Six things you must consider before providing any guarantee

October 31, 2023
Stephan Smoktunowicz


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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:

Performance guarantee  You ‘guarantee’ (i.e., promise to ensure) that the debtor will perform its obligations to the beneficiary on time.   So, if you break that promise, you are in breach of the guarantee and could face a damages claim for loss suffered by the beneficiary.  
Performance undertaking  You must perform if the debtor does not.   So, for example if a borrower fails to pay back a loan or interest on time, you are on the hook to pay it instead. And if you do not pay when required, the beneficiary could claim against you for your unpaid debt.  
Indemnity  You make good any loss, cost or liability suffered by the beneficiary if the debtor’s obligations to the beneficiary are or become unenforceable, invalid, or illegal.   So, you cover the ‘legal risk’ of what the debtor bargained for being or becoming legally defective. (Contrast that legal risk with the ‘performance’ risk in the performance guarantee and performance undertaking above).  

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:

Performance guarantee  If you guaranteed to the supplier that the buyer would pay all amounts on time, but it does not, then you could be on the hook for a damages claim for the loss suffered by the supplier as a result of non-payment.   If alternatively, you guaranteed to the buyer that the supplier would perform on time and deliver the goods of a specified quality when required under the supply contract, but it failed to do so, then you could be on the hook for a damages claim for the loss suffered by the buyer as a result of that.   Importantly, the actual loss suffered by the beneficiary could be materially higher than the headline value of the underlying contract or goods and may not be precisely ascertainable at day one. Consequently, careful thought should be given before agreeing to provide a performance guarantee, particularly if you think you would be incapable of preventing a breach should you become aware that one might happen.   If you intend to limit your liability under a performance guarantee, you will need to think about (i) the maximum amount you are willing to guarantee and (ii) which payment and/or non-payment obligations the performance guarantee relates to under the supply contract – e.g., is it just in respect of the first delivery of goods or others too?      
Performance undertaking  If you undertake to pay when the buyer does not pay, then you are potentially on the hook for anything the buyer has or might have to pay under the supply contract.   If you undertake to perform on demand if the supplier does not deliver goods, then you would have to deliver those goods instead. If you do not, you could be on the hook for loss suffered by the beneficiary for your failure to perform.   As with a performance guarantee, careful thought should be given before agreeing to give a performance undertaking. What is the likelihood of the performance undertaking being called upon and could you perform if asked to?   Do you intend to limit your liability? If you do, the same considerations mentioned above for a performance guarantee should be considered.  
Indemnity  If you have to make good any loss, cost or liability suffered by the beneficiary if the supply contract obligations are or become unenforceable, invalid, or illegal, then as with a performance guarantee, the amount you are committing to under the indemnity could be materially higher than the face value of the underlying contract of goods.   However, any indemnity wording should always be checked to see if it goes any wider than the above.   As with both a performance guarantee and performance undertaking, if you intend to limit your liability to a specific amount, then that would need to be catered for in the indemnity drafting.   The fact that liability is limited for a performance guarantee or performance undertaking does not necessarily mean the same applies to an indemnity unless the drafting caters for that (and vice versa).  

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?

Performance guarantee  If you have guaranteed that the debtor will perform its obligations to the beneficiary on time and it does not, then you will be in breach of the guarantee immediately when the debtor fails to perform.   As between the guarantor and beneficiary, the guarantee will only have real teeth when the beneficiary actually brings a valid claim for breach of guarantee.   However, if the guarantor has other agreements and a breach of the guarantee constitutes a default, termination event, mandatory payment trigger or other similar event under any of them, that could have undesirable consequences for the guarantor, irrespective of whether the beneficiary actually makes a claim under the guarantee.  
Performance undertaking  A performance undertaking will usually bite after the debtor has failed to perform its obligations.   However, when the beneficiary can demand performance by the guarantor instead will depend on what the performance undertaking says.   For example, the performance undertaking might say the beneficiary can demand at any time after non-payment, there might be a time gap before demand can be made, or tangible evidence of the actual breach might need to be provided when making demand.  
Indemnity  When an indemnity bites will again depend on the actual wording, what the indemnity actually covers and when the beneficiary can make demand.  

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.

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