Termination of Cautionary Obligations Flashcards
How is the principal obligation extinguished?
1) Extinction of the principal obligation
These will extinguish in the same way that payment can be extinguished (express discharge or extinguished based on grounds of essential validity).
It can be terminated because the principal obligation has been paid off. If this is extinguished (either by payment, negative prescription, novation, compensatio), the accessory obligation will be extinguished too.
When the principal debt is extinguished (see methods of extinction in the handout on payment and commercial paper)
However it is possible to have the discharge of a cautionary obligation where there is a material alteration in the underlying contract.
2) Material alteration
Any alteration of loan terms, without consent of cautioner, implies discharge of cautioner, even if not prejudicial.
For example, where the creditor “gives time”.
If A is the creditor, and A has a right against B, and C is the cautioner, so A has a right against C. If A and B reach an agreement that materially alters the debt owed by B to A, a material alteration there can serve to distinguish the cautionary obligation. If it wasn’t in the consideration of the parties originally then this is a material alteration. C can escape liability because it is to her prejudice.
3) Prejudicial conduct by the creditor
BoS v Macleod
If it was envisaged at the time of the original cautionary obligation then this obligation would not be able to be escaped as it was originally envisaged by the parties so C’s position is not prejudicial because there has not been a material alteration — it is part of the same loan agreement.
NB so if you change the terms of the principal obligation, the cautioner could escape liability.
What happens where the principal obligation guaranteed is an overdraft?
An overdraft could be fluid or it could be something which is strictly confined. There is potential that the parties might be in the position that an increase in the overdraft limit might be materially prejudicial, or it might not, this depends on the wording of the original overdraft agreement including what the cautioner agreed to guarantee.
What are the three ways of escaping liability under prejudicial conduct?
There are three other ways of escaping liability against the creditor:
1) Giving time
This is the creditor agreeing that payment can be delayed up to a particular point, but if the creditor says “I am never going to claim payment from the principal obligation” this does not discharge the cautioner from their liability. But if the creditor says “I am going to delay payment for 2 years” that does prejudice the cautioner and they can escape liability. So giving a specific time is sufficient. This is because the cautioner is not going to be put in a worse position where he is never going to ask for payment.
Where creditor does not demand payment when it falls due (which serves to impact on the cautioner’s right of relief).
[See Stair Encyclopaedia]
2) Where the creditor gives up securities
If the creditor voluntarily discharges a security the cautioner is released (to the extent of the security released)
If the creditor has a right in security against a principal obligations assets, and they decide they are not going to enforce it, this prejudices the position of the cautioner as they would be entitled to get that security where the debt was enforced against them. The cautioner is in a poorer position than they originally were, so the cautioner’s liability is extinguished.
3) Discharge of a co-cautioner
If there are multiple cautioners discharging one can lead to release of the other cautioners.
Where the creditor has a right against multiple cautioners, one may be put in a poorer position where he is chosen rather than the debt being enforced or shared.
What are the rules on Bankruptcy Issues?
[Read Sandra Eden para 913-952]
Depends whether it is the whole debt or a guarantee for a portion of the debt. If it is a portion of a debt the cautioner will not necessarily
Bankruptcy (sequestration and liquidation): the basic rules:
Ranking rules different as between (a) real security and (b) personal security.
⁃ Example 1. Arthur owes Boris £60,000. Arthur is sequestrated. Boris holds standard security over property worth £40,000. Property sold, Boris takes £40,000, and ranks as unsecured creditor for shortfall, ie £20,000. Suppose trustee in sequestration pays dividend of 20%, Boris gets £4,000. Total recovery: £44,000.
⁃ Example 2. Arthur owes Boris £60,000. Arthur sequestrated. Loan guaranteed by Cindie to maximum of £40,000. Boris recovers £40,000 from her. Boris still ranks in sequestration for full original debt. Suppose dividend 20%: Boris paid £12,000 by trustee. Total recovery: £52,000. (NB creditor cannot recover more than 100%.)
What are the rules against double ranking?
⁃ Take last example. Cindie has right of relief ie is creditor of Arthur to extent of £40,000. Can she rank for this? No. This debt already “ranked for” by Boris (as part of the £60,000). If Cindie could rank for it, that would be unfair to other creditors, since more than 20% would be paid on the original debt of £60,000.
You cannot rank for the same debt twice on insolvency.
Where the principal obligant has claimed for the full amount and only paid a proportion the cautioner cannot claim again.
Cannot rank for the same debt twice on insolvency:
Hence right of relief seldom of much value. (1) Practical reason: principal obligant probably unable to pay anyway. (2) Legal reason: rule against double ranking.
