When entering into a franchise agreement with a corporate franchisee, it is common practice for the franchisor to require a director or shareholder to provide a personal guarantee. Thereby acting as security to ensure the franchisee company meets its obligations, in particular its obligations to pay fees. A recent case highlights the care required to ensure that such guarantees are enforceable.

Background

English courts have historically come to the aid of guarantors where it is perceived that the guarantor was not aware of the full implications of signing the guarantee.

For some time now, the courts have raised a presumption of "undue influence" where a party to a bank loan (whether a guarantor or a mortgagor) seems to have no commercial connection with the transaction. Typically, this might be a wife acting as guarantor or allowing the family home to be mortgaged as security for her husband's business in which she has no direct interest. In such instances, the courts will usually require proof that the wife has been independently advised and knew full well the obligations she was signing up to. If the beneficiary of the guarantee/mortgage cannot show this, they will often be unable to enforce their guarantee / mortgage.

The Yardley case

The High Court recently looked at lease guarantees in the case of The Trustees of Beardsley Theobalds Retirement Benefit Scheme v. Yardley. The circumstances of the case were extreme. One of the tenant's directors deliberately concealed from Mr Yardley, an employee (and former director), that he was signing a guarantee, rather than simply witnessing a signature. As a result, Mr Yardley's guarantee was held to be unenforceable and the landlord was left without a viable party to sue. The tenant was already insolvent.

Lessons to be learned

In order to make sure that a personal guarantee is enforceable, the Yardley case suggests a number of key items that must be checked or considered.

  • Does the guarantor have a legitimate interest in signing the guarantee? The courts would be surprised to see a mere employee give a guarantee, but not a director or shareholder.
  • If the guarantor is referred to as being a director or shareholder of the corporate franchisee, has this been independently verified? This check should be repeated just before the guarantee is signed.
  • Even if the guarantor seems to have a legitimate interest in giving the guarantee (for example, the wife of the principal operator who is also a shareholder or director in the franchisee company), has it been recommended that they seek independent legal advice? Although seemingly not vital if there are no other warning signs, a franchisor would nevertheless be well advised to recommend this as standard practice.
  • If there are any warning signs in the transaction, for example the guarantee is required in light of the franchisee being in financial difficulties, the franchisor may need to insist on the guarantor taking independent legal advice and producing proof of this. A waiver letter from the guarantor declining to take such independent legal advice may not be enough. Proof of independent advice would usually be a simple letter issued by the solicitors who advised the guarantor and it would be advisable to require production of such a letter as standard practice in taking such a guarantee.

The issue

If the franchisor is unable to show that it has acted reasonably in believing that the guarantor was not acting under "undue influence", by following the above suggestions or taking similar precautions, then the franchisor will usually be deemed to have constructive knowledge of the undue influence and therefore be unable to enforce the guarantee. Being unable to enforce the guarantee will not stop the franchisor pursuing the corporate franchisee of course, and if it has assets and continues to exist that might prove to be an adequate solution. However if it does not, then the inability to enforce the guarantee may mean the franchisor cannot recover what it is owed.

Keeping the records

It is all well and good following the above suggestions to rebut an undue influence/constructive knowledge defence by a guarantor, however, the key is being able to prove that the process was followed. As with many things legal, accurate recordkeeping is vital. In the case of a guarantee by deed you may need to keep the records (ideally the original documents) for 12 years and more beyond your last possible claim date just in case you need to pursue a guarantor.