Discharge of contract and remedies - Guarantees

Learning Outcomes

This article explores the ways in which contractual obligations can be discharged, with a particular focus on the nature and effect of guarantees and indemnities. For the SQE1 assessments, you will need to understand the different methods of contract discharge, such as performance, agreement, breach, and frustration. Critically, you must be able to distinguish between guarantees and indemnities, identify their respective legal requirements, and apply these principles to advise on liability in various scenarios. This knowledge will enable you to analyse contractual situations and identify appropriate remedies, particularly concerning third-party obligations, in SQE1-style questions.

SQE1 Syllabus

For SQE1, you are required to understand the core principles relating to the discharge of contracts and the specific legal implications of guarantees and indemnities. This includes applying these rules in practical contexts often encountered in dispute resolution and business law. Your revision should focus on:

• The different ways a contract can be discharged (performance, agreement, breach, frustration).
• The key characteristics distinguishing a guarantee from an indemnity.
• The legal requirements for creating a valid guarantee (including the need for writing).
• The nature of liability under guarantees (secondary) and indemnities (primary).
• Circumstances that may discharge a guarantor from their obligations.
• Advising on the enforceability of guarantees and indemnities in specific factual scenarios.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following statements concerning guarantees is INCORRECT?
   1. A guarantee creates a secondary obligation.
   2. A guarantee must generally be evidenced in writing to be enforceable.
   3. The guarantor becomes immediately liable upon the creation of the principal debt.
   4. The guarantor's liability is dependent on the principal debtor defaulting.
2. Identify the method of discharge where a contract ends due to an unforeseen event making performance impossible or radically different.
   1. Performance
   2. Agreement
   3. Breach
   4. Frustration
3. Primary liability is characteristic of which type of contractual arrangement?
   1. Guarantee
   2. Indemnity
   3. Novation
   4. Assignment

Introduction

A contract creates legally binding obligations. The 'discharge' of a contract refers to the process by which these obligations come to an end. Parties can be released from their contractual duties in several ways: through complete performance, by mutual agreement, as a consequence of a serious breach, or due to frustration where external events make performance impossible or radically different. Understanding how contracts are discharged is fundamental to advising clients on their rights and liabilities.

This article also examines two important related concepts often encountered in commercial and financial contexts: guarantees and indemnities. Both involve undertakings regarding the obligations of another party (the principal debtor), but they differ significantly in the nature of the liability assumed. Distinguishing between them is essential for determining enforceability and advising on potential remedies.

Discharge of Contractual Obligations

Contractual obligations do not last forever. They are discharged (brought to an end) in one of four main ways:

1. Performance: This is the most common method. The contract ends when both parties fully perform their obligations exactly as agreed under the contract terms. Partial or defective performance may amount to a breach.
2. Agreement: Parties can mutually agree to end the contract. This might be through a new agreement (accord and satisfaction), replacing the old contract entirely (novation), or simply releasing each other from outstanding obligations (release). Consideration is generally required for the discharge agreement unless it is made by deed.
3. Breach: A failure by one party to perform their obligations without lawful excuse constitutes a breach. A sufficiently serious breach (a 'repudiatory breach', often a breach of a condition or a serious breach of an innominate term) gives the innocent party the option to either terminate further performance of the contract or affirm it, while still claiming damages. An 'anticipatory breach' occurs when one party indicates, before performance is due, that they will not perform their obligations.
4. Frustration: A contract may be automatically discharged by frustration if, after the contract is formed, an unforeseen event occurs without the fault of either party, making performance impossible, illegal, or radically different from what was contemplated. Examples include the destruction of the subject matter or supervening illegality.

Guarantees and Indemnities

Guarantees and indemnities are commonly used arrangements where one party provides security or assurance regarding the debt or obligation of another. Although often confused, they create distinct legal liabilities.

Guarantees

A guarantee is a promise made by one party (the guarantor) to a creditor, undertaking to be responsible for the debt or default of another party (the principal debtor) if the debtor fails to meet their obligations.

Key Term: Guarantee
A contractual promise by one person (guarantor) to answer for the debt, default, or miscarriage of another (principal debtor).

Key Term: Secondary Obligation
An obligation that only arises if there is a failure in the performance of a primary obligation by another party.

Key Term: Guarantor
The party who provides the guarantee, promising to meet the debtor's obligation if the debtor defaults.

