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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. (Feature 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.

A. 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.

B. 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 has had an extensive history since that early beginning. There are articles that chronicle the development of the doctrine, discuss court decisions and point out fallacies in the doctrine. It appears that many United States courts have followed the doctrine despite these fallacies and some responsible criticism of it. (11)

In the creditor-debtor-guarantor context, the creditor's extension of time to pay the debt was considered to be a serious variation in the terms of the underlying obligation, and this led to the parallel treatment of extensions of time and the release of the debtor. Certainly in the modern world of surety bonds, the obligee's extension of time for the principal to perform the underlying obligation would not rise in seriousness to the degree of a release of the principal. Generally, changes in the time for performance by the principal of underlying obligations to perform a construction contract and to pay bills will not represent such a substantial change as to justify the automatic discharge of the surety. The relief to be accorded to a surety on such bonds as a result of the obligee's extension of time would be based on the rule relating to material modifications of an underlying obligation.

Professor Williston has written that the rule that a release of a joint debtor discharges all of the joint debtors has been settled for centuries. The reason for the rule is that a joint obligation is one and indivisible. (12) It also is said that in the law of suretyship, "it is well settled that as a general rule the creditor's release of the principal ... discharges the surety." (13)

The justification for the discharge of the surety has been stated: "The reason why a simple release of the principal debtor discharges the surety is, that it would be a fraud on the principal debtor to profess to release him, and then to sue the surety, who in turn would sue him." (14)

Williston found it impossible to reconcile the general rule discharging a surety on the creditor's granting the debtor an extension of time with the special rule allowing the extension if the creditor reserved rights against the surety. He explained how the inconsistency arose:
      The general role forbidding the giving of
   time is a modern one in equity.... About a
   century before ... it had been laid down that
   a covenant not to sue one joint debtor did
   not discharge the others. Before the adoption
   by courts of law of the role protecting sureties
   from agreements between creditor and
   principal debtor for forbearance a case had
   presented the question of the effect of a release
   of one joint debtor with a reservation
   of rights against another. The court purported
   merely to construe a release in terms
   contradictory and held it to amount in effect
   to a covenant not to sue one joint debtor and
   therefore, under well-recognized law to have
   no effect on the liability of his co-debtor.
   The doctrine of this case persisted and was
   even applied to cases where the joint debtor
   against whom rights were reserved was a
   surety, which side by side with this doctrine
   there flourished the newly arisen doctrine
   discharging sureties if time was given to the
   principal debtor. (15)


Thus, to sustain the reservation of rights doctrine as applied to the creditor's release of a principal with a reservation of rights against a surety, the courts have disregarded the contradiction between a complete release of the debtor and a reservation of rights against the surety by construing the release, not as a discharge, but as a covenant not to sue thereby permitting the recognition of the reservation.

Some decisions construing a release as a covenant not to sue have done so under the guise of carrying out the "intent of the parties." (16) The consequence of this idea led to the creditor pursuing the surety and the surety then seeking indemnity from the principal. Thus, the principal faced a claim on the obligation it thought had been discharged by the creditor's release. It is difficult to see how this result conforms to the debtor's intent. The Restatement recognizes this unfairness to the principal, who likely would not realize that the release was not really a discharge from liability. (17)

It is obvious that the examination into the "intent of the parties" was concerned only with the intent of the creditor. The creditor enters into an agreement with the principal, with adequate consideration, pursuant to which the underlying obligation is "released and forever discharged," but the creditor insists on a provision reserving rights against the surety. It should be obvious that the principal's interest is to obtain a discharge from the obligation and, having obtained the release, it would be unconcerned with the creditor's reservation. The principal's intention in furnishing the creditor with consideration for the release is clearly to obtain that discharge. Justifying the reservation of rights doctrine as carrying out the intent of the parties to the release is just plain wrong. It gives one party to the release what it wants, but it denies to the other party that which it bargained for.

The release of the underlying obligation and the reservation of rights against a surety are completely contradictory, as Williston termed them. (18) The Restatements of Contracts refer to them as repugnant. (19) Having been firmly established that a release of the debtor discharged the surety, the courts should have resolved the matter by holding that the creditor could not circumvent this established principle without the consent of the surety, and that absent such consent, the reservation could not alter the impact of the general rule. The result forged by the courts ignored the debtor's only intention in entering into the release and distorted the release language in an effort to allow the creditor to have the benefits of his conflicting positions.

