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What are personal guarantees and why are they important for your business?

By Prue Greenfield, Principal Lawyer, Macpherson Kelley

 

These documents are useful for supplementing credit agreements but it is crucial that they are set up properly.

A personal guarantee is a promise made by a guarantor that they will personally meet the obligations of another person or company if that person or company defaults to the creditor under the original, or primary, agreement.

In other words, Party A and Party B have made an agreement. This is the original agreement. The personal guarantor is then making a promise to Party B that it will personally fulfil Party A’s obligations under the original agreement if Party A fails to fulfil them. This is the secondary agreement.

Personal guarantees are a useful tool to supplement a credit agreement. However, there are several critical points that if missed, can prove fatal to enforcing a guarantee.

 

Why seek a personal guarantee?

Personal guarantees are legal documents commonly used by creditors to ensure that company directors and business owners are personally responsible for their companies’ debts. Guarantees in these circumstances are particularly useful where the company is at risk of insolvency. This is a way to ‘pierce the corporate veil’, and avoid falling victim to illegal phoenix activity, where a director of a company sets up a new company to continue the business of a liquidated company in order to avoid paying outstanding debts.

Guarantees can also add an extra level of security to ensure that services or goods are received as promised, or that other contractual obligations are performed. The promise made does not have to be restricted to a financial guarantee, it is simply a promise to fulfil the obligations of the original agreement.

 

What should be in a guarantee?

There is no ‘one-size-fits-all’ when it comes to personal guarantees. While there are elements that need to be satisfied for the guarantee to be valid, the parties are free to include a variety of different terms depending on the desired effect and agreed arrangement. For example, guarantees can limit the level of obligations of the guarantor, cap the monetary obligation to a specific amount, limit the time for which the obligations exist or specify particular notice periods.

It is essential that the wording of a guarantee accurately reflects what is intended by the parties. Without clear drafting, a guarantee may be unenforceable. For example, unless a personal guarantee expressly states that it is irrevocable, it may be able to be withdrawn by the guarantor at any time. Another example of the importance of wording is that unless a guarantee states that it is for ‘all monies’, it may be limited to present debts, and may not include any future debts.

Ultimately, guarantees can include any terms which are agreed by the parties and should contain wording that is clear and easily understood.

 

Essential elements

Beyond wording, there are essential elements that must exist to ensure that the guarantee is valid and binding. These elements include:

1.Personal guarantees must be in writing

2.Personal guarantees must be executed by all the relevant parties

3.Personal guarantees must be executed correctly

A personal guarantee can be made in any form, however the form chosen will dictate the required execution clauses. For example, a deed must be ‘signed, sealed and delivered’. This means that it must include the company seal and be delivered to the other party. A deed executed by an individual must clearly include the names and signatures of the signatory. A witness is also required to execute a deed signed by an individual.

 

4.The elements of offer, acceptance, intention to be bound by law and consideration must be satisfied

This also slightly varies depending on the form of the agreement. Personal guarantees are often written in the form of a deed because deeds do not require consideration. This means that there does not have to be an exchange of something of value for the arrangement to be binding. As personal guarantees rarely give a benefit to the guarantor, a deed is a common choice for form of guarantees.

 

5.The usual contract law and equity doctrines such as privity of contract, capacity, certainty, undue influence and unconscionable bargaining also apply

 

Charging clauses

A personal guarantee can take many forms. It could be a simple guarantee, in the sense that it is a promise to fulfil the financial obligations to repay the debt of another person/company in the event that they default. However, it could also include a charging clause, where the guarantor nominates specific assets as security in the event of non-payment.

Where a personal guarantee includes a charging clause over real property, the creditor is entitled to lodge a caveat over land owned by the guarantor. This acts as a notice to other creditors that the creditor has a secured interest in the property. An appropriately worded charging clause prevents the guarantor from selling or transferring ownership of their charged real property without the creditor’s knowledge.

 

The Carruthers Clause

An issue that creditors may run into is receiving payment from the original debtor under the original agreement, and the debtor subsequently going into liquidation. Payment of a guaranteed debt automatically discharges a guarantor from all liability. If, however that payment is later set aside and clawed back as an unfair preference by the liquidator, the guarantor remains discharged from liability despite the debt continuing to exist.

To avoid such a scenario, guarantees can include a clause which states that any payments made to the creditor which are later avoided by application of statute will not release the guarantor from liability. This type of provision is known as a Carruthers’ clause, and has the effect of reviving the liability of the guarantor in situations where the debt has been discharged but later reinstated.

 

Common problems with personal guarantees

Strict interpretation

Because signatories to a personal guarantee are bound by the wording of the guarantee as signed, care must be taken when drafting and reviewing personal guarantees.

You need to be sure that all relevant terms are included, and all relevant parties are named and have validly executed the guarantee. You should also ensure that any future alterations to either the original agreement or the guarantee are done in writing and signed. Variations to the original agreement may have the effect of creating a new agreement that is not subject to the guarantee.

While a court may consider the factual circumstances surrounding the creation of the guarantee, it is important that the written agreement accurately reflects the intention of the parties. A properly drafted agreement with clear and unambiguous language will always assist in the contract being interpreted as intended.

 

Guarantor’s inability to fulfil their obligations

As a creditor it is important to ensure that the guarantor has sufficient assets in their own name in the event the guarantee is called upon. There is no point in having an air-tight personal guarantee signed if the guarantor is not in a financial position to be able to repay the debts of the original agreement.

To avoid surprises, it is best practice to take due diligence steps by conducting title searches and other background checks on the guarantor prior to signing.

 

Webinar – Trading terms and debt recovery in a COVID world:

To learn more about personal guarantees and a whole lot more, join our webinar: Trading terms and debt recovery in a COVID world, at 11:30am on Tuesday 23 November. Hosted by CreditorWatch’s Head of Content, Michael Pollack, the panel features Prue Greenfield – Principal Lawyer, Macpherson Kelley; Kelly Dickson, Managing Principal Lawyer – Dandenong, Macpherson Kelley and Nathanael Kitingan, Managing Principal Lawyer – Melbourne, Macpherson Kelley.