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Principles Of Business Law - CHAPTER IV
























































Sec. 31. Introduction. Although security often takes the form
of a lien on property, credit may be extended upon the combined
financial standing of the debtor and some third person.
StrrceTfiuchof the business carned~~on today is conducted by
agents, it becomes necessary for the principal to exact the utmost
honesty and good faith of his agent in the performance of his duties.
Whenever the principal is unwilling to repose such confidence in
the agent alone, he usually obtains what is known as a bond for
faithful performance, which is signed by the agent and some third
party. This bond also amounts to a contract of suretyship. A
contract of suretyship, therefore, appears to have for its objective,
security either for the payment of money or for the faithful per-
formance of some other duty, in the latter case often being known
as fidelity insurance.

The person primarily bound to perform is known as the principal
or principal debtor; the party secondarily liable is called the surety
or guarantor; while the party entitled to performance is custom-
arily spoken of as the creditor.

Sec. 32. Nature of relation. Whenever, as between two par-
ties, one of them is primarily liable and the other secondarily liable
for the faithful performance of an obligation, a suretyship relation
exists. As soon as interested third parties learn of this status, they
become bound to treat it as such. To illustrate: Let us assume
that A and B are partners in the mercantile business. A disposes
of his interest in the firm to B, who assumes all outstanding obliga-
tions. A suretyship relation immediately comes into existence;
B is primarily liable and A is secondarily liable. As soon as the
creditors are notified of the new relation, they are called upon to
treat A as any other surety.

The same general situation arises where a mortgagor of property
disposes of his equity to one who is willing to assume the mortgage
debt. The mortgagor becomes in effect a surety for the faithful
performance of the purchaser.

Sec. 33. Results from contract. The suretyship relation re-
sults from a contract. This contract, like any other, must be sup-



ported by some consideration. In addition, the Statute of Frauds
requires aiTapeemeM^^^reby one is to become responsible for the
debt, default, or miscarriage of someone else, to be in writing.

The duties assumed by the surety are largely determined by the
contract terms. In the absence of a stipulation to the contrary,
the suret^J^ responsible only for the future_cond^ct of ihi3j3rincipaL
The contract^oeslTotTelale^to pasTTransactions or conductoTthe
principal, unless there is a definite stipulation to that effect, because,
in the interpretation of ambiguous language, the courts tend to
favor the voluntary unpaid surety at the expense of the third
party. The courts incline to give words their normal meaning, even
though it works a hardship upon the surety because of language
unhappily employed, but, if the meaning is uncertain, they construe
it most strongly against the user. In the case of unpaid sureties,
the language is usually framed by the creditor, and so is construed
against him.

It should be noted that defenses of a personal nature which the
surety may have against the principal debtor are not available
against the creditor. A surety who is persuaded to become such
because of misrepresentations made by the principal is nevertheless
liable to the creditor. Similarly, an understanding between the
surety and the principal that the obligation will not be effective
until signed by some third party cannot affect the rights of the cred-
itor. 1 Even the failure of the principal to pay the premium re-
quired by the surety does not relieve the latter of his duties to the

Sec. 34. Fiduciary relationship. The suretyship relation is one
of trust and confidence. In ordinary contracts one party in posses-
sion of vital information is under no duty to disclose it to the party
with whom he is contracting. The rule governing the formation of
a contract of suretyship is different, however. A creditor in posses-
sion of unusual and important facts must impart those facts to the
surety at the time the agreement is made. Failure to do so justifies
rescission by the surety and permits him to evade liability. The
courts deem it unfair to permit a creditor to take advantage of a
suretyship contract when he knows that the surety is unwittingly
assuming an unusual risk. An employer who is aware of past de-
falcations or embezzlements of an employee must make such fact
known to anyone who assumes the suretyship relation in his favor.
Likewise, a surety is released if the creditor is aware that the surety
is relying upon misinformation and he fails to warn the surety of
his error.

An employer who discovers that an employee has been guilty

1 Watkins Co. v. Brund et al., 1931, 160 Wash. 183, 294 Pac. 1024; p. 788.


of misappropriation of funds should immediately discharge him.
Failure to do so releases a surety from liability for future defaults.
An employer who desires to give such an employee his "second
chance" can safely do so only with the consent of the surety.