As early as 1912, Williston observed that the Uniform Negotiable Instruments law apparently reversed the rule of suretyship and permitted the creditor to covenant not to sue the principal debtor and to continue to have rights against a surety. (20) The 1941 Yale note declared: "Despite the flimsy legal structure supporting the reservation clause, the question of whether or not such a clause should be given effect when negotiable paper is involved has been almost wholly foreclosed by the Negotiable Instruments Law." (21)

The Reporter's Note to Comment f in Section 39 of the Restatement indicates that under Section 3-695(b) of the Uniform Commercial Code (1995), a release of an accommodating party (the principal) never discharges the accommodation party (the surety).

The reservation of rights doctrine has been characterized by Professor Cohen, Reporter for the Restatement, and in the Restatement materials as "pernicious" and "unfair," (22) "archaic," (23) the subject "of frequent and forceful criticism," (24) and "of frequent and effective criticism," (25) "long criticized by commentators and some courts," (26) and as having "outlived whatever usefulness it may have had." (27)

Comment a to Section 38 of the Restatement identifies two problems with the doctrine. First, it causes unfair surprise to a principal who, "but for the most sophisticated" principal, would not realize that the release did not relieve it of liability to the surety. Second, it is based on unlikely assumptions about the behavior of sureties: that the surety is willing and able to perform on the original terms; that it will be monitoring the principal's actions; and that it might reasonably believe that the principal had performed and it was no longer liable. This recognizes the unfairness of the doctrine to the principal and to the surety.

Comment b to Section 39 states in part:
   Since performance of the underlying obligation
   will discharge all duties owed to the
   secondary obligor, it would be the reasonable
   expectation of a principal obligor that
   the release of the principal obligor's liability
   to the obligee not accompanied by a preservation
   of the secondary obligor's recourse
   (see Comment c) also discharges the
   principal's corresponding duty to the secondary
   obligor.


This statement indicates that the reasonable expectations of a principal will be the same whether the duties pursuant to the underlying obligation are discharged by performance or by a release--that is, that the principal will be discharged of any corresponding duties to the surety. The reservation of rights doctrine does not require that the obligee's release preserve the surety's recourse against the principal; it simply ignores this reasonable expectation of the principal. Thus, the doctrine, as it has developed, produces a result that the Restatement indicates is not within the reasonable expectation of the principal.

Certain conclusions can be reached about the reservation of rights doctrine from a review of its history:

* It has flaws and inconsistencies.

* Despite this, it has been widely accepted by the courts as being "well settled."

* A few courts have rejected the doctrine because of these flaws and inconsistencies.

* Statutes dealing with negotiable instruments have embraced the doctrine and have gone even further in derogation of generally accepted suretyship principles.

Given the history of the doctrine, it is not surprising that Section 122 of the 1941 Restatement of the Law of Security provided that where the creditor released a principal, the surety was also discharged unless the surety consented or the creditor reserved rights. Comment d to that section indicates, as justification for the doctrine, that the release is construed as a covenant not to sue, that the creditor had no intention to release the surety, and that the principal had "no cause for complaint since, having accepted his release with the reservation, he necessarily accepted the consequence that the liability might still be enforced against him through action by the surety."

How easy it is to rework that language, without changing the substance, to reach the opposite result:
   The principal's intention in entering into
   the release arrangement was to obtain his
   discharge from further liability; the creditor's
   reservation of rights against the surety
   was completely inconsistent with such a reservation.
   The creditor has no cause for complaint
   because, having given a release to the
   debtor of the underlying obligation, he necessarily
   accepted the consequences that the
   reservation was in conflict with the release
   and that it could not therefore be effective.


Comment d's language in the 1941 Restatement that a principal has "no cause for complaint" because, by accepting the release with the reservation of rights, he necessarily accepted the consequences that the surety might still enforce liability against him, is completely rejected by language of Comment a to Section 38 in the Restatement:
   ... this doubtful that any but the most sophisticated
   principal obligors realized that a
   release ... accompanied by the incantation
   of a "reservation of rights" against the secondary
   obligor could result in liability to the
   secondary obligor based on the original
   terms of the underlying obligation.


