Following on from our previous discussion on security interests (see A-Z of Banking and Finance: F is for Fixed and Floating Charges), guarantees provide lenders with another limb of credit support, giving the lender a further remedy if the borrower fails to pay. Often the two work together, with group entities giving cross-guarantees for each other’s obligations under a loan facility, each guarantee being backed by security over the guarantor’s assets. In this article we consider guarantees in the context of bank lending.
So, what is a guarantee?
The typical guarantee is a promise by the guarantor to the lender to pay the amount owing to the lender in the event of the borrower’s failure to make a payment or comply with its obligations. It is both a secondary and a contingent obligation, because the guarantor will be liable to make payment only if the borrower fails to perform. Importantly, the contingent nature of a guarantee means that any alteration to the underlying obligations of the borrower (for example, to the terms of the loan) without the consent of the guarantor risks the guarantor being wholly or partially released from his liability. (Contrast this with an indemnity which instead creates a separate obligation of the “guarantor” which stands alone from the obligation owed by the borrower and so is not released by changes to the terms of the underlying loan – a topic for a future issue!)
A guarantee can be for “all monies” and so encompass all amounts that the borrower owes to the lender under any arrangements (including any past and future arrangements), or it may be limited to a specific amount.
Guarantees are often mistaken for security but sadly on their own guarantees do not give the beneficiary recourse to specific assets of the guarantor, nor do they elevate the beneficiary into a preferential position upon the guarantor’s insolvency – in other words, unless the beneficiary takes separate security over the guarantor’s assets (in addition to the guarantee), the beneficiary will rank as an unsecured creditor in the guarantor’s insolvency. It is therefore quite common for lenders to require both “all monies” guarantees and security interests from a guarantor so that in the event of any loan default they have a number of potential enforcement opinions and in the event of an insolvency proceeding they have both maximised the size of their claims and have senior recourse to the group’s assets.
What formalities must be met?
Generally, a guarantee must be in writing and signed by the guarantor. In order to sidestep any issues arising from a lack of consideration, guarantees are also usually executed as a deed; in the event of any change to the borrower’s obligations, a confirmation by the guarantor of the continuation of the guarantee should be obtained and this should also be by way of deed.
Remedies of a guarantor
Once the guarantor has made payment to the lender under the guarantee, the guarantor obtains rights against the borrower, reflecting that the underlying liabilities were the borrower’s primary obligation to satisfy. These include the right to be indemnified by the borrower for all liabilities incurred by the guarantor and, when the guarantor has paid the full amount which it guaranteed, the right to step into the shoes of the lender in respect of the amount owed by the borrower and obtain the benefit of all security interests granted by the borrower to the lender to secure that amount (known as “subrogation”). In group financings, the guarantor will be required to suspend its exercise of these rights until all obligations owing to the lender have been satisfied.