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Guarantees and indemnities in general contracts

This Article summarises the key elements of #guarantees and #indemnities, the circumstances in which they are used, issues that beneficiaries and lenders should consider in respect of the form of the guarantee or indemnity, and in the context of indemnities or guarantees granted by individuals or corporate entities.

Elements of a guarantee

A guarantee:

• is a promise by the guarantor to the beneficiary that a third party (the primary obligor) will perform an obligation, and/or if the third party does not perform, the guarantor will perform it or procure its performance
• creates a secondary obligation (i.e. an obligation dependent on the primary obligor’s obligation), and
• can never exceed the obligation of the primary obligor in the absence of wording to the contrary (i.e. if the primary obligor’s obligation falls away for any reason (e.g. illegality), the guarantor’s liability falls away too)

Guarantors enjoy a right of subrogation; once the guarantor has paid the beneficiary it may step into the beneficiary’s shoes to recover what it has paid, so if the beneficiary had any security or rights of set-off against the primary obligor the guarantor can enforce them.

References in this Article to ‘guarantees’ are generally to traditional, surety or ‘see to it’ guarantees. These should not be confused with ‘on demand’ guarantees the legal nature of which is very different.?

Elements of an indemnity

An indemnity:

• is a promise to be responsible for (or make good) another’s loss, and
• creates a primary obligation (i.e. an obligation independent of the primary obligor’s obligation); if the primary obligor’s obligation falls away, the indemnifier’s liability still stand

Distinguishing guarantees from indemnities

Whether a guarantee or an indemnity has been provided is a question of construction in each case. The courts will look at the substance of the agreement rather than any particular labels used. Therefore, using headings and descriptions such as ‘indemnity’ or ‘guarantee’ will not be conclusive, although they may provide some guidance. A contract may contain both guarantee and indemnity obligations.

Advantages of indemnities

An indemnity has the following advantages over a guarantee:

• an indemnity is a primary obligation, independent of the primary obligor’s obligation—if the latter obligation is invalid, the indemnity still stands
• if the agreement under which the primary obligor’s obligation arises is changed, an indemnity will not be discharged, whereas a guarantee (in the absence of wording to the contrary) will be
• an indemnity need not comply with section 4 of the Statute of Frauds (1677), whereas a guarantee must—section 4 states that a guarantee must be in writing and signed by the guarantor or a person authorised by them before it will be effective; the following guarantees were held to be invalid:

where the promise was not made in writing

where the guarantee statement was in a bid document (which was ‘subject to contract’) but not in the final signed contract

where the guarantee was evidenced in an email but was not ‘signed’ (the sender’s email address in the header of the email was insufficient)—however, the courts have adopted a relatively lenient approach to what will constitute a signature, provided that the signature is inserted into the document by the signing party with the intention of authenticating the document

Reasons for using guarantees

Commercial transactions—performance guarantees

Performance guarantees given by parent companies are common in commercial transactions. The parent company guarantees the performance of its subsidiary’s obligations, with the effect that the parent company performs its subsidiary’s obligations or procures that they are performed where the subsidiary fails to do so.

From the beneficiary’s viewpoint, a parent company guarantee is only worth having if the parent is in a better financial position than the subsidiary or has the means to perform the contract itself.

From the parent company’s viewpoint, this kind of promise should only be given if it can exercise some control over the operations of the subsidiary and is able to perform the contract itself or procure the performance by some other person.

Banking transactions—payment guarantees

In banking, most forms of guarantees are actually indemnities or a combination of both.

As part of a security package, a lender often requires guarantees from the borrower’s parent and/or sister companies and/or subsidiaries (ie cross-guarantees or inter-company guarantees), whereby the non-borrower companies guarantee:

?????????each other’s liabilities to the lender (as guarantor), and

?????????the borrower’s liabilities to the lender (as borrower)

If the borrower fails to pay or becomes insolvent, the lender can look to any other company in the borrower’s group who has provided a cross-guarantee for payment.

The cross-guarantee net minimises the possibility that assets will fall outside the lender’s reach. To maximise the lender’s protection, the guarantor companies are often required to give security over their own assets to support their liabilities as guarantors.

Issues to consider—form of guarantee/indemnity

A guarantee must be in writing and signed by the guarantor or a person authorised by them in order to be effective. This requirement does not apply to indemnities, but best practice is to have them in writing and signed.

A guarantee or indemnity must satisfy all requirements for forming a valid contract. It is sometimes difficult to prove that consideration exists, since the guarantor or indemnifier may not benefit from the transaction it is guaranteeing or indemnifying.

