Six things you must consider before providing any guarantee

Guarantees are an important part of modern business, providing creditors with recourse to third parties if things go wrong.

However, guarantees are complex documents and failing to understand them can have undesired consequences. It is therefore essential that you not only assess, but understand what a guarantee does before committing to it.

This article looks at six key questions any prospective guarantor should consider before signing on the dotted line:

• What am I committing to?
• How much am I committing to?
• When does it bite?
• How long am I committing for?
• What happens if the underlying deal changes?
• Can I provide the guarantee without breaching any of my existing agreements?

1. What am I committing to?

A guarantor will usually provide a guarantee in support of obligations owed to the beneficiary of the guarantee (beneficiary) by a party under another contract (debtor). For example, by a borrower to a lender under a loan agreement.

A guarantee might be a standalone document or be embedded within another agreement (for example, an agreement for the sale and purchase of shares, property or other assets).

The first key thing to understand is that a document or clause titled ‘guarantee’ could be one or any number of things. Typically, it will be one or any combination of the following:

A common misconception is that a guarantor must only pay up if the debtor does not pay and all attempts to recover from the debtor are exhausted. Unless the guarantee says that, it is unlikely that will be the case and as we will see at point three below (When does it bite?), the timing of when you are on the hook under the guarantee could have knock on consequences under your other agreements.

Whilst the above are common examples of what guarantees might say or include, there may also be nuances in the guarantee wording which widen or extend what you are committing to. Each guarantee should therefore be assessed on a case by case basis.

• How much am I committing to?

Let us say that you are guaranteeing payments or the performance of obligations under a £10 million contract for the supply of goods. How much you are committing to under the guarantee will depend on what the guarantee says. By way of example, taking the guarantee components we looked at previously:

So, when considering the question of how much you are committing to, it is imperative that the guarantee wording is carefully assessed, particularly if you intend a liability cap to apply.

Additionally, if any other costs or liability apply under the guarantee (for example, interest on unpaid sums or enforcement costs), if you intend the liability cap to extend to those, then the guarantee will need to say that.

• When does it bite?

Guarantees are usually provided on the basis that the guarantor is confident that the guarantee will never be called upon (unless for example, the guarantee is a bank guarantee payable on demand or upon delivery of specified documents). However, the fact that a guarantee is not actually called upon by the beneficiary, does not necessarily mean that it will not bite in other ways. So, when might a guarantee bite?

A guarantor should remain mindful that a guarantee could bite on its other agreements and of any associated reporting requirements, both public (e.g., to listing authorities) and contractual, particularly as a minor breach by a debtor could put a guarantor in immediate breach of a performance guarantee.

• How long am I committing for?

How long you are committed for under a guarantee could depend on several factors including:

• whether the guarantee has a longstop date;
• whether the guarantee allows the guarantor to exit early (e.g., by giving notice);
• the length of the underlying agreement between the beneficiary and the debtor; and
• how liability cap mechanics are drafted.

The wording of the guarantee should be assessed on a case-by-case basis.

If your future commercial plans include new key contracts or material changes to existing contracts, it is worth considering how the length of the proposed guarantee might interplay with them. For example, can you exit the guarantee if you need to and does the guarantee impose any other restrictions that might impact your ability to provide additional guarantees or future security?

• What happens if the underlying deal changes?

Before providing a guarantee, you should consider whether you are willing to let it cover any future changes to the debtor’s obligations to the beneficiary. For example, what happens if:

• a loan facility amount is increased;
• a supply agreement is extended for a year; or
• an agreement is amended to materially extend payment terms?

In each scenario, that might increase the amount you are committed to under the guarantee and/or the length of time the guarantee might be capable of being called upon.

That may not be problematic, for example, where a parent company is guaranteeing the obligations of its subsidiary and the parent has full visibility on the financial health of the subsidiary. However, in more complex group arrangements where a company is considering guaranteeing the obligations of a sister company in another part of the group with less day-to-day visibility over its affairs, more careful thought is needed on the level of oversight that might be necessary to assess and monitor the impact of future changes.

Whilst there are potential legal arguments that might let a guarantor off the hook if the underlying deal changes and becomes fundamentally different to that entered into between debtor and beneficiary at day one, the changes to any given deal will not always be so wide. Guarantors and their directors should therefore be vigilant of the fact that the actual scope of a guarantee could increase over time.

• Can I provide the guarantee without breaching any of my existing agreements?

Aside from what the guarantee document actually says and means, before entering into any guarantee, you should always check whether any of your existing or other proposed agreements restrict your ability to provide the guarantee. Such restrictions are not uncommon in loan and other finance agreements. Constitutional documents, shareholder agreements and similar documents should be checked too.

If there are restrictions, then you may need to consider approaching counterparties for their consent, a waiver of any potential breach of agreement or an amendment. Before doing so, it is important to consider any commercial sensitivities or confidentiality provisions that might otherwise impede your ability to discuss or progress matters in the way that you wish.

Final thoughts

This article has examined six key questions that you should ask before committing to any guarantee. However, it is not an exhaustive list and other considerations may apply depending on the underlying nature of the guarantee and surrounding circumstances. Guarantees are not simple documents and great care should be taken when approaching them.

Understanding guarantee terminology and navigating it safely is key to ensuring that you are not on the hook under a guarantee for more or longer than you are willing to be. If you are unsure how a guarantee will impact you now, or in the future, you should always consider taking professional advice.

To discuss any of the matters raised in this article or to find out more about his practice, you can contact Stephan by clicking here.

Important: Information in this article is for information purposes only. It is not legal advice and may not be read, taken, or relied upon as such.