This statement recognizes that most principals will not realize that "reservation of rights" against the surety will involve the principal's liabilities to the surety stemming from the underlying obligation. Moreover, it brands as pure fiction the proposition that construing the release as a covenant not to sue so as to permit action by the obligee by the surety and the surety's action against the principal carries out the intent of the parties. Principals do not have such an intent in contracting for a release.

DEVELOPMENT OF RELEASE RULE

Preliminary Draft No. 2 (June 3, 1992) of the Restatement provided in Section 27 that the principal could use a release by the obligee as a defense to a claim by the surety, unless the obligee informed the principal (1) that it was preserving rights against the surety and (2) that the surety retained its rights against the principal. Section 28(3) of that draft provided that, with respect to a release of the underlying obligation, the surety remained liable unless it was discharged under Section 36 to the extent that the release caused the surety a loss, as then defined.

In summary, Preliminary Draft No. 2 ameliorated the unfairness to the principal of the "reservation of rights" doctrine (1) by requiring notice to the principal of the two consequences of the reservation or (2) by relieving the principal of liability to the surety but leaving the surety still liable to the obligee except to the extent of harm. This transferred the unfairness of that doctrine from the debtor-principal to the guarantor-surety. The guarantor-surety was discharged only to the extent that it suffered a loss in its ability to recover from the debtor-principal as a result of the release.

The advisors from the surety law field at the meeting on Preliminary Draft No. 2 contended, without any success, that the obligee's release of the principal always released the surety. Council Draft No. 2 (November 19, 1992) described "Suretyship Defenses" with some new and different language and with an introductory note indicating the adoption of the model five principle. The release rule remained unchanged in substance.

At the ALI Council meeting on Council Draft No. 2, the associate reporter (one of the authors of this article) objected to the release provision, pointing out that in the construction contract setting in which the owner-obligee and the contractor-principal are in substantial dispute as to the status and quality of construction and on the issue of money due and owing, the proposed Restatement rule would allow the owner-obligee and the contractor-principal to settle their disputes and exchange releases, with the owner-obligee reserving rights against the surety. The owner-obligee then could assert claims against the surety, which would be left without the facts, documents, witnesses and the assistance of the contractor with which to defend against the owner' s claim.

The unfairness of this to the contract bond surety should be obvious. A suggestion was made that a distinction be made between a release of an underlying obligation other than the payment of money and one for the payment of money. The ALI Council took favorable action on this suggestion, but recollections differed as to what that action was.

The reporter's recollection was that the council approved, in the case of an underlying obligation other than the payment of money, a shifting to the owner-obligee of the burden of persuasion that the release did not cause loss to the surety. This concept was embodied in Section 35(c)(iii) of Tentative Draft No. 2.

At the ALI annual membership meeting on May 12, 1993, the associate reporter again objected to the release rule and pointed out that the shifting to the owner-obligee of the burden of persuasion with respect to the absence of loss or harm to the surety still left the surety without any means of challenging the owner's claims and refuting evidence presented by the owner-obligee purporting to show absence of harm to the surety as a result of the release. After considerable discussion, the members voted in favor of the proposition that the obligee's release of the principal from an underlying obligation other than the payment of money will discharge the surety from any further obligation on the secondary obligation. (28)

Language to this effect ultimately was approved by both the ALI Council and the ALI membership when they considered Council Draft and Tentative Draft No. 4. That concept appears in Section 39 of the Restatement.

OBLIGEE'S RELEASE OF PRINCIPAL ALWAYS SHOULD DISCHARGE SURETY

A. Obligee's Release of Underlying Obligation Leaves Nothing for Secondary Obligor to Perform

In the case of a financial guarantee, the guarantor agrees with the creditor to pay the obligation of the debtor if the debtor does not. In the surety bond context, the surety agrees with the obligee, in effect, to provide funds to perform the principal's obligation to the obligee if the principal fails to perform. A release by the creditor-obligee to the debtor-principal results in a discharge of the underlying obligation. Since the guarantor-surety obligation is simply to perform the underlying obligation if the debtor-principal does not, the discharge of the underlying obligation leaves nothing for the debtor-principal to perform.

This is the general rule and the justification for it where there is no reservation of rights. As noted in the earlier discussion of the reservation of rights doctrine, the creditor's attempted reservation of rights against the surety is inconsistent with and repugnant to the release, and it should be disregarded. Construing an absolute discharge as a covenant not to sue is artificial. Allowing the creditor to proceed against the surety and, in all fairness, allowing the surety to recover from the debtor, deprives the debtor of that for which the debtor bargained.

The 1941 Restatement stated the rationale for the general rule that the obligee's release of the principal discharges the surety with these words in Comment d to Section 122:
      Where the surety and principal are not
   bound jointly, but the obligation of the
   surety is to answer for the duty of the principal,
   the termination of the principal's duty is
   also a termination of the surety's obligation.
   If the principal has no longer a duty as a
   result of the creditor's act, the surety should
   not be held to an obligation to answer for a
   default of that duty. Furthermore, if the
   surety could be compelled to pay after the
   principal's release, he would be entitled to
   reimbursement if he had become a surety at
   the principal's request or with his consent.
   Such an outcome would be unfair to the
   principal after a release because it would afford
   the creditor a means of attacking the
   principal indirectly through the surety.


The justification advanced for the departure from this basic rule is that if "the creditor releases the principal but reserves rights against the surety, this is construed as a covenant not to sue the principal." The reservation of rights doctrine rewrites the release as a covenant not to sue in an effort to accommodate the intention of the creditor. In so doing, it completely disregards the intention of the principal that the release should discharge it from any further liability with respect to the underlying obligations.

A release of a primary obligor with a reservation of rights against a secondary obligor is a contradiction in terms, and the reservation should be a nullity. If the underlying obligation is discharged by the action of the obligee, there is nothing left to which the promise of the secondary obligor can respond. (29) The nature of the promises compels this conclusion.

B. Recognition of Obligee's Reservation of Rights Against Surety after Release of Principal Imposes Substantial and Unreasonable Hardships on Surety and Should not be Permitted

To persuade the ALI membership to accept the rule that a release of the principal always should discharge the surety, the associate reporter presented a scenario involving a construction contract as the underlying obligation, a number of disputes between the owner and the contractor, and a settlement between the owner and the contractor including a release of the latter. Allowing the owner to proceed against the surety because of a reservation of rights clause is manifestly unfair to the surety. The surety is left without the assistance of the released contractor and without the facts, witnesses and documents to deal with the owner's claim. Were it not for the exclusion of releases from the operation of Section 41 of the Restatement, the surety would be discharged under Subsection (b)(i) of that section because such a release imposes risks on the surety fundamentally different from those involved in the transaction prior to the release. (30)

Some authorities who reject the reservation of rights doctrine point out that (1) the expectation of the three parties is that the principal will perform the underlying objection; (2) the obligee's release of the principal removes the incentive for the principal to perform that obligation; (3) this destroys the tripartite relationship which was created by the original undertakings; and (4) this substantially and fundamentally changes the risk assumed by the surety at the onset. (31)

The obligee should not have the right to discharge the primary obligor and expect to retain any rights against a secondary obligor. A contrary result means the obligee has improved its position vis-a-vis the surety who does not have the knowledge, information and assistance of the principal in dealing with the subsequent claim of the obligee, which is fully fortified with the support for its positions.

C. These Same Hardships Exist When Underlying Obligation Is to Pay Money

These contentions apply with equal validity to the situation in which the underlying obligation is the payment of money.

Illustration 1. The supplier of merchandise on an open account to a business requires the business to provide a guarantor of the payment of the account. The supplier and the business have disputes as to the merchandise supplied, its quantity and quality, and payments made. The supplier and business settle their disputes, and the supplier gives a release with a reservation of rights. The guarantor is left helpless to defend any subsequent claim made by the supplier.

Illustration 2. An importer supplies a bond to the government conditioned on the payment of import duties. The importer and the government have disputes as to goods imported, the duties imposed, and the payments made. The government settles with the importer and provides a release with a reservation of rights. Again, the surety is left without the means of evaluating and dealing with a later claim by the government.

