How to Create a Guarantee

The shareholders and directors of a limited liability company are normally not responsible for the company’s obligations. This means that a creditor can only look to the assets of the company when seeking repayment of a debt. In some cases, however, it becomes necessary for the principal shareholders and/or directors to personally guarantee a liability of the company. For example, a guarantee may be required by a bank in order to make a loan, a landlord to enter into a long-term lease, or a supplier to grant credit.

Whether or not a guarantee is necessary or appropriate will be determined by the credit risk to the lender and the relationship between the company and the person who will provide the guarantee. In the case of a solely owned company with limited assets that is applying for a bank loan, it would be natural for the lender to demand a guarantee from the owners. In contrast, if the company has significant assets and the person from whom the guarantee is requested has limited influence over the company’s operations, then the request may reasonably be resisted, or the guarantee minimized. In each case, the outcome of the negotiations will depend on the risk and relative bargaining power of the parties.

With respect to a loan, a guarantee is a promise to pay the lender if the borrower fails to do so. However, a guarantee is what is called a “secondary obligation.” This means that the guarantor's obligation depends upon the borrower's obligation. Therefore, if the borrower is relieved of responsibility to pay some or all of the debt, so is the guarantor. In addition, a guarantee may be discharged if the loan documents are changed in a way that could adversely affect the guarantor.

Anyone acting as a guarantor should be aware that a secured lender is not obligated to go after the borrower’s assets before making a claim on the guarantee. If the borrower defaults on the loan, the lender can demand payment on the guarantee before or after enforcing any security interests granted by the borrower, it is up to the lender. If the guarantor is forced to pay the lender, however, the guarantor normally has the right to make a claim against the borrower who defaulted on the loan. But many lenders require guarantors to waive some of these rights in order to make sure they don’t conflict with the lender’s own rights.

One of the primary issues that must be addressed when a creditor requests security from a shareholder or director is whether it will be in the form of a pure guarantee, or will also be an indemnity. In contrast to a guarantee, an indemnity is a “primary obligation”. This means that the indemnitor’s obligation to the lender is not co-extensive with that of the borrower. So even if the borrower is no longer liable to the lender, the indemnitor remains on the hook for any unpaid amounts under the loan.

Most Guarantee Agreements include both a guarantee and an indemnity because the lender is more secure with both. However, the burden is on the lender to prove that an indemnity, as opposed to a guarantee, was intended by the parties, so the language used in the agreement is critical to both parties.

A guarantee must be in writing and signed by the guarantor. The provisions normally included in a Guarantee Agreement include:
  • Creation of the Guarantee and/or Indemnity
  • Joint and several liability
  • Continuing guarantee
  • Appropriations
  • Waiver of guarantor rights
  • Deferral of guarantor rights
  • Lender protections
  • Interest
  • Costs
  • Representations and warranties
  • Termination
  • Payments
  • Third party rights

With respect to a loan guarantee, the document usually states that the guarantee and/or indemnity covers the payment of all debts owed by the borrower to the lender with respect to both present and future amounts loaned under the relevant facilities. The guarantor promises to pay the lender on demand whenever the borrower does not pay any of the guaranteed obligations when due.

The lender will request a “joint and several liability” clause if there is more than one guarantor, such as when several key shareholders personally guarantee the loan. This often happens when a loan is granted to a company in a group of companies and the bank asks each company to guarantee the repayment of the loan. But it also occurs when several individuals who hold company shares provide a guarantee. The joint and several liability provision allows the lender to take action against any one of the guarantors for the entire amount due.

The “continuing guarantee” provision applies when a borrower has a loan facility that it can draw down, pay off, and draw down once again. Without this provision, a guarantor would only be liable for future advances if it has specifically agreed to provide a guarantee each time a new advance was made. A continuing guarantee provision states that the guarantor agrees in advance to cover such future draw downs.

Because a guarantee is a secondary obligation, any variation to the primary loan agreement may discharge the guarantor's obligation, including an extension of the repayment period on the loan. To provide the lender and the borrower with negotiating flexibility, lenders often ask for a “waiver of guarantor rights”, under which the guarantor waives the right to consent to these types of amendments to the loan agreement.

As mentioned above, a guarantor who is forced to pay under the guarantee will have the right to make a claim against the borrower for the amounts it is forced to pay the lender. This means that if the borrower still owes money to the lender, then the lender would be in competition with the guarantor for the borrower’s remaining assets. For this reason, lenders often ask for a “deferral of rights” provision, under which the guarantor waives the right to go against the borrower until the borrower no longer owes any money to the lender.

In general, guarantors should review each provision of the guarantee to make sure the terms are appropriate under the circumstances. Those who have little or no control over the borrower may reasonably request notice and information provisions, a cure period between the borrower’s default and the guarantor’s obligation to pay, a duty for the lender to enforce its security interests in the borrower’s assets before acting on the guarantee, and a duty of the lender to mitigate the amount to be paid under the guarantee.  In contrast, if the guarantor is the sole shareholder of a small limited liability company, he or she may be asked to stand firmly in the shoes of the company should it not be able to pay.

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