Dear Everyone
The best-laid plans of mice and men often go awry
My initial advice to anyone who wishes to guarantee someone else’s obligations is to think twice and unless you are benefitting, do not do it, as you are putting your own assets at risk.
I have provided advice to many clients regarding providing a guarantee to a close friend, family member, spouse, business partner or company. I always emphasise that the financial risk to which they are placing themselves. In some cases, I have managed to negotiate the terms of a guarantee. As most parents wish to help their children, it is very important to understand the ramifications of being a guarantor.
My advice is unless you are benefitting from the guarantee, it is preferable to lend the money if you are able, rather than give a guarantee. Fortunately, this advice was accepted by my clients who wished to assist their son in his business. At that time the business was booming and the son wished to expand and required a guarantor for his company’s business loan. After receiving advice regarding the guarantee and the risks involved, my clients decided to lend his son money by an increase in their house mortgage.
This increased their repayments but those were manageable. Regretfully, several years later, due to Covid, the son’s business failed and he lost everything. My clients were in a position to assist him at that time. If they had provided their guarantee, it would have resulted in them losing everything as well.
A request to “just sign as guarantor” has serous ramifications. A guarantee is a serious legal commitment. By signing a guarantee, a person will become personally responsible for another person’s debts or contractual obligations (“the principal creditor”). Usually, the guarantor’s liability will extend to the whole debt, interest, legal costs and other amounts payable under the underlying agreement.
- When a bank or financial institution lends money to a company it will usually require the company’s director, shareholder or another individual to personally guarantee repayment. Similarly, guarantees are commonly encountered in:
- business loans;
- commercial leases;
- residential leases;
- finance arrangements;
- trade accounts;
- loans between family members;
- property transactions;
- building and construction contracts; and
- arrangements involving companies or trusts.
The important to note that the person signing the guarantee usually has no direct benefit from the transaction, whilst assuming substantial personal liability. In the event that the principal creditor defaults on the loan, most guarantees include that the guarantor is also liable for the following payments:
- the principal debt;
- accrued interest;
- default interest;
- fees and charges;
- enforcement expenses;
- legal costs;
- collection costs; and
- other amounts which the principal debtor becomes liable to pay.
Very often guarantees are unlimited whilst others may contain a monetary limit, but the apparent limit may not necessarily represent the guarantor’s total exposure once interest, costs and other liabilities are taken into account.
A common misconception is that if the borrower does not pay, the bank will simply take the property that was provided as security. If the sale of the property is insufficient to cover the debt, then the guarantor will usually be liable for any shortfall and the costs incurred by the lender.
Another common misunderstanding occurs when a company asks its director to provide a personal guarantee. Whilst a company is a separate legal entity where ordinarily, shareholders and directors do not automatically become personally liable for the company’s debts due to their involvement with the company, a personal guarantee changes the position and the guarantor assumes personal liability for the debt.
Trust is not a substitute for legal protection. Many guarantees are given for family members, friends or business associates. The problem may not arise because the borrower intends to default. Circumstances can change unexpectedly as follows:
- a business may fail;
- a relationship may break down;
- a borrower may become seriously ill;
- interest rates may increase;
- property values may fall;
- a business partner may disappear;
- a company may become insolvent; or
- the borrower may simply stop making payments.
The lender is generally concerned with whether its debt is paid - not with the personal relationship between the borrower and guarantor. Particular care is required where a guarantee is described as creating joint and several liability.
Another misconception occurs where there are multiple guarantors who are jointly and severally liable. In the event of default, the creditor usually has the ability seek recovery from any one of guarantors, for the total liability. The precise wording of the guarantee must be examined.
It is important to know whether a document provides a continuing guarantee, potentially covering present and future obligations of the borrower. This can be particularly dangerous in relation to:
- company overdrafts;
- business finance;
- trade accounts;
- commercial leases; and
- ongoing credit facilities.
A person may believe that they are guaranteeing one particular debt when, in fact, the document creates continuing obligations.
One of the most important issues is whether the document contains an indemnity as well as a guarantee. An indemnity can create obligations which operate independently of the traditional obligations of a guarantor. This distinction can be extremely important. A document may be called a “Guarantee and Indemnity”, but the legal consequences depend upon the precise wording and circumstances. Do not assume that the title of the document tells you the extent of your liability.
If the borrower becomes bankrupt or a company becomes insolvent, the creditor may seek to enforce its rights against available security and then pursue the guarantor for any remaining liability, subject to the terms of the relevant documents and applicable law. The guarantor should therefore consider the possibility of the borrower becoming insolvent before signing, not after the problem arises.
A guarantor should establish:
- whether the guaranteed debt can increase;
- whether the lender can extend further credit;
- whether interest rates can change;
- whether the loan term can be extended;
- whether additional obligations can become guaranteed;
- whether the guarantee can be renewed; and
- whether the guarantor’s consent is required for variations.
The wording of the guarantee determines the extent to which future changes may affect the guarantor. Whether a guarantor can terminate or limit a guarantee depends upon the terms of the document and the circumstances. Some guarantees provide mechanisms for termination, but termination may not necessarily release the guarantor from liabilities which arose before termination.
I consider that when a person is being asked to guarantee another person’s obligations, obtaining independent legal advice is strongly recommended. This is particularly important where:
- a spouse or partner is asking the other to guarantee a debt;
- a parent is guaranteeing a child’s loan;
- a director is guaranteeing a company’s borrowing;
- a shareholder is guaranteeing company obligations;
- a family member is guaranteeing a business;
- a guarantor has limited financial resources; or
- the guarantee is described as unlimited or continuing.
I always explain to my clients the nature and practical consequences of the guarantee and, importantly, identify provisions which may create unusually broad liability as a guarantee puts all your assets in danger. A guarantee is a legally binding document. Once signed, it may be difficult and expensive to undo. If you are going to agree to be a guarantor you need legal advice to know the answers to the following questions:
- What exactly am I guaranteeing?
- Is my liability capped?
- If there is a cap, does it include interest and legal costs?
- Is this a continuing guarantee?
- Can the underlying debt increase without my consent?
- Does the document contain an indemnity as well as a guarantee?
- Am I jointly and severally liable with other guarantors?
- What happens if the borrower becomes insolvent?
- What security is being provided by the borrower?
- What of my assets could potentially be exposed?
- Can I terminate the guarantee in the future?
- Will I remain liable for obligations incurred before termination?
- Can the underlying agreement be varied without my consent?
- What happens if the borrower defaults?
- What is the worst-case financial outcome for me?
A guarantee that you may give may cost you everything you own. If you are asked to sign a guarantee, do not sign it until you understand the maximum extent of your potential liability. If you are uncertain about any provision, I am available to provide the necessary advice.
I have assisted many clients with advice regarding loan documents and guarantees. If you or anyone you know requires assistance in this regard, please do not hesitate in contacting me.
Wishing you a wonderful day,
Jeffrey Choy
JCL Legal
0419 233 670
[email protected]
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Liability limited by a scheme approved under Professional Standards Legislation
Legal Disclaimer: This guide is for informational purposes only and does not constitute legal advice.