One of the Restatement illustrations on this point posits a debt of $10,000, payments on account of $3,000, and default at that point at which the debtor has only $5,000. The creditor releases the debtor in return for the $5,000 and reserves rights against the guarantor. According to the Restatement, the guarantor remains liable. (32)

This is at best an exceptional situation in that the debtor has only a smaller but definable amount of assets to apply to the balance due. Rules of general application should not be based on such unusual fact patterns.

In any of these situations in which the obligee wishes to make a deal with the principal that the obligee thinks is the best the principal can do, the solution is simple and obvious. The obligee should consult the surety first. If the deal is as obvious as the one in the illustration from the Restatement described above, a reasonable surety would be quick to concur that the obligee make the deal and to agree with the reservation. If the surety declines, the obligee should than require the surety to pay the full balance due.

Consider a situation in which an obligee and a principal are negotiating differences between them involving amounts the principal owes. The obligee proposes a compromise by which the principal pays a stated sum of money and the obligee reserves rights against the surety. Under the Restatement's rule, the principal could not care less about the reservation of rights because such a release will discharge it from all obligations. It will not "pay more" for the reservation but the obligee may be willing to "take less" from the principal because of the reservation of rights against the surety.

The unfairness of this to the surety should be manifest. The law should not countenance this result and should strike down the obligee's "reservation of rights" against the surety as totally inconsistent with the discharge of the underlying obligation.

There is no logical reason for limiting the rule that the obligee's release of the principal also discharges the surety to situations involving underlying obligations other than the payment of money. The Restatement makes this difference because it started with a bad premise that a surety should never be discharged by obligee action except to the extent of loss or harm and its resolution of the unfairness, to the debtor-principal, of the reservation of rights doctrine by transferring that unfairness to the guarantor-surety.

As noted, it took a good deal of persuasion even to modify these original concepts so as to limit the recognition of the obligee's reservation of rights to underlying obligations to pay money.

D. Obligee Does Not Have Right to Discharge Obligations Between Principal and Surety

It is incredible that these rules dealing with obligee's release of the principal give the obligee and the principal the right to abolish all of the rights that suretyship status gives the surety against the principal. The rules purport to allow two parties in a three-party setting to contract away obligations owed by one of them to the third party. Nothing in the tripartite relationship justifies their having that power.

In other parts of the Restatement, for instance, Sections 21(1)(a) and (b), the principal owes to the surety the duty to perform the underlying obligation and to refrain from conduct that impairs the expectation of the surety that the principal will perform that obligation. This is truly a "restatement" of the law because those duties, enforced by exoneration and quia timet, and are well imbedded in the decisional law of suretyship. (33)

In Section 22 through 28, the Restatement recognizes the duties of the principal to the surety of reimbursement and subrogation, duties equally recognized in case law. (34) Under Section 39(a), a release of the principal by the obligee, with a reservation of rights against the surety, discharges the principal from the these duties, absent an express preservation, in compliance with Section 38, of the surety's recourse against the principal. These provisions purport to give the obligee and the principal the right to contract away in such a release the obligations of the principal to the surety.

It is true that Section 24(d) provides that the principal has no duty to reimburse the surety if the obligee's release of the principal discharges that duty under Section 39 No such qualification on the principal's duty to reimburse is recognized by decisional law. (35) This qualification was made necessary by the Restatement's handling of the reservation of rights doctrine. Comment a under Section 37 states in part:
   General Principle. Suretyship status gives
   the secondary obligor both the right to have
   the principal obligor bear the cost of performance
   owed to the obligee and several
   mechanisms of recourse against the principal
   obligor to effectuate that right. The existence
   of this right and these mechanisms is
   a fundamental component of the secondary
   obligor's bargain.


The release rule permits the obligee and the principal to abolish this "fundamental component of the [surety's] bargain" without the surety's knowledge and consent. The law simply does not permit two parties, the obligee and the principal, to abolish by agreement the obligations of one of those parties, the principal, to a third party, the surety, which have arisen by reason of the surety's status as surety.

E. Changes in Rights of Surety Are Even More Fundamental Than Those Contemplated by Restatement Rule Dealing With Modifications Which Do Result in Complete Discharge of Surety

In the first drafts of the Restatement, the obligee's modification of the underlying obligation resulted in discharge of the surety only if the modification was so fundamental as to amount to a substituted contract, that concept having been enunciated in Section 279 of the Restatement (Second) of Contracts. By the time of Draft No. 4, Professor Cohen, the reporter, was persuaded to incorporate the principle of surety law that a modification that imposes risks on the surety fundamentally different from those imposed by the transaction prior to the modification also will discharge the surety. However, release and extensions of time are excluded in Section 41 from the Restatement's modification rule.

