Redefining Variance: Making Surety Bonds Effective

[By Smriti Jaiswal]

The author is a student of National Law University of India, Bangalore.

 

Introduction

In January 2022, the Insurance Regulatory Development Authority of India (‘IRDAI’) released IRDAI (Surety Insurance Contracts) Guidelines, 2022 for India’s emerging surety bonds market. As the current guidelines stand, the surety bonds in India shall be treated as a contract under Section 126 of the Indian Contracts Act 1872 (‘ICA’).

Section 126 of ICA defines a special type of contract – the Contract of Guarantee – and the subsequent Sections 127-147 of ICA lay down the law for governing such contract. Therefore, the existing principles of suretyship as interpreted by the courts within the confines of ICA will be applicable to surety bonds. This means that even Section 133 of ICA which deals with discharge of surety by variance in terms of contract will be applicable to the surety bonds. This would act  as a hindrance in the growth of the surety bonds market as there are remarkable differences in surety contracts as envisaged under ICA and surety bonds. Therefore, this paper argues that the position of law for Section 133 should not be applied to surety bonds for the sake of economic efficiency and infrastructural growth.

Firstly, this paper analyses the position of law in India with respect to Section 133 of ICA by tracing case laws from 1920 to 2021. Secondly, the key differences between surety contracts as envisaged under ICA and surety bonds will be highlighted to show that the effect of applying Section 133 to surety bonds will be unfavorable for the emerging surety bonds industry. Thirdly, the potential solutions will be explored for promoting the surety bond growth in India.

Legal Position of Section 133 under ICA
a.      Section 133: General Explanation

Section 133 of ICA states that the surety is discharged from his obligation if any alteration (‘variation’) is made in the contract without his consent. This is based on the principle of equity and consent of the parties. [1] The liability of a surety is stricissimi juris as surety is considered a favourable debtor and he receives no benefit or consideration. This is the strict rule of variance where even a slight change would be considered variance without any inquiry into its materiality or effect on the surety. This strict rule was rejected in Holme v. Brunskill stating that if the change in the contract is prima facie unsubstantial or for the benefit of the surety then surety may not be discharged; yet, if the court cannot conclude that the change is unsubstantial or cannot be prejudicial to the surety, the surety shall determine whether to continue or be discharged with the contract. The strict rule was also criticized for being repugnant to justice and common sense as it would render various contracts unenforceable.

The shortcomings of the strict rule led to the emergence of materiality of variance rule. Therefore, the Bombay High Court in Keshavlal Harilal Setalvad v. Pratapsing Moholalbhai Sheth stated that – if any material variance is made in the terms of the contract, the surety alone is to judge whether he should undertake the burden in respect of the new contract or not. Section 133 discharges the surety once a material variance is made without his consent in the contract of continuing guarantee but not in cases of trivial or unsubstantial changes.

b.     Materiality of Variance Rule

The materiality of variance rule is not crystal clear in itself. The courts grappled with the challenge of determining what constitutes material variance and what does not. Though materiality is to be decided on a case-to-case basis, a trend can be observed in Indian case laws revealing the main factors to be considered for determining the materiality of variance in contracts.

  1. Would surety have agreed if the variance was known while entering the contract (hereinafter ‘would have entered test’):

In the case of D.K. Mohammad Ehiya Sahib v. R.M.P.V.M. Valliappa Chettiar, the Madras High Court stated that if upon revealing the variance made in the contract to the surety while entering the contract would have prevented him from becoming a part of the contract, then the variance is material. The test assumes a reasonable man standard for determining the surety’s judgement about the variance.

  1. Contemplation of Parties (hereinafter ‘contemplation test’):

In the case of Parvatibai v. Vinayak Balwant Jangam, the Bombay High Court stated that if the contractual parties had contemplated the variance while entering the contract, then the variance is not material. This test shows a wide departure from the strict rule. The surety could be made liable for something more than he agreed if he could reasonably foresee the variance. However, the court made it clear that the nature of the contract should not be altered.

