New Restatement of Suretyship and Guaranty raises some practical problems.

• Author: Leo, T. Scott

The new Restatement poses problems with respect to construction contracts by failing to delineate clearly the duties of obligees

RESTATEMENTS of the law fashioned and promulgated by the American Law Institute are designed to state the basic principles of American law. If case law is inconsistent, or when there does not appear to be a uniform doctrine or policy, the Restatement might examine the policy or the reasons for the inconsistency in an attempt to determine what the law ought to be.

Lawyers know that the "law" is neither static nor certain. The belief that it is fixed, certain and immutable, to be learned entirely from the past and precedent, is a myth maintained by those who have not studied or practiced law. The Restatements, therefore, while appearing to some to be dry, academic syntheses of principles of law, also are the products of the creative process of practitioners, academics and judges who, as members of the ALI, have undertaken a critical evaluation of the areas of American law.

Since 1941, Sections 82 to 211 of the Restatement of Security had been the principal document defining the law of suretyship in the United States. In 1995, the ALI approved a new Restatement in the field of surety law, officially titled Restatement of the Law Third: Suretyship and Guaranty.(1) The reporter was Neil B. Cohen of the Brooklyn Law School. Daniel Mungall Jr. of Philadelphia was associate reporter. The writer was one of the advisers to the project.(2)

THE GENESIS

The impetus for updating and creating a Restatement of suretyship on its own was spurred by practitioners in the credit enhancement area. The ALI conducted a study of the need for a new restatement in this area, and that study included a conference with a number of the members of the Fidelity and Surety Law Committee of the American Bar Association Section of Insurance and Tort Practice during the summer of 1989.

From the perspective of the surety industry, the project was long overdue. Since the publication of the original Restatement, the Supreme Court had decided United States v. Munsey Trust Co.(3) and Pearlman v. Reliance Insurance Co.,(4) and the Uniform Commercial Code was adopted. Second and third incarnations of Restatements had been published in other substantive areas of law. The last published textbook on suretyship remained the fifth edition of The Law of Suretyship, by Steams, published in 1951.

During the preliminary meeting in the summer of 1989, representatives of the American Law Institute, together with some academics and practitioners from the commercial lending side of surety practice, met with approximately a dozen lawyers from the ABA section's committee to discuss (1) whether there was a need for an updated Restatement, (2) what problems in surety law remained uncertain, and (3) whether the practitioners and company representatives from the committee might be interested in participating in the Restatement project as advisers. The committee representatives agreed that the Restatement project should be undertaken and that the committee would form a group of advisers for the project.

The questions said to be uncertain were those issues about which industry people have long heard surety lawyers equivocate by offering "on the one hand, but then on the other hand" opinions. Here are some of the issues that the fidelity and surety practitioners said were not resolved by clear authority:

* When and to what extent is a surety discharged by a material change in the underlying obligation?

* How does a surety discharge its performance obligation when faced with a dispute over the underlying obligation between the principal and the obligee?

* What are the scope and basis for the surety's subrogation rights?

* What are the rights and liabilities of dual obligees, usually lenders, on bonds?

* Does a co-prime contractor have a claim on another co-prime's bond?

* More generally, who can claim as an intended beneficiary on the bond? Intended beneficiary v. creditor beneficiary rule?

* What is the effect of a judgment against the principal?

* Is the surety bound by the principal's arbitration clause?

* Is the surety's liability limited to the penal sum of its bond? More generally, under what, if any, circumstances can the surety's liability exceed the terms of its bond?

* May the surety successfully assert the defense of its insolvent principal?

* What are the duties of the obligee to declare a default and to preserve the contract assets?

This is by no means an exhaustive list of the issues that remain unresolved. The black-letter rules of the new Restatement provide some guidance, but a number of the issues remain mired in uncertainty.

"TWO WORLDS" OF SURETYSHIP

The advisers to the Restatement project quickly learned that there are two very distinct areas of practice affected by the law of suretyship. One is the world of the professional surely, in which the prototypical arrangement is the construction performance and payment bond. But there also is the world of the commercial lender who deals with commercial guarantees.(5) Many of the problems noted by practitioners who represent professional sureties arise because some of the Restatement's rules apply to different types of transactions from the commercial lending world of suretyship.

Different policies are fostered in the different worlds. Practitioners dealing with commercial guarantees want to make sure there is no impediment to the closing of the transaction and the ultimate payment. Their first experience with suretyship law may occur when they draft waivers of suretyship defenses.(6) The underlying policy in drafting these provisions and in the structure of the transactions is negotiability. For this reason, the commercial practitioners look favorably on the provisions of the Uniform Commercial Code, and, where possible, they hope that the common law of suretyship is interpreted consistently with the UCC. Suretyship defenses are not revered by these practitioners, who typically represent the interests of the lender. Those defenses are reviled as an impediment to closing transactions.

On the other hand are practitioners who represent surety companies in the handling of contract surety claims and disputes. The most common application of the performance bond is to secure the performance of construction contracts. In this context, the purpose of the bond is not to foster negotiability but to assure performance of the contract. Although construction contracts are governed by rules of contract and are freely assignable unless that is prohibited by the contract, as a practical matter a construction contract tends to have the same expectations as a personal service contract.

Performance is expected from the principal who enters into the contract. In light of the nature of the transaction and the purpose of the bond from the perspective of professional sureties, suretyship defenses are important to make certain that the risks are not greater than the surety expected and to provide an incentive for the principal to complete the underlying contract. Performance by the principal is part of the surety's security.(7)

Transactions from both worlds fall within the general definition of suretyship transactions, insofar as they are obligations to answer for the debt of another. Arriving at rules that consistently treat both worlds of suretyship transactions and that make sense in light of the practical circumstances relating to these transactions was one of the...