Guarantees - why do Courts seem to hate them so much?
There's a 1997 English case called Credit Lyonnais Bank Nederland v Burch [1997]1 All ER 144 which is, in its way, an heartening example of staff loyalty. In this case a junior employee gave a mortgage over her flat and an unlimited personal guarantee as security for borrowings by her employer's company. This is, I'm sure many readers are thinking, something to be encouraged. However, far from encouraging it, the Court said that the guarantee and mortgage were unenforceable. The transaction was so manifestly stupid - potentially losing her home and going bankrupt for the benefit of a company in which she had no interest - that she had to have been subjected to undue influence by her employer. We've had accounts clerks come up to us at morning tea in our seminars and admit to similarly dim-witted acts. "Where it says 'personal guarantee' on application forms I'm filling in for our business, I've just been filling them in and signing them. I probably shouldn't be doing that should I?"
Because our core clientele are creditors, we generally take the view that guarantees are a wonderful thing but
they are also the cause of many a sad tale. This article looks at some aspects of the law relating to guarantees,
and in particular the trend in respect of guarantors who claim they didn't know what they were signing or were
being forced to sign.
First, just to make the point clearly, get them off the directors/wives/family of your clients and customers if
you can. We're often told that they're not worth having because smart debtors put all their assets in trusts,
and dumb debtors have signed so many of the things that they are effectively worthless. We disagree.
There are lots of guarantors who have both assets and reputation to lose.
If your credit manager can get a director of a debtor company to sign a guarantee you obviously have someone else to chase if the company doesn't pay. Even more importantly, the director now has an extra incentive to make sure you're paid. When the company's going down the gurgler, who will get paid: the creditor who holds the director's personal guarantee and will sue him and take his house, or the one who doesn't? (Worry about the issue of voidable payments when and if the liquidator makes demand.)
Because there are always so many hard luck cases when it comes to guarantees, Courts have always looked for ways to reject their validity. Section 2 of the Contracts Enforcement Act 1956 requires that, unlike most other contracts, a contract for guarantee must be in writing. Some of the traps relate to the drafting of the guarantee which should be the domain of your legal advisers.
To give an example of a drafting problem, a major New Zealand builders' supply company bought the business of a regional builders' supply company some years ago. Builders are very definitely a class of debtor from whom you want personal guarantees if at all possible, and the regional company had some thousands filed away. None could be enforced by the new owner. For the lack of a couple of lines of print, all were worthless. All they could do was go out to their customers to try to get new ones signed.
Because there are so many traps, we strongly recommend that the drafting of guarantees is left to qualified and experienced lawyers. There are many more traps than we have space to list here, but one point worth thinking about is that it is not easy to cover all eventualities in a few lines. A rule of thumb is that you probably need to go to at least a page in length to cover most situations. Or, to put it another way, if it's only two lines long it will have holes you can drive a truck through. It should be noted that a good percentage of guarantees which are challenged in court do not stand up.
We'll now turn to what can go wrong when you are getting the guarantor to sign. There are three main, potential problems.
The law is somewhat confused in respect of what a creditor needs to tell a guarantor. The fact that a creditor is demanding a guarantee should put the guarantor on notice that the debtor is not considered a good risk. It is clear however that a creditor needs to tell the guarantor about anything which might not normally be expected to take place between the debtor and the creditor.
A contract (and most guarantees are contracts) may also be set aside on the ground that it is unconscionable. It may be unconscionable for guarantors at a "special disadvantage" so that, in the circumstances, they could not make a judgment as to what was in their own interest. "Special disadvantages" might be poverty, sickness, infirmity of body or mind, drunkenness, illiteracy, lack of education, or lack of assistance or explanation where assistance or explanation is necessary.
As with any contract, guarantees can be set aside by a court for undue influence. This is where the two parties enjoy a special relationship of trust or confidence and the stronger party takes advantage of the weaker. In the case of, say a husband exerting undue influence to induce his wife to sign a guarantee, this will only be set aside if the creditor knew the guarantee had been obtained by undue influence, or the court decides that the husband is an agent of the creditor (that is, the husband was authorised to act on the creditor's behalf to get the guarantee).
But the Courts are stretching the boundaries in this area. A recent West Australian Supreme Court case is an example of this. In Commonwealth Bank of Australia v Ridout Nominees Pty Ltd & Ors [2000] WASC 37 (28 February 2000) the family business empire was run by the patriarch. The judge held that guarantees by his sons were unenforceable for undue influence. "I was an employee of my father," said one son (thirty-three at the time he signed the guarantee, and still living on a family farm), "and a very poor-paid one at that, and I did as I was told because he was my employer, and I had nothing, and I owned nothing to the day he died."
The judge went further than this. He also held that the companies of which the sons and there wives were directors had also been subject to undue influence. This is the first case we are aware of where a corporate guarantor has been let off the hook on these grounds.
At its simplest, the claim of many guarantors (particularly consumer guarantors) is that they thought they were just vouching for the principal debtor. You need evidence to show a court (or Disputes Tribunal) that they did know what they were doing. The best evidence is a solicitor's certificate. A creditor is generally protected against the problems of unconscionability and undue influence if the guarantor has had independent legal advice. The young employee in Credit Lyonnais v Burch was advised to get such advice but turned down the opportunity. The fact that the bank advised her to do so was not enough.
From the creditor's point of view there are two problems with independent legal advice. One is that lawyers are expensive and this will put some guarantors off. The other is that the lawyers will invariably advise their client not to sign.
Peter Hattaway LL.B. is a director of Hattaway & Associates, Credit Consultants.