Guarantees are commonly used in loans, leases and corporate group financing arrangements. However, directors, creditors and guarantors often underestimate the legal and commercial risks guarantees create.
This article explains what a guarantee is, the common risks that may affect its enforceability, and the enforcement rights available to creditors under a guarantee.
What is a guarantee?
A guarantee is a promise by one person (the guarantor) to answer for the debt or obligation of another person (the debtor) if the debtor fails to pay or perform.
What is a guarantor’s obligation?
A guarantor’s obligation is usually secondary. This means the guarantor is liable only if the debtor remains liable for the underlying debt and fails to perform its obligations. It also means that defects in the principal loan contract may affect the guarantor’s obligations.
However, parties may draft a guarantor’s obligation as a contingent principal obligation, exposing the guarantor to broader potential liability. An example is the following clause:
The guarantor agrees to pay the Guaranteed Money on demand from the Financier as if it were the principal debtor if:
- the Debtor does not pay the Guaranteed Money on the due date;
- an obligation of the Debtor to pay the Guaranteed Money is found to be void, voidable or unenforceable; or
- an Ipso Facto Event occurs.
In practice, commercial parties should carefully consider this distinction when drafting guarantee clauses. The wording used may significantly affect the scope of the guarantor’s liability and whether the obligation operates as a purely secondary obligation or gives rise to a principal and independent payment obligation.
What are a guarantor’s rights?
As a party assuming obligations under the guarantee, a guarantor is also afforded several important rights.
First, the guarantor generally has an indemnity (reimbursement) right against the debtor. This means that if the guarantor pays money under the guarantee, the guarantor may recover that amount from the debtor because the debtor remains primarily responsible for the underlying liability.
Secondly, the guarantor may have a right of subrogation. After satisfying the debt, the guarantor may step into the creditor’s position and rely on the creditor’s rights and securities against the debtor, such as mortgages or security interests previously held by the creditor.
Thirdly, where there are multiple guarantors, a guarantor who has paid more than their fair share may have a right of contribution against co-guarantors, allowing the paying guarantor to seek proportional reimbursement from the others. In some circumstances, a guarantor may also seek quia timet relief, being an equitable remedy under which the guarantor may obtain a declaration preserving an entitlement to contribution before any payment is made under the guarantee.
In practice, these rights may be modified or limited by contract. Commercial parties should therefore carefully draft or review indemnity provisions, security enforcement provisions, and co-guarantor contribution arrangements to ensure the intended allocation of risk and recovery rights is properly reflected.
How is a valid guarantee formed?
A guarantee generally requires that the guarantor has legal capacity to enter the arrangement, that the parties intend the guarantee to be legally binding, and that the guarantee is supported by value or benefit given in exchange for the promise.
Commercial parties should also be aware of statutory formalities. In all Australian jurisdictions other than New South Wales, South Australia and the Australian Capital Territory, a guarantee must generally be in writing (or evidenced in writing) and signed by the guarantor to be enforceable.
Where there are multiple guarantors, there may also be an implied understanding that the guarantee will not bind one guarantor unless all intended guarantors have signed the guarantee. In practice, guarantee documents commonly address this risk through an express clause stating that the guarantee remains enforceable even if one or more co-guarantors do not execute the document.
Common risks affecting the enforceability of guarantees
A guarantee may be discharged by performance (once all guaranteed money has been repaid in full) or by agreement of the parties. However, the law also recognises several events that may discharge the guarantee, render it void or voidable, or temporarily stay its enforcement. Private creditors should therefore be careful to avoid unintentionally compromising the enforceability of the guarantee.
When can a guarantee be accidentally discharged?
Variation of the principal contract
A guarantee may be discharged if the creditor and debtor materially vary the underlying contract without the guarantor’s consent in a way that prejudices the guarantor.
To address this risk, guarantee documents commonly include clauses stating that amendments or variations to the principal contract will not affect the guarantor’s liability. However, such clauses may not be effective where the variation is so substantial that it amounts to the substitution of a new contract.
In practice, the safest approach is to require the guarantor to expressly consent to any amendment to the guaranteed contract.