  1. Intention of Parties (hereinafter ‘intention test’):

The Supreme Court in MS Anirudhan v. The Thomco’s Bank Ltd., said that if the variance is made in order to give effect to intention of the parties or something that parties unintentionally omitted, then the variance is not material. This intention should be apparent on the face of the deed. The Madras High Court applied this intention of the parties test in S. Perumal Reddiar v. BoB while dealing with the question whether filling in the material information after obtaining the surety’s signature would amount to variance. The court held that any material additions cannot be done once the surety has consented to the contract. The case of Lachmi Rai v. Srideo Rai was referred to show that addition of any word unintentionally omitted in the original contract shall not amount to material variance.

  1. Beneficial to the Surety (hereinafter ‘benefit test’):

While in Holme’s case, the court said that the surety “may not be discharged” if the variance is beneficial to the surety, Indian courts have stated that the cardinal rule is that the surety cannot be liable for beyond the terms of engagement. When the variance benefits the surety, it is not beyond but within the terms of engagement. Therefore, any changes accruing benefit on the surety are presumed to be immaterial and therefore, will not discharge him.

The courts have considered the above-mentioned factors jointly and separately in determining the materiality of variance depending upon the facts and circumstances of the case. However, a combined test can be formulated on the basis of the reasoning of the courts in the cases applying these tests.

c.      Combined test – Benefit, Intention and Contemplation

From the case laws analyzed for this article, it can be observed that courts have repeatedly defined immaterial variance as unsubstantial or beneficial to the surety. This position is based on the economic logic of enforcing the contracts rather than annulling them. [2] Both parties will benefit from the enforcement of such variance and therefore, the contract should be enforced with the variance. It is evident that the benefit test triumphs over the other tests as once it is proved that the variance is beneficial to the surety, the court will presume the immateriality of the variance without delving into the question of intention or contemplation of the parties.

In case, the benefit test is not satisfied, the courts shall apply the intention of the parties test because it covers the ‘contemplation’ and ‘would have entered’ test into it. The unintentional omission made by the parties is a mistake not intended by any of the parties, therefore the corrected or altered form of the contract is the contemplated contract or the contract which surety wanted to enter in. However, the intention test would cover very few cases as modern-day commercial contracts are drafted by experts and the possibility of unintentional omission in the text of contract is very low. [3]

If the intention test is not satisfied, then contemplation or would have entered test can be applied. Indeed, both the tests overlap and therefore, can be applied as one test (hereinafter ‘contemplation test’) – would the surety enter the contract if he contemplated such variance? The courts have said that the contemplation test assumes the consent of the surety to such variance that would not affect the nature of the contract. The question of what variances affect the nature of the contract is to be determined by the courts on the basis of the legal effect of the contract.

The materiality of any variance can be determined by the courts on the basis of the above-mentioned three-pronged test. However, this combined test does not solve the problem of litigation that can arise from variances made in the surety bonds. The application of the test has to be done by the courts only to give relief to the parties. This impinges upon the economic efficiency of such bonds thereby discouraging the growth of the surety bonds market. The surety bonds require a different standard for governing the materiality of variance due to the different nature of surety bonds.

Different Approach of Materiality for Surety Bonds
a.      Differences in Surety Contracts under ICA and Surety Bonds

The surety contracts as envisaged under ICA are remarkably different from surety bonds. Under Section 127, anything done or promised for the benefit of the principal debtor forms a sufficient consideration for surety. However, the principal debtor or the contractor is required to pay the premium for buying security bonds. The surety in this case is no longer a ‘favourable debtor’. The surety receives benefit or consideration for becoming a guarantee for the contractor. The premium charged by the surety depends upon the risk assumed by the surety company in guaranteeing the performance of the contractor. These risks are based on the market conditions surrounding the construction industry. [4]

The construction industry is prone to price changes, delays in construction, labour strikes and many external conditions capable of affecting the terms of the construction contract. The probability of variances is high in the construction contracts that may be guaranteed by surety bonds as compared to surety contracts envisaged under ICA. If the courts are approached for discharge of surety in case of any variance resulting from the above-mentioned market conditions, the courts will be flooded with cases of surety bonds. Therefore, the legal position based on Section 133 is insufficient for dealing with the variances in surety bonds.

b.     Consent to Anticipated Variance

As stated above, the implied consent of the surety can be assumed if the variance does not alter the nature of the contract and surety would have contemplated it while entering into the contract. However, can this implied consent of surety be assumed for any variance made in the contract to reduce the litigation arising out of variances made in surety bonds? In other words, can the rights of the surety to be discharged on the variance be waived by including express terms in the contract? This question arose before Indian courts as early as 1920 in the case of K.R. Chitguppi v. Vinayak Kashinath Khadilkar. The court found that implied consent can be given to the anticipated variance.

