Suretyship: guarantee or indemnity

By Roger Fayers

"What's in a name?" Shakespeare wrote, "That which we call a rose by any other name would smell as sweet (1), but he surely didn't have in mind English law on suretyship. This, as recently described by the judge in Vossloh Aktiengesellschaft v Alpha Trains (UK) Ltd(2), is an area bedevilled by imprecise terminology in which it is all too easy to become confused by the words used or the labels given by the parties in suretyship undertakings they have entered into.

In former times it seems it was simpler to differentiate between two main categories of suretyship - the guarantee and the indemnity. Not so today. Over time parties have come to negotiate ever more complex commercial contracts with accompanying security undertakings that contain clauses, often couched in archaic language, modifying the respective rights and liabilities. It is not unusual nowadays to find the term "guarantee" used as a label to describe what is in reality an indemnity, and vice versa.

Accordingly, a field of law exists in England that covers a wide spectrum of contractual possibilities. A consequence is that the parties to an agreement - and in the last resort, the courts - now increasingly face and have to interpret provisions that point (often ambiguously) towards both primary and secondary obligations. Just where on the spectrum a particular agreement may fall becomes, therefore, a matter of "nice judgment" calling for the detailed examination of wording (in Vossloh six out of the guarantee's twelve clauses) in order to determine its indication of a primary or a secondary obligation. This task is not helped by the fact that provisions often overlap and duplicate themselves.

The Vossloh case

So, to the Vossloh case. Briefly, a Vossloh subsidiary (VL) entered into a contract to manufacture and supply trains to Alpha in respect of which Vossloh was required to give a parent company guarantee (the VAG guarantee). Alpha complained of various defects in the engines and gearboxes in some of the trains supplied by VL and, at the same time, it made a demand under the VAG guarantee. The contract dispute is the subject of separate court proceedings. The present action concerned the basis on which VAG as guarantor could be required to pay under its guarantee.

Suretyship: the variants

Since the term "suretyship"' can embrace a variety of undertakings, perhaps the best way to explain it is by describing the types of instrument under which VAG could have incurred a liability towards Alpha.

First, the VAG guarantee could have been a guarantee in the strict sense(3). Here, VAG, as surety (or guarantor) would have promised Alpha to be responsible for the due performance of VL's existing or future obligations towards Alpha under the contract if VL failed to perform any of them.

An essential distinguishing feature of this type is that the liability of VAG would have been ancillary (or secondary) to that of VL, which would remain primarily liable to Alpha. There would be no liability on VAG unless and until VL had failed to perform its obligations. What is called the "principle of co-extensiveness" would ensure that VAG was only liable to Alpha to the same extent that VL was liable to Alpha. For example, there could be no liability on VAG if the contract between VL and Alpha was void or unenforceable, or if the obligation of VL under that contract ceased to exist.

A variant of this type is the so-called "see to it" guarantee. In such a case VAG would have undertaken that VL would carry out its contract and that VAG would answer for VL's default. If for any reason VL did then fail to perform as required by its contract with Alpha, VL would not only break its own contract, but it would also put VAG in breach of its agreement with Alpha, thereby entitling Alpha to sue VAG for damages. These damages would be for the loss suffered by Alpha due to VL having failed to do what VAG undertook to Alpha that VL would do (i.e., supply trains with workable engines and gearboxes) (4)

In contrast, VAG's agreement could have been a contract of indemnity. In this case, VAG's agreement would have been by way of a security to Alpha for the performance by VL, its essential distinguishing feature being that (unlike under a guarantee) a primary liability would fall upon VAG wholly independent of any liability that may arise as between VL and Alpha. The fact of VAG's obligation to indemnify Alpha being primary and independent would have the effect that the principle of co-extensiveness would not apply. The indemnity would not only shift the burden of VL's insolvency on to VAG, but it would also safeguard Alpha against the possibility that its contract with VL was void or unenforceable. It would also prevent the discharge of VL or any variation or compromise of Alpha's claims against VL from necessarily affecting VAG's liability to Alpha. Otherwise, the rights and duties of the parties to a contract of indemnity are generally the same as those of the parties to a contract of guarantee.

Another variant needs to be mentioned. This has been described as "in essence a particularly stringent contract of indemnity". It is the so-called "performance bond" - sometimes known as a "demand bond" or "demand guarantee" or even as a "first demand guarantee" or "demand bond". If this were its agreement, VAG's liability would be to pay a specified sum of money to Alpha on the occurrence of a stated event, namely, the non-fulfilment by VL of a contractual obligation to Alpha. The wording of the VAG guarantee could result in VAG's liability arising on the mere demand by Alpha (even though it may be evident that VL was not in default or even if Alpha itself was in default under its contract with VL). Alternatively, the VAG guarantee wording could indicate that in addition to Alpha's demand, it was necessary that Alpha demonstrate the existence of a breach or failure of some obligation by VL.

What did VAG undertake?

Whether a particular agreement is of the one kind or the other or, indeed, a combination of all of them, is a matter of construction. Accordingly, whether the trigger for VAG's obligation was by Alpha's demand alone or by one accompanied by specified documents, or whether it was a guarantee (strictly so called) conditional on proof by Alpha of default by VL could only be answered by looking into the actual wording of the VAG guarantee itself. This involved "construing the instrument in its factual and contractual context having regard to its commercial purpose", a task which the court approaches "by looking at it as a whole without any preconception as to what it is".

Not surprisingly, the parties differed on what triggered liability. VAG argued that its obligation was only triggered by proof (whether by admission or the decision of a court) of a breach of contract by VL. Alpha, on the other hand, contended the trigger to be its demand alone.

The court's decision

The court's approach was as follows.

(a) The decision of the court of appeal in Marubeni Hong Kong v Government of Mongolia (5) established that in cases where undertakings are given not by a bank and not in a banking context there is a strong presumption that the payment obligation does not constitute a "demand bond";

(b) VAG was not a bank;

(c) accordingly, the question was whether there was clear language in the operative clauses of the VAG guarantee or in its contractual context to rebut this presumption;

(d) viewing the instrument as a whole, the court did not consider that the presumption against construing it as a demand bond had been rebutted; and

(e) a strict approach was to be adopted to the wording of a "conclusive evidence" clause. The particular provision in the VAG guarantee was not to be read as having the effect of turning VAG's undertaking into one analogous to a bond payable simply on demand.

In the result, the court held that liability under the VAG guarantee was premised upon there being a failure of performance of some underlying obligation by VL, the intention of the guarantee being to make good the loss thereby suffered. The guarantee was premised upon the establishment of that loss by Alpha.

Roger Fayers' e-mail is

1 Romeo and Juliet, Act 1, scene 2.
2 [2010] EWHC 2443 (Ch).
3 The need to add these four words or to describe it as a classic guarantee illustrates how things have changed.
4 See Moschi v Lep Air Services Ltd [1973] AC 331.
5 [2005] 2 Lloyds Rep. 255.