Suretyship Law 101: Basics and Applications

What Constitutes Suretyship in Law

At its most basic, suretyship is a legally binding relationship for the payment of a specific debt or performance of a specific act by one party (the "Surety") to a second party (the "Creditor") in the event that a third party (the "Principal") defaults in its obligations. The Surety assumes the liability of the Principal in the event that the Principal defaults on a contract with the Creditor, and, in exchange, the Creditor pays the Surety a premium that is calculated based on the Surety’s assumption of risk.
Parties to suretyship arrangements come from many different industries and backgrounds. For example, when a general contractor constructs a building for an owner , the general contractor is typically required to furnish a performance bond to guarantee the owner’s rights under the construction contract, in the event that the general contractor defaults on its obligation to perform. Similarly in the context of expansion, an owner of a shopping center may be required to furnish a letter of credit to its lender to guarantee the owner’s loan obligations under a loan agreement, in the event that the owner defaults in making payments to the lender. In short, the parties to each of these arrangements place trust in the Surety to perform obligations owed by the Principal to the Creditor.

Who Are the Parties to a Suretyship Agreement

The parties involved in a suretyship agreement are the principal, the surety and the obligee. Each party will be discussed separately below.
• The principal is the individual or business entity which has requested the suretyship. This person or entity has an obligation (e.g., to pay a debt) which necessitates a surety. As a primary obligor, it is the individual or entity who usually requests the suretyship in order to be qualified for a contract, for example, or to facilitate a transaction that otherwise could not be secured.
• The surety is the individual or business entity who signs the bond. The surety has an obligation to pay or perform the obligation of the principal. The surety’s purpose is to enable and facilitate a particular transaction. Usually the surety has a commercial interest, with a compensated expert reviewing the principal’s financial qualifications and/or estimating the risk assumed by the surety.
• The obligee is the individual or business entity requiring the bond. In a construction project, for example, the "obligee" is the "owner" of the construction contract; i.e., the party to the construction contract who requires the contractor to obtain a contractor’s bond from a surety to secure the owner’s protection. The "interest" of the obligee may range from an arms-length business transaction to a close personal relationship. The interest of the obligee is facilitated by the surety.

Different Types of Surety Bonds

Bonds can be used in a few different contexts. The concepts of bid bonds, performance bonds, payment bonds, and general contractor-subcontractor scenario are all explained below.
Bid Bonds
A bid bond is used between the party seeking a contract (the Obligee) and a potential contractor (the Principal) who has submitted a bid for the contract. The Obligee will require the Principal to get a bid bond from a surety company as part of the bidding process. The bid bond assures the Obligee that the Principal is qualified to perform the work and will enter into and execute the contract according to the bid response and any contracts from the Obligee.
Performance Bonds
A performance bond is a bond whereby the surety guarantees that the contractor will perform all obligations under the contract. The bond is put in place to make sure that the project can be completed.
Payment Bonds
A payment bond is a three-party agreement between a surety, an Obligee (the property owner who says work must be paid), and a Principal (the contractor who owes money). Under the statute, a surety guarantees payment to all persons who provide labor, service, materials, or equipment on the bonded project.
General Contractor – Subcontractor Scenario
If you are a subcontractor on a bonded project, it is imperative that you follow the statutory notice requirements in order to preserve your rights and guarantee payment.