Sec. 35. Duration of relation. A surety who becomes respon-
sible for the faithful performance of a particular contract continues
as such so long as the principal and creditor operate under the orig-
inal agreement. The liability terminates with the complete per-
formance of the contract.

Some question arises where a surety agrees to be responsible for
goods of a certain kind sold to the principal. Thus, A signs the
following writing: "Let bearer have what leather he needs. Charge
it to him and I will see you paid." In this and similar cases special
attention is given to the specific language used, in an attempt to de-
termine the intention of the parties. However, in many instances
it is not clear whether A becomes surety for only one transaction or
many. The general rule is that a guaranty unlimited as to amount
or time covers one transaction only. 2 If it is limited as to amount,
but not as to time, it is considered a continuing guaranty; that is,
it covers all goods sold from time to time, but the amount of the
unpaid balance for which the surety continues liable may not be in
excess of the amount stated in the agreement. A guaranty of gen-
eral credit which carries a limit on its duration but none as to
amount is impliedly limited to a reasonable amount. The existence
of a surety does not authorize the creditor to extend credit in excess
of the reasonable needs of the debtor. Difficulty in such cases
might be avoided by a more elaborate agreement setting forth the
terms somewhat in detail.

A continuing guaranty can be terminated at any time the guaran-
tor desires. As soon as his notice of revocation is brought to the
attention of the creditor, his liability for future obligations ceases.
He remains responsible, however, for all obligations created prior to
the receipt of his notice by the creditor. Death or insanity of the
guarantor automatically revokes a continuing guaranty. The ma-
jority of the courts do not require the giving of notice to the creditor
in such cases.

Sec. 36. Surety and guarantor. Thus far, mention has been
made of both surety and guarantor. In certain respects there is a
difference in the two relations, although the vast majority of the
rules are applicable to both relations. Therefore, unless a distinc-
tion is made in the subsequent sections, it may be assumed that the
laws of suretyship apply also to guaranty.

Technically speaking, asurety is liable jmnjblyj\j^

Joseph Card v. James E. Stevens, 1864, 12 Mich. 292; p. 789.


and may be sued with him_on_the contract, Ajguar_an tor's liability
arigesjromjmjndependen A guaranty may be either

absolute or conditional. An absolute guarantor warrants perform-
ance by the principal and becomes liable as soon as the principal
fails to perform. His liability is almost identical with that of the

A conditional guarantor usually warrants that the creditor will
be able to force performance by the principal. A guaranty of col-
lectibility is conditional, the condition being the creditor's inability
to collect. In such cases the guarantor is entitled to notice within
a reasonable period after default ; the surety and absolute guarantor
are not entitled to such notice, unless required by the terms of the

Rights of Creditor

Sec. 37. Immediate recourse to surety. The surety becomes
liable to the creditor as soon as the principal defaults in the per-
formance of his duties ; the creditor need not exhaust his remedies
against the principal before looking to the surety. This rule seems
to be true, although the creditor has in his possession securities
placed with him by the principal. He may immediately resort to
the surety without disposing of the securities.

Where several sureties are jointly liable, the creditor may join
all of them in one action and, after obtaining judgment, recover the
entire amount from any one of them. The claim, unless the credi-
tor has agreed otherwise, is entire and need not be divided for the
convenience of the sureties.

Sec. 38. Subrogation. Sjjbrogationjs the_substitution ofone
^^ rights which theJatteFKas

against__a third .j^arty. Securities placed witE the surety by the
principal for the protection of the former in case the latter defaults
may be made available to the creditor. 4 To the extent of his claim,
the creditor may substitute his position for that of the surety, with
reference to the securities. Thus, it has been held that, in the event
of the return of securities by the surety to the principal, the creditor
is entitled to follow them into the hands of the debtor and subject
them to a lien in his favor. This rule applies only where the rights
of innocent third parties have not intervened. He may also secure
an injunction against their return to the principal, thus having the
securities impounded by the court until the principal debt falls due,
at which time they may be sold for the benefit of the creditor.
The right of subrogation does not exist where the securities are

3 See form #9.

"First National Bank v. Davis et al., 1901, 87 Mo. App. 242; p. 789.


left with the surety by some third party. The theory is that se-
curities placed with the surety form a trust of that portion of the
estate of the principal which he sets aside for the payment of his
debt. Securities belonging to third parties do not form part of the
principal's estate, and, therefore, are not subject to subrogation.

