Guarantee unenforceable due to amendments to an underlying agreement: a “trap for the unwary”

The claimant, the defendant and the defendant’s subsidiary entered into a cost-sharing agreement relating to the provision of certain services (the Agreement). The claimant, the subsidiary and the claimant’s parent company later entered into an addendum which varied the Agreement (the Addendum). The subsidiary failed to pay sums to the claimant under the Agreement, raising the defence of equitable set-off, on the basis that the sums owed by the claimant to the subsidiary were equal to or exceeded those owed by the subsidiary to the claimant. Those claims were referred to arbitration. The court here determined preliminary issues regarding whether the defendant was liable to the claimant under certain surety obligations in the Agreement. The relevant extracts of the provisions provided (emphasis added):

 

“[The defendant] agrees to indemnify and hold [the claimant and its parent company] harmless from and against and in respect of any and all losses, liabilities, claims, judgments, expenses, costs (including attorneys’ fees) and settlements incurred in connection with any failure by [the defendant’s subsidiary] to timely fulfil its payment obligations… under this Agreement.” (Clause 6.2)

“As a separate and independent stipulation, [the defendant] agrees that any obligation, commitment or undertaking expressed to be undertaken by [its subsidiary] (including, without limitation, any moneys expressed to be payable under the Agreement) which may not be enforceable against or recoverable from [its subsidiary] by reason of any legal disability or incapacity on or of [its subsidiary] or any fact or circumstance (other than any limitation imposed by the Agreement) shall nevertheless be enforceable against and recoverable from [the defendant] as though the same had been incurred by [the defendant] and [the defendant] were the sole or principal obligor in respect thereof and shall be performed or paid by [the defendant] on demand.” (Schedule 6.2)

Guarantee or indemnity

The claimant sought to characterise Clause 6.2 as an indemnity, providing a primary obligation for the defendant to pay when triggered. It argued that the primary obligation had been triggered by the subsidiary’s refusal to pay, regardless of its defence of equitable set-off. The defendant relied on the set-off defence to claim that none of the surety obligations had been triggered.

The court reiterated the difference between a guarantee and an indemnity. A guarantee is a contractual obligation to either discharge a debt owed by the principal debtor or to procure the principal debtor’s compliance with its guaranteed obligation: the liability of the surety is ancillary, or secondary, to the primary liability of the creditor. In contrast, an indemnity imposes a primary obligation on the surety that is wholly independent of the liability (if any) arising between the principal debtor and the creditor.

In interpreting the provision, neither party relied on the factual context, but rather “commercial common sense” and the words used. The court held that the provision was an indemnity, relying on the presence of express guarantees elsewhere in the Agreement and the type of loss covered (arising from a failure to timely fulfil payment obligations, which extended beyond the losses and costs of the claimant as principal creditor).

No “no set-off” clause

The key question, regardless of whether Clause 6.2 was an indemnity or a guarantee, was whether the surety obligations in the Agreement had been triggered despite the subsidiary’s set-off defence. They had not.

The court held that, although a defence of equitable set-off does not extinguish liability until such point that it is agreed (or otherwise determined) that the relevant claims should be netted off, the defence is substantive and prevents the claimant from enforcing or relying on its claim. No demand for payment can be made until the party no longer relies, or is no longer entitled to rely, on the defence. Clear wording would be needed to demonstrate that the parties intended for the surety obligation to nevertheless be triggered (such as a “no set-off” clause). That wording was missing and the provisions had not been triggered:

• Clause 6.2 did not capture any sum contractually due to the claimant which was unpaid by the subsidiary, but instead only those losses “incurred in connection with any failure… to timely fulfil its payment obligations”. That loss was distinct from the sum claimed by the defendant and Clause 6.2 was not therefore triggered. Even if that was wrong, the surety language required a breach of an obligation to pay by the subsidiary, which had not occurred given the validly asserted defence of set-off. The claimant was not entitled to assert otherwise.
• Schedule 6.2 did not capture circumstances in which a party relied on a set-off defence. Instead, it required circumstances where the obligation was not enforceable or recoverable “by reason of any legal disability or incapacity”, neither of which applied.

The court placed particular emphasis on the absence of a “no set-off” provision in the Agreement, noting that such provisions are commonplace in commercial agreements and straightforward to draft. The absence of such wording supported the interpretation that the parties did not intend to allow a party to enforce a claim in circumstances where the other party had validly asserted a defence of set-off.

Guarantees discharged by amendments to the Agreement

Under the rule in Holme v Brunskill, a guarantor’s liability is discharged where amendments are made to the primary underlying agreement after giving of the guarantee, unless either: (i) the guarantor consented to the variation; or (ii) the variation was patently insubstantial or incapable of adversely affecting the guarantor. The defendant argued that its surety obligations had been discharged by the Addendum.

The court considered the rule “unduly favours guarantors”, a “trap for the unwary” and “merits reconsideration”. However, the rule was clearly not a fundamental right of a guarantor as parties are permitted to contract out of it and “all well-advised creditors therefore do so”. The court held that the rule remained restricted to its current parameters (ie not extending to indemnities) and considered it in relation to the pure guarantee obligations in the Agreement (which neither Clause 6.2 nor Schedule 6.2 qualified for). 

In relation to consent, there was no evidence that the signatories to the Addendum had actual (nor implied or ostensible) authority to consent to the variation on the defendant’s behalf. In relation to materiality, the onus on the claimant to show that the amendments were immaterial was a strict one. It was not clear on the facts that the amendments were self-evidently to benefit or not prejudice the surety, and immateriality could not therefore be demonstrated.

The court found in the defendant’s favour: its guarantee obligations under the Agreement had been discharged.

Comment

The ruling is an important reminder of the utility of two commonly included clauses within commercial agreements. The substantive impact of the set-off defence, which prevented the surety obligations from being triggered, demonstrates why “no set-off” clauses are included in so many commercial contracts. The “trap for the unwary” created by the rule in Holme v Brunskill, which allows a creditor to unwittingly release a guarantor from its obligations by amending an underlying agreement, demonstrates why the rule is commonly excluded by waiver of defences clauses and guarantor consent is routinely sought when amending finance documents. The burden on a creditor to prove immateriality, in the absence of consent, is a strict one: it must positively demonstrate that the amendments were immaterial, which may be a high bar. It is therefore welcome confirmation that the rule does not extend to indemnities.

Further information

For more information please contact Amy Edwards.