When additional financial support is needed on a transaction, a personal guarantee can often be the solution. This note looks at the questions that arise when taking a personal guarantee and the issues that lenders should be aware of.
Who is the guarantor?
It is important to establish who the guarantor is and their relationship with the borrower debtor. There are advantages and disadvantages to the guarantor being connected to the borrower and in the same way there are issues and benefits with having a third party guarantor.
|Taking security from an ultimate beneficial owner and/or a director|
|Increased focus – The guarantor will have personal liability for the debt which may lead to a greater focus and involvement by the individual on the project.||Aligned sources of wealth - If the ultimate beneficial owner’s principal source of wealth is tied up in the debtor company or their sole income is paid by the debtor company then this lead to the guarantee being of no benefit at all. It is advisable to consider whether the guarantor has access to other sources of wealth other than income from the company debtor.|
|Access to the personal wealth of a director – The guarantee provides recourse to the personal wealth of the director/UBO. As there is established case law that a limited liability company’s directors and shareholders do not have responsibility for a company’s debts, this is a way of circumventing this principle and obtaining further financial support for the debt repayments of the principal debtor. Please see paragraph 3 below.|| |
Directors conflict of interest – When a director provides a personal guarantee to pay or perform the obligations of a company of which they are a director, they will place themselves in two conflict situations:
Provided the articles of association permit it and none of the Companies Act 2006 transitional provisions apply, then these conflicts can be dealt with through a shareholder’s resolution and declarations of the interest (depending on which conflict applies). It is important for the lender to make these resolutions a condition precedent to ensure the correct corporate governance procedures have been followed and there are no possible grounds for challenging the validity of the guarantee.
|Taking a guarantee from an unrelated party|
|Additional skills beyond the management board - A guarantee to perform the obligations of the debtor when provided by an individual that is not directly involved in management could possess skills which may prove to be beneficial if the debtor falls into difficulty or they could simply be a better source of funds than someone with a vested interest.||Limited recourse – Often when a third party individual provides a guarantee they will look to limit their liability under the guarantee by ensuring the guarantee is not all monies but instead for a specific debt and/or there is a cap on their liability so that their exposure is limited. This is often because the benefit to the guarantor for providing the guarantee is limited and therefore they prefer to reduce their exposure to the lender as much as possible.|
What is the financial standing of the guarantor and are their assets accessible?
It should be straightforward to establish the financial standing of the guarantor at completion of the transaction as know your customer and due diligence procedures will have been followed. The real risks arise after completion when a guarantor can subsequently dispose of its assets or put them out of reach of a creditor. The main issues to be aware of are:
Assets in a trust are not necessarily the property of the guarantor
Guarantors can sometimes make representations about their assets that are held in a trust that lead to the lender believing they can access those funds. Life interest trusts and interest in possession trusts give the beneficiaries of the trust access to income from the trust assets but not capital. Likewise the assets of a discretionary trust, where the beneficiaries have no entitlement to the assets of the trust will not form part of the assets of the beneficiary until the beneficiary receives the funds. Therefore, if assets are held in a trust, this does not necessarily mean that the lender can access those assets on enforcement of the guarantee.
A family home is not an easy asset to realise
It is likely that one of the principal assets of a guarantor will be their family home. Whilst this may look like a substantial asset when assessing the financial standing of the guarantor, if the lender has to petition for the guarantor’s bankruptcy to realise the assets then there are restrictions on dealing with the bankrupts family home. For example, if the spouse of the guarantor does not co-operate, court orders must be obtained in order to sell the house and automatic possession may be blocked if the guarantor’s family occupy the home.
Property and assets held abroad cannot always be accessed
If the guarantor has moved abroad or they have moved their assets to another country, although the guarantee may be subject to English law, in order to take possession of the assets, the lender will have to enforce an English law judgment abroad. Whether or not this is possible will depend on the law of the country where the assets are situated. Currently, as a member of the European Union, English law judgments are enforceable in the European Union pursuant to the Brussels and Lugano conventions but this may change post Brexit. For other countries there are other conventions that deal with enforcement abroad but in all cases foreign counsel advice must be sought to enforce the judgment successfully. Using an arbitration clause is often a suggested solution but this must be considered in the context of the transaction.
What enforcement options are available
Presuming most modern guarantees are drafted as both a guarantee and indemnity and it is likely that most guarantees will follow the standard form and contract out of the various common law protections for guarantors, a guarantee can be called in by a lender if the guarantee has become enforceable in accordance with the terms of the facility documentation and the guarantee. If the guarantor does not pay when the demand is made by the lender the lender has the following options:
- pursue a claim for the debt by issuing a statutory demand if the guarantee creates a debt obligation on the guarantor;
- pursue a claim for damages if the obligations that are guaranteed are performance obligations; and
- petition for the bankruptcy of the guarantor.
There are reputational issues associated with taking action against an individual generally. In addition, looking at the options available, the lender must decide whether the enforcement would result in the recovery of the amounts that are due. For example, if the lender is an unsecured creditor and the guarantor has secured creditors that rank ahead of the lender then issuing a statutory demand may not result in the monies being recovered. If the lender has concerns about the financial standing of a proposed personal guarantor or the availability of their assets the following alternatives are available:
Not only does this make the guarantor a secured creditor, but it also gives the lender direct recourse to an asset that can be sold to recover the funds that are due thereby avoiding the need to bring a contractual claim or commence bankruptcy proceedings against the guarantor. In addition, if the asset is secured and the security is registered, this restricts the guarantor’s ability to dispose of the asset which gives more certainty about the financial standing of the guarantor after completion. It is important to carry out due diligence on the assets that the guarantor owns and ascertain if there is any existing security. If there is, then subordination arrangements will need to be put in place to achieve the requisite ranking of security. Please note, taking security over a family home can lead to additional procedural steps being required (please see below).
Request an on demand bond
An alternative method of obtaining the financial support required is for the guarantor to obtain an on demand bond from a third party bank. The bond is supported by collateral held by the bank that is provided by the guarantor and on a demand by the lending bank, the bond bank will pay out to the lender bank. This provides a solution where a guarantor has liquidity issues or is over leveraged but has alternative assets that can be used as collateral with the third party bank.
Create an escrow account
If the other alternatives are not available, monies can be placed in a blocked account that is managed by an escrow agent who permits withdrawals under certain prescribed circumstances that are set out in an escrow agreement. Escrow agreements must be carefully drafted to avoid any dispute in the event the lender needs to withdraw the “guarantee” monies.
Not following procedure leads to guarantee failure
Case law has established a clear procedure that must be followed when dealing with a personal guarantor. If this procedure is not followed, the guarantee can be challenged and it may not be enforceable.
Undue influence and misrepresentation
Case law has established that where there is a relationship of trust and confidence between the debtor and the guarantor, for example between siblings or spouses, there is a presumption of undue influence in favour of the guarantor. Therefore when an individual provides a guarantee for a debtor’s debt, there are three questions the lender should ask:
- is there a relationship between the principal debtor and the guarantor that gives rise to undue influence;
- if there is undue influence then does the lender have constructive notice of this i.e. should they have known about this as a reasonable person would have known about this;
- and have any steps been taken to rebut these presumptions.
If the answer to the first two questions is yes then the answer to the third question must be yes to ensure the guarantee cannot be set aside. In Barclays Bank Ltd v O’Brien  1 AC 180 the doctrine of undue influence was developed further to establish that as the debtor is the agent of the lender, unless the lender can show that they have taken reasonable steps to satisfy themselves that there is no undue influence between the parties then they will be deemed to have known about of the undue influence and the guarantee could be unenforceable.
Solutions and practical steps
The solution to this is issue has been clearly set out by the House of Lords in Royal Bank of Scotland Plc v Etridge  UKHL 44 which set out two options for a lender:
- Insist that the guarantor attends a meeting in person with the relationship manager at the lender where the relationship manager will set out the risks and explain the need to obtain independent legal advice; or
- Require that the guarantor obtain a certificate of independent legal advice from an independent solicitor having been advised by that solicitor without the debtor being present.
Practically, a lender often does not want to take on the responsibility or liability for advising the personal guarantor and therefore it is now common practice for an independent legal advice certificate to be a condition precedent to all lending transactions where a personal guarantee is being provided by an individual. It is important to note that in addition to providing the certificate, it is advisable for lenders to insist that the solicitor witnesses the guarantor’s signature on the guarantee document. This enables the lending lender to ensure that the solicitor did indeed meet the guarantor in person and therefore was able to verify that the debtor was not present when the advice was given and the document was signed.
The key case law referred to above refers to the relationship between husband and wife. In this way, the Etridge process is often referred to as only being necessary for non-commercial relationships between the debtor and the guarantor. However, common practice now is to obtain an independent legal advice certificate from all individuals to avoid any defence of undue influence.
Have we addressed any consumer credit issues?
Breaching consumer credit legislation can have an impact on a lender’s reputation for client care. In addition, there are severe sanctions and censures that can be imposed by public authorities and the Financial Conduct Authority if the consumer credit issues are not addressed correctly.
Does consumer law apply to the guarantee?
Since 1 October 2015, the Unfair Contract Terms Directive (93/13/EC) has been implemented in the Consumer Rights Act 2015 (CRA). Consequently, the decisions of the Court of Justice of the European Union are followed when questions of interpretation of the CRA arise. This is particularly relevant in relation to the case of Dumitru Tarcău, Ileana Tarcău v Banca Comercială Intesa Sanpaolo România SA (C-74/15) which changed the existing tests to establish whether consumer law applied to a guarantee provided by an individual. The new test sets out the following conditions that need to be satisfied in order for consumer law to apply:
- is the guarantee made with a natural person;
- is the natural person acting for purposes outside his trade, business or professional purpose;
- and the natural person has no link of a functional nature with that company.
If all three limbs apply, then a public authority may be able to challenge the guarantee on the grounds of unfairness under pursuant to the consumer credit legislation.
Regulated Mortgage Contracts
If the personal guarantor is providing security over their family home then the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544)I (RAO) will apply. The position has changed recently and now both first and second charge mortgage contracts are subject to the legislation. Pursuant to Article 61(3)(a) of the RAO a contract is a regulated mortgage contract if the following conditions are met:
- the contract is with an individual or trustees where credit is provided;
- there is a mortgage on the land owned by the individual which secures the loan repayments; and
- at least 40% of the land is intended to be used:
- where there is an individual – as or in connection with a dwelling;
- and where there is a trustee – as or in connection with a dwelling to be used by a beneficiary of the trust.
There are means of exempting the mortgage from the legislation if the correct process is followed but if the lender does not follow the correct process the sanctions imposed by the Financial Conduct Authority can be severe. Therefore, if a charge is being taken over a residential home, it is important to seek advice before proceeding.
This article was written by Isobel Young-Herries. For more information please get in touch via firstname.lastname@example.org or +44 (0)20 7203 5078.