal has paid the remainder.
Contribution. Two or more persons jointly liable for the debt, default, or obligation of a certain person coguarantors or cosureties. Guarantors or sureties who have paid more than their proportionate share of the debt are entitled to recover from the other guarantors or sureties the amount in excess of their pro rata share of the loss. This is the right of contribution. It does not arrive until the surety of the guarantor has paid the debts of the principal in full or has otherwise settled the debt.
Exoneration. A surety or guarantor they call upon the creditor to proceed to compel the payment of the debt otherwise the surety or guarantor will be released. This is the right of exoneration. The creditor may delay in pressing the debtor to pay because of the security of the suretyship. A creditor who fails to compel payment when due releases the surety in cases where the debtor can pay. The surety then has no uncertainty concerning potential liability.
Discharge of a Surety or Guarantor
The usual methods of discharging any obligation, including performance, voluntary agreement, and bankruptcy of the surety or guarantor, discharge both a surety and a guarantor. However, some additional acts that will discharge the surety or the guarantor include:
Extension of Time. If the creditor extends the time of the debt without the consent of the surety or the guarantor and for a consideration, the surety or the guarantor is discharged from further liability.
Alteration of the Terms of the Contract. A material alteration of the contract by the creditor without the surety's or guarantor's consent discharges the surety or guarantor. In most states the change must be prejudicial to the surety or the guarantor. A reduction in the interest rate has been held not to discharge the surety, whereas the change in the place of payment has been held to be justifying a discharge of the surety. A material change in a contract constitutes substituting a new contract for the old. The surety guaranteed the payment of the old contract, not the new one.
Creditor's Loss or Return of Collateral. If the creditor through negligence loses or damages collateral security given to secure the debt, a surety or guarantor is discharged. The return of any collateral security to the debtor also discharges a surety of or guarantor. Collateral must be held for the benefit of the surety until the debtor pays the debt in full.
*SOURCE: LAW FOR BUSINESS, 15TH ED., 2005, JANET E. ASHCROFT, J.D., PGS. 471-475*
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