Week 2.

Insurance continued
Caution and guarantees

Cautionary Obligations and other rights in security

Guarantees

General rules applicable to caution and guarantees; judicial protection

of guarantors; the contra proferentem rule; rights in security

1. If Tom says he’s going to pay you some money for services you have rendered
him, short of suing him, how can you be sure that you can get your money
even if he later disappears or becomes insolvent?

2. You could
insure against Tom’s default;
make Tom pay a deposit refundable on completion or full payment;
take a security over an asset of Tom’s, just as a pawnbroker does;
make Tom insure against his own default and hand over the policy to
you;
obtain a guarantee from a friend of Tom’s;
make Tom obtain a guarantee, for a fee, from an insurance company or
bank which he hand over to you.

3. In Scotland, a guarantee is sometimes known as “caution”, pronounced “kay-

shun”. In most commercial undertakings the word guarantee is used, but in
specific circumstances, to be discussed later, caution is used.

Strictly speaking a cautionary obligation is a personal one, so a grant of a

standard security for the debts of a third party used not to be a cautionary
obligation as that involved a real right.

If it is a personal right, all of the cautioner’s assets can be used to satisfy the
debtor’s debt; if a guarantor grants a standard security in security of a debtor’s
debt, the creditor only has rights under the standard security and cannot claim
against the debtor’s other assets.

This rather arcane difference (as far as non-lawyers are concerned) is now
effectively gone because of Smith v Bank of Scotland 1997 SLT 1061 and
Hewitt v Williamson 1999 SLT 313.

You do know what a standard security is, don’t you?

 A cautionary obligation is always accessory to a principal debt, and it usually
requires that debt to be dishonoured before the obligation comes into force.
But equally, if the debt is unenforceable, so too is the cautionary obligation.

An indemnity does not require the presence of a principal debt, and is a free-
standing obligation to do something if somebody else doesn’t do something,
even if that “something” doesn’t involve a debt. Sometimes the difference can
be pretty narrow.

4. What matters would you expect to see in a bond of caution/guarantee?

5. Suggestions?

6. Why would you want to use a guarantee?

Suggestions?

7. Gratuitous guarantees were traditionally looked upon kindly by the courts.

Why?
Where there is consideration, the grant of a guarantee is treated as a contract
just like any other contract.

8. Banks and others which have the benefit of guarantees have got smarter at
drafting their guarantees, so that it is hard to get out of them. Nevertheless
banks now generally have to explain the significance of consumer customers
granting guarantees
Barclays Bank plc v O’Brien [1994] 1 AC 180,

Smith v Bank of Scotland 1997 SC (HL) 111,

and the important case, Royal Bank of Scotland v Etridge (No.2) [2002] 2 AC
773.

There is an argument that Etridge is not part of Scots law (see also Clydesdale
Bank plc v Black 2002 SLT 764 and Royal Bank of Scotland v Wilson 2004
S.C. 153, 2003 S.L.T. 910) and that the elaborate requirements in Etridge go
further than what is required under Scots law. See Commercial Law in
Scotland at pp.258-260. Gloag and Henderson also has a good discussion of
the matter at Ch.16. para. 17.

Etridge suggests that if the cautioner is to avoid liability, at the least has to
prove that there has been misrepresentation or undue influence, and that the
caution was granted gratuitously.
 If a creditor has reason to think that there has been misrepresentation or undue
influence he should not accept a bond of caution from the cautioner.
A creditor is entitled to rely on a bond of caution if the cautioner has been
advised by a solicitor (even if that solicitor is the debtor’s solicitor as well)
and to assume that the conflicts of interest have been thought about, unless
there is evidence to the contrary (Forsyth v Royal Bank of Scotland, 2000
S.L.T. 1295). But if there is something that should put the creditor on enquiry,
the creditor may not then rely on the bond of caution (Thomson v Royal Bank
of Scotland (No.3.) 2003 S.C.L.R. 964).

A further difficulty is that sometimes the cautioner knew exactly what the
liability was but was trying to find a way to wiggle out of it: Ahmed v
Clydesdale Bank plc, 2002 SLT 423.