Laws Governing Suretyship

The legal framework governing suretyship varies from jurisdiction to jurisdiction, and the specific legal principles and statutes that apply to a particular suretyship arrangement depend upon the location of the debtor, surety and creditor. In the United States, for example, suretyship is governed by both the common law (judge-made law) and by the Commercial Code. The Commercial Code is a compilation of statutes that has been adopted (in whole or in part) by every state or territory of the United States. Article 3 of the Commercial Code deals with negotiable instruments. Article 9 deals with security interests (collateral). Article 3 supersedes Article 9 when the underlying obligation is in the form of a negotiable instrument. Because an obligation can be a bond or a negotiable instrument, a suretyship may be governed by both Article 3 and Article 9. There are variations between the Commercial Code as adopted by different states. Likewise, there are variations in common law between the different states. And there may be variations between the laws of different countries and territories.
One should also be aware that jurisdictions and countries vary in their treatment of bonds (as opposed to other written instruments).
The law of suretyship is typically found in the following places:
International laws and treaties may also affect suretyship. The Convention on International Interests in Mobile Equipment was created to address the difficulties that arise when mobile equipment is financed and transferred across international borders. The Aircraft Protocol to the Convention provides a remedy for international creditors. There exists as well the Cape Town Convention on International Interests in Mobile Equipment (the "Cape Town Convention"), which applies to various types of mobile equipment, and provides certain rights to international creditors.

Sureties: Rights and Responsibilities

The law provides certain rights to sureties, which they may be able to enforce against the principal debtor. These rights are often a large part of the calculation made by sureties before agreeing to indemnify the creditor.
The most common right, recognised in statute, is the right of reimbursement. This right allows the surety to seek reimbursement from the principal debtor for any payment made to the creditor. For example, where the surety has guaranteed a debt owing by the principal debtor, and that debt remains unpaid by the principal debtor when called upon by creditor, the surety will be under an obligation to pay the creditor and should therefore be able to recover this from the principal debtor.
The right of subrogation is most commonly found in contract law and allows a surety who has paid the creditor in place of the principal debtor to stand in the creditor’s shoes in order to pursue the principal debtor for reimbursement. Essentially, the creditor’s right to repayment from the principal debtor becomes the surety’s right. The contract with the creditor may expressly allow the creditor’s rights to be transferred, or the common law may do so as a matter of course.
While it is a civil wrong to exclude an express statutory right of subrogation by agreement, the creditor and surety can contract out of the common law right (Smith v Bank of India).
The right of exoneration is most commonly recognised in equity. It requires that the debtor must pay out to the creditor without calling on the surety . The creditor holds the duty to use the least intrusive means available to it to make recovery.
The common law and equitable rights listed above protect the surety by providing a means to recoup any losses sustained as a result of having guaranteed the debts owed by the principal debtor. Under the principle of indemnity, the creditor and surety may negotiate between themselves to exclude any statutory or common law rights, but the creditors statutory rights cannot be contracted out of.
If a credit agreement requires the guarantee or suretyship of more than R250,000, the Consumer Protection Act may not permit the exclusion of such statutory or common law rights.
Indeed, a greatest risk in extending credit to a consumer is that the customer’s reliance on guarantees or suretyships will be excluded, limiting the remedies available to the creditor. Thus creditors should exercise caution in entering into a credit agreement with a consumer requiring a guarantee or suretyship, unless the provisions of the Consumer Protection Act either permit the exclusion of all rights or allow the creditor to substitute such rights at a later stage.
Where neither the common law nor Equity has precluded the surety from enforcing their rights, the surety’s rights have been excluded or the consumer has agreed to limit them, the creditor may be limited by the rights of the surety and may not be able to recover the amount owed by the principal debtor as a result.

