Bank Guarantees

Nature

Strictly speaking, a guarantee is an agreement to meet the obligations of another person.  Where that other person’s liabilities do not, for some technical reason, arise or are legally invalid, then the guarantee would not apply. Standard bank guarantees take many of the rights that might otherwise be available to the guarantor against a bank and against the guaranteed party.

For this reason, many bank guarantees are given by way of a guarantee and indemnity.  The indemnity is effectively an obligation to compensate the bank pound per pound for any loss by reason of the failure of the guaranteed person to pay.  The difference between an indemnity and a guarantee may depend on the wording.

A guarantee is different to a contract of insurance.  In a contract of insurance, the beneficiary of the insurance must disclose all material facts.  An insurance contract will relate to an uncertain event or risk whereby payment is made if the risk occurs.  A guarantee, in contrast, is an undertaking to answer the obligation of a debtor, should he fail to perform or default.

A letter of comfort is generally framed in as a non-legally binding undertaking.  Sometimes, it is given by a parent company for the benefit of a subsidiary. The label “letter of comfort” is not necessarily critical.  The key matter is what in substance the agreement / letter provides.

Some documents labelled “letters of comfort” are not legally binding whereas orders are guarantees.  If it is intended in a commercial transaction that the document is not to be legally binding, this should clearly be stated.

In the building industry performance bond are commonly used.  These are a form of insurance. Typically, the bond is on the basis that a sum will be paid if a certain precondition is met.  In this context,  the precondition will relate to failure of performance.

Secured Obligation

A guarantee can be in respect of a specific amount or can be continuing.  Most bank guarantees are continuing in respect of liabilities, are outstanding from time to time by the debtor. A guarantee may be limited for a period or for an amount.   The wording of the covenant to pay,  determines the position.

The so called “rule in Clayton’s case” is of importance in guarantees.  The rule is a presumption that the monies paid firstly into account discharge earlier debts.  Most standard form guarantees prevent the rule from applying, so the bank may choose to appropriate sums in respect of any unguaranteed or unsecured part of the account.

Where a guarantee is limited in respect of time,it may in principle terminate, if there has been no default in the relevant period. More commonly, it will apply to liabilities incurred within  the relevant time period. The  time limitations may simply provide that the liability is capped to at that this amount and that it does not terminate until the amount is paid. The position will depend on the wording.

Sometimes,  guarantor will be technically liable for the full amount, but recourse will be limited to the specified amount.  One effect of this, is that even if the guarantor pays off the full amount, he will not have a right of subrogation against the principal debtor, because of the amount outstanding is still technically due by him.

Most guarantees are “demand” guarantees.  The liability only arises once demanded by the relevant institution.  This has the important consequence that the time limit under  the Statute of Limitations, runs from the date of the guarantee.

Guarantees may be joint and several.  Joint guarantees mean that each person may be sued for the full liability.  In this event, the person against whom full recovery has been obtained will  have a right of contribution against the other co-guarantors. Several guarantees make each guarantor individually liable.  Several guarantees sometimes  limit liability to a specific proportion of an overall debt However, specific wording is required to achieve this limitation.

A guarantee must be evidenced in writing.  There must be a consideration or it must be under seal / executed as a deed.

Formal Requirements

Particular issues may arise in relation to guarantees given by company, particularly where there is a corporate group.  Group companies may not have the power to guarantee the obligations of fellow group members, because this is outside its commercial interests.

Banks frequently insist that the terms of company Memorandum and Articles be changed, on the giving of a guarantee in order to ensure the requisite power is present.  See the separate section on company borrowings.

Consumer credit guarantees are not valid unless the guarantor is given a copy of the agreement within 10 days of signature. See the section on Part III Consumer Credit Act.

Common Law Rights of Guarantor

The following rights are almost invariably removed or reduced in the case of bank and professionally drafted guarantees. Specific wording is required to disapply the rights.

A guarantor is not entitled to insist that the guaranteed party sues the debtor or indeed relies on other security. If the guarantor pays the guaranteed party, he acquires rights of subrogation and indemnity against the debtor.