This position was later changed to state that no consent can be given in advance for any material variance made into the contract because the ICA does not allow a ‘contract to the contrary’ under Section 133. The court relied on the language of Sections 133 and 135 to hold that the consent for the variance should be made simultaneous to such variance and not in advance.

Surprisingly, in 2008, Bombay HC delivered a judgement stating that the rights under Sections 126, 133, 134, 139 and 141 ICA can be waived on the principle of contracting out. The principle of contracting out states that “any person can enter into a binding contract to waive the benefits conferred upon him by an Act of Parliament” unless waiving such benefits is contrary to public policy. Upon the enactment of IBC laws, the case of SBI v. Ramakrishnan came before SC where the binding nature of the resolution plan approved by the Committee of Creditors without surety’s consent was contested by the guarantor. The court held that the statutory provision of IBC laws clearly states that any plan approved will be binding on the debtor and guarantor. The guarantor cannot invoke Section 133 of ICA to get absolved of such liability. This position was reiterated in Lalit Kumar Jain v. Union of India. The court held that a resolution plan is “statutorily” presumed to be consented to by the guarantors under Section 31 of IBC. The court justified this by stating that the guarantors assume the risk of any variance before entering the contract. Therefore, the stance that the right of surety under Section 133 can be waived or statutorily taken away was accepted by the court.

  • A Developed Approach to Variance for Surety Bonds

The reasoning given by the court in Lalit Kumar case can be applied to the surety bonds where the payment of premium covers the risk, therefore covering variances under the construction contract. Such a waiver by the surety companies will encourage the growth of the surety bonds market and reduce unnecessary litigation related to the variance in such contracts. This waiver will also favour infrastructural development as the surety companies will perform the contract in case of non-performance by the contractor rather than claiming discharge from it. The owners will have the incentive to award the construction tenders to the secured contractors. Thereby, raising the demand and popularity of surety bonds in the market.

However, such a waiver of rights should not mean that surety companies are not able to claim any defence against the performance of the contract. The other defences such as invalidity of the bond, late notice, and any alteration that benefits the principal but compromises the surety should be explicitly included in the terms of the contract so that the interests of both parties can be balanced. The principal or the contractor should not be allowed to take any unfair advantage of the waiver of rights by the surety.

Conclusion

The growth of surety bonds for the construction sector in India may not be supported by the existing legal position of discharge by variance in surety contracts under Section 133 of ICA. The three-pronged test derived from the analysis of Indian case laws are suitable for the type of surety contract under Section 126 of ICA and not surety bonds which operate differently. The charging of premiums by the surety companies includes the industry risks undertaken by the contractor. Such industry risks make construction contracts vulnerable to variances. The application of the materiality of variance rule to surety bonds will lead to an increase in legal disputes among the contractual parties. Therefore, the existing materiality of variance rule is insufficient for the surety bonds. Rather, the consent can be assumed for the anticipated variance as accepted by the courts in case of IBC laws and express waiver. This will make the surety bonds more lucrative for owners of construction sites and contractors. This will also lead to infrastructural growth as the performance of the contract will be given importance over discharge. However, this shall not mean that the surety should be made liable for more than the risk assumed by the means of premium. The variances that can discharge the surety from the performance of the contract should be explicitly included in the contracts.

 

[1] Chitty J and Beale HG, Chitty on Contracts (1999).

[2] Richard A. Posner, Economic Analysis of Law (2nd Edition, 1977) 1705.

[3] Russell JS, Surety Bonds for Construction Contracts (American Society of Civil Engineers Press, 2000) 16.

[4] ibid 63.

Comments

Leave a Reply

Your email address will not be published. Required fields are marked *

Contact Us

Kerwa Dam Road., 
National Law Institute University, Bhopal
Madhya Pradesh, India. 462044​.

write to us at – cbcl@nliu.ac.in