What is a personal guarantee?

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Summary

• A personal guarantee is an important legal mechanism for providing assurance to one party in the case that another party fails to meet their legal obligations
• It needs to be distinguished from other related but distinct mechanisms such as indemnities, letters of comfort, letters of credit and performance bonds
• All parties to a personal guarantee need to ensure that they are aware of the formal requirements, how the obligations of a guarantor are discharged and how to enforce a guarantee
• Personal guarantees must comply with the National Credit Code and the Banking Code of Practice, where applicable
• Anyone making a personal guarantee or relying on one needs to be familiar with the effect an insolvency event has on a personal guarantee.

What is a personal guarantee?

A personal guarantee is the promise of one or more people to be answerable for a debt or obligation of another person or entity in the event that that person or entity defaults on that debt or performing an obligation. Most commonly, it is offered by a third party to a creditor to support a debtor (for ease of explanation, we will assume throughout this article that the personal guarantee is for the payment of a debt, the most common type of personal guarantee).

One defining feature of a personal guarantee, which has significant legal consequences, is that it always involves a ‘secondary obligation’: the obligation to pay is based on the existence of a separate ‘primary obligation’ of another party. For example, in the case of a personal guarantee from the director of a company, the primary obligation is often a loan to the company which the director personally guarantees.  The primary obligation is enshrined in a ‘principal contract’.

From the perspective of the creditor, personal guarantees are a useful mechanism for ‘piercing the corporate veil’ and ensuring that directors and owners are responsible for corporate debts.  From the perspective of the guarantor, signing a guarantee means taking on significant obligations and must be approached with care, both prior to signing and for the duration of the personal guarantee.

As a general caution, anyone signing a personal guarantee needs to be aware that this is a serious legal obligation and ensure that they are sufficiently protected. For example, “all monies guarantees” and irrevocability clauses are of significant benefit to creditors but may mean considerable liability for the guarantor (more on these clauses below).

What a Personal Guarantee is not?

It is important to recognise that a personal guarantee has different legal consequences from some similar legal concepts, so the differences between these different concepts need to be understood:

• These are the ‘guarantee on steroids’. An indemnity means a promise of an indemnifier to be responsible to the creditor for any losses if the debtor fails to pay. This generally creates a ‘primary’ obligation on the indemnifier and means that the responsibility to pay will remain irrespective of any problems with the validity or enforceability of the debt contract itself;
• Letters of credit. This is a direction from one bank to another directing payment if certain conditions are satisfied. A letter of credit requires payment by the bank immediately upon conditions being satisfied, whereas a personal guarantee would require payment only where there has been non-performance of an obligation.
• Letters of comfort. These are often provided by a parent company of a subsidiary where the parent company undertakes to provide for the subsidiary company in certain respects. E.g. the policy “to ensure that the business of the subsidiary is at all times in a position to meets its liabilities to you under the above arrangement”. In Kleinwort Benson Ltd v Malaysian Mining Corporation [1989] 1 WLR 379,  the court found that the wording indicated above was not sufficient to create legal relations between the parties.  Nevertheless, depending on the facts of a case, a letter of comfort may be legally binding.
• Performance bonds. One party promises the fulfilment of a particular contract by another party. These are common in the construction industry. In some cases, where the bond is unconditional, a performance bond may not be a guarantee as it is not dependent on a principal contract being breached. This means that the issuer of the bond is not protected in various circumstances where a guarantor would be.

General Requirements of a Guarantee

In order for a personal guarantee to have its intended legal effect, individuals involved need to ensure that they have fulfilled the formal requirements for a personal guarantee. These requirements are quite strict so it is important that parties to the arrangement get it right. There are a range of matters to be considered, including:

• Legal form. A personal guarantee can take the form of a contract or a deed. Where the requirements for deed are not met (e.g. ‘signed, sealed, delivered’), the usual principles of contract law will apply including requirements for offer, acceptance, consideration and an intention to create legal relations. In the case of a contract, general laws of contract and equity will apply including privity of contract, capacity, certainty and undue influence and unconscionable bargain.
• Correct wording. The words of a personal guarantee are very important and the enforceability of the guarantee may be contingent on the precise wording used (Aquawest Pty Ltd v Twynham [2017] NSWSC 652 2019). A personal guarantee will often include a statement such as:

“In consideration of [creditor] agreeing to supply goods and services to [debtor], at the request of its directors, I/we agree to jointly and severally personally guarantee the performance of all obligations and payment of all debts incurred by [the debtor].”

Unless a personal guarantee expressly states that it is irrevocable, it may be withdrawn by the guarantor at any time. Therefore, if seeking to protect the interests of the creditor, a clause stating that the guarantee is irrevocable, is important. Further, creditors should be aware that, unless a guarantee states that it is ‘all monies’ the guarantee may be limited to ‘present debts’ and may not include all present and future debts. In order to ensure completeness of the guarantee, a creditor should seek to include a clause similar to the following in the guarantee:

“This is a continuing and irrevocable guarantee for all monies which are now or may be from time to time owing or remain unpaid by [debtor].”

• Written documentation. While it is not a strict legal requirement in all cases, it is strongly advisable to have the guarantee in writing as oral agreements are notoriously difficult to enforce in court.

