Director Guarantees: Don't get tripped up by guarantees

Geoff Stevens provides some guidance through the complex maze of director guarantees.

As a director, you will often be requested to provide guarantee support for your company’s obligations. This can be in the context of financial accommodation from a financier, leases relating to premises, sale contracts as well as many other commercial arrangements.

It is important to understand what obligations you are exposing yourself to, how your obligations can be limited and what rights you have as a guarantor both as against the company as principal and also as against other guarantors.

When will directors’ guarantees be sought?
Director guarantees can be requested in any situation where a party dealing with a company desires extra protection or security for a transaction. They are sometimes simply sought to ensure that individuals connected to a company remain ‘interested’ in the success of the relationship. Further, there are often good credit reasons for a party dealing with a company to take guarantees from directors, especially in circumstances where the party dealing with the company suspects that the company is likely to default or where the company does not (or may not) have the financial means to fulfil its obligations – for example, where the company is a $2 company.

Once you have made the decision to provide the support, what issues do you need to be particularly aware of in terms of your potential obligations and exposure under the guarantee?

Guarantees (and indemnities) will often be drafted in a way which potentially extends their operation and life well beyond what you may be intending. The following are some examples of how this may occur and also of how the issues can be dealt with.

Joint and several liability
Where there is to be more than one guarantor, a guarantee will often be expressed as being ‘joint and several’. This effectively means each guarantor is liable separately from, as well as along with, other guarantor parties.

Guarantees are also often drafted so that they apply irrespective of whether other intended guarantors actually end up signing a guarantee.

Where there are other guarantors, you should therefore try to get the party obtaining the guarantee to agree:

• That you have a several liability, for a limited proportion or percentage of the principal obligation;

Where you are providing a guarantee with related parties (for example, your spouse, your company etc), that the liability of your ‘guarantor group’ – that is, each of the entities with which you are related – is in aggregate limited to an agreed amount or proportion of the principal debt or obligation. This avoids the holder of the guarantee being able to recover the limited amount from each party in your ‘guarantor group’; and

All moneys guarantees
Often, a guarantee will be drafted so as to be an ‘all accounts/all moneys’ guarantee, even though it may be granted in the context of a specific transaction. Under such guarantees, the guarantor is liable for all debts and obligations of the company. This happens even if the company is liable as a primary borrower/obligor or as guarantor for other entities and even if the transaction is the specific one contemplated or some other arrangement now or in the future.

It is therefore important to limit the transactions or facilities covered by the guarantee to, for example, a specific amount and/or to a specific transaction. As part of this, directors should enquire as to what other relationships or obligations the company has with, or to, the holder of the guarantee, as this may affect the director’s overall liability under the guarantee.

All moneys securities
If a guarantor has granted a mortgage or other security, such as a mortgage over a home for a private loan, in favour of the party to hold the guarantee even for an unrelated transaction, the guarantor’s liability under the guarantee may be recoverable under the mortgage or other security.

It is therefore important to understand the possible inter-relationship between the guarantee and the mortgage or other security.

Notice of default
Guarantors are ordinarily not entitled to notice of the company’s default. Where possible, guarantors should obtain agreement from the party holding the guarantee to provide notice to the guarantor of any default by the company.

Order of enforcement
Guarantors usually have no right to insist that the party holding the guarantee proceeds first against the debtor – that is, the company – or enforces mortgages or other securities it holds before enforcing under the guarantee.

Where possible, you should seek agreement from the party holding the guarantee that they will first take action against the company and/or under other securities before taking action against guarantors.

Release from liability under a guarantee
Most guarantees will contain provisions specifying that the obligations and liability of the guarantor are not affected by certain events (for example, a variation to the arrangement in relation to which the guarantee is granted, the release of other guarantors and the like).

These types of events should be reviewed carefully. Changes should be negotiated if any of the events are not appropriate or are unacceptable in the circumstances.

A director will not, ordinarily, be automatically released from its obligations under a guarantee simply because the guarantor ceases to be a director of, or involved with, the company. The safe practice is to therefore get an express release from the party holding the guarantee whenever it is required or appropriate.

Stopping running accounts
A guarantor may, in certain circumstances, stop a guarantee from covering future liabilities by providing written notice to the party holding the guarantee that the guarantor no longer guarantees any further liabilities. The guarantor normally remains liable for existing liabilities but this mechanism can assist guarantors in limiting their exposure, particularly when the guarantee relates to a series of dealings or fluctuating financial facilities.

Contribution and subrogation
Contribution is the right of a guarantor to seek contribution from other guarantors in relation to a common liability when a guarantor has paid more than his or her individual share. Subrogation is the right of a guarantor, upon payment of the ‘guaranteed moneys’ under a guarantee, to step into the shoes of the holder of the guarantee, such as the financier or landlord. This right of subrogation can be significant given that the guarantor takes over the rights to not only the debt or other obligations owed by the company, but also the benefit of any securities held by the creditor.

Guarantees will usually contain clauses providing that the guarantor cannot exercise rights of contribution and subrogation until all of the principal obligations of the company to the party holding the guarantee have been satisfied or paid in full.

While it will often not be possible to negotiate a change to this position, guarantors need to be aware of their rights under contribution and subrogation.

External administration
Under the Corporations Act (section 440J), a guarantee of a liability of a company cannot be enforced during the administration of the company as against a director of the company (or a spouse/de facto or relative of such a director), without the leave of the court.

This can be of significance if directors are faced with solvency issues in relation to a company, or action by parties to enforce guarantees against them.

The Code of Banking Practice
Many financiers have elected to be governed by theCode of Banking Practice. Under this code, financiers must adhere to certain procedural requirements when taking a guarantee from an individual in relation to facilities provided to an individual or a qualifying small business.

Under the code:
1. A guarantee must be limited to a specific amount (plus other liabilities such as interest and recovery costs), or to the value of a specific security granted by the guarantor at the time of recovery.
2. Before the guarantee is signed, the financier must give a prominent notice to the guarantor that they should seek independent legal and financial advice in relation to the guarantee, and that the guarantor has the right to limit their liability and otherwise request information about the transaction or facility to be guaranteed.
3. The guarantee (and any other disclosure materials) must be delivered directly to the guarantor, and not to the borrower or broker, for example.

Finally, remember there’s no substitute for reading and if necessary, seeking advice as to the specific terms of the guarantee and the rights and entitlements of the guarantor. Dealing with guarantees is complex and there are usually many unforeseen issues lurking within the words of the guarantee.

Geoff Stevens is a banking and finance partner at Lavan Legal.