Effect on surety of obligee's release of principal: a critical look at the rules in the restatement: the Restatement (Third) of Suretyship and Guaranty addresses the consequences of the obligee's release of the principal.

AuthorMungall, Daniel, Jr.
PositionFeature Articles

THE Restatement (Third) of Suretyship and Guaranty, which was adopted by the American Law Institute in 1995 and supersedes the suretyship law provisions of the 1941 Restatement of Security, addresses, in Sections 37 through 39, the consequences of the obligee's release of the principal on (1) the rights and duties of the principal and the surety to the obligee and (2) the rights and duties between the principal and the surety.

Three situations are covered:

  1. If the obligee releases the principal without more, (a) both the principal and surety are discharged from duties to the obligee, and (b) the principal is discharged from all duties to the surety. Section 39(a) and (b).

  2. If the obligee releases the principal but expressly provides in the release for (a) a reservation of the obligee's rights against the surety ("reservation of rights") and (b) a preservation of the surety's rights against the principal ("preservation of recourse"), Section 38, (i) the principal is discharged from its duties to the obligee, (ii) the rights of the obligee against the surety remain unchanged by the release, and (iii) the principal is not discharged from its duties to the surety. Section 39(a) and (b).

  3. If the obligee releases the principal under circumstances showing an intent on the part of the obligee to reserve its rights against the surety (Section 39(a)(ii)), (a) the principal is discharged from its duties to the obligee and the surety (Section 39(a)), and (b) the surety is discharged from its duties to the obligee (i) completely, if the underlying obligation is for other than the payment of money (Section 39(c)(iii)), but (ii) only to the extent that the release causes the surety loss, if the underlying obligation is for the payment of money (Section 39(c)(ii)).

The first rule merely recognizes the long-standing principle that a discharge of one debtor of joint debtors or joint and several debtors discharges them all. (1)

The second rule, later but also long standing, recognizes a reservation of rights doctrine by which a creditor may release a debtor and reserve rights against a guarantor with the consequence that the debtor remains obligated to the guarantor. (2) However, the Restatement modifies the reservation of rights doctrine by providing that the debtor is also relieved of its duties to the surety unless there is an express preservation of the surety's recourse against the principal. If there is such a recognition, the principal bargains, in effect, for a release from the obligee but expressly recognizes that the obligee may enforce the underlying obligation against the surety and that the surety may then assert the same claim against the principal. One may wonder why a principal would make a deal that, in effect, closes the front door but leaves the back door wide open.

The third rule, as originally presented, also made a modification in the reservation of rights doctrine and provided simply that a release of the principal with a reservation of rights against the surety discharged the principal from its obligations to the obligee and the surety, but discharged the surety only to the extent of loss. (3) The final form came as a result of a compromise because of a contention by surety practitioners that such a release should result in a complete discharge of a surety in all circumstances. A distinction is made based on the nature of the underlying obligation--that is, whether it is to pay money or an obligation other than the payment of money.

It is instructive to an understanding of the Restatement to discuss first the principles that were adopted in the early stages of the drafting process and that prompted the original concept that a release by the obligee of the principal, with a reservation of rights against the surety, should discharge the surety only to the extent of loss, and to point out the shortcomings in those principles. Next, it is important to describe the manner in which the difference evolved in treatment between an underlying obligation to pay money and one other than the payment of money. Finally, the authors will indicate why there should be no such distinction and why such a release by the obligee of the principal should always release the surety.

TWO PROPOSITIONS

There are two propositions that were responsible for the concepts of the release rule in the first drafts of the Restatement. The first was that the surety should be discharged as a result of actions of the obligee only to the extent of any loss. The second was the reservation of rights doctrine.