See the Lending Code at

http://www.lendingstandardsboard.org.uk/thecode.html

See S.Eden, Cautionary Tales—the Continued Development

of Smith v Bank of Scotland 2003 Edin Law Review 107- 118

There are other cases on this area: as this is probably the crunchiest bit of law
on this topic it may be a good idea to look them up in the textbooks. Banks
follow the Lending Code very carefully and there have been no recent cases
on this particular area.

9. Much of the common law on guarantees arose when lawyers were less careful
in their drafting. What is not in doubt is that from a practical point of view a
guarantee must be in writing: it is not necessarily invalid by being verbal, but
it is much harder to prove. If a guarantee is gratuitous and not in the course of
business, it must be in writing (Requirements of Writing (Scotland) Act 1995
s.1(2)(a)(ii)); but if it is a commercial guarantee and in the course of business
it need not be in writing.

If a commercial guarantee is not in writing, and the creditor has acted in the
belief that there is a valid guarantee and thereby has acted to his detriment, he
can use the statutory rei interventus of RoW(S) Act 1995 s. l (3) to enforce the
terms of the guarantee.

Guarantees under the Consumer Credit Act 1974 s.105-113 must be in writing
(s.105(1)), properly executed (s.105(4),(5)) and otherwise in accordance with
the requirement of the Act by copies being given, cooling off periods etc.
There can be no greater duty on a CCA guarantor than on the debtor.

10. Where the guarantee is silent on a particular issue, it is possible to use s.8 of
the Law Reform (Miscellaneous Provisions)(Scotland) Act 1985 to have the
court rectify the document following extrinsic evidence as to what the parties
meant to say. This over-rides the normal rule that what is expressed in the
contract is what the parties have to live by.
11. If a guarantee is ambiguous, it is normally construed contra proferentem.
Why? See Stirling v Norwest Holst Ltd 1997 SL T 973 for an application of
the contra proferentem rule.
Bell’s Principles ss.251, 285.

12. What happens when a guarantor grants a guarantee, but there is something
wrong with
the underlying obligation for which the guarantee has been granted;
the creditor’s behaviour
the debtor’s behaviour?

13. The underlying obligation might be void - does this mean the guarantee is
void? In principle, probably yes -see

Swan v Bank of Scotland (1830) Shaw 721, HL - but also see

Stevenson v Adair (1872) 10 M 893.

Much depends on the state of knowledge of the guarantor.

What is the position for young persons?
See Age of Legal Capacity (Scotland) Act 1995 s.1 (1)(a).
Error in the substantials can also cause a guarantee to be reduced (i.e. the
price, the duration, the parties etc).

14. What if the creditor had misrepresented the position?

Assuming the misrepresentation is material and induced the guarantor to enter
into the guarantee, the guarantee is void (Royal Bank of Scotland v Ranken
(1844) 6D 1418). Any duty on the creditor to warn the guarantor?

Young v Clydesdale Bank (1889) 17 R 231.

Does a bank have a duty of care to a guarantor to warn the guarantor of the
consequences of his own inaction? – Bank of Ireland v Morton (No 2) 2003
SC 257. Not generally, but if the guarantor is clearly confused as to the true
position, and the creditor is aware of this, the creditor should disclose the true
position (per Lord Clyde in Smith v Bank of Scotland 1997 SLT 1061). Note
also the previous discussion about spousal guarantees.

15. What if the debtor had misrepresented the position, painting an overly
optimistic view of his own solvency?

Young v Clydesdale Bank (1889) 17R 231

Royal Bank of Scotland v Greenshields 1914 SC 259.
However, since Smith v Bank of Scotland 1997 SLT 1061 this rule is no longer
absolute. If a reasonable person would have suspected that a fraud is taking
place, a creditor no longer has an unfettered right to enforce the cautionary
obligation.
 This case is very important, as it imported from English law, for reasons of
policy, the decision in Barclay’s Bank v O’Brien [1994] 1 AC 180.

16. Is the guarantor entitled to relief from the debtor after honouring the
guarantee, even at a later date?

Smithy's Place Ltd v Blackadder and McMonagle 1991 SL T 790 (OH).

The creditor should also assign to the guarantor any security or other rights
than he may have had against the debtor (Thow’s Tr. v Young 1910 SC 588) if
the guarantor has had to honour the guarantee. This is known as the
beneficiam cedendarum actionum. See Bell’s Principles ss.255 and 558.