Pitfalls and Perils of Suretyship

The risks in suretyship are many, as default by the principal in its obligations exposes the surety to liability which can have significant financial implications for the surety. Sureties are not owners by default, but are rather instruments for the performance of the underlying contract. Risk mitigation in suretyship is critical to its application and evolution from a potential escape route, into a real alternative to owners requiring security. The surety’s liability is typically stipulated as being capped at the lesser amount of the suretyship or the underlying claims, and subject to the performance of the main contract. Where the suretyship extends beyond pure suretyship to an indemnity suretyship guaranteeing payment, then the surety may also be liable for damages arising from the breach. The surety is entitled to ample notice of the stage of default of the principal and must be fully apprised of the owner’s loss before being exercised. The surety must also be cognisant of the underlying contract being duly performed by the principal and is able to require restitution upon cancellation of the underlying contract. The risk to a surety who is called upon to make good on a default is that it does so at a time when the underlying contract is often rapidly devolving into a claim situation, meaning that the surety could well be parting with money that would otherwise be available to assist with claims litigation in pursuit thereof, thus increasing the overall claims liability out of what may have been a potential pure suretyship position. Suretyship provisions also dictate that any amount paid by a surety to an owner before it has received demands for payments under the underlying contract is recoverable from the principal. Clarifying this obligation and fixing the obligation to pay once the surety has itself satisfied the claim against the owner will also ensure that the surety proceeds in the manner intended and that the surety does not lose the benefit of its security. The risk to the surety or principal who fraudulently obtains a release of the surety’s claim under a suretyship will only be recoverable in appropriate circumstances. The so-called ‘surety rule’, which entitles an owner to look to the surety exclusively and to avoid consolidation of claims between the surety and the principal, is not very relevant to suretyship as the surety position is established by virtue of a contract or guarantee. The suretyship is an accessory obligation and the principal is not the debtor in respect of the amount. As the suretyship is a contract for whose damages an owners may sue, the surety may only be sued once, cumulatively for most added up with damages arising out of the underlying contract. When claiming against a surety, the owner is not required to undertake any special action in this regard, barring a technical defence applicable to all types of suretyships such as duress, misrepresentation, fraud, incompetent parties as signatories, extortion, lack of consideration, no intention to create a legal relationship, etc. There are challenges to suretyship which should not be overlooked by owners and sureties in the process of a suretyship being considered or designed. There are also challenges to the present law of suretyship and to the law of contract which should be revisited in the light of evolving best practice.

Recent Updates to Suretyship Laws

Recent Developments in the Law of Suretyship
The application of the general principles of suretyship is a long-established and well-developed area of the law. Nevertheless, recent years have seen an increasing sophistication of both contractual terms and statutory interpretation. Furthermore, the digital age has brought new and unique issues to be resolved.
On the contractual front, a recent series of cases in the UK has helped clarify the enforceability of terms commonly found in those jurisdictions which purport to create primary obligations rather than secondary obligations (in the US context, guarantees rather than sureties) or which seek to make the creditor’s acceptance or waiver not a condition of the validity of the contract. The UK Supreme Court has offered several decisions in that regard: see Marks & Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Limited (bonus payments cannot be claimed after indicated cut-off date); G&S Investments Services Ltd v Richard Brady & Ors [2012] EWHC 1201, concerning a clause intended to preserve legal remedies post-termination rendered unenforceable by English law; and Haymarket 4 Investments Inc v Royal Bank of Scotland [2013] EWHC 2984.) In particular, it is now firmly established in England that a clause purporting to postpone the creditor’s right to take action under the guarantee until he has sued the debtor and recovered against him (or has exhausted attempts to do so) is unenforceable as a matter of law.
The interpretation of the words "guaranty" and "suretyship" has likewise been clarified. In Anheuser-Busch , Inc. v. I-Flow Corporation, 2013 WL 5199478 (C.D. Cal. Sept. 13, 2013), the court considered the award of contractual damages for the unlawful procurement of a guarantee under the California Guaranty Law. Reversing the District Court, the 9th Circuit held that a corporate guaranty is not a suretyship under the law, since a surety operates in the interests of his debtor, while a corporate entity can only operate for the interests of itself. Anheuser-Busch’s arguments in favor of the contrary reading of the statute were rejected and its claim to recover damages under the Guaranty Law was dismissed.
The digital age has created many new issues. Cryptocurrencies, for example, create complex and challenging issues of suretyship in the structuring of assignment and other forms of sub-participation, which require careful drafting to ensure that international firms can meet the requirements under French and English law (and indeed under US law too). Blockchain investment schemes are now being offered, exposing participants to risks arising from possible breaches of customary regulatory protections. It is for example highly probable that participants in such schemes will not receive a US Certificate of Depository although one may be scrollable under English law. This obviously raises the question of risk allocation and cover against wrongful acts or defaults.