Rights of Sureties

Sec. 39. Extension of time. The creditor should be careful not
to extend the time for performance without the consent of the
surety. An agreement between the principal and the creditor,
which definitely extends the time within which performance may
be demanded, releases the surety. The reason for this rule is that
thj3jmancial status of the principal may become less
thejperiod of the extension. Such a change in

would work to the disadvantage of the surety. The^court does not
consider in each case whether the position of the surety has been in-
jured by the extension, but merely applies the general rule that an
extension of time releases the surety.

Mere indulgence upon the part of the creditor, or passively per-
mitting the debtor to take more time than the contract calls for,
does not release the surety. The latter is in no sense injured by
such conduct, because he is free at any time to perform on his part
and immediately start suit against the principal. The surety is not
discharged unless there is a binding agreement between the princi-
pal and the creditor for a definite period of extension.

The consent of the surety may be obtained either before or after
the extension has been granted. Consent given after the extension
amounts to a waiver of the right to rescind and is valid, although
it is not based upon any new consideration. Notice to the surety
that an extension has been granted, or a failure on the part of the
surety to reply to a request seeking permission to extend, is not
equivalent to consent. In the latter case, silence should act as a
warning not to grant the extension, since the surety is apparently
unwilling to extend the risk.

Sec. 40. Extension with rights reserved. An extension of
time by the creditor, in which the extension agreement stipulates
for reservation of rights against the surety, does not release the
surety. Such an extension is conditional and does not bind the sur-
ety. He is free at any time to complete performance for the prin-
cipal and immediately sue him for damages suffered. To illus-
trate : S becomes surety for P on a note in favor of C. The note
falls due on a certain date, and P requests from C an extension of
ninety days. The extension is granted with the express stipulation
that C reserves all rights against S. S is not released, although he


receives no notice of the transaction. He is still entitled to pay the
debt at any time he desires and to turn to P for reimbursement.

An extension of time in which the surety is amply protected by
securities placed with him by the principal, does not effect a dis-
charge. In such a case it is impossible for the surety to be damaged
by the extension.

A third exception to the rule concerning an extension seems to be
in the process of development by the courts. In several cases it has
been held that a paid surety one who has received some compensa-
tion for the risk which he assumes is not released unless he is dam-
aged as a result of the extension of time granted to the principal. 5
In such a case the surety is released only when he can show that the
ability of the principal to perform has perceptibly weakened during
the period of extension.

An extension of time on an obligation arising out of a continuous
guaranty does not release the guarantor except where the maximum
liability is thereby exceeded. To illustrate, let us assume that G
guaranteed payment of goods sold to P by C up to a maximum of
$10,000. If a claim for $3,000 falls due, an extension of time by C
will not release G as long as other claims in addition to the $3,000
do not exceed $10,000.

Sec. 41. Change in contract terms. Any material change in
the terms of the contract between the principal and the creditor,
without the consent of the surety, discharges him. Inasmuch as
the principal contract governs the surety's liability, any change in
its terms must be assented to by him.

A discharge of the principal debtor, or of any one of them if there
are two or more, unless assented to, releases the surety. This rule
is subject to those exceptions existing in the case of an extension of
time; that is, the surety is not released if the principal debtor is
discharged with reservation of rights against the surety, or if the
surety is protected by securities.

