Indulgence Clauses in Guarantees and Conditional Bonds

Conditional bonds and guarantees are ubiquitous on UK construction projects. They are a specialised form of contract, which provide another person (the surety) with a liability which matches that of the contractor or subcontractor.

In legal terms, they provide secondary liability – this means that the liability of the surety is dependent on and the same as the liability of the contractor under the guaranteed contract. The surety’s liability is neither longer nor deeper!

But, because the surety’s liability is dependent on the terms of a contract to which it is not a party, the general rule is that the original contract cannot be varied without the surety’s consent. To do so may change its liability and prejudice its position:

“It is a well-established principle that any variation in the terms of the underlying agreement which could prejudice the position of a guarantor will, unless his consent is sought and given or

unless the contract expressly provides to the contrary, discharge him from all liability. The authorities establish that it is immaterial that the variation has not in fact prejudiced the

guarantor or that the likelihood of its so doing is remote. Provided the variation could prejudice the guarantor, the nature of the risk undertaken has been altered and he is the person entitled to decide if the guarantee is to be continued notwithstanding that change. This principle has been

consistently and strictly applied by the English Courts”1

Any material variation or alteration of the principal contract, without the surety’s consent, is sufficient to discharge the surety from further obligations under the guarantee: Holme v Brunskill,2 as upheld by the Court of Appeal in Triodos Bank NV v Dobbs.3

The issue of variation was reviewed by the Court of Appeal in Hackney Empire v Aviva,4 in which Lord Sugar makes a cameo appearance.

The rule in Holme v Brunskill has the effect of requiring the employer to obtain the prior consent of the surety to any variation of the obligations that have been guaranteed or of other matters which might affect the rights of the surety and the risk it has undertaken.

If the employer does not seek consent, then the surety will defend any claim on the bond or guarantee. The employer may be able to argue that such a defence is not available if it is ‘self-evident’ that either the amendment could only be beneficial to the surety or that its effect was insubstantial to the risks undertaken by the surety.5 These are high hurdles to overcome!

What Can Discharge the Surety?

Whether there has been actual prejudice or detriment is not relevant. It is judged objectively – a merest whiff of ‘not insubstantial’ detriment, or a variation which may or may not be detrimental to the surety, is sufficient. So what do you need to look out for?

The answers may come as something of a surprise, because, without the ‘no variation clause’ which occurs in the majority of bonds and guarantees, the surety can be discharged from liability for myriad reasons:

Variation of the works themselves – variations under a contract as expressly provided for do not discharge the surety;6

Void principal contract – where the guarantee provides secondary liability, if the principal contract is void or unenforceable in its entirety, then there is no liability to secure and the surety is discharged;7

Novation by operation of the law – this does not discharge the surety, see Maritza;8 Forbearance or waiver – this discharges the surety, see Nisbet v Smith (1789)9 where the

employer gave the debtor further time for payment; and also Associated British Ports v Ferryways10: ‘it has long been held that even the shortest extension of time [to pay] will discharge the surety’;

Settlement of disputes – this may discharge surety, as will the rescheduling of debts, see e.g. Marubeni Hong Kong & South China Limited v The Mongolian Government;11

Replacement of original principal contract with second contract – will discharge the surety, Triodos Bank v Dobbs, if not within the scope of the original agreement;

Surrender of other security or of another surety – discharges the surety;12 Absolute release of the principal debtor – discharges the surety;13 Non-repudiatory breach of contract – will not discharge the surety, although an accepted

repudiatory breach will.14

Conclusion

As the court does not find it easy to ‘draw a hard and fast line between permissible and impermissible variations’,15 then you need to ensure that any conditional bond or guarantee does contain an indulgence clause.

The Author

Sarah Fox of Enjoy Legal Learning wrote this note. She is a speaker and trainer who cuts through the

complexities of construction law. She provides confidence to construction companies to read, use

and understand their contracts. She is also author of the 500 Word Contract™.

To find out how Sarah can help you love your terms and conditions, contact her on: 07767 342747 or

by email: sarah@enjoylegallearning.co.uk

Footnotes

1 Mr Colin Reese QC in Oval (717) v Aegon Insurance Limited 85 BLR 997. Emphasis of the court. 2 (1877) 3 QBD 495. 3 [2005] EWCA Civ 630. This case concerned the extent to which a surety was bound by subsequent agreements. 4 [2010] EWHC 2378. As at July 2012 this case was going to Appeal. 5 See e.g. The Wardens and Commonality of the Mystery of Mercers of the City of London v New Hampshire

Insurance Co Ltd, cited above, where a short delay in possession was not sufficient to discharge the surety as the surety had been unaware at the time of granting the bond what the date of possession would be. See also Marubeni & Hong Kong, cited below.

6 Stewart v McKean (1855). 7 See e.g. dicta of Eveleigh LJ in Potton Homes Ltd v Coleman Contractors Ltd (1984) 28 BLR 19 (CA), where he

considered alternative defences apart from the fraud exception for on-demand bonds. “If the contract is avoided or is there is a failure of consideration between the buyer and seller for which the seller undertook to procure the issue of the performance bond, I do not see why, as between the seller and buyer, the seller should not be unable to prevent a call upon the bond.”

8 AES-3C Maritza v Credit Agricole [2011] EWHC 123 (TCC). 9 29 ER 317; (1789) 2 Bro CC 579. 10 [2008] EWHC 1265 (Comm), appealed on different grounds. 11

[2004] EWHC 472 (Comm). 12 E.g. Smith v Wood [1929] 1 Ch 14. 13 Commercial Bank of Tasmania v Jones, PC, [1893] AC 313. 14

National Westminster v Riley [1986] BLCL 268. 15 Paragraph 17, Longmore LJ in Triodos Bank v Dobbs, above.