17. A guarantor has various defences to an action for payment under his
guarantee, but his defences may well be limited by the terms of the guarantee
itself.

Debt paid?

Premature?

Counterclaim?

Fraud?

Centriforce Engineering Ltd v Bank of Scotland 1993 SLT 190

Royal Bank of Scotland v Holmes 1999 SLT 563.

18. The distinction between a guarantee and an indemnity.

A guarantee is ancillary to a principal debt owed to a creditor by a debtor, and
only applies on the debtor’s default. It ensures that whatever the debtor ought
to have paid is paid by the guarantor.
An indemnity is a requirement to do something if something uncertain
happens, not necessarily the non-payment of a debt. The distinction is
significant because with a cautionary obligation if the underlying transaction is
avoided or unenforceable, the cautionary obligation falls, but with an
indemnity, even if the underlying transaction is avoided, the indemnity still
remains in place. See Yeoman Credit Ltd v Latter [1961] 1 WLR 828.

19. Judicial bonds of caution.

Certain persons who hold an office, such as insolvency practitioners, judicial
factors etc need to provide a bond of caution to act as security in case they
decamp with the money they have ingathered in the course of the insolvency
work or their judicial factory. The bond is lodged with the Accountant of
Court or Accountant in Bankruptcy or other relevant official.
 In court cases, if there is a doubt as to whether one party will ever be able to
meet the other’s legal fees, the dubious party may be asked to lodge a bond of
caution to ensure that funds would be forthcoming if he lost.
Other uses of caution are by executors-dative, messengers-at-arms and sheriff
officers.
In conveyancing, uncertain title problems may be dealt with by purchasing a
property bond.
In commercial matters, there are performance bonds which will pay out in the
event of the insolvency of or non-performance by the company being
guaranteed.
In international agreements, there are styles of demand guarantees used by the
International Chambers of Commerce.

20. Termination
On repayment, the guarantee is discharged, but where the debt remains unpaid
the guarantee remains valid, unless the guarantee states otherwise. Bankruptcy
of the debtor does not invalidate the guarantee (Bankruptcy (Scotland) Act
1985 s.60). The creditor is not however allowed to make the guarantor’s
position any worse than that which he undertaken to accept (see Huewind Ltd
v Clydesdale Bank plc 1995 SL T 392 (OH).

21. Death of the debtor prevents any further liability to the guarantor (Woodfield
Finance Trust (Glasgow) Ltd v Morgan 1958 SLT (Sh. Ct) 14).

22. Rights in security

A right in security is the process of putting an asset in the hands of a creditor

as security for an obligation to that creditor. The essential point of a security is
that it overrides the right of a trustee in sequestration or a liquidator. How this
is done depends on the type of asset.

Where the asset is a corporeal moveable asset, the process is known as

“pledge” or pignus in Latin.
It is important that for corporeal moveable assets the pledged asset is
physically handed over by the debtor to the creditor if the security is going to
work. Why is this?

Traditionibus, non nudis pactis, dominia rerum transferunter.

This is not very convenient for some things, so occasionally there will have to
be other means used, such as putting things under lock and key for the benefit
of the creditor: West Lothian Oil Co Ltd v Mair (1892) 20 R 64

Sometimes there will have to be symbolic delivery, so that a document e.g. a

bill of lading, as in Hayman & Son v McLintock (1907) 936.

A factor under the Factors Act 1889 ss.2,3 is allowed (assuming the owner
consents) to pledge his owner’s goods in his hands, and do so by pledging
documents of transfer.

However, note Sale of Goods Act 1979 s. 25(1) which protects a purchaser
acquiring assets subject to a retention of title clause.

For incorporeal moveable property, such as shares, there needs to be a

transfer together with an undertaking to transfer back on the fulfilment of the
 obligation (known as a fiduciary transfer or fiducia cum creditore). This
transfers ownership of the shares to the transferee for the duration of the
obligation. For shares. See Farstad Supply A/S v Enviroco Ltd [2011] UKSC
16.

For life policies it is usual to assign the policy to the creditor by a deed of
assignation, and at the end of the period of the loan or other obligation, the
creditor retransfers the policy to the owner by a deed of retrocession.