Sec. 42. Payment. The surety is discharged by payment, or
tender of payment, by the principal. Whenever a payment is made
by a debtor who owes several obligations, he has the right to desig-
nate which item shall be credited with the payment. In the ab-
sence of any instructions, however, the creditor is at liberty to apply
it where he desires. A creditor who holds both secured and unse-
cured claims, in the absence of instructions to the contrary, would
naturally credit all payments against the unsecured items. The
surety is not in a position to object to this practice. His protection

6 Murray City v. Banks et al, 1923, 62 Utah 296, 219 Pac. 246; p. 790.
6 Magazine Digest Pub. Co., Limited v. Shade et al., 1938, 330 Pa. 487, 199 Atl. 190;
p. 791.


lies in his persuading the debtor to stipulate that the payments
shall be applied upon the claim which is secured by the surety. In
the absence of instructions by the debtor or of a particular applica-
tion by the creditor, the court applies the credits against the obliga-
tions in the order of their maturity.

The mere receipt of a note or check of the principal debtor by the
creditor does not release the surety, as the debt is not paid until the
note or check is honored. If a new note is given in settlement of an
old one, the old one being canceled and returned, an extension of
time has taken place, which releases the surety. Where both notes
are retained by the creditor, the courts hold that the second is
merely collateral to the first and the surety is not released.

Sec. 43. Defenses of principal. Defenses available to the prin-
cipal may be asserted by the surety against the creditor. Such de-
fenses as mistake, fraud, undue influence, and lack of consideration
may be taken advantage of by the surety. The defenses of infancy
and bankruptcy form exceptions to this rule. In these instances
the surety is required primarily to avoid any loss resulting from
such situations.

Similarly, the surety may set off against the creditor any claim
which the creditor owes him. If the creditor calls upon the surety
to pay the principal's obligation of $500, the surety may deduct any
amount which is due him from the creditor. Thus, it may be said
that the surety can interpose either his own or his principal's de-
fenses against the creditor.

Sec. 44. Subrogation. The surety who fully performs the ob-
ligation of his principal is subrogated to the creditor's rights against
the principal. The surety who pays his principal's debt becomes
entitled to any securities which the principal has placed with the
creditor. Likewise, if the creditor has obtained a judgment against
the principal, the surety receives the benefit of the judgment when
he satisfies the principal's debt. Where the creditor has^ collateral
as^ general security for _ajvumber of^bjigations,_ the sjorety s right
o^^tbrogatioi^ does notjinsejL^^ obligations are satis-

fied/ It should be noted that subro^atioF^pplies^nly toTogKTs" of
tfte creditor against the principal. If some third person, to secure
the principal's debt, also pledges collateral to the creditor, the surety
has no equity in the security, although the creditor calls upon him
to satisfy the debt.

A creditor in possession of collateral given to him by the principal
is not at liberty to return it without the consent of the surety. Any
surrender of securities releases the surety to the extent of their
value, his loss of subrogation damaging him to that extent. Failure
of the creditor to make use of the securities, however, does not re-


lieve the surety, since the latter is free to pay the indebtedness and
to obtain the securities for his own protection.

Sec. 45. Recovery from principal. Every contract of surety-
ship carries an implied term that the principal will reimburse the
surety for any loss caused by the principal's default. Normally,
the surety is not permitted to add any attorney's fees which he has
been compelled to pay on his own behalf by way of defense, or fees
paid to the creditor's attorney. All attorney's fees can be avoided
by performance of contract terms; when the principal fails to per-
form, it becomes the immediate duty of the surety to act. Attor-
ney's fees incurred in a bona fide attempt to reduce the amount of
the recovery form an exception to this general rule.

The surety may recover only the amount paid by him. Thus, if
he settles a claim for less than the full amount owing the creditor,
his right to recover is limited to the sum paid under the settlement.
Furthermore, bankruptcy on the part of the principal, although it
takes place before the surety is called upon to perform, releases him
from further liability to the surety.

Any securities falling into the possession of the surety at the time
he settles his principal's obligation may be disposed of so far as is
necessary to extinguish the surety's claim for indemnity.

Sec. 46. Cosureties' liability. Cosureties exist whenever two
or more parties become liable for the faithful performance of the
principal. The creditor may compel one surety to pay the entire
claim, it not being necessary for him to distribute the loss among
the various sureties. This leaves the burden of recovery from the
other sureties upon the surety first paying the claim.

