04. guarantees

The question

The previous sub-unit examined security taken over property, the real security by which a creditor obtains a right in an asset. A creditor may also obtain security of a different kind, security taken over a person, by which a third person undertakes to answer for the debtor's obligation, so that the creditor may look to the third person if the debtor does not pay. This personal security is the subject of the present sub-unit, which examines the guarantee, the principal instrument of personal security, asking what a guarantee is, how it differs from related undertakings, and how it operates in commerce. The answer completes the module's treatment of security by adding personal security to the real security already examined, and it draws on the principle of autonomy encountered in the documentary credit to distinguish a particular and important form of guarantee.

The guarantee and the surety

A guarantee is an undertaking by one person, the surety or guarantor, to answer to a creditor for the debt or default of another, the principal debtor, so that if the principal debtor fails to perform the obligation, the surety becomes liable to the creditor for it. The guarantee is a form of personal security: it gives the creditor, in addition to its claim against the principal debtor, a claim against the surety, so that the creditor may recover from the surety if the principal debtor does not pay, and the creditor is thereby protected against the principal debtor's default by the addition of a second person answerable for the obligation.

The defining legal feature of the guarantee is that the surety's obligation is secondary, in the sense that it depends upon and is co-extensive with the principal debtor's obligation: the surety undertakes to answer for the principal debtor's obligation, and so the surety is liable only if and to the extent that the principal debtor is liable, and the surety may ordinarily raise against the creditor the defences available to the principal debtor. This secondary character connects the guarantee to the obligation it secures: because the surety's liability is parasitic on the principal obligation, if the principal obligation is void, discharged, or reduced, the surety's liability is correspondingly affected, and the surety who pays the creditor ordinarily acquires a right to be reimbursed by the principal debtor, stepping into the creditor's position against the debtor. The guarantee thus adds the surety's creditworthiness to the principal debtor's, giving the creditor recourse to a second person while leaving the primary responsibility with the principal debtor.

Consider a lender who lends to a company and requires a guarantee from a third person, such as a director or a parent company, who undertakes to answer for the company's debt. If the company pays, the surety is not called upon; if the company defaults, the lender may recover the debt from the surety, who, having paid, may then seek reimbursement from the company. The lender has obtained personal security, a second person answerable for the debt, supplementing its claim against the company. The example shows the guarantee adding the surety's liability, secondary to the principal debtor's, as personal security for the creditor.

A guarantee is therefore an undertaking by a surety to answer to a creditor for the debt or default of a principal debtor, a form of personal security whose defining feature is that the surety's obligation is secondary, dependent upon and co-extensive with the principal debtor's, so that the creditor gains recourse to a second person while the primary responsibility, and the ultimate burden, remain with the principal debtor.

The guarantee and the indemnity distinguished

The secondary character of the guarantee distinguishes it from a related but different undertaking, the indemnity, and the distinction is of practical importance. An indemnity is an undertaking by one person to make good a loss suffered by another, a primary obligation independent of any obligation of a third party, by which the indemnifier assumes its own liability to bear the loss rather than undertaking to answer for another's obligation. The difference between the guarantee and the indemnity lies in the distinction between a secondary and a primary obligation.

The guarantee, being secondary, depends on the principal debtor's obligation, so that the surety is liable only if and to the extent that the principal debtor is liable, and the surety may raise the principal debtor's defences; the indemnity, being primary, does not depend on any third party's obligation, so that the indemnifier is liable on its own undertaking irrespective of whether any other person is liable, and the indemnifier cannot escape by pointing to a defect in some other person's obligation. The practical consequence is that an indemnity gives the creditor a more robust protection than a guarantee, for it is not vulnerable to defects in the underlying obligation that would defeat or reduce a guarantee: if the principal obligation turns out to be void or unenforceable, a guarantee of it may fail, whereas an indemnity, standing on its own, may still bind the indemnifier. The distinction connects to the analysis of obligation in Course 1 and matters greatly in practice, for the characterisation of an undertaking as a guarantee or an indemnity determines whether it survives a defect in the underlying obligation, and the form and wording of the undertaking must be attended to in order to determine which it is.

Imagine a creditor who takes an undertaking from a third person in respect of a debtor's obligation that later proves to be unenforceable. If the undertaking is a guarantee, secondary to the debtor's obligation, it may fail with that obligation, for the surety is liable only to the extent the principal debtor is. If the undertaking is an indemnity, a primary obligation independent of the debtor's, it may bind the indemnifier nonetheless, for the indemnifier has assumed its own liability irrespective of the debtor's. The example shows the secondary guarantee vulnerable to a defect in the underlying obligation and the primary indemnity standing independently of it.