The changes permitted by the release rule, that is, discharging the principal from the obligation to perform (a) the underlying obligation, (b) the obligation to the surety (i) to perform that underlying obligation and (ii) to refrain from conduct impairing the principal's obligation so to perform, and (c) the obligation to reimburse the surety, alter completely and fundamentally the risks to the surety involved in the transaction before the release. The modification rule as finally approved would encompass such a release were it not for the express exclusion provided in Section 41.

Comment b to Section 37, dealing with fundamental modifications, reads:
   b. Acts that fundamentally alter risks imposed
   on the secondary obligor. Subsection
   (2) describes acts that fundamentally alter
   the risks imposed on the secondary obligor.
   When either of these acts occurs, the secondary
   obligor is placed in a position fundamentally
   different from that for which it bargained.
   It is simply not appropriate to apply
   the secondary obligor's promise to a situation
   for which it was not designed. Thus,
   Subsection 2 and the sections referred to
   therein discharge the secondary obligor from
   any unperformed duties upon such actions
   by the obligee.


This observation applies with equal force to a release of a duty to pay money. It may be that the distinction between an underlying duty to pay money and one other than the payment of money was prompted by the decision already made by the Uniform Commercial Code in the area of financial accommodations that a release of the principal obligor "never discharges the ... secondary obligor." (36)

Whatever may be the motivating forces for that rule in the case of negotiable instruments and accommodation parties, such a rule makes no sense in the case of surety bonds, regardless of whether the underlying duty is to pay money or one for other than the payment of money. The obligee's release of the principal should always discharge the surety and any efforts by the obligee to reserve rights should be disregarded as "repugnant" to the release.

F. Development of Restatement Rules Dealing with Obligee's Allowing Statute of Limitations to Run

The subject of the consequences to the surety of the obligee's allowing the statute of limitations to run on the underlying obligation was first presented, beginning in June of 1993, in the third series of drafts. In Preliminary Draft No. 3 (June 3, 1993), Section 59 provided, in effect, that the obligee's allowing the limitation period to expire on the underlying obligation would result in discharge of the surety to the extent of any harm or loss.

Essentially the same rule was presented to the ALI membership in Section 61 of the Tentative Draft No. 3 at the ALI annual meeting in May 1994. On their own initiative, the ALI members challenged this rule and contended that if the obligee allowed the statute to run on the underlying obligation, the secondary obligation was automatically discharged. It appeared to be the view that, if the underlying obligation was no longer enforceable, the secondary obligation also was discharged. After full discussion, the members voted in favor of the rule that such conduct would result in the discharge of the surety. (37)

The inaction of the obligee in allowing the statute to run on the underlying obligation is, in substance, no different from the obligee's affirmative action of releasing the principal from the underlying obligation. While the limitation rule voted by the ALI members was identical to the position taken by the surety advisers when the release rule was first presented, that position had not prevailed except to the extent of an underlying obligation other than the payment of money. That limited achievement was reached only after objection at the advisors meeting in June 1992, the ALI Council's meeting in the fall of 1992 and, finally, the members meeting in May 1993.

There was a clear inconsistency between the limited release rule, achieved only by compromise and the eventual convincing of the ALI members in 1993, and the limitation rule adopted by the members in 1994. It may be, as the saying goes, that "consistency is the hobgoblin of small minds," but an ALI Restatement should not contain this kind of inconsistency. Accordingly, the ALI Council and the members were asked to approve in the fourth series of drafts a limitation rule similar to the release rule, thus making a distinction between an underlying obligation to pay money and one other than the payment of money. Members approved the change in May 1995, so that the limitation rule parallels the release rule and appears in Section 43 of the Restatement.

One can only speculate as to whether the ALI members would have voted for a release rule paralleling their original vote on the limitations rule if the release rule had not been presented in the first instance with the distinction between the two types of underlying obligations.