An extension of time to one of the cosureties or the release of one
of them does not necessarily discharge the rest of the sureties. It
merely releases the remaining sureties of the share which the fa-
vored one should have paid, they remaining liable for their portion
of the obligation.

Sec. 47. Right against cosurety. There is an implied contract
among cosureties that each shall assume the same risk, unless they
have fixed different amounts for their maximum liability. In this
event, they agree to share the loss in proportion to their maximum
liabilities. Because of the implied contract, any surety who settles
the claim of the creditor may recover from his cosureties their pro-
portionate share. 7 Should certain of the sureties prove to be insol-
vent or residents of another state, the loss is first divided among the
solvent sureties within the state. 8 Each contributing surety then
possesses an independent action against the insolvent or nonresi-

7 Acres v. Curtis, 1887, 68 Tex. 423, 4 S.W. 551; p. 792.

8 Smith et al. v. State of Maryland, 1877, 46 Md. 617; p. 794.


dent surety for the amount which he paid on behalf of that inca-
pable cosurety.

A surety has no right to contribution until he has paid more than
his share of the outstanding claim. As soon, however, as he pays
more, he may recover the excess from any of the cosureties, provided
the cosurety is not compelled thereby to pay more than his share.

No surety has a right to profit at the expense of a cosurety. Nei :
ther has he a right to reduce his personal risk by secretly procuring
collateral from the principal debtor. Any such collateral, obtained
either before or after he became a surety, must be held for the bene-
fit of all the sureties. 9 It is possible, of course, for all the sureties
at the time they become such to agree that one of them may be
favored by receiving collateral for his protection, but, in the absence
of such an arrangement, all have a right to share in the collateral
held by one.

Review Questions and Problems

1. What are the purposes of a contract of suretyship? What arc the
three parties to a suretyship transaction usually called?

2. Suppose S signs a statement to the effect that he will be second-
arily liable for groceries, not exceeding $300, furnished to X. How long
will such a guaranty continue?

3. Must the creditor first sue the principal before he attempts to re-
cover from the surety?

4. S became surety for his brother P and for protection was given cer-
tain bonds owned by P. Both S and P became insolvent and S was con-
sidering the possibility of returning the bonds to P when C, the creditor,
brought a bill to have the bonds impounded for his protection. Was he
entitled to do so?

5. What is the effect of an extension of time allowed to the principal
by the creditor? Is the surety bound if he assents to the extension after
it takes place? How would you extend the time for performance and
still expect to be able to look to the surety?

6. C held an obligation of P's upon which S was surety. C permitted
the obligation to run several years past its maturity date, although the
interest was always paid. No definite extension period was ever agreed
upon between P and C. After a number of years, although within the
period required by the Statute of Limitations, C attempted to recover
from /S. Should he have been allowed to recover?

7. What is meant by subrogation? Is the surety entitled to subroga-
tion after he has only partially performed his principal's obligation?
What effect upon the liability of the surety has the surrender of securities
by the creditor to the principal?

8. A and B are sureties upon an obligation of P. At the time A be-
came a surety he obtained a mortgage from P upon certain personal

e Hoover, Appellee v. Mowrer et al., 1891, 84 Iowa 43, 50 N.W. 62; p. 795.


property, to protect himself in case P defaulted, P failed to perform and
A and B were compelled to carry out the agreement. Did A hold the
mortgage for his own protection alone or for the mutual protection of the
sureties? If you were A, how would you arrange the matter to protect
yourself only?

9. What is the effect of insolvency of one of the sureties upon the lia-
bility of the other sureties? May one of the sureties recover from the
others if he has paid no more than his share, although the others have
as yet paid nothing? What is the result of a discharge of one of the
sureties by the creditor?

10. If you hold various obligations of P, some secured by sureties and
some unsecured, and a payment is received, have you a right to apply it
on the unsecured claims, although the secured claims are due first?

11. A and S signed a mortgage note in favor of P for $15,000, it being
known to P that S was merely a surety. Some time later, A became
insolvent and P accepted $7,000, discharging A from further liability.
May P recover the $8,000 balance from SI

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