Mackinnon’s Trs v Bank of Scotland
[must read]
⁃ Suppose that Cindie paid the £40,000 before Arthur’s sequestration. Then Boris ranks only for £20,000. Total recovery £40,000 + £4,000 = £44,000. Cindie ranks for £40,000. Recovers £8,000. Her total loss only £40,000 minus £8,000 = £32,000. So it is in her interest to pay early: Mackinnon’s Trs v Bank of Scotland 1915[ Need to read this case.] SC 411.
⁃ [The principle is that if the cautioner pays before the debtor’s insolvency the creditor cannot claim for the full debt due to him or her, only for the balance. And the cautioner can rank for the debt paid.]
- If cautioner pays before debtor’s insolvency creditor cannot claim for full debt due to him or her — only for balance. And cautioner can rank for debt paid. - Better position for cautioner to pay early - But this may be dealt with by contract.
How much is the cautioner to pay?
*look up pages 263, 264 of Davidson!
The first thing to consider is what is actually guaranteed? (What is the cautioner saying that they will pay?)
⁃ There are two types of debts which are potentially relevant:
⁃ 1) The PO is due to pay a fixed sum.
⁃ 2) The PO is due to pay a fluctuating sum (e.g. an overdraft).
What happens when the PO is due to pay a fixed sum?
⁃ Where the PO is due to pay a fixed sum and the cautioner grants a cautionary obligation securing payment of that fixed amount, the cautioner cannot, (other than on the basis we’ve already discussed in section 3 above), escape liability. If the PO borrows more money, this is not added to the amount secured by the cautionary obligation.
What happens when the PO is due to pay a fluctuating sum?
⁃ Where the PO is due to pay a fluctuating sum the position is different since the amount of the debt may increase or decrease over time. If this is the case then the cautioner can unilaterally end liability after a particular date by giving notification to the creditor. The effect is that the liability of the cautioner is crystallised at the amount outstanding at the time when they withdraw the agreement to act as a cautioner.
⁃ This has implications for Clayton’s Case:
⁃ Example. If you have £10k debt in the overdraft. £2k is paid into the bank. £5k is withdrawn. £3k is paid in. At this point the total debt is still £10k. But what happens if there is a cautionary obligation at the beginning and the cautioner says they are no longer guaranteeing the debt. So the account starts £10k in debt on day 1. If the cautioner on day 2 says that they are no longer going to guarantee debts, the cautioner’s liability is fixed at the outstanding debt at this time which is £10k. Then the £2k is paid in so that the cautioner’s liability is now only £8k. The £5k which is subsequently withdrawn from the account is not covered by the cautionary obligation. The next £3k which is paid in goes to pay the earliest debt which means that the cautioner’s liability is now limited to £5k.
⁃ So the cautioner’s liability keeps getting reduced when money is paid in, and new debts do not extent the cautioner’s liability.
How can you limit liability?
Cautioner’s don’t typically want to pay everything that the PO is due to pay - the cautioner will often seek to limit the amount that they pay. There are two ways:
⁃ 1) Limit the whole debt subject to a cap
⁃ 2) Limit a proportion of the debt
Why does the difference in ways of limiting liability matter?
Harmer & Co v Gibb (1911)
⁃ The guarantee given in this case was a guarantee of all goods “up to a value of £200” and creditor had a security for £120. The debt in this case was £300. When you have a right in security this is paid first. So the creditor is entitled to payment of £120 from the secured property. But how much are they entitled to get from the cautioner?
⁃ 1) If the cautionary obligation is for the whole of the debt, subject to a limit of £200, this means that even if the creditor has already received £120, the cautioner is liable for the any remaining debt up to the value of £200, and would thus pay the £180 debt in this example. So in this case the cautioner is guaranteeing every penny but they are capping the amount that they will pay.
⁃ 2) If the cautioner is guaranteeing a proportion of the debt. This means that the cautioner is guaranteeing £200 worth of £300 of debt (2/3) of the debt. Therefore when the creditor receives the right in security worth £120, 2/3 of this, £80, is relevant to the part secured by the cautionary obligation. Thus of the £180 left over the cautioner only owes £120. Thus where the cautioner limits their liability to part of the debt they are generally going to have to pay less than where they agree to pay fixed sum. (look up Davidson page 261)
⁃ Generally the creditor will try to make sure that the cautioner is guaranteeing the whole debt subject to a limit and that it is worded in that way.
⁃ *SW: if you’re wanting to look at material on this then look up Volume 4 of the Stair Memorial Encyclopedia on Cautionary Obligations paras 952 and ?913? they go through worked examples of this.
