Section 4 of the Statute of Frauds 1677 provides that contracts of guarantee must be in writing and must be signed by or on behalf of the guarantor. In Pitts v Jones [2007] EWCA Civ 1301; [2008] 1 All ER 941, the Court of Appeal considered the effect of an oral promise that the majority shareholder of a company would pay minority shareholders the sums that a third party had promised to pay for their shares should the buyer fail to make the payments when they fell due. The court rejected the minority shareholders’ argument that the promise constituted a contract for indemnity. It decided that the promise was an unenforceable guarantee.
Guarantees and indemnities play a key part in property transactions. However, section 4 of the 1677 statute applies only to guarantees. Consequently, promisees must be able to recognise when a promisor is entering into a contract of guarantee, as opposed to one of indemnity.
Indemnity agreements enable one party to look to another to defray losses. A guarantee is a specific type of indemnity that obliges the promisor to pay the debts of another party. One of the tests used by the courts to distinguish between the two contracts has been to ask whether the promisor has a real interest in the underlying transaction. If it will derive some benefit, the contract is one of indemnity; if it is totally unconnected with the transaction, the promise constitutes a guarantee. The Court of Appeal explained that the court must ascertain the object of the contract or transaction. If the obligation to pay the sums promised is incidental to the contract or transaction, the obligation will constitute an indemnity. If it is the central obligation, it will constitute a guarantee and must comply with section 4. It is also important to note that the courts may treat transactions as separate, even though they may be linked.
The decision also reminds us that some form of consideration must pass between the parties to a legally binding contract. The legal status of the offer to pay in this case was also in doubt because the minority shareholders did not provide any obvious consideration for the promise that was made to them. The Court of Appeal eventually decided that the minority shareholders had co-operated with the majority shareholder as a result of its promise to pay. This constituted “consideration”, even though the shareholders did not consciously realise that they were providing consideration for the promise made to them.
The case underlines the importance of compliance with all the formalities. A guarantee must satisfy the requirements of section 4 of the 1677 statute. However, a promise to pay that meets the requirements of section 4 will none the less be unenforceable unless the promise constitutes a contract, because it is supported by consideration, or, alternatively, is made in a deed. Consequently, it is best practice to ensure that guarantees are executed as deeds.
Allyson Colby is a property law consultant