  1. Discharge Only to the Extent of Loss

    In a law review article, Neil B. Cohen of Brooklyn Law School, the reporter for the Restatement, described five models of sanctions imposed on an obligee whose conduct may have an adverse impact on the surety's position. (4) The first was automatic discharge of the surety for any change without regard to harm to the surety. The second was complete discharge for harmful acts. The third was a complete discharge if the obligee's action was either a release of the principal or a modification that materially increased the surety's risk; otherwise the surety was discharged only to the extent of loss. The fourth model, which the reporter indicated appears in revised Article 3 of the Uniform Commercial Code, was that a release never discharges the surety. The fifth model, which he indicated was adopted for the Restatement, was that the surety is discharged only to the extent of loss.

    The Restatement contains no express statement of obligations owing to the surety from the obligee; rather, it defines obligee conduct that impacts on the surety under the heading "Suretyship Defenses." (5) This subject was treated first in Preliminary Draft No. 2 (June 3, 1992) and presented to the ALI advisors in June of that year. Section 33 of that draft, dealing with "Suretyship Defenses--Generally," stated the general rule consistent with model five that the surety was discharged to the extent that the obligee took action that would cause the surety a loss. Section 36, dealing specifically with a release of the underlying obligation, reiterated that principle.

    However, other detailed sections in the draft contained exceptions to this model five concept of discharge only to the extent of loss. Section 38(a), dealing with modifications in the underlying obligation, provided that if the modification was so fundamental as to amount to a substituted contract, the surety was discharged. Absolute discharge under such a circumstance had already been adopted in Section 279 of the Restatement (Second) of Contracts. Section 39 of Preliminary Draft No. 2, dealing with impairment of collateral, also provided for discharge of the surety to the extent of any such impairment. Section 40, covering tenders of performance, which were explicated by Comment a to the section, provided that the obligee's refusal of complete performance discharged the surety.

    Thus, from the very outset of the drafting process, there were exceptions to the concept of discharge only to the extent of loss.

    In the Restatement as finally approved, three other situations involving the consequences to the surety of the obligee's action or non-action were recognized as resulting in discharge of the surety without the necessity of a showing of harm: (1) a release of the principal from an underlying obligation other than the payment of money, (6) (2) fundamental modification in the underlying obligation, (7) (3) failure of the obligee to institute an action on an underlying obligation other than the payment of money until after the action is barred by the statute of limitations. (8)

    Thus, the model five concept of discharge of a surety only to the extent of its established harm was not the universal principle at the very outset and was further eroded as the drafting process proceeded. A better approach would have been to consider separately each different situation involving the consequences of obligee action or non-action on the obligation of the surety, thereby determining a "punishment to fit the crime," rather than to attempt a general rule of punishment that started with a number of exceptions.

  2. Reservation of Rights Doctrine

    The second proposition impacting on the release rule is the reservation of rights doctrine referred to in Comment a to Section 38 and in the Introductory Note to Sections 39-41 of the Restatement. That doctrine apparently developed in the credit enhancement area. A simple example will demonstrate its operation. A creditor releases the debtor from the debt obligation and reserves all rights against the guarantor. Under the reservation of rights doctrine, the creditor is permitted to assert claims against the guarantor without regard to the release, and the guarantor then is permitted to recover from the debtor, despite the creditor's release of the debtor.

    A 1941 Yale Law Journal note describes briefly the apparent origin and development of the reservation of rights doctrine. (9) The origin is said to be an unreported 18th century English decision, Richard Burke's Case, which apparently involved an action by a creditor who had given an extension of time to the debtor. The note and the decisions cited in it, including the arguments of counsel in an 1851 case, Owen v. Homan, (10) suggest that Richard Burke's Case did not involve a reservation of rights; that, nevertheless, the case had been so construed in subsequent decisions "without any satisfactory reason"; that the rule had been expanded beyond extensions of time for the payment of debt to include releases of the principal; and that by 1846 the rule, so expanded, was "considered as settled." Lord Chancellor Truro still had considerable doubt about it in 1851 in Owen v. Homan.

    This background is helpful in understanding why the Restatement's handling of releases began as :it did and why the path to the ultimate resolution was somewhat bumpy.

    The reservation of rights doctrine...

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