Guarantee - Law, and Practice in UAE
“Credit is a 'system' wherein a person who can't pay, gets another person who can't pay, to guarantee that he can pay.”
In this modern world of fragile finances, the irony of Charles Dickens’ statement is well understood. In these volatile financial markets, debtors and borrowers alike are struggling to meet their financial obligations. As such, it is essential for the lending banks and institutions to be cautious and take measures toward safeguarding and securing their investments.
Guarantees play a significant role in debt financing transactions. As a matter of regular commercial practice, guarantees provided by corporations or individuals for third party debts are often relied on by facility creditors as a form of security. While guarantees mitigate risk, they do not eliminate it from the realm of financing securities, and even a guarantor can default on their liability. Hence, the creditor must satisfy itself of all probabilities in respect of such guarantees in the UAE.
Regardless of the above, guarantees provide added security to the creditor, which is why guaranteed securities are often a requisite for extending financing to the principal debtor. The present article seeks to examine the legal landscape of guarantees, and the applicability of such guarantees in cross-border transactions, along with the laws relating to enforcement of these guarantees within the purview of UAE regulatory and operational framework.
Legal Framework of Guarantees under the Law of the UAE
The concept of the Guarantee derives its legal basis from UAE Federal Law Number 5 of 1985 as amended (the Civil Code). Chapter V of the Civil Code sets out in detail the effect of guarantee (surety) vis-à-vis the rights and obligations of the principal debtor (obligor), the creditor (obligee), and the guarantor (surety). Article 1056 of the Civil Code defines guarantees as a suretyship consisting of ‘the combining of the liability of a person called the 'surety' with the effective liability of the obligor in the performance of his obligations.’
The Civil Code explicitly provides the terms and conditions which govern the issuance and performance of guarantees, which among other things include that:
- For a guarantee to be valid, the principal debtor must be indebted to the creditor in respect of a debt or property of a known person, and it should be well within the capacity of the guarantor to discharge the obligation;
- Unless there is a third party claim, the principle debtor and guarantor shall be discharged of their obligations if the creditor is accepting of an alternate mode of debt satisfaction;
- the obligation of a guarantor is secondary to the obligation and duties of the principal debtor. Any discharge (whether part or otherwise) of the principal debtor’s obligations may extinguish the (part of otherwise) obligations of the guarantor;
- if the principal debtor becomes bankrupt, the creditor must prove its debt in the bankruptcy; otherwise, it will lose its right to claim or recourse against the guarantor to the extent of loss suffered or any outstanding dues, on account of not having proved its debt in the bankruptcy;
- upon the discharge of debt, the creditor is duty bound to handover to guarantor each and all papers necessary and expedient in the interest of guarantor to exercise his/her right of recourse against principal debtor: and
- the creditor shall be entitled to a claim, or legal recourse, against the principal debtor or the guarantor, or both.
Priority of Claim
As witnessed in most regulatory financial regimes the world over, the legal regime in the UAE recognizes the priority of creditors and acknowledges that the mere execution of a guarantee does not make a bank or a financial institution a secured creditor. To establish itself as a secured creditor, and have a pari passu rank with other creditors at the time of enforcement of the claim, a creditor must back the guarantee by security. Such securities may take the form of a mortgage or pledge over assets of the guarantor.
Time Limitations for Enforcement of Guarantees
A further consideration is concerning the period of limitation within which the creditor may proceed against the guarantor for payment of debts due to it. Article 1092 of the Civil Code provides that ‘the creditor should claim the debt within six (6) months from the date when the debt fell due, and otherwise the guarantor shall be deemed to have been discharged.’ The Courts of UAE have however had conflicting applications of the provision mentioned above, as a matter of interpretation.
While the Dubai Court of Cassation has established that a guarantee is a civil obligation and that a claim against a guarantor must be initiated within six months from the due date of payment, the Supreme Court in Abu Dhabi has limited its interpretation of the same article in such a manner that the time limitation does not apply to guarantees in commercial transactions. As such, it is standard practice to leniently interpret the limitation provision of 6 months, in the relevant transactional documents, particularly in cases where the beneficiaries are banks and financial institutions that have extended the applicable time limitation much beyond six months. However, this practice does not ensure that the provision shall cease to have an effect, and creditors must take prudent steps to safeguard their interests.
In free zones or offshore jurisdictions, these laws differ. For instance, the legislation in the Dubai International Financial Center Courts (the DIFC Courts) provides a much wider margin of time. Excluding cases of fraud, a claim cannot be commenced after a lapse of more than six years from the date which the cause of action arose. It should be noted that where free zones’ legislation is silent on such limitations, the provisions contained in the UAE Civil Code shall operate and apply.
To establish whether a Guarantee is valid and legally enforceable, it is important to establish the nature of the Guarantee. In an ‘all monies’ guarantee, a guarantor guarantees any and all obligations of the principal debtor to the creditor, whether existing at the time of the guarantee or arising in the future. However, such guarantees may not be enforceable in the UAE.
Article 1061 of the Civil Code requires the issuance of guarantees subject to specified 'debt' or a thing that is certain in amount, and must, therefore, refer to the amount or facility guaranteed by the Guarantor. Further, the Dubai Court of Cassation has held that the guarantee contract shall be void unless it determines the guaranteed amount; or includes the basis on which the amount guaranteed should be calculated; or refers to the credit facility granted to the principal debtor.
While there have been judgments where the UAE Courts have recognized and enforced ‘all monies’ guarantees, such judgments do not set precedence.
