Have you provided good consideration for your guarantee?

Introduction

The use of a guarantee, whether to be provided by a bank, insurance company or the parent company of the contracting party, is common in commercial contracts, particularly in construction contracts. For example, an employer may wish to minimize the risks of a contractor’s non-performance or defective performance by requiring the contractor to take out a bond to guarantee its performance for an amount equivalent to 5% to 10% of the contract sum.

Lack of Good Consideration?

A classic example: Contracting parties (Party A and B) may agree that Party B shall secure a stipulated guarantee from the bank / an insurance company / Party B’s parent company (the Surety) in due course after the signing of the contract (underlying contract). In other words, at the time of the signing of the underlying contract, the guarantee has not been executed. After the underlying contract has been signed, upon the request of Party B, the Surety executes a guarantee in favour of Party A. Party A did not pay any fees to the Surety; the fees were paid by Party B, who is not a party to the guarantee. Was there any consideration for the guarantee? The fees paid by Party B are not valid consideration in law, as the consideration must move from the promisee (i.e. Party A) but not anyone else.

Can Party A argue that by previously entering into the underlying contract with Party B, Party A has provided the consideration for the contract of guarantee? On the face of it, the answer appears to be “no”, as it is trite law that past consideration is not good consideration in law (i.e. the underlying contract preceded the giving of the guarantee). However, case law demonstrates that where the giving of the guarantee can be regarded as substantially one single transaction together with the underlying contract, the court is willing to find good consideration moving from Party A as the promisee in the context of the transaction as a whole.

Single Transaction Analysis and Forbearance to Sue

In considering whether consideration is “past” consideration, the court is not bound to adopt a strictly chronological test. In the English case of Classic Maritime Inc v Lion Diversified Holdings Bhd & Anor [2010] 1 CLC 445, the Plaintiff, Classic, brought an action against the Defendant, Lion, under a written guarantee dated 28 August 2009 by which Lion guaranteed the obligations of its subsidiary, Limbungan, under a Contract of Affreightment (COA) with Classic dated 13 August 2008, i.e. the COA preceded the written guarantee. It was a term in the COA that Limbungan shall procure a guarantee to secure its performance. One of the defences raised by Lion was that the guarantee was unenforceable because any consideration given by Classic was past consideration.

Cooke J firmly rejected Lion’s defence and criticised this argument as “totally devoid of commercial sense”. He approved a passage in the authoritative textbook, Chitty on Contracts, that if the giving of the consideration (in this case, Classic entering into the COA with Limbungan) and the making of the promise (Lion’s giving of the guarantee pursuant to Limbungan’s obligation to procure the same under the COA) are substantially one transaction, the exact order in which these events occur is not decisive. Since the guarantee was specifically required by the COA, the reality was that the guarantee was given as part and parcel of a single transaction. As such, he found that consideration did move from Classic as the promisee in the context of the transaction as a whole.

A similar “single transaction” analysis has been adopted by the Hong Kong Court of First Instance in the case of Cargo Services Airfreight Limited v GKC Holdings Limited (HCA 18842/ 1998, 1 November 2000, unreported).

In addition to the single transaction analysis, the court in Classic Maritime was also ready to find consideration on the basis that forbearance to sue on a valid claim constitutes good consideration, i.e. thatwhen Classic accepted the guarantee, Classic was taken to have discharged Limbungan from its obligation to provide one under the COA. Consideration did move from Classic in giving up that right.

Conclusion

To avoid unnecessary disputes in relation to the validity of a guarantee for lack of consideration, it is preferable to execute the guarantee under seal or if that is not possible, to expressly state the consideration (namely, the underlying contract) in the guarantee.