A personal guarantee is a contract that obliges the guarantor to become responsible upon non-payment for another person’s debt. This post explores the law of personal guarantee including privity and essential drafting requirements and provides a guarantee checklist.
What is a personal guarantee?
A personal guarantee is the promise of one or more people to be answerable for a debt or obligation of another person or entity in the event that that person or entity defaults on that debt or performing an obligation. It is a surety offered by a third party to a creditor to support a debtor.
A personal guarantee is a unique form of contract and there is a complex body of law surrounding personal guarantees.
A personal guarantee is founded on the existence of a principal obligation being owed by one party to another. A personal guarantee is a secondary obligation (to the principal obligation) because it relies on the existence of that principal obligation.
A guarantor’s obligation under a personal guarantee only continues to the extent that the guaranteed debt (i.e. the principal obligation) is enforceable. Further to this, a guarantor’s liability is contingent upon the principal debtor’s default (i.e. non-payment of a debt that is due and payable).
Obtaining a personal guarantee from the directors of a debtor company is a common way for a creditor to limit their risk in commercial credit arrangements. In circumstances where a creditor has a personal guarantee against the directors of a company and where the company defaults on its obligations with the creditor (e.g. by non-payment), the creditor can seek payment of the unpaid debt from the guarantors (e.g. the directors).
What is Privity of Contract in a personal guarantee?
For a contract of guarantee to be enforceable the person seeking to recover on the guarantee must be a party to the contract of guarantee. This is called privity of contract and means that a person (e.g. a Plaintiff) may not enforce a guarantee at law unless they were a party to the contract.
Is a personal guarantee required to be in writing?
A personal guarantee should be in writing and signed by the guarantor(s). In some contracts of guarantee it is a requirement for the guarantee to be in writing for it to be enforceable. In circumstances where the guarantee is not supported by consideration the guarantee must take the form of a deed.
The basic elements of a contract also apply to contracts of guarantee including offer, acceptance and consideration.
Although personal guarantees that have been made orally are enforceable at law in certain circumstances, creditors should avoid relying on oral guarantees.
Where a contract of guarantee is not in the form of a deed (i.e. signed, sealed and delivered) it must be supported by consideration. Consideration is an essential element in Australian contract law. Broadly, consideration is a legal principle that means both parties to a contract must “get something out of it”. This is in contrast to a gratuitous promise (i.e. a gift) that is not enforceable as a contract (where one or more parties provides/receives something without any requirement for consideration from the other party).
In the context of a personal guarantee, the consideration could be the creditor entering into a principal transaction that is linked or conditional upon a personal guarantee being provided.
In order to ensure that the consideration requirement of a guarantee is satisfied in a commercial credit application the personal guarantee is often included in the commercial credit account opening form itself. This means that when a creditor agrees to open a commercial credit account for a debtor (e.g. a new customer) the terms of the guarantee are contained in the commercial credit account opening form and the creditor is obliged to provide a guarantee in order to open the commercial credit account.
To ensure that a guarantee is legally binding a creditor should require a guarantor(s) to execute a deed.
If the contract of guarantee is entered after the principal obligation agreement has been entered is it binding?
A contract of guarantee is only enforceable in circumstances where it is entered before, or concurrently with the principal obligation. This is because a guarantee given for past or executed consideration will fail. However, this does not mean that a contract of guarantee will be unenforceable where the consideration refers to future events.
In a commercial credit application, a problem will arise if the creditor seeks to obtain a personal guarantee after a credit account has been opened (where the issue of consideration may arise). For example, if a creditor intends to rely on email correspondence from Proposed-Guarantor-A in which he promises to guarantee all the debts of Debtor-Company-A, the promise contained in the email may fail as a personal guarantee for want of consideration.
In these circumstances, where the principal contract or agreement has already been reached (e.g. a commercial credit account has already been opened), it is very important that the parties obtain a deed of guarantee to overcome the obstacle of consideration. A deed is a legal instrument where a promise is binding without consideration being required.
Important considerations to be considered in the preparation of a personal guarantee
In a contract of guarantee, the guarantor generally does not obtain any benefit from acting as guarantor but the liabilities incurred by providing a guarantee are often substantial. Below are essential tips to consider when preparing a personal guarantee.
- Use the correct wording
The words of a personal guarantee are very important and the enforceability of the guarantee may be contingent on the precise wording used.
A personal guarantee will often include a statement such as:
“In consideration of [creditor] agreeing to supply goods and services to [debtor], at the request of its directors, I/we agree to jointly and severally personally guarantee the performance of all obligations and payment of all debts incurred by [the debtor].”
Unless a guarantee expressly states that it is irrevocable it may be withdrawn by the guarantor at any time. Therefore a clause stating that the guarantee is irrevocable is important in a personal guarantee to protect the creditor’s interest. Further, unless a guarantee states that it is ‘all monies’ the guarantee may be limited to ‘present debts’ and may not include all present and future debts. In order to ensure completeness of the guarantee a clause similar to the following should be included in the guarantee:
“This is a continuing and irrevocable guarantee for all monies which are now or may be from time to time owing or remain unpaid by [debtor].”
- Make sure the guarantee does not become unenforceