Pitt v Jones [2007] EWCA Civ 1301

The issue of whether a contract of suretyship is a guarantee or an indemnity regularly appears before the courts. The distinction can impact on the enforceability of the contract and the nature of the liability of the obligor. The essential feature of a guarantee is that the liability of the guarantor is always ancillary to that of the principal debtor, who remains primarily liable to the creditor, and is co-extensive with the primary liability ie, there will be no liability under the guarantee if the underlying contract is void or unenforceable. An indemnity is a primary liability to the creditor which exists independently of the contract between the principal debtor and creditor. The formalities required for a guarantee are well known, having been laid down in section 4 Statute of Frauds 1677 (section 4): the contract must be in writing and signed by the guarantor. A contract of guarantee that does not comply with this ancient statutory provision is unenforceable by the creditor. This requirement does not apply to an indemnity. One common feature of both types of surety is that, as contracts, they each require consideration.

In the recent case of Pitt v Jones, a majority shareholder who had negotiated for the sale of his shares, gave an undertaking to the minority shareholders to pay for their shares in the event the purchaser failed to do so at a later date. In return for this undertaking, the minority shareholders agreed to the holding of a shareholders’ meeting at short notice to approve the transactions relating to the sale of the majority shares and entered into option agreements with the purchaser for the subsequent sale of their minority shareholding. The purchase of the minority shares did not take place and the claimants were seeking to enforce the undertaking for the payment of their shares.

The court had to consider:

  1. Had the minority shareholders given any consideration for the undertaking to them?
  2. Was the undertaking a guarantee or an indemnity?
  3. Was the undertaking, which had not been given in writing, enforceable?

Consideration

The claimants were successful in establishing that their agreement to hold the shareholders’ meeting at short notice and to enter into option agreements with the purchaser in order that the sale of the majority shares could be concluded was adequate consideration for the undertaking made by the majority shareholder, even though they were not consciously aware of what consideration they were giving for the promise they were accepting. The undertaking was a contractual agreement.

Guarantee and indemnity

The determination of whether the undertaking was a guarantee or indemnity would be crucial to establishing the liability of the defendant pursuant to the undertaking. In the Court of Appeal’s analysis, the test for distinguishing between the two types of surety was to consider whether the promise to pay arose as an incident to the central object of the contract or transaction, in which event it would be an indemnity, or whether it was a central obligation of the contract or transaction, in which case it would be a guarantee.

It was held that the main object of the transaction was the sale of the majority shares. Whilst the majority shareholder had negotiated the option agreements for the minority shares, he had no interest and derived no benefit from them as they were only incidental to the performance of his own contract and not part of the main transaction, nor were the two sales part of the same larger transaction. On this basis, the undertaking to the minority shareholders was incidental to the main contract and properly classified as a guarantee.

Enforceability of guarantee

As a guarantee, the undertaking would have to comply with the requirement under section 4 that it be in writing and signed by or on the authority of the obligor for it to be enforceable. The undertaking to pay the minority shareholders for their shares had only been made orally and was therefore unenforceable by them.

The minority shareholders were unfortunate in this case. Their request for the undertaking to be given in writing had been rejected. Section 4 may be an old piece of legislation, but it is still a very important provision.

The Pitts v Jones test of the connection between the main transaction and the promise of surety has been very recently followed in Associated British Ports v Ferryways NV ([2008] EWHC 1265 (Comm)) where it was held that a promisor’s financial interest in the subject matter of the underlying agreement was not a real interest in the subject matter of the underlying agreement and therefore was not enough to make the promise an indemnity rather than a guarantee.

There are many protections in the law for guarantors which obligors may seek to benefit from when a claim under a guarantee is made against them. These cases show that, whilst an indemnity can be created without some of the formalities required of guarantees and may survive independently of the underlying agreement, there are still significant issues to address in establishing that an indemnity has been given. Any party wishing to rely on a guarantee or indemnity must take care to ensure that the appropriate requirements for each have been met.