Where a guaranteed sum has been paid, the guarantor has a common law right of indemnity against the principal debtor.  This is a right to recover the sum paid plus interest.  This right of indemnity applies where the guarantee was given at the implied or actual request of the principal debtor.

A guarantor who pays on the guarantee is  usually subrogated to the creditor’s / guaranteed party’s security, so that he succeeds to the creditor’s security and may enforce it against the debtor The equitable right of subrogation seeks to prevent unjust enrichment.  Under the principle, the guarantor is  entitled to enforce every security and means of payment.  Effectively, the guarantor steps into the shoes of the creditor.

The guarantor is entitled to expect that the creditor’s securities are kept in place.  Where a part only of the debt has been guaranteed the guarantor is entitled to proportionate part of the security, under equitable principles.

Under a guarantee (as opposed to an indemnity), the guarantor can invoke against the guaranteed parties the debtor’s defences.  These include any right to counterclaim and set off against the creditor.  In practice,  such rights are generally excluded in written guarantees, until the guaranteed party is paid in full.

Generally, a guarantor is not entitled to information regarding the background to the guarantee.  However, the creditor may be obliged to ensure the guarantor is informed of the consequences.

Where there is a possibility of undue influence or misrepresentation the creditor is obliged to ensure the guarantor is fully informed.  However, the creditor need not disclose unusual features of the loan agreement or matters which impact on the creditworthiness of their debtor.

Termination of Guarantee

The guarantee may terminate on its wording because it has lapsed. Standard guarantees may provide for revocation by notice.  If there is no provision, notice must be reasonable.  Usually, notice must be in writing.  Once notice has expired, liability is released for monies lent after this period.  Standard provisions usually provide the guarantor to remain liable up to the end of the period of notice.

The existence of a contractual right of revocation is a question of interpretation.  If guarantee covers future advances, it is arguable that notice can be given in relation to advances after the time of the notice.

Notice of the death of the guarantee is generally notice of determination.  If co-guarantors guarantees are determined their obligations does not necessarily discharged the other guarantor.  However, the obligations of the remaining guarantor may be affected to the extent that his right of contribution in impaired. Payment in full on the guarantor, will discharge it.

If a guarantor is prejudiced by the creditor’s actions, the guarantee may be discharged.  This may include where the creditor acts in bad faith  is guilty of concealment and misrepresentation or connives in the default of the debtor. It  also occur where  the terms of a principal contractor are changed so as to prejudice the guarantor.

Generally, if the creditor releases the principal debtor, this will discharge the guarantee.  If the creditor is in breach of a condition on the contract as would entitle the principal debtor to determine, this may discharge future liability. If there was a material alteration in the times of the underlying loan agreement, the presumption is that this would discharge the guarantee.

Similarly, if the creditor gives more time, this would otherwise interfere with the guarantor’s right against the principal debtor and the guarantee is discharged under the default position. If the principal debtor fails to give an agreed security or if the guaranteed party releases a security, the guarantee would be discharged under the default position.

Standard Forms

However, most lending institutions use standard form guarantees.  These are subject to the unfair terms in consumer contracts regulations in a consumer case.

Most standard guarantees will be both guarantees and indemnities.  Standard form bank guarantees usually permit the guaranteed party to change the guarantee, advance monies and do a range of thing, without affecting the guarantee.

Standard guarantee forms usually allow variations without affecting the obligations of the guarantor under it guarantee.There will be provisions that entitle the creditor to do things which would otherwise discharge the guarantee at common law or in equity.

Undue Influence

Guarantees may be set aside on the basis of undue influence.  These may include where the undue influence emanates from the principal debtor rather than lenders.  In some cases, in the absence of independent legal advice a guarantee may be set aside.  Without legal advice in this situation, the lender may be deemed on notice of the circumstances and the guarantee may be set aside.

For this reason lenders generally insist that independent legal advice is being taken.  Independent legal advice may obviate undue influence and duress.