CONCLUSION

It was apparent from the very beginning of the drafting process for what has become the Restatement (Third) of Suretyship and Guaranty that the worlds of financial guarantees and surety bonds are quite different, despite the fact that the basic relationships are similar. In each there is an underlying obligation with a debtor-principal and a creditor-obligee, and a secondary obligation with a guarantor-surety running to the creditor-obligee. The basic rights among the parties are quite similar. That there are differences in the two worlds may have prompted the decision, made subsequent to Tentative Draft No. 4 in 1995, to add the words "and Guaranty" to the title of the Restatement.

Problems arose in the "Suretyship Defense" area in part because case law is varied in deciding the consequences to the surety of obligee acts and in part because the drafting process started with the concept of eliminating these variations by following a single concept that a surety should be discharged by obligee conduct only to the extent of loss or harm. Decisional law and common sense, however, did not justify going that far.

Greater problems arose because of the attempt to ameliorate the unfairness to the principal of the reservation of rights doctrine by, in effect, saddling that unfairness on the surety. In so doing, it was necessary to permit the alteration, by two parties, of the basic rights of another party to the relationship. The reservation of rights doctrine, while widely criticized, apparently served and continues to serve the financial guarantee community well. This made it difficult to eradicate the effect of the amelioration even as to underlying obligations other than the payment of money.

The reservation of rights doctrine has become well settled in many jurisdictions and in the law relating to negotiable instruments, despite criticism of it and its inconsistencies, flaws and contradictions. Principles of stare decisis may compel a court, which is convinced as to the corrections of the contentions advanced here, to express its agreement with those contentions but to adhere to prior precedent. While a restatement of the law can hardly disregard the doctrine entirely because it is now a legislative matter insofar as negotiable instruments are concerned, it certainly should not attempt to modify such a rule by transferring the inequities of it to another party. A better course would have been to recognize the status of the doctrine, indicate its flaws, and lay down a correct set of principles as a guide to a better treatment of the issue.

The distinction in the release rule made on the basis of the nature of the underlying obligation, whether to pay money or otherwise, really does not make sense because the problems in the situation of an underlying obligation to pay money can be just as difficult and unfair to the surety as when that obligation is other than the payment of money. It is to be hoped that courts, when called on to deal with this issue, at least in the area of surety bonds where the reservation of rights doctrine and its consequences have not become so well settled, will recognize that a release of the underlying obligation discharges both the principal obligor and the secondary obligor without regard to any reservation of rights.

(1.) Annotation, Creditor's Reservation of Rights Against Surety in Releasing or Extending Time to Principal Debtor, 139 A.L.R. 85, 85-86 (1942); 74 Am Jur. 2d Suretyship [section] 73 (2001); Samuel Williston, Releases and Covenants Not to Sue Joint, or Joint and Several Debtors, 25 HARVARD L. REV. 203, 204 and 206 (1912); RESTATEMENT OF THE LAW OF SECURITY [section] 122 (1941).

(2.) Annotation, supra note 1, at 86; 74 AM JUR. 2D at [section] 74.

(3.) RESTATEMENT (THIRD) OF SURETYSHIP [section] 36 (Preliminary Draft No. 2, 1992).

(4.) Neil B. Cohen, Striking the Balance: The Evolving Nature of Suretyship Defenses, 34 WM. & MARY L. REV. 1025 (1993).

(5.) RESTATEMENT (THIRD) OF SURETYSHIP AND GUARANTY, Ch. 3, Topic 3, Title B (1995).

(6.) Id. at [section] 39(c)(iii).

(7.) Id. at [section] 41(b)(i).

(8.) Id. at [section] 43.

(9.) Note, The Effect upon the Surety of a Reservation Clause in a Release of the Principal Debtor, 50 YALE L. REV. 1485 (1941).

(10.) 42 Eng. Rep. 307, 311 (Ch. 1851).

(11.) Note, supra note 9, at 1487; Williston, supra note 1, at 214; Annotation, supra note 1; Bank of the United States v. Moskowitz, 268 N.Y.S. 705, 711 (N.Y. Civ.Ct. 1934); City Nat'l Bank & Trust Co. v. Burnham, 17 N.E.2d 505, 515 (Ill.App. 1938). See also Gunnell Constr. Co. v. Hartford Accident and Indem. Co., 374 F.2d 278, 282 (D.C. Cir. 1966) (Tamm, J., dissenting).

