by Don Mayer, Daniel M. Warner, George J. Siedel, and Jethro K. Lieberman

## 19.4 Suretyship

### Learning Objectives

1. Understand what a surety is and why sureties are used in commercial transactions.
2. Know how suretyships are created.
3. Recognize the general duty owed by the surety to the creditor, and the surety’s defenses.
4. Recognize the principal obligor’s duty to the surety, and the surety’s rights against the surety.
5. Understand the rights among cosureties.

## Definition

Suretyship is the second of the three major types of consensual security arrangements noted at the beginning of this chapter (personal property security, suretyship, real property security)—and a common one. Creditors frequently ask the owners of small, closely held companies to guarantee their loans to the company, and parent corporations also frequently are guarantors of their subsidiaries’ debts. The earliest sureties were friends or relatives of the principal debtor who agreed—for free—to lend their guarantee. Today most sureties in commercial transaction are insurance companies (but insurance is not the same as suretyship).

## Contribution

Two or more sureties who are bound to answer for the principal’s default and who should share between them the loss caused by the default are known as cosuretiesAn arrangement where two or more surety companies directly participate on a bond.. A surety who in performing its own obligation to the creditor winds up paying more than its proportionate share is entitled to contributionThe sharing of a loss or payment by two or more persons or sureties. from the cosureties.

## Defenses of the Parties

The principal and the surety may have defenses to paying.

## Defenses of the Principal

The principal debtor may avail itself of any standard contract defenses as against the creditor, including impossibility, illegality, incapacity, fraud, duress, insolvency, or bankruptcy discharge. However, the surety may contract with the creditor to be liable despite the principal’s defenses, and a surety who has undertaken the suretyship with knowledge of the creditor’s fraud or duress remains obligated, even though the principal debtor will be discharged. When the surety turns to the principal debtor and demands reimbursement, the latter may have defenses against the surety—as noted—for acting in bad faith.

One of the main reasons creditors want the promise of a surety is to avoid the risk that the principal debtor will go bankrupt: the debtor’s bankruptcy is a defense to the debtor’s liability, certainly, but that defense cannot be used by the surety. The same is true of the debtor’s incapacity: it is a defense available to the principal debtor but not to the surety.

## Defenses of the Surety

Generally, the surety may exercise defenses on a contract that would have been available to the principal debtor (e.g., creditor’s breach; impossibility or illegality of performance; fraud, duress, or misrepresentation by creditor; statute of limitations; refusal of creditor to accept tender or performance from either debtor or surety.) Beyond that, the surety has some defenses of its own. Common defenses raised by sureties include the following:

• Release of the principal. Whenever a creditor releases the principal, the surety is discharged, unless the surety consents to remain liable or the creditor expressly reserves her rights against the surety. The creditor’s release of the surety, though, does not release the principal debtor because the debtor is liable without regard to the surety’s liability.
• Modification of the contract. If the creditor alters the instrument sufficiently to discharge the principal, the surety is discharged as well. Likewise, when the creditor and principal modify their contract, a surety who has not consented to the modification is discharged if the surety’s risk is materially increased (but not if it is decreased). Modifications include extension of the time of payment, release of collateral (this releases the surety to the extent of the impairment), change in principal debtor’s duties, and assignment or delegation of the debtor’s obligations to a third party. The surety may consent to modifications.
• Creditor’s failure to perfect. A creditor who fails to file a financing statement or record a mortgage risks losing the security for the loan and might also inadvertently release a surety, but the failure of the creditor to resort first to collateral is no defense.
• Statute of frauds. Suretyship contracts are among those required to be evidenced by some writing under the statute of frauds, and failure to do so may discharge the surety from liability.
• Creditor’s failure to inform surety of material facts within creditor’s knowledge affecting debtor’s ability to perform (e.g., that debtor has defaulted several times before).
• General contract defenses. The surety may raise common defenses like incapacity (infancy), lack of consideration (unless promissory estoppel can be substituted or unless no separate consideration is necessary because the surety’s and debtor’s obligations arise at the same time), and creditor’s fraud or duress on surety. However, fraud by the principal debtor on the surety to induce the suretyship will not release the surety if the creditor extended credit in good faith; if the creditor knows of the fraud perpetrated by the debtor on the surety, the surety may avoid liability. See Figure 19.6 "Defenses of Principal Debtor and Surety".

The following are defenses of principal debtor only:

• Death or incapacity of principal debtor
• Bankruptcy of principal debtor
• Principal debtor’s setoffs against creditor

The following are defenses of both principal debtor and surety:

• Material breach by creditor
• Lack of mutual assent, failure of consideration
• Creditor’s fraud, duress, or misrepresentation of debtor
• Impossibility or illegality of performance
• Material and fraudulent alteration of the contract
• Statute of limitations

The following are defenses of surety only:

• Fraud or duress by creditor on surety

• Illegality of suretyship contract
• Surety’s incapacity
• Failure of consideration for surety contract (unless excused)
• Statute of frauds
• Acts of creditor or debtor materially affecting surety’s obligations:

• Refusal by creditor to accept tender of performance
• Release of principal debtor without surety’s consent
• Release of surety
• Release, surrender, destruction, or impairment of collateral
• Extension of time on principal debtor’s obligation
• Modification of debtor’s duties, place, amount, or manner of debtor’s obligations

### Key Takeaway

Creditors often require not only the security of collateral from the debtor but also that the debtor engage a surety. A contract of suretyship is a type of insurance policy, where the surety (insurance company) promises the creditor that if the principal debtor fails to perform, the surety will undertake good-faith performance instead. A difference between insurance and suretyship, though, is that the surety is entitled to reimbursement by the principal debtor if the surety pays out. The surety is also entitled, where appropriate, to exoneration, subrogation, and contribution. The principal debtor and the surety both have some defenses available: some are personal to the debtor, some are joint defenses, and some are personal to the surety.

### Exercises

1. Why isn’t collateral put up by the debtor sufficient security for the creditor—why is a surety often required?
2. How can it be said that sureties do not anticipate financial losses like insurance companies do? What’s the difference, and how does the surety avoid losses?
3. Why does the creditor’s failure to perfect a security interest discharge the surety from liability? Why doesn’t failure of the creditor to resort first to perfected collateral discharge the surety?
4. What is the difference between a guarantor and a surety?