There are problems with the common law relating to pledges. See the case of
Hamilton v Western Bank, (1865) 19 D 152, which said that a when a delivery
order was transferred by way of security, the ownership of the goods passed.
This is thought to be wrong, because the point is that only the right to have the
goods delivered (i.e. to obtain possession) passed but ownership remained
with the owner.

Note also the Law Commission’s criticism of North Western Bank, Ltd v John
Poynter, Son and MacDonalds (1894) 22R (HL) 1, [1895] AC 56 – this case
refers to the apparent competency of a non-possessory security (a pledge)
over goods held on a bill of lading. The bill of lading was transferred by the
security holder back to the pledger to enable the goods to be sold and the
pledger was then acting as a trustee for the security-holder. You would of
course expect the pledge to be extinguished on return, and this raises
interesting questions of trust – could that trust defeat creditors? Who knows?

23. Pledges under the Consumer Credit Act 1974 ss. 114-122 – Pawn
 This only applies to non-corporate debtors. A pawnbroker can advance up to
£25,000 under the CCA by means of a pledge, with safeguards to allow the
pawner to redeem his goods, or if the goods are sold, to get back from the
pawnbroker any surplus on sale (s.121).

Watch out for provisions where the debt is under £75. If the goods are worth
less than £75, and the debtor fails to redeem the goods, the debtor forfeits his
title and the pawnbroker gets title after 6 months, even if the goods are worth
more than the loan (s.120). The pawnbroker can keep the surplus.
See also the Consumer Credit (Pawn-Receipt) Regulations 1983.

24. Maritime securities

Bonds of bottomry and respondentia
A bond of bottomry is a security over a ship when money is needed to help it
complete its voyage and which cannot be raised any other way. It prevails over
other creditors’ claims but not the crew’s wages.

A bond of respondentia is the same but is a security over the cargo under the
same circumstances.

The only interesting thing about these two securities is their ridiculous names.
They are virtually obsolete.
25. Statute now supplies many types of security, often know as a “charge”, such
as mortgages over ships under the Merchant Shipping Act 1995, registered at
the Register of British Shipping, and over aeroplanes under the Civil Aviation
Act 1982 s.86 and the Mortgaging of Aircraft Order 1972 (SI 1972/1268).

Companies can grant floating charges. This is done in Companies later in the
course. But if you’re sensible you’ll find out about them anyway.

26. Security or charges over land

As far as heritage is concerned, it is possible to grant a standard security over
land and buildings in Scotland (duly recorded in the register of Sasines or the
Land Register) with similar provisions in England (mortgages). This is done in
Property Law.

27. Patents and trade marks are assignable once they are registered (Registered
Design Act 1949 s.19, Patents Act 1977 ss.31-33, and Trade Marks Act 1994
ss.22-24)

28. Certain other types of rights in security arise by operation of law, these being
lien (a right of retention until payment, though with a requirement to get a
court order before sale (Gibson and Stewart v Brown and Co (1876) 3 R 328)).

There are “general” liens, (the normal one of retention) and “special” liens,
which are unusual but include an innkeeper’s lien, and solicitors’, bankers’
and factors’ liens.

An unpaid seller has a statutory right of retention so long as goods are in his
possession (Sale of Goods Act 1979 s.39(1)(a)).

26. A landlord’s hypothec is a specific type of security available only to landlords

over moveables, usually one where the goods are in the hands of the debtor. A
landlord can have a hypothec over his tenant’s own assets but no longer over
any sub-tenant’s assets. Under common law, the hypothec is up to the value of
one’s year rent. It only extends to commercial premises, and the Debt
Arrangement and Attachment (Scotland) Act 2002 limits further use
particularly as to the dates of operation and what may seized. The Bankruptcy
and Diligence etc (Scotland) Act 2007 s.208 restricts its applicability to giving
the landlord a right in security over the debtor’s assets but only on the debtor’s
sequestration or liquidation, and is a preference in the debtor’s sequestration or
liquidation to the extent of one year’s arrears of rent.

27. A solicitor has a hypothec over sums received by way of damages and is
entitled to take his expenses from them.

28. The normal rule about any form of pledge other than one regulated by the
Consumer Credit Act or one where the parties have expressly agreed to sale is
that the pledgee cannot sell the pledged goods without the consent of the
pledger or a court order. Any surplus has to be refunded to the pledger (see
Andrew Steven, Pledge and Lien 2008 para 8-11).