(12.) Williston, supra note 1, at 204.

(13.) Annotation, supra note 1, at 85-86.

(14.) Nevill's Case, 6 L.R.-Ch. 43, 47 (Ch. 1870), quoted in Williston, supra note 1, at 204.

(15.) Williston, supra note 1, at 213-14.

(16.) Note, supra note 9, at 1488 and the authorities cited therein in footnotes 18 and 19.

(17.) Preliminary Draft No. 2, supra note 5, at [section] 38 cmt. a.

(18.) Williston, supra note 1, at 211.

(19.) RESTATEMENT (FIRST) OF CONTRACTS [section] 122 cmt. a; RESTATEMENT (SECOND) OF CONTRACTS [section] 294 cmt. a.

(20.) Williston, supra note 1, at 217-218.

(21.) Note, supra note 9, at 1492.

(22.) Cohen, supra note 4, at 1043-44.

(23.) RESTATEMENT (THIRD) OF SURETYSHIP, Introductory Note to Table B, Suretyship Defenses, at page 105 (Council Draft No. 2, 1992).

(24.) RESTATEMENT (THIRD) OF SURETYSHIP [section] 34 rptr, note (Tentative Draft No. 2, 1993).

(25.) Council Draft No. 2, supra note 23, [section] 34 rptr. note.

(26.) Council Draft No. 2, supra note 23, Introductory Note to Title B, Suretyship Defenses, at page 105.

(27.) Preliminary Draft No. 2, supra note 3, at [section] 33 cmt. d.

(28.) Transcript of Meeting of American Law Institute Membership, at 183-204 (May 12, 1993).

(29.) Annotation, supra note 1, at 108 and authorities therein cited.

(30.) See 2 SAMUEL WILLISTON ET AL., WILLISTON ON CONTRACTS [section] 339 (rev. ed. 1936); 4 SAMUEL WILLISTON ET AL., WILLISTON ON CONTRACTS [section] 1230 (rev. ed. 1936).

(31.) Equitable Sav. & Loan Ass'n v. Jones, 522 P.2d 217, 220-21 (Or. 1974), quoting HERSCHEL ARANT, ARANT ON SURETYSHIP, [section] 50 (1931).

(32.) RESTATEMENT (THIRD) OF SURETYSHIP AND GUARANTY [section] 39 cmt. d, ill. 6.

(33.) See THE LAW OF SURETYSHIP ch. 28 (Edward G. Gallagher ed., 2d ed. 2000); THE LAW OF SURETYSHIP ch. 28 (Edward G. Gallagher ed. 1993); and GEORGE J. BACHRACH, The Surety's Rights to Obtain Salvage: Exoneration, Reimbursement, Subrogation, and Contribution (1997) (available, ABA, Tort Trial and Insurance Practice Section, Fidelity and Surety Law Committee, SRS&Y Library No. 2714).

(34.) See THE LAW OF SURETYSHIP chs. 23, 26 (Edward G. Gallagher ed., 2d ed. 2000); and THE LAW OF SURETYSHIP chs. 26, 29 (Edward G. Gallagher ed. 1993).

(35.) See notes 34-34.

(36.) Tentative Draft No. 2, supra note 3, at [section] 33, cmt. a.

(37.) Minutes of American Law Institute Membership Meeting, at 68-93 (May 19, 1994).

Daniel Mungall Jr. a retired partner of the Philadelphia firm of Stradley Ronon Stevens & Young, LLP, is a long-time and respected surety law practitioner and served as associate reporter on the Restatement (Third) of Suretyship and Guaranty. A former member of the International Association of Defense Counsel, he is a graduate of Yale College and Harvard Law School.

IADC member Samuel J. Arena Jr. is a senior partner in Stradley Ronon and chair of its Fidelity and Surety Law Practice Group. He served as an advisor to the American Bar Association Tort and Insurance Practice Section on the development of the Restatement. He is a graduate of Ursinus College and Villanova Law School.

Both authors, who participated in all the official American Law Institute advisor meetings, thank Thomas W. Dymek for his assistance in the preparation of this article.
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Author:Mungall, Daniel, Jr.; Arena, Samuel J., Jr.
Publication:Defense Counsel Journal
Date:Jul 1, 2003
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