Personal Guarantees – Where Do You Stand? What Are Your Rights?

A guarantee is a contractual undertaking made by one person (the guarantor) in favour of another (the creditor) to settle a debt or fulfil the promise of a third party (the principal debtor) to the creditor, if the principal debtor fails to discharge such obligations.

Generally this obligation relates to the payment of money but may also relate to payment for the performance of services.

You need to be careful in granting a guarantee. The following are some of the points to consider before doing so:

• Guarantees often state that the obligations of the guarantor are equivalent to the borrower’s obligations. In this instance the creditor may call on the guarantor to pay the debt in full without requiring payment from the principal debtor, without exercising all of the remedies against the principal debtor, or without exercising any rights under any securities given by the principal debtor.

• An “all obligation’s guarantee”, (standard with most banks and finance companies) means that the guarantor is liable for all the principal debtor’s obligations to the creditor and the guarantee is not limited to the particular transaction which gave rise to the guarantee. In such a case the guarantor’s liability extends to future lending and all the debts that the principal debtor already owes to the creditor.

• In addition, under an “all obligation’s guarantee” the guarantor becomes liable for any interest payable and any legal costs incurred by the creditor in enforcing the principal obligation against either the borrower or the guarantor.

• Guarantees should not be confused with indemnities. Indemnities have become increasingly common in complex financial transactions, especially for limited recourse transactions.

• Difficulties often arise as to whether a guarantee or an indemnity is the most appropriate undertaking.

• Some institutions attempt to incorporate both an indemnity and a guarantee in a single document. The danger with this approach is identifying whether a guarantee or indemnity is intended. The courts may interpret the document as a guarantee, where in fact an indemnity was intended.

• A guarantor undertakes a secondary obligation to make good particular defaults of the principal debtor compared with an indemnifier who under-writes the profitable success of a transaction.

• The rights of a creditor against an indemnifier and principal debtor are normally different to the rights of a creditor, against the guarantor and principal debtor, which are normally the same.

• A guarantor’s liability under a guarantee can never be greater than that of a principal debtor. The liability of an indemnifier to the creditor may be greater than that of the principal debtor.

• A creditor’s claim against an indemnifier is one for loss, therefore, an agreed loss clause should be provided for. In the absence of an agreed loss clause then the creditor will be required to prove loss suffered or incurred.

Under a guarantee a creditor will only need to prove that the guaranteed amounts are owing by the principal debtor.

• Guarantees can be limited or unlimited, thus a guarantee can be provided with a limitation on the amount, which the guarantor can be called upon to pay and therefore covers only part of the principal debtor’s liability, co-extensive with the amount of the guarantee.

Because a guarantee exposes a guarantor to potential liability for the debts of another person, without any direct benefit to themselves, they should carefully consider whether or not and to whom they give a guarantee.

22nd April 2003
Source: David Solomon, Director, New Zealand Financial Planning
Telephone: (03) 375 4040; davids@chchnzfp.co.nz