Extension of time to the debtor
If a creditor grants the debtor additional time to pay, the guarantee may be discharged. This risk is often addressed by including a clause stating that extensions of time or other concessions given to the debtor will not affect the guarantor’s liability. A typical provision might state:
The Guarantor agrees that rights given to the Financier under this document, and the Guarantor’s liabilities under it, are not affected by … giving the Debtor a concession (such as more time to pay).
Release of the debtor
If the debtor is released from liability, the guarantor will generally also be discharged. This risk is commonly addressed by including a reservation of rights clause preserving the creditor’s rights against the guarantor despite any release of the debtor or other security parties. A typical provision might state:
The Guarantor agrees that rights given to the Financier under this document, and the Guarantor’s liabilities under it, are not affected by … releasing the Debtor; or releasing any person who gives a guarantee or indemnity in connection with any of the Debtor’s obligations.
Release of a co-guarantor
The release of one co-guarantor may also release the remaining guarantors, particularly where the liabilities are expressed as “joint” or “joint and several”.
This risk is commonly addressed through express drafting stating that the release of one guarantor does not affect the liability of any other guarantor.
Breach by the creditor
If the creditor breaches a condition or material term of the guarantee, the guarantor may be discharged from liability. Where there is uncertainty as to whether a term is a condition or merely a warranty, courts will generally prefer an interpretation favourable to the guarantor.
To reduce this risk, guarantees can be drafted as “irrevocable and unconditional” obligations, so that certain breaches by the creditor will not necessarily discharge the guarantor.
Unfair preferences and uncommercial transactions
A guarantee may also be affected if the debtor later enters external administration or bankruptcy. For example, a payment made by the debtor to the creditor may discharge the guarantor’s liability, but the payment itself may later be clawed back as an unfair preference or uncommercial transaction.
This creates a risk that the creditor may be required to repay the money to the liquidator while simultaneously losing recourse against the guarantor.
To address this risk, guarantees can incorporate a reinstatement of rights clause. Such clauses generally provide that if a payment or transaction is later avoided, clawed back or set aside in insolvency proceedings, the creditor’s rights against the guarantor are automatically reinstated as if the payment had never occurred.
When may a guarantee be void or voidable due to lack of corporate benefit?
A company guarantee may be vulnerable where the guarantor company receives insufficient corporate benefit from the transaction.
Directors must exercise their powers bona fide in the interests of the company and for a proper purpose. If a company gives a guarantee without sufficient corporate benefit, the guarantee may be vulnerable to challenge.
This issue commonly arises where a subsidiary guarantees the obligations of a parent or related company despite receiving little direct commercial benefit itself. Importantly, a transaction is not necessarily for the benefit of a company merely because it benefits the broader corporate group.
In practice, creditors should carefully assess and document the commercial benefit flowing to the guarantor company, particularly in related-party financing arrangements.
When can ipso facto provisions stay enforcement of a guarantee?
The ipso facto regime may stay the enforcement of certain contractual rights triggered solely because a company enters insolvency or restructuring procedures.
This may prevent a creditor from accelerating the underlying loan based on the insolvency event, which can in turn delay or restrict enforcement of the guarantee.
However, the stay does not generally prevent draw-stop rights triggered by insolvency events, nor does it prevent acceleration or enforcement for other defaults, such as non-payment.
In practice, creditors should carefully draft default and acceleration clauses, so enforcement rights do not depend solely on insolvency-triggered events.
How can a guarantee be enforced?
For creditors, a guarantee provides an additional and often immediate enforcement pathway. A creditor is generally entitled to make a demand directly against the guarantor without first taking enforcement action against the debtor.
Creditors should also be aware that a claim under a guarantee is generally treated as a claim for a debt rather than a claim for damages. Accordingly, the creditor is ordinarily not required to mitigate its loss before enforcing the guarantee.
Final words
For commercial parties, guarantees are often signed quickly and later enforced strictly. Small drafting choices, routine commercial concessions, or later insolvency events may significantly affect whether a guarantee remains enforceable and the scope of liability that follows.
Ironbridge Legal regularly advises creditors, directors and guarantors on guarantee drafting, enforcement strategy, insolvency risk and commercial disputes arising from secured lending arrangements.
Further Information
For further information about guarantee drafting and review, guarantor rights and liability risks, and enforcement strategy in secured lending and insolvency contexts, please contact the author of this article:
