It is becoming increasingly common for lenders (usually banks) to require third parties to give guarantees for the obligations of a borrower. Where the borrower is associated with other entities the bank wants to ensure that securities given to the bank by the other entities are available to the bank in the event of default of the borrower. Also where a borrower has insufficient security available to meet the banks’ lending criteria a guarantee from a family member may be sought.
At BlackmanSpargo we advise any person who has been asked to give a guarantee to be cautious. This article explains the nature of a guarantee and what can be done to reduce risk.
What is a Guarantee?
A guarantee is a promise by a party that they will assume responsibility for the obligations of a borrower to a creditor (the bank) if the borrower defaults.
The party giving the promise is called the guarantor. The document that is signed is called the guarantee.
The guarantor is guaranteeing the responsibilities of the borrower directly to the bank. There is no direct legal contract between the guarantor and the borrower. The legal contract is between the guarantor and the bank.
Features and Risks of Bank Guarantees
Guarantees come in many forms. Each bank may have a different form, but the obligations are essentially the same.
Guarantees used by a bank are drafted by the bank’s solicitors in such a way as to provide the bank with as much protection as possible. The guarantor should always be aware of the risks of entering into a guarantee.
Common Features and Associated Risks of Bank Guarantees
- The guarantor is liable as principal debtor under the guarantee. This means that the guarantor is treated as if the guarantor is a borrower. This increases the legal remedies available to the bank against the guarantor.
- A bank guarantee is an all obligations guarantee. This means that the guarantor is liable for present and future obligations undertaken or incurred by the borrower. In other words, the guarantee is not limited to those legal obligations that exist at the time the guarantee is signed.
- A bank guarantee may be limited to the amount of the liability to be incurred by the guarantor, or it may be unlimited. Most banks would want the liability to be unlimited. This means that the guarantor would be liable for the amount owed to the bank at the date of the enforcement of the guarantee.
- Unless there is a monetary limit in the guarantee, the guarantee will apply to all advances which the bank chooses to make to the borrower, even if these occur without the guarantor’s knowledge or consent.
- A limited guarantee is one where the amount of the liability is limited to the sum specified in the guarantee. However, the guarantor needs to know that the maximum amount specified is not the total amount of the liability. All bank guarantees provide that, in addition to the amount specified in the guarantee document, the guarantor is also liable for certain costs and interest. In circumstances where the borrower is in financial difficulty, the costs and interest can increase significantly and quickly. The result is that the total amount of potential risk to the guarantor may be much higher than the amount shown in the guarantee document.
- If there is a default by the borrower, the bank has full discretion to decide whether to try and enforce repayment of the debt directly with the borrower, or whether it will pursue the guarantor.
- Even if there is more than one guarantor, if the guarantee is joint and several, the bank can choose whether it will approach only one, or more guarantors, to remedy the default. There is no obligation on the bank to seek equal contributions from all guarantors unless this is specifically negotiated at the time the guarantees are given. Where there is more than one party signing the guarantee, the standard bank guarantee provides that each party will be jointly and severally liable. This means that a guarantor will be liable for the total amount and the bank is not obliged to share that liability equally amongst the guarantors. The individual guarantor may be able to claim compensation from his or her co-guarantors, but it is often difficult to do so.
- If the bank has security from the guarantor, by way of funds in a bank account at the same bank, or by way of security over a specific asset, such as a mortgage over property, the obligation under the guarantee is likely to allow the bank to enforce the guarantee by having recourse to such assets. Guarantors risk losing family homes or even farms where these assets are given as security. When the borrower is seriously in default and the bank has no option, the guarantor’s asset can be sold to repay the debt.
- A bank guarantee does not usually have a specified period of enforcement. Once a guarantee is given, it will usually continue to operate until it is withdrawn by the guarantor or released by the bank. Guarantors may have forgotten that they gave a guarantee.
- The guarantee does not contain any obligation on the part of the bank to disclose to the guarantor any information regarding the borrower’s financial or banking affairs. The current law on privacy would prevent the bank from disclosing this information to a guarantor. This is despite the fact that the guarantor may be liable for a substantial sum and could lose a home or a business.
What are the Risks?
- The risk of the guarantor being treated as a principal debtor – This means that the bank has the legal right to treat the guarantor as if such guarantor actually borrowed the money or incurred the obligations to the bank. The bank has the legal right to sue the guarantor for any loss it suffers.
- The guarantor is liable for present and future obligations of the borrower to the bank – If the borrower enters into any new transaction with the bank, the guarantor may have no knowledge of this fact but the new obligations are generally covered under the guarantee. If this occurs, the risk of enforcement may increase without the guarantor being aware of new developments.