Consider:

• examining the relationship and dealings between the guarantor and primary obligor to establish the commercial benefit (e.g. is the guarantee downstream, upstream or cross–stream)—if the guarantor is the parent company (downstream guarantee), it may benefit from the beneficiary entering into the transaction with the primary obligor by getting increased dividends and thus consideration is present; it is for this reason that some guarantees say ‘in consideration of [X] entering into [the agreement] with [Y], the guarantor grants this guarantee…’ (see also the section on ‘Commercial benefit’ in Issues to consider—guarantees/indemnities from companies below)
• inserting a statement into the guarantee or indemnity that the guarantor has received a fee from the primary obligor in consideration of the indemnity or guarantee (and that the fee is actually paid or is recorded as an inter-company debt)
• executing the guarantee or indemnity as a deed, which removes the requirement for consideration

An additional benefit of executing the guarantee or indemnity as a deed is that it will benefit from an extended limitation period (12 years).?

Importance of clear wording

The document must make it clear whether a primary or secondary obligation is intended. Words such as ‘payable on demand’, ‘unconditionally’ and ‘expressed to be due’ will indicate a primary obligation regardless of the name given to the document or the promisor.

Interpretation

The principles of construction that apply to contracts generally also apply to guarantees and indemnities; the object is to ascertain the objective meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract. The contract must be considered as a whole.

Traditionally, where the meaning of the words used remained ambiguous after the application of the various contract interpretation principles, the courts applied the?contra proferentem?rule, construing the document in favour of the promisor (ie taking the less onerous interpretation).

However, the court in?Multiplex v Dunne, in construing the terms of a suretyship agreement to determine whether it was an indemnity or a guarantee, noted (albeit obiter) that the?contra proferentem?principle now has a very limited role when interpreting suretyship agreements entered into by companies of equal bargaining power.?

The effect of termination on any guarantee is dependent on the wording and construction in each case.?

Issues to consider—guarantees/indemnities from individuals

When taking a guarantee or indemnity from an individual, there are a range of issues to be considered in addition to those which arise generally in the context of guarantees and indemnities. These are briefly discussed below.?

Capacity of an individual

Under English law, it is presumed that everyone has capacity?to?contract; however, there are certain categories of individuals with limited or no capacity. If a person proves that they belong to one of these categories of individuals (and therefore lack capacity), the contract may be unenforceable. Before taking a guarantee or indemnity from an individual, the beneficiary or lender should ensure that the individual has capacity to enter into the document containing the guarantee or indemnity.

Undue influence

Undue influence is improper pressure imposed on the guarantor by somebody else. It means that the guarantor did not provide the guarantee on the basis of a free and informed decision. A guarantee considered to have been given under undue influence will not be enforceable against the guarantor.

The court also set out various principles in respect of the duty of the solicitor acting for the guarantor, including various core minimum requirements for advice. A solicitor may act for the guarantor even if they are also acting for the lender or the principal obligor, provided they are satisfied that it is in the guarantor’s best interests and that it will not give rise to any conflicts of duty or interest. Solicitors acting for the lender or principal obligor and the guarantor should also note the conflict of interests rules in the Solicitors’ Code of Conduct 2011, chapter 3.

Voidable transactions

A guarantee granted by an individual can be set aside in certain circumstances. The key grounds for setting aside a guarantee from an individual arise in the event of the individual’s bankruptcy if the guarantee is considered to be:

?????????a transaction at an undervalue, or

?????????a preference

Where a beneficiary or lender is concerned about the financial standing of the individual providing the guarantee, it should conduct appropriate bankruptcy searches to find out whether the individual is subject to any bankruptcy petitions or an individual voluntary arrangement.

Debt respite scheme

The Debt Respite Scheme (Breathing Space Moratorium and Mental Health Crisis Moratorium) (England and Wales) Regulations 2020, SI 2020/1311 allow an individual who meets the relevant eligibility criteria to apply, via a debt advice provider, for either a breathing space moratorium or, where the individual is receiving mental health crisis treatment, a mental health crisis moratorium.

In either case, the effect of a moratorium is to restrict enforcement action by creditors, and to freeze interest, fees and charges on debts caught by a moratorium, in respect of any qualifying debt.

The debt respite scheme may be relevant to commercial lending transactions if they involve an unsecured personal guarantee.?

Consumer Rights Act 2015

The Consumer Rights Act 2015 (CRA 2015) applies to business-to-consumer contracts. CRA 2015 contains a ‘black list’ of certain contract terms and notices which are legally ineffective (i.e. not binding on or enforceable against consumers). Terms and notices can also be ineffective and unenforceable if they are found to be unfair by reference to the general fairness test in CRA 2015, Pt 2. However, if they are blacklisted, they are automatically unenforceable, without the need to apply this test. CRA 2015, Sch 2 Pt 1 also contains an indicative and non-exhaustive ‘grey list’ of terms in consumer contracts that may be regarded as unfair.

