Introduction
It has become common business practice to rely on guarantees as a mechanism for securing contracts. To name a few examples, guarantees are now used where banks and finance companies lend money, where landlords lease property, where goods are leased, and in supply agreements.
Whilst this adds an extra level of protection for the lender, it is important that the guarantor understands precisely what their liabilities are under the guarantee. This article will consider the nature of a guarantee, how it differs from an indemnity, why guarantees are used, as well as some of the factors and defences which are commonly used to limit a guarantor’s liability.
Ultimately whilst guarantees may appear to be simple in theory, in practice there are a number of complexities which may affect the validity and enforceability of a guarantee.
What is a guarantee?
A guarantee is a legally binding agreement which makes a person liable for the debts and obligations of another party. It represents a further example of the piercing of the corporate veil. A guarantee signifies that if that party fails to fulfil their obligations under the contract, then the guaranteed party can seek to have the guarantor fulfil those obligations. Commonly this relates to circumstance in which the separate party fails to pay a sum of money, and therefore the lender (being the guaranteed party) seeks to have these monies paid by the guarantor. For this reason providing a guarantee has been described as the equivalent of a person signing a blank cheque without a date.
There are four types of guarantees:
- A ‘standard’ guarantee is one that makes a person liable for the debts and obligations of a third party.
- A ‘several’ guarantee is where there are a number of people who make the guarantee, however each person is only liable for a portion of the third party’s debt.
- A ‘joint and several’ guarantee means that there are a number of people who make the guarantee and each is liable for the full debt of the third party.
- An ‘all monies’ guarantee is when a person is responsible for all debts owed by the third party, even those that arise in the future.
Difference between guarantee and indemnity
It is also important to recognise that there is a difference between a guarantee and an indemnity. Whilst a guarantee ensures performance of a contract, an indemnity is where one person promises to compensate a lender for any losses. Whilst in principle the effects are similar, that the lender is repaid any monies which they are owed, in reality a guarantee operates very differently to an indemnity.
Unlike an indemnity, a guarantee is created under a separate contract and consequently the guarantor’s liability only arises once the primary contract has been breached. This also affects the rights of the guarantor, since the indemnifier cannot generally sue the lender whilst a guarantor maintains this right.
Generally the wording of a contract will determine if a person has become a guarantor or an indemnifier. However, even more distinctly, an indemnity is created by the contract through which the monies or goods are lent, whilst a guarantee is created under a separate contract.
Why are guarantees used?
Guarantees are commonly used by lenders as a mechanism for motivating managers and business owners to pay the debts owed by the business. This is because it gives managers and business owners a personal incentive since (as guarantors) they will be personally responsible for any debts not paid by the business. Additionally, as a result of the personal liability, it also gives the guaranteed party significant leverage in the event that the third party breaches their obligations under the contract.
Further, guarantees are also used because it adds an extra level of protection over the transaction. Accordingly it means that the lender will be able to enforce the debt against the business and all of its assets, and then secondly against the guarantor and all of their assets.
What to check before signing a Guarantee?
The following provides a summary of some of the main factors that a person should be aware of before signing a guarantee. These factors may also be used by a person to limit the scope of the guarantee.
- Understand the form of the guarantee. Often guarantees are drafted broadly to include “all monies” however it may be possible to limit the guarantee to the specific transaction or to a certain amount of money. Similarly, the guarantee may state that it is a continuing guarantee which means that the person is not only responsible for the debt being accrued at the time that they are signing the guarantee but also any new debts which continue to be incurred in the future.
- Attempt to limit the duration of the guarantee. This will prevent a lender attempting to enforce the guarantee years into the future.
- Understand when a guarantee can be enforced. Generally a guarantee can be enforced as soon as the primary contract has been breached. This means that a guaranteed party does not have to try to recover any amounts owing from the party in breach before they can seek to recover their losses from the guarantor.
- Understand the capacity in which the guarantor is signing the guarantee. Is it being signed in a personal capacity, or is it being signed on behalf of a company or another entity?
- Understand the risks involved in the guarantee and how high your potential liability is as the guarantor.
Defences available to a Guarantor
Similarly, although a guarantee may seem air tight there may be a number of avenues open to challenging a guarantee.
- Execution – if the guarantee has not been properly drafted in writing, if it has not been formerly signed by the guarantor (either in writing or electronically), or if the lender is unable to produce an original or verified copy of the guarantee, then the guarantee may be invalid.
- Condition precedents – the guarantee may specify that certain actions have to be taken, or certain criteria must be met before the guarantee can be enforced. If those conditions have not been complied with, this may make the guarantee unenforceable. In addition, a guarantee may not be enforceable if the guaranteed party is in breach of the contract which is secured by a guarantee.
- All of the guarantors have not signed the contract – in the event that there is more than one guarantor it is essential to have all of the guarantors sign the guarantee. A failure to ensure that everyone has signed the guarantee could mean that it is not only invalid against those who failed to sign it but also against those who actually signed it as well.
- Ensure that the proper entity is listed in the guarantee – regardless of which party it relates to, it is important that the correct entity for all parties is listed in the contract. For example if ABC Parent Company Pty Ltd attempts to enforce the guarantee, however the contract only allows ABC Subsidiary Company Pty Ltd to enforce the contract, then it may be difficult for ABC Parent Company Pty Ltd to proceed since they were not listed in the guarantee.
- Actions which discharge the guarantee – it is important to look at the terms of the guarantee carefully to understand in what circumstances a guarantee will expire. In a number of standard guarantee contracts this occurs when there is full payment or a variation of the terms of the loan. For this reason if a lender agrees to refinance the debtor, or enter into a repayment plan, this may have the effect of voiding the original guarantee.
- Amendments to the responsibilities of the party – In many circumstances where the original contract between the guaranteed party and the debtor is varied or amended, and the guarantor has no knowledge of these amendment or does not consent to them, this may have the effect of releasing the guarantor from their obligations.
- Absence of proper consideration for the guarantee – If a creditor enters into a principal transaction prior to the execution of a guarantee, then the guarantee may be of no effect.
- The principal lender registered any relevant security interest – a failure by a lender to register a security interest may mean that the lender may not be able to make a claim on the guarantor after the occurrence of an event of default by a borrower.
- Statutory restrictions – where the Conveyancing Act 1919 (NSW) applies, section 111(5) states that the lender must exercise their right to sell the property before a guarantee can be enforced. Where the Corporations Act 2001 (Cth) applies, and in event of the administration of the company, under section 440J the lender may be limited in their ability to enforce the guarantee. There may also be an argument that the guarantee is an unjust, unconscionable, harsh or oppressive under sections 7 and 9 of the Contracts Review Act 1980 (NSW). Further, with the introduction of the Personal Property Security Act 2009 (Cth) it may be necessary to register guarantees on the Personal Property Security Register in order to ensure that remain effective.
Conclusion
Guarantees are where a third party agrees to repay a debt or perform some obligation on behalf of another party. These are different to indemnities since a guarantor performs the contract as opposed to an indemnity where they compensate for any loss. Guarantees are often used as a mechanism for ensuring that business managers have a personal incentive to ensure that businesses fulfil the contract. There are however a number of hazards which can prevent the validity of the guarantee.
