A surety follows
A surety is an accessory security for a main obligation. This means that a surety follows the main obligation. The guarantor, an insurer or a bank, promises the same performance as the principal debtor. The object of a surety is therefore the performance of the obligation towards the principal. The guarantor is only obliged to do so within the limits of the main obligation.
Concretely, a surety can only exist for a valid agreement. The guarantor can therefore invoke all the exceptions of the principal debtor. This also means that when a surety is used, the guarantor can oppose the payment in case of disagreement and will only proceed with the payment when there is a final judicial decision in favour of the beneficiary, or when the principal has failed and is no longer able to perform his obligations.
A guarantee stands alone
A guarantee is an independent, abstract own commitment of the insurer or bank that is separate from the main obligation. This is a big difference with a surety and means that the guarantor cannot invoke the exceptions of the principal debtor based on the underlying contract. Even if the underlying obligation is null, the guarantor has to fulfil its obligation. Only in case of manifest abuse of rights (very narrowly interpreted) the guarantor can refuse to pay the guarantee formally called correctly.
The guarantee thus has both a collateral function and a payment function if called on first demand.
On first demand
Sureties as well as guarantees can be given on first demand. However, given the nature of the commitment, this 'first demand' is more and better used in a guarantee agreement. There it replaces the deposit-guarantee and the guarantor cannot obtain repayment from the beneficiary, but only from the originator.
First demand for of a surety means 'pay first, and then recover'. In that case, there is a reversal of position in the process and a reversal of the burden of proof. The beneficiary, with the sum of money in hand, steps into the role of defendant.
When to use a surety and when a guarantee?
It is clear that a guarantee is more risky for a principal because no link exists with any breach of the guaranteed contract. In any case, the guarantor will pay and all the principal can do is turn to the beneficiary afterwards in order to obtain reimbursement through the courts of any amounts that may not have been due.
As the principal, therefore, be cautious and try to avoid effectively issuing a guarantee during the contract negotiations or try to include in the guarantee text a number of conditions of the underlying contract that must be met in order for the guarantor to pay out. If there is trust between the two contracting parties, a surety, possibly on first request, offers a nice additional protection to the contractual agreement for the beneficiary.
The negotiating positions between, for example, contractor/producer and builder/customer obviously play a role. Fierce competition between contractors plays into the hands of the beneficiaries, who can thus make tough demands. For some large (public) projects with structured financing, financiers often expect bank guarantees on first demand.
Both the guarantor of a guarantee and a surety run a credit risk on the principal for exercising his right of recourse. This risk is greater for a guarantee than for a surety. The guarantor of a guarantee, unlike the guarantor of a surety, is also not placed or subrogated in the creditor's rights upon payment, which obviously increases the risk of the former. The conditions for granting will therefore differ for the two types.
Get good advice
Sureties and guarantees are often mentioned in the same breath and used interchangeably but they are two different instruments with different legal and economic implications. As a principal, be well advised when issuing a guarantee on first demand and be aware of the risks that such guarantees entail.
Both banks and insurers offer sureties and guarantees. Discover five good reasons why a specialized insurer is the best option.
At Euler Hermes, we are specialized in sureties and guarantees for real estate projects, international trade, capital goods producers and construction and installation. Read more about it here. Or feel free to get in touch with us.