Understanding Personal Guarantees: What you should know before signing

It is not uncommon for us to be approached by potential clients concerned about their financial position, after signing a personal guarantee.  However, what is particularly concerning is that most of these individuals did not (and continue not to) have a proper understanding of the nature and effect of that guarantee at the time of signing it.

In this article, we seek to provide individuals with a better understanding of the “fundamentals” of the guarantee. Specifically, we touch on the crucial issues of the extent of a guarantor’s liability under a guarantee, the difference between a ‘guarantee’ and an ‘indemnity’, and what considerations ought to be borne in mind prior to signing a personal guarantee.

What is a personal guarantee?

A personal guarantee is a written promise by a third party individual (the guarantor) to satisfy the obligations of a party to an underlying agreement (the primary obligor) in favour of the other party to the underlying agreement (the beneficiary), in the event that the primary obligor fails to satisfy those obligations.

By signing a personal guarantee, a guarantor becomes subject to a secondary liability to fulfil the guaranteed obligations of the primary obligor, should the primary obligor fail to carry them out. The primary obligor is still principally liable for the guaranteed obligations pursuant to the underlying agreement and the beneficiary must first make a demand on the primary obligor to satisfy the guaranteed obligations before pursuing the guarantor.

The liabilities of the guarantor, by virtue of being secondary, cannot exceed the liabilities of the primary obligor. Accordingly, if there is a defect in the underlying agreement which results in the obligations of the primary obligor being extinguished or reduced, the guarantor’s obligations under the guarantee are also reduced or extinguished.

Parties to lease agreements, credit applications and loan agreements will often require a personal guarantee. In some industries, for example building and construction, it is common practice for small company directors to sign personal guarantees in order for the company to obtain a loan or credit finance.

What is the difference between a guarantee and an indemnity?

Many guarantee documents will also include an indemnity. It is a common misconception that guarantees and indemnities are one and the same. However, indemnities are distinct from guarantees in a number of ways and this ought to be considered by those who are contemplating executing a guarantee that includes, in its terms, indemnity provisions.

An indemnity is a contractual promise from one party (the indemnifier) to compensate another party (the beneficiary) for loss suffered by it. In contrast to a guarantee, an indemnity imposes a primary obligation on the indemnifier.  This is a critical point of difference.  In effectively imposing an obligation of a primary nature, the indemnity therefore provides the beneficiary with an additional level of protection of its rights. Relevantly, an indemnity differs from a guarantee in the following ways:

a.     The liability of the indemnifier is not dependent on the failure of the primary obligor to perform its obligations;

b.     A beneficiary can enforce its rights against the indemnifying party even if there is a defect in the underlying agreement with the primary obligor that renders it unenforceable, void or illegal;

c.     An indemnity is not required to be in writing. Rather, the courts may imply the existence of an indemnity by the conduct of a party; and

d.     A beneficiary may pursue an indemnifier for a principal obligor’s failure to fulfil its obligations without first attempting to pursue the principal obligor.

In assessing whether or not an indemnity within a personal guarantee is valid and binding, the courts will look to the wording of the guarantee document. If the indemnity provisions are uncertain or unclear, the indemnifier will not be bound by them.

Advice for prospective guarantors

It is worth noting that some lenders may accept a bank guarantee or a related company guarantee in substitution of a personal guarantee. A prospective guarantor may want to discuss these options to reduce their personal exposure.

In the event that a personal guarantee is unavoidable, prospective guarantors should carefully read the document that they are provided with and negotiate to limit the scope and wording of the guarantee. There are a number of ways to limit the scope of a personal guarantee, for example:

a.     by setting a financial cap on the guarantee;

b.     by including a time limit on the operation of the guarantee;

c.     by making the guarantee only in favour of the beneficiary not assignable to any other party; and

d.     in the case of a company director, executing the guarantee in their capacity as company director, and have the guarantee only remain valid while they are a director of the company.

The above information is meant as a guide only. If you require specific advice or assistance in understanding your obligations pursuant to a personal guarantee, we recommend contacting EMS Legal.