Guarantees in Relation to Subsidiaries
In most scenarios, a parent company can guarantee a loan extended to its subsidiary (or a corporate group company subject to the parent company's constitutional documents) provided that the necessary corporate approvals are obtained, including a board resolution, and perhaps a shareholders’ resolution. Likewise, a subsidiary can also grant a security in respect of a loan to its parent, subject to the aforesaid conditions.
However, there are certain reservations on guaranteeing obligations by a company. For instance, a director of an onshore company in the UAE is required to act prudently and in the company’s best interests, as set out in the Federal Law No. 2 of 2015 (the Company’s Law). Articles 153 and 154 of the Company’s Law impose restrictions on a company to guarantee any loan agreement entered into by the board members with a third party and also restrict a director from entering into any loan agreements which may include guarantees for a term which exceeds three years.
Similarly, free zone registered entities place comparable responsibilities on managing directors. Article 53 of the DIFC Law Number 2 of 2009 states that ‘directors must, act bonafide, (in good faith) and lawfully with a view to the best interests of the Company.’ In these circumstances, Directors for both onshore and offshore companies should cautiously proceed when entrusting their entity to guarantee the financial risk of another company.
Guarantee for Cross-Border Financing
The UAE legal framework does not impose any restrictions on guarantees extending from domestic parties to foreign lenders. As long as such guarantees are in compliance with the provisions of the UAE law, or the laws of the offshore jurisdiction, as the case may be. Such guarantees must be in writing and specify the amount secured by the guarantee, as previously stated.
However, in the event security is executed over immovable property, such security cannot be granted to foreign banks unless the bank has a commercial banking license in the particular Emirate where the immovable property is located. In practice, however, foreign banks lending to UAE borrowers generally appoint a local bank as its security agent to hold the UAE security.
Security over movable property may be granted to non-resident foreign banks, except if it is:
i. If it is a business mortgage in relation to assets in the Jebel Ali Free Zone established under the Commercial Transaction Law. In this case, it may only be extended to banks or financial institutions with a commercial banking license.
ii. a pledge of funds in a bank account. Such pledges can only be granted to the account-holding bank. However, in practice, foreign non-resident banks typically appoint a local, onshore security agent to hold the security on their behalf.
Further, a DIFC incorporated entity may provide a guarantee for the debt of a borrower, irrespective of whether the borrower is based within or outside the DIFC or for that matter - the UAE. The essential condition to be satisfied is that the granting of the guarantee is as per the company’s constitutive documents (articles of association), and after obtaining the necessary approvals.
Expiry of a Guarantee
Expiration of the Guarantee is enumerated in Article 1099 of the Civil Code which provides for termination or expiry of the guarantee inter alia upon the following:
i. discharge of the debt;
ii. deterioration/loss of security in the hands of the principal debtor by a force majeure before a claim is made;
iii. the primary contract between the creditor and principal debtor terminating whereupon the creditor accrued its right against the principal debtor;
iv. the creditor discharging the guarantor of its liability or the debtor of the debt;
v. the death of the principal debtor.
Additionally, in line with provisions contained in Article 1101 of the UAE Civil Code, it is provided that if the debtor(s), creditor(s), and guarantor(s) record a settlement concerning 'part' of the total debt, then the guarantee will finally terminate, and the balance debt will be waived. That said, the settlement contract should clearly stipulate whether parties desire to waive guarantor's liability. If the settlement does so specify, the Guarantor will not be liable, and the automatic termination of the guarantee will be triggered. By virtues of the said Article, the creditor may choose to claim the debt (either partially or in full) against the principal debtor.
Enforcement of a Guarantee
A creditor, upon notifying the guarantor of the default of the principal debtor, can proceed to enforce a guarantee in court. Legal recourse by the creditor can be taken in the form of either an attachment first, and commencement of substantive legal proceedings later, or commencement of substantive legal proceedings immediately. Once the final judgment is obtained, the creditor may proceed with the execution of such a judgment by way of liquidation of the guarantor’s assets, and any funds realized thereof, will be appropriated towards the outstanding dues of creditor and surplus if any would be transferred to the Guarantor.
In the event of the death of personal guarantor, a claim will need to be instituted against the deceased person's estate. The applicable legal position relating to probate and inheritance under UAE Federal Law No. 28 of 2005 shall govern the distribution of the estate of a UAE resident or national. Under Article 275 of the law mentioned above, the creditors of the deceased person would have first priority over any other distribution except that for any burial expenses. The manner of creation of security interest and enforcement thereof is covered in detail in our previous Article.
Release of Security
Most unregistered securities, particularly movable assets, are released by way of transferring possession of the security asset back to the guarantor, but can also be released with a release and discharge letter from the creditor. For registered securities such as mortgage, it is necessary to follow the procedure of the relevant regulatory authority as outlined.
The UAE legal framework, including laws of offshore jurisdictions, clearly enunciates the manner in which a guarantee must be executed. Though the interpretation of limitations may be a bit of a gray area, the structure and landscape applicable to guarantee obligations are, in effect, clear. Therefore, while the guarantor should adhere to, and understand the repercussions and effect of its/his act of, guaranteeing, the creditor should ensure that any uncertainty is avoided for an impediment-free enforcement process.
As prudently explained in Shakespeare’s Merchant of Venice, had Antonio realized the gravity of the situation while agreeing to guarantee Bassanio’s debt to the cunning Shylock, he could have avoided coming so close to losing his ‘pound of flesh’!