In?Barclays Bank v Kufner, the court held that for a guarantee to be covered by the Unfair Terms in Consumer Contracts Regulations 1994, SI 1994/3159 (now superseded by CRA 2015, Pt 2), both the guarantee and the principal contract to which it had been ancillary should be executed by a ‘consumer’. By analogy, it is therefore likely that both the guarantee and underlying contract must be executed by a ‘consumer’ for them to fall within the scope of the CRA 2015.

Issues to consider—guarantees/indemnities from companies

There are several specific issues to consider when taking a guarantee or indemnity from a company. These are briefly discussed below.

Registrable charges

Guarantees and indemnities are not registrable security as they do not create any charge that falls within the categories of registrable charges.

A set-off and guarantee arrangement (i.e. where a group of companies agree that their liabilities can be set off against each other’s bank balances, in essence creating a guarantee and security arrangement) may be registrable. The cautious approach is to register the document with Companies House within the 21-day limit.

A potential lender will therefore not discover the existence of a guarantee simply by looking at the company’s charges register. If possible, a warranty should therefore be taken from the guarantor (and the borrower if they are connected) to the effect that the guarantor has not given a guarantee.

Commercial benefit

The guarantor company’s directors owe the company a fiduciary duty to act in a way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. Part of this duty is that directors should not commit their company to entering into transactions where the company is taking on obligations without receiving some equivalent commercial benefit.

If a company enters into a transaction where there is no commercial benefit, that transaction can be set aside at the instance of the shareholders of the company. Any third party such as a lender may be unable to enforce the transaction and/or hold the proceeds derived from the transaction as a constructive trustee.

It is not always clear whether a guarantor derives a benefit from granting a guarantee. When a company borrows and gives security for a loan, it clearly derives benefit from the arrangement. Where a parent, sister company or subsidiary of the borrower grants a guarantee, it may not be so clear what benefit these companies get. The benefit must be exclusive to the individual company rather than to the group as a whole.

If the guarantee is:

• downstream (from a parent to its subsidiary)—it may derive benefit from the increased dividends from the borrower
• upstream (from a subsidiary to its parent)—benefit is harder to establish but may be derived from the parent-subsidiary relationship (e.g. intra-group loan to subsidiary, trading arrangement with parent)
• cross-stream (e.g. from a subsidiary to another subsidiary in the same group)—most difficult to establish benefit, but may be justified by, for example, intra-group trading arrangements

In the case of doubt, a guarantee may still be given if the company’s shareholders unanimously agree and the company is not insolvent at the time and does not become insolvent as a result of giving the guarantee.

Capacity of a company

A company incorporated under the Companies Act 2006 (CA 2006) is incorporated with unrestricted objects unless it has chosen to restrict its objects. Any such restrictions are set out in its articles. The articles should therefore be checked to confirm that the company’s objects are unrestricted or that its objects confer on it the necessary power to enter into the transaction, along with any resolution and any shareholders agreement which may fetter the company’s powers. For example, there might be limits on the amounts which the company can guarantee or indemnify.

Where the articles contain restrictions or prohibitions against granting guarantees or indemnities, they can be amended beforehand by special or written resolution.

Voidable transactions

If the guarantee falls into any of the following categories of transactions, it may be set aside:

• a transaction at an undervalue (i.e. where the company receives no consideration or significantly less than the value it provided) may be set aside by court order upon the application of an administrator or liquidator
• a preference (ie where the company intentionally puts a creditor in a better position than it would otherwise have been in) can similarly be set aside by court order
• a floating charge given in exchange for past consideration may be invalid

Financial assistance

CA 2006 abolished the prohibition against private companies giving financial assistance. The prohibition against public companies doing so continues to exist. Financial assistance includes the giving of guarantees and indemnities.?

Company voluntary arrangements (CVAs)

CVAs are compromise arrangements made between a company and its creditors. Proposals are put to the creditors and shareholders and, if approved by a majority in value, will be binding on all except preferential and secured creditors.

As CVAs are agreements between a company and its creditors, there is nothing to prevent the creditor from enforcing an agreement with a third party (such as a guarantee). To effectively remove claims against the company, the CVA can provide that a creditor cannot enforce a guarantee if to do so would give rise to a right of recourse by that third-party guarantor against the company.

If this argument is upheld, guarantees would become worthless, as the beneficiary will be prevented from enforcing it at precisely the time when the beneficiary needs it.

One solution is to have the guarantee prohibit the guarantor from exercising its right of recourse against the company. Only a guarantor who is connected in some way to the company (e.g. being a parent or subsidiary) is likely to agree to this; an independent guarantor is unlikely to give up its right of recourse. This method remains untested by the courts.

#guarantee #indemnity #smallbusiness #knowledgemanagement