The case of Pitts & ors v Jones [2007] concerned the shareholders of a company, HM Shopfitting Ltd. The appellants were employees and minority shareholders in the company, while Andrew Jones, the respondent, was the managing director and majority shareholder. The Court of Appeal had to decide on two facts:

(1) whether an undertaking that was given by Mr Jones to the employees amounted to a contract supported by consideration; and

(2) if any such contract had been made between the parties, whether it was one of guarantee or indemnity.

Background

Mr Jones reached agreement in principle to sell his 700 shares in the company to a third party. A price was agreed but the agreement was subject to the fact that three employees (holding 50, 50 and 25 shares respectively) had rights of preemption in terms of the articles of association of the company, which entitled them to buy out shares being sold. He informed the employees of his intention to sell his shares and of their right to buy the shares themselves at the price agreed with a third party. He also advised them that the third party had offered to buy the employees’ shares at the price to be paid for the majority shareholding. The employees agreed to sign waivers of their right of pre-emption and to sell their shares to the third party.

Subsequently, Mr Jones agreed with the third party that the purchase would be in the name of a company called WG Birch Ltd (Birch). The price was to be paid in instalments and Birch was to borrow the purchase price from the company. Such an arrangement is contrary to s151 of the Companies Act 1985 and so a resolution needed to be passed at a company extraordinary general meeting (EGM). The meeting was called at short notice.

During the meeting Mr Jones’s solicitor told the employees that their shares were to be paid for in later instalments than those being paid to Mr Jones for his shares. In addition, he advised them that there was no security available to cover the payment due to the employees. This meant that the employees had no protection in the event of Birch failing to pay or becoming insolvent before their shares had been paid for. On the basis of this information, the employees were unwilling to sign the option agreements for the purchase of their shares by Birch. Mr Jones then gave the employees an undertaking that if Birch did not pay them for their shares, he would make the payment. The employees requested a written undertaking to this effect. However, this was not granted, based on advice Mr Jones received from his solicitor. On the basis of trust, the employees accepted Mr Jones’s verbal promise.

Mr Jones subsequently received the money for his shares from Birch, less a deduction to take account of bad debts of the company. Before the employees received payment for their shares, Birch became insolvent and so the employees never received payment for their shares. They requested the money from Mr Jones, who refused to pay the price that the shares were originally to be sold for. He offered them a reduced sum being a share of the money he had received from Birch, divided on a pro rata basis. The employees did not accept this offer and sued for the original value of their shares.

Initial decision

In the initial decision the recorder held that Mr Jones’s undertaking was not a contractual promise because it was unsupported by consideration and therefore of no legal effect. The recorder also held that even if that conclusion were wrong, the claim by the employees would still fail. If there was a contract between the employees and Mr Jones it was a contract of guarantee and unenforceable because it was not evidenced in writing and signed by or on behalf of the guarantor.

In the Court of Appeal

The employees appealed the decision to the Court of Appeal. The Court concerned itself with two questions:

(1) Was Mr Jones’s promise supported by consideration?

(2) Was his undertaking enforceable? The Court was of the view that in order to succeed in their appeal, the employees needed an affirmative answer to both these questions.

The consideration point

The Court held that the employees did give consideration to Mr Jones. The option agreements had been arranged as an inducement to the employees to dissuade them from exercising their rights of pre-emption. In addition, there was a clear link between Mr Jones’s offer of the undertaking and the employees’ willingness to sign the share agreement documentation and to agree to the shortnotice EGM. According to the Court that amounted to good consideration, even though there may not have been conscious thought to give consideration. The undertaking was therefore said to be a contractual agreement between the parties.

The enforceability point

The Court agreed that the contractual agreement appeared to be a guarantee. Therefore, in order to be enforceable in accordance with s4 of the Statute of Frauds 1677, the guarantee had to be in writing and be signed by the guarantor or a person authorised by the guarantor.

In reaching this decision the Court reviewed a number of authorities. In the case of Sutton and Co v Grey [1894] the interest of the person making the promise was key to determining whether the contract was one of guarantee or indemnity. If there was only a promise to pay, it was regarded as a contract of guarantee. However, if the promisor was to derive some benefit, it was regarded as a contract of indemnity. The distinction is important because the formalities set out in the 1677 Statute do not apply to contracts of indemnity.

Another case considered by the Court was Harburg India Rubber Comb Company v Martin [1902]. Here an indemnity was described as creating ‘a new liability which is undertaken by the promisor’ – quite different from a guarantee which bears reference to the debt of another party.