- If the guarantee is unlimited (i.e. it has no monetary cap) the extent of the guarantor’s liability cannot be quantified –
The borrower may continue to increase the debt without the guarantor’s knowledge. A risk analysis by the guarantor of whether such guarantee should be given cannot be accurately assessed because of the potential for a future increase in liability.
How to Reduce Risk
- It is strongly recommended that the guarantee be limited to a specified sum – The sum specified generally excludes interest and costs. The effect of compounding interest on a penalty basis can result in a significant increase in the guarantor’s liability. The bank’s legal costs for enforcement of the guarantee can be extensive, thus increasing the expected liability of the guarantor significantly.
- Where there is more than one guarantor, the liability should be shared equally amongst each of the guarantors – This will only occur if the guarantee specifically provides that the guarantors’ liability is limited to a sum for each of the guarantors and that on enforcement each guarantor will be responsible proportionately for the debt.
- Consider the security position – Consider taking security or obtaining an indemnity from the borrower so that the guarantor can take enforcement action against the borrower in circumstances where the bank enforces the guarantee by making demand from the guarantor without first having recourse against the borrower. The bank may approach the guarantor directly to enforce a loan, especially if this is the simplest and most expeditious way of recovering the loan.
- Obtain legal advice before giving any guarantee – It is very easy to give a guarantee and support that guarantee by a mortgage or general security agreement over a valuable asset. It is devastating to any guarantor to lose a home or a valuable asset, many years later, as a result of a lack of understanding and care. For this reason, it is of vital importance that the guarantor seriously considers the risks and manages those risks by obtaining legal advice.
- Limit the term of the guarantee or review the need for the guarantee periodically – There is no provision in a standard bank guarantee for the guarantee to be given for a fixed term. It is therefore incumbent upon you, the guarantor, and your legal adviser to diary the date on which a guarantee is given, in order to review the circumstances and, if possible, to invite the bank to release the guarantee and any security that might have been given. The diarying of a guarantee is an important process that your legal adviser should implement in order to protect your position.
- Limit the guarantee to a particular loan or facility – This ensures that the guarantee does not cover all obligations of the borrower but only those arising under a certain facility. Specific drafting of the guarantee will be required.
- Properly assess the risk before giving any guarantee and ensure you continually monitor that risk – The guarantor should insist, as a minimum requirement, on sighting the annual financial accounts of the borrower to assess whether there is risk of the guarantee being enforced and whether, because of an improved financial performance, the guarantee should be released. It is very important that the borrower provides to you a signed deed, giving you the legal right to access information from the borrower’s bank. The best way to manage the risk of giving a guarantee is to require the borrower, the borrower’s advisers and the bank, to provide you with any and all information you may require with a view of determining the risk. If the risk increases, you can withdraw the guarantee. Please note that this is likely to result in an obligation for the debt to be repaid. Depending on the circumstances, repayment of the debt may be a necessary step in order to avoid any further liability which can increase substantially over a short period of time.
- Negotiate the release of the guarantee at the earliest possible time – If the indebtedness of the borrower has reduced significantly or if the bank has adequate security for the indebtedness from other sources, then it would be wise to negotiate the release of the guarantee (and any supporting securities) at the earliest opportunity.
Before you enter into a guarantee, you should:
Explore other options you might have that would allow the borrower to have access to the money without you being personally liable.
Ensure that the bank obtains a guarantee only in circumstances where it is necessary to “top up” the security level. Avoid the position where the bank takes a guarantee because “the bank has always done it that way”.
If possible, avoid supporting the guarantee by a registered security over an important asset you own.
It may be better to lend a fixed sum of money to the borrower and take a second security, than to give a guarantee. At least, in this way, your liability is fixed to the amount actually lent.
If you have to give a personal guarantee, make sure that the extent of the liability, including interests and costs, is an amount that you can afford to lose.
Last but not least, obtain good independent legal advice that enables you to understand the implications and consequences of giving a guarantee and ensure that your legal adviser undertakes the necessary procedures to protect your position in the future. These actions include diarying the date of the signing of the guarantee for review and withdrawal and having a deed signed giving the guarantor the legal entitlement to access information.
If we, at BlackmanSpargo, have acted for you in relation to the giving of a guarantee we will contact you periodically to determine whether the borrower’s circumstances have changed and if so whether a release of the guarantee should be requested from the bank. Our view is the sooner you can get any guarantee released the better. Because of the onerous nature of guarantees they should, if at all possible, be avoided.
Always seek independent legal advice before giving a guarantee. If you require any further advice please contact one of the team at BlackmanSpargo.
Written by Sandy Van Den Heuvel