Construction_of_limitations_as_to_amount
*Stair Encyclopaedia
CAUTIONARY OBLIGATIONS AND REPRESENTATIONS AS TO CREDIT (Volume 3)/3. EXTENT OF CAUTIONER’S LIABILITY/913. Construction of limitations as to amount.
- Construction of limitations as to amount.
If a cautionary obligation is stated to be limited to a certain sum, then this is capable of two possible constructions. It may either be a guarantee for a limited part of the debt, or it may be a guarantee for the entire debt subject to a limit to the amount of the cautioner’s liability. The distinction may at first appear semantic, but in fact has important practical consequences when determining the rights of the cautioner to share in any security or dividends to which the creditor may be entitled1.
If the guarantee is construed as covering the entire debt subject to a limit on the cautioner’s liability, the creditor is entitled to take any dividends to which he is entitled in the event of bankruptcy, plus the benefit of any security he may hold in respect of the debt, and then, if there is still a shortfall, apply to the cautioner for the balance up to his stated limit. If the alternative construction is placed on the obligation, that the cautioner is only liable for a limited amount of the debt, then he is entitled to share in any dividends payable to the creditor, or securities held by the creditor available over that portion. This arises out of the cautioner’s entitlement to all the creditor’s rights to a dividend and to securities on payment of the sum guaranteed. The creditor must notionally apply the same proportion of any dividends paid or securities realised as the guaranteed part of the debt bears to the whole debt to reduce the cautioner’s liability. So if a debtor goes bankrupt with debts of £1,000 in respect of which there is a limited guarantee for £200, and the creditor recovers £500 from the debtor’s sequestration, a fifth of the recovered amount must be set against the cautioner’s maximum liability, resulting in the cautioner only being liable for £100. If the guarantee had been for the whole debt, subject to a limit on the cautioner’s liability, the creditor could have been called upon for the whole £200.
Similarly, if the cautioner becomes bankrupt, the creditor is entitled to rank on his estate only for the limited amount in the case of a restricted guarantee, whereas if the guarantee is for the whole sum to a limited extent, the creditor may rank for the whole sum and is entitled to receive up to the cautioner’s limit. Not surprisingly, the present practice of most lending institutions is to provide guarantee forms which contain a ‘whole debt’ clause, followed, where appropriate, by a clause providing that the amount recovered is in no case to exceed a particular sum. In the absence of clear indicators, such as a ‘whole debt’ clause, the matter becomes a question of construction of the terms of the obligation. Thus a guarantee for ‘all such goods as you may from time to time sell and deliver to M or his order up to the value of £200’ was held to be a guarantee for a limited amount of the debt, and not for the whole debt up to a limit. It was thought that the use of the word ‘value’ referred to the value of goods of that amount and thus the limit applied to the transaction and not to the amount guaranteed. If the cautioner had said instead ‘up to the amount of £200’, then the alternative construction would have been placed on the guarantee2.
One rule of construction which may assist in the absence of any clear indication to the contrary is that where the limited obligation is in respect of a floating balance, for example a bank account, the presumption is in favour of it being in security of part only of the debt, as the creditor can continue to increase the debt without notice to the cautioner. Where the guarantee is in respect of a debt of a fixed amount, the presumption is that it is for the whole debt, albeit for a limited amount3.
Usually, a limit in a contract of caution is construed as referring to the extent of the cautioner’s liability4. Given the appropriate wording however, it could be construed as referring to the extent of the loan or debt being guaranteed, so that if the maximum is exceeded, the cautioner is released entirely from his obligations. An example of wording where it may not be clear whether the limit refers to the cautioner’s liability or the principal obligation would be a guarantee ‘for goods supplied to the extent of £100’, where it would be a question of construction to be answered by reference to the other circumstances of the case.
1 This is discussed further in para 952 below.
2 F W Harmer & Co v Gibb 1911 SC 1341, 1911 2 SLT 211.
3 Ellis v Emmanuel (1876) 1 Ex D 157, CA, approved in Veitch v National Bank of Scotland 1907 SC 554, 14 SLT 800.
4 Tennant & Co v Bunten (1859) 21 D 631; F W Harmer & Co v Gibb 1911 SC 1341, 1911 2 SLT 211; Bank of Scotland v MacLeod 1986 SLT 504. In an exceptional case, a limit might be construed as being a lower limit to the amount of the loan, it being a condition precedent of the cautioner’s liability that a loan of a certain amount be given: cf Burton v Gray (1873) 8 Ch App 932.
Can cautionary obligations prescribe?
Prescription runs from the Quinquennial from date of demand: Royal Bank of Scotland v Brown 1982 SC 89.