The Court looked at Mr Jones’s interest in relation to both aspects of the transaction, namely his share sale to Birch and the signing of the share option agreements by the employees. It did not conclude that these were parts of the same single transaction, rather they were separate. It held that the promise given by Mr Jones was in relation to the share option agreements and since there was no potential of either liability or benefit in relation to those agreements to him, the promise was a guarantee; as it did not comply with the strict formalities of the 1677 Statute, the guarantee was unenforceable.

Comment

Extending what amounts to consideration

It is a basic rule in English contract law that a contractual promise with no consideration in return is not recognised as enforceable, unless it is contained in a deed (see box opposite for the principles relating to a deed). The principles relating to deeds are not affected by this decision, but given that contracts can be verbal and also written ‘under hand’, these simple forms of contract may be affected by the way the Court determined that there was good consideration. Whereas the general rule was that actual consideration was required in exchange for a promise, what can amount to consideration appears to have been extended. In this case, even though there appears to have been no conscious intention to give consideration in exchange for Mr Jones’s promise, the employees were regarded as having given good consideration by their actions.

Guarantees and indemnities: distinguished and extinguished

The clear distinction between a guarantee and an indemnity is straightforward enough. A guarantee is required to have been in writing and to be signed by or on behalf of the party giving the guarantee to be effective. In addition, any variations of the guarantee are also required to be in writing. There are no statutory formalities required for a contract of indemnity.

The difficulty lies in the fine distinction between whether the obligation promised is a guarantee or an indemnity in the first place, so as to determine how it should be documented in order to be enforceable. A guarantee is used where it is the intention that the guarantor stands in for another’s failure to perform, whereas an indemnity is used where the person making the promise is primarily liable.

In this case, the Court looked at the level of interest the promisor had in the transaction and distinguished between having a motive to give a promise and having a real interest. The Court drew the conclusion that there was a promise to satisfy the liability of another. To ascertain fully that the contract was therefore one of guarantee, the Court asked the question: ‘What was the subject matter of the transaction or contract in which the… promise was made?’ First of all the Court agreed with the view that although the two aspects of the transaction, namely the share purchase options and the sale of Mr Jones’s shares, were linked, they did not merge so as to be the same subject matter. The Court only saw the promise being made in respect of the share purchase options. The decision was made that to have a real interest, there needed to be some benefit to the party in response to honouring the promise. It was concluded that there was no such benefit to the promisor in this regard and therefore it could not be the case that the promise extended so as to be a contract of indemnity.

Limitations of guarantees

Guarantees and indemnities are often used together in property transactions. The obligations of a guarantor are no greater than those of the party whose obligations are being guaranteed. This is known as the co-extensive principle. This principle also operates at the time of the extinction of obligations under the main contract whereby the obligations of the guarantor will extinguish at the same time as those under the main contract. Another example of the discharge of a guarantee could be in the event of partial satisfaction of a contract extinguishing the guarantee because the guarantee is not expressed to be a continuing obligation. In such a case even if the indemnity is part of the same clause, the indemnity could remain in force. In addition, any variation to the main contract (without the consent of the guarantor) usually has the effect of discharging the guarantee entirely.

A recent case where this was not the outcome was Wittman (UK) Ltd v Willdav Engineering SA [2007]. In that case the parent company that had given the guarantee and indemnity was aware of the alterations to the original contract with the inclusion of financing arrangements. This knowledge was sufficient to keep the guarantor responsible for the obligations under the original contract not affected by the alterations. The alterations were not regarded as a complete discharge of the original obligations and the grant of new contracts. The Court of Appeal did make the point, however, that contrary to the decision of the judge at first instance, the guarantee would not have extended to new contracts in the event of the original contract having been discharged.

It is as a result of the various rules relating to guarantees that many contracts of guarantee are contracts that include indemnities against potential losses also. Indemnities are stand-alone obligations and are not affected by the rules for guarantees. They do, however, need to be in exchange for consideration. All that said, there should also be a word of caution that those granting guarantees and who are also required to give indemnities should be careful not to extend their obligations, by virtue of the terms of the indemnity, beyond that originally envisaged by the guarantee.

Consider your options carefully

No doubt the outcome of this case will focus attention on the level of undertaking that the parties intend to grant generally. In lease transactions, authorised guarantee agreements are frequently requested from outgoing tenants in order to protect the landlord’s investment. Giving such guarantees is regarded as an improvement on leases granted before 1996 where there is ongoing liability under the privacy of contract rules. However, there is still great risk to the outgoing tenant by granting the guarantee, as the outgoing tenant has little or no control over the actions of the incoming tenant. The outgoing tenant may of course obtain an indemnity from the incoming tenant in order to protect against losses under the guarantee. This will go some way to protect the outgoing tenant’s position although a note of caution is that protection is not absolute, for example in the case of the incoming tenant becoming insolvent.