Discharging the Guarantee

Before agreeing to a personal guarantee, both the creditor and the guarantor need to consider the grounds under which that guarantee can be discharged. At law, a personal guarantee may be discharged upon the occurrence of one of the following events:

• Variation of the principal. This may discharge the guarantee if the variation could prejudice the guarantor. Note, however, that this would not apply if the contract includes a clause excluding this.
• Discharge of the principal debtor;
• If it is a condition of the guarantee that there are co-guarantors (where there is more than one personal guarantor), the release of a co-guarantor will release all co-guarantors from liability under the guarantee.
• The creditor breaching any provision of the principal contract or the guarantee that is a condition or essential term of the contract.

On advantage of a deed, from a creditor’s perspective, is that it can contain continuing and irrevocable obligations to avoid the possibility of the debt being discharged in an ordinary way.

Requirements for personal guarantees in legislation and codes

In addition to the general legal requirements for personal guarantees, parties need to consider the impact of legislation and codes that apply to particular types of personal guarantee. For example, in the case of consumer credit contracts, the following matters must be considered :

• The guarantee must be in writing and signed by the guarantor;
• Before signing, the guarantor must receive a copy of the credit contract and a document explaining their rights and responsibilities as a guarantor;
• Within 14 days of signing, the creditor must provide a copy of the signed guarantee and a copy of the contract.

If the guarantee is for a loan offered by a bank which is a signatory to the 2019 Banking Code of Practice, then the lending bank must ensure that:

• The guarantee is limited in certain ways including to a specific amount or value;
• The guarantor can exercise their right to request a further limit of liabilities;
• Notification requirements prior to the signing of the guarantee are complied with;
• Notification requirements about the borrower’s deteriorating financial position are complied with;
• The guarantor can extend the guarantee in certain circumstances;
• The guarantor can exercise their right to withdraw under certain circumstances.

Enforcing the Guarantee

In the case of default of the principal contract, the lender can decide whether to proceed against either the borrower or immediately and directly against the guarantor.

In order to have a realistic chance of enforcing a personal guarantee, a creditor needs to ensure in advance that the personal guarantee has been set up in such a way that it will not become unenforceable. There are a number of key risks that might cause a guarantee to be unenforceable by a court, such as:

• The principal contract with the debtor is either discharged or varied.
• The guarantee is put at risk by waivers or extensions of time granted to the principal debtor;
• There is a deficiency with the execution of the guarantee document;
• The terms of trade between the creditor and the debtor are changed;
• One guarantor is released from the guarantee but not the other;
• The creditor company is in fundamental breach of the contract with the debtor.

If the creditor has decided to enforce the personal guarantee there are a few matters to consider:

• Is there security in place for the debt (e.g. a mortgage or personal property security)? In may make sense to enforce this security first, though note that this will often be a slower option than enforcing a bank guarantee;
• Is it necessary to resort to winding up proceedings? If the guarantor is in financial difficulties this may be the only way to enforce the personal guarantee;
• Is it a guarantee of debt or for another obligation? If the former, a case can be brought to enforce the guarantee for a sum of money. In the latter, an action can only be brought for damages.

Personal Guarantees and Insolvency

We mentioned earlier that, where a director guarantor is worried that a company might go insolvent, they may want to prioritise the payment of any debts backed by a personal guarantee. There are other matters that all parties should be aware of relating to the prospect of insolvency:

• ‘Unfair Preferences’. When a company is being wound up, it is common for liquidators to seek to recover money from previously paid creditors via a claim under section 588FA of the Corporations Act 2001 that that payment was an unfair preference over other creditors. If successful this, voids the creditor’s payment of the debt, however, it does not void the guarantee. Therefore, payment by a borrower to a lender might discharge the guarantor even if that amount is later recovered. To avoid this, specific wording to that effect would need to be contained in the guarantee itself.
• ‘Uncommercial transactions’. It is possible that a personal guarantee which is of no benefit to the company may constitute an uncommercial transaction under section 588FB of the Corporations Act 2001. If this also occurs when there is insolvency, then the transaction will be voided. This applies whether or not there has been a breach of director’s duties and doesn’t depend on creditor knowledge of insolvency.

Some practical advice: a personal guarantee checklist

The matters that need to be considered when entering into a personal guarantee will depend on the party in question. Some aspects of the arrangement will benefit the guarantor, while others will benefit the creditor. When considering a personal guarantee by a director of a company’s debt, the following matters should be considered to protect the creditor’s interests.

• The guarantee should be contained in the company’s new credit application, or, if the creditor and debtor are not entering into a new credit application relationship the guarantee should be executed in the form of a deed with witnesses;
• The guarantee should be in writing and be executed by the proposed guarantors;
• The guarantee should provide certainty about when the personal guarantee will be discharged;
• The guarantee should use a form of words that includes “continuing and irrevocable” and “all monies”;
• If providing consumer credit, compliance with all the requirements of the Consumer Credit Code is required; and
• A credit check should be undertaken of the debtor and the personal guarantor(s) to ensure the identities of all parties and that the guarantor(s) are not bankrupt.