Key Term: Creditor
The party to whom the debt or obligation is owed.

Key Term: Principal Debtor
The party whose debt or obligation is being guaranteed.

Due to its nature, a guarantee must generally be evidenced in writing to be enforceable under the Statute of Frauds 1677. This requirement protects potential guarantors from inadvertently undertaking significant liabilities based on informal promises.

Indemnities

An indemnity is a promise by one party (the indemnifier) to compensate another party (the indemnitee) for loss suffered as a result of a specific event. It creates a primary obligation, independent of any default by a third party.

Key Term: Indemnity
A contractual promise by one party to accept responsibility for loss or damage suffered by another party.

Key Term: Primary Obligation
An obligation that exists independently and is not conditional on the default of another party.

Unlike a guarantee, the indemnifier's liability arises directly from the occurrence of the specified loss or event, regardless of whether a third party has defaulted. Because it is a primary obligation, an indemnity does not need to be evidenced in writing to be enforceable (though it often is in practice).

Worked Example 1.1

Alpha Ltd needs a loan from Beta Bank. Gamma, a director of Alpha Ltd, tells Beta Bank, "If Alpha Ltd doesn't repay the loan, I will." Beta Bank grants the loan, but Alpha Ltd defaults. Is Gamma liable to Beta Bank, and what type of obligation has Gamma undertaken?

Answer: Gamma has likely provided a guarantee. Gamma's promise is to pay only if Alpha Ltd defaults. This creates a secondary obligation. For the promise to be enforceable by Beta Bank, it must generally be evidenced in writing. Gamma is liable only because Alpha Ltd has defaulted.

Worked Example 1.2

Delta Construction contracts with Echo plc to build a factory. The contract includes a clause where Delta agrees to "indemnify Echo plc against any claims or losses arising from damage to adjacent properties caused by the construction works." During construction, Delta's negligence causes damage to a neighbouring property, and the owner successfully sues Echo plc. Can Echo plc recover the amount paid from Delta?

Answer: Yes, Echo plc can recover the amount from Delta based on the indemnity clause. Delta's obligation to pay Echo plc arises directly from the loss suffered by Echo plc (being sued due to damage caused by Delta's works). This is a primary obligation, and Echo plc does not need to prove any default by another party before claiming against Delta under the indemnity.

Exam Warning

Incorrectly identifying an arrangement as a guarantee when it is an indemnity (or vice versa) can lead to wrong conclusions about enforceability (especially regarding the writing requirement) and the trigger for liability. Pay close attention to whether the obligation is conditional on another's default (guarantee) or arises directly from a specified event or loss (indemnity).

Discharge of a Guarantor

A guarantor's secondary liability can be discharged (brought to an end) in several circumstances, meaning the guarantor is no longer liable even if the principal debtor defaults. Key situations include:

1. Variation of the Principal Contract: If the original contract between the creditor and the principal debtor is materially altered without the guarantor's consent, the guarantor is generally discharged. The reasoning is that the guarantor agreed to guarantee a specific obligation, and any change fundamentally alters the risk they undertook.
2. Release of the Principal Debtor: If the creditor releases the principal debtor from their obligation, the guarantor is also discharged, as the primary obligation no longer exists.
3. Creditor's Actions Prejudicing the Guarantor: If the creditor acts in a way that prejudices the guarantor's rights (e.g., by releasing security held for the debt which the guarantor could have benefited from via subrogation upon payment), the guarantor may be discharged fully or partially.

Revision Tip

When analysing a guarantee scenario, always check if any post-contract events might have discharged the guarantor's liability. Consent from the guarantor is often key to maintaining their liability following changes to the original debt or contract.

Key Point Checklist

This article has covered the following key knowledge points:

• Contracts can be discharged by performance, agreement, breach, or frustration.
• A guarantee creates a secondary obligation, conditional on the principal debtor's default.
• Guarantees generally require written evidence to be enforceable (Statute of Frauds 1677).
• An indemnity creates a primary obligation, independent of any third-party default.
• Indemnities do not require written evidence for enforceability.
• The distinction between primary and secondary liability is essential for determining enforceability and remedies.

Key Terms and Concepts

• Guarantee
• Secondary Obligation
• Guarantor
• Creditor
• Principal Debtor
• Indemnity
• Primary Obligation