The guarantee and the indemnity are therefore distinguished by the secondary character of the one and the primary character of the other: the guarantee depends on the principal debtor's obligation and shares its defects, while the indemnity is an independent primary obligation that binds the indemnifier on its own terms, a distinction that determines the robustness of the security and that turns on the proper characterisation of the undertaking.

The demand guarantee

A particular and commercially important form of personal security combines the structure of a guarantee with the autonomy encountered in the documentary credit, namely the demand guarantee, also called the first-demand guarantee or, in some forms, the performance bond or standby credit. A demand guarantee is an undertaking, characteristically given by a bank, to pay a sum to the beneficiary on the beneficiary's demand, often accompanied by specified documents or a statement of default, independently of the underlying transaction and without the guarantor's inquiring into whether the principal debtor has in fact defaulted.

The defining feature of the demand guarantee is its autonomy, which connects it directly to the documentary credit examined earlier in this module. Unlike the ordinary guarantee, whose secondary character makes the surety's liability depend on the principal debtor's actual default and allows the surety to raise the principal debtor's defences, the demand guarantee is autonomous of the underlying transaction: the guarantor must pay against a conforming demand regardless of any dispute about whether the principal debtor has defaulted, just as the issuing bank under a documentary credit must pay against conforming documents regardless of disputes about the goods. This autonomy makes the demand guarantee a much stronger and more readily realisable security than the ordinary guarantee, for the beneficiary may obtain payment on demand without proving the principal debtor's default, and it is for this reason widely used in international commerce, particularly to secure a party's performance of a contract, the beneficiary being able to call the guarantee if it considers the other party to have defaulted. The same narrow exception for a fraudulent demand that qualifies the autonomy of the documentary credit applies to the demand guarantee, but otherwise its autonomy holds, and the party who procures a demand guarantee against itself accepts the risk that the beneficiary may call it on demand, leaving any dispute about the underlying default to be resolved afterwards. International rules issued by bodies such as the International Chamber of Commerce govern demand guarantees in practice, as the UCP governs documentary credits.

Consider a contractor required to provide security for its performance of a construction contract. It procures a demand guarantee from its bank in favour of the employer, undertaking to pay the employer on demand. If the employer considers the contractor to have defaulted, it may call the guarantee and obtain payment from the bank on demand, without first proving the default, and any dispute about whether the contractor truly defaulted is resolved afterwards between contractor and employer. The example shows the demand guarantee operating autonomously, like a documentary credit, to give the beneficiary payment on demand.

The demand guarantee is therefore a form of personal security, characteristically given by a bank, that is autonomous of the underlying transaction, requiring the guarantor to pay against a conforming demand regardless of disputes about the principal debtor's default, an autonomy that connects it to the documentary credit and makes it a strong and readily realisable security widely used to secure performance in international commerce.

Personal and real security together

The guarantee, with the other instruments of this module, completes the law's provision of security, and seeing how personal security complements the real security of the previous sub-unit connects the two and concludes the module's treatment. A creditor seeking to protect itself against a debtor's default may take real security, a right in the debtor's property, or personal security, the undertaking of a third person, or both, and the two forms of security protect the creditor in different ways and against different risks.

Real security gives the creditor a right in an asset, which protects it particularly against the debtor's insolvency by giving it priority over the unsecured creditors in that asset, but it is limited by the value of the asset and by the priority of competing claims to it. Personal security gives the creditor recourse to a second person, which protects it against the debtor's default by adding the surety's creditworthiness, but it is limited by the surety's own solvency and, in the case of an ordinary guarantee, by the secondary character that ties it to the principal obligation. A creditor commonly takes both, securing a debt by a security interest in the debtor's property and a guarantee from a third person, so that it may resort to the asset and to the surety alike. The choice and combination of securities, and the choice among the forms of each, allow a creditor to construct the protection appropriate to the risk it faces, and the law of security examined in this module furnishes the instruments from which that protection is built. The reader who has understood both the real security of the previous sub-unit and the personal security of this one has grasped the means by which commercial credit is secured.

Consider a lender extending substantial credit to a business. It may take a charge over the business's assets, giving it real security with priority on insolvency, and also a guarantee from the business's parent company, giving it personal security against a second person; if the business defaults, the lender may resort to the charged assets and, for any shortfall, to the guarantor. The lender has combined real and personal security to protect itself against both the insufficiency of the assets and the default of the debtor. The example shows real and personal security combined to construct the creditor's protection.

Personal and real security together therefore furnish the creditor with complementary protections, real security giving a right in an asset with priority on insolvency and personal security giving recourse to a second person against default, and the creditor constructs its protection by choosing and combining these securities according to the risk, drawing on the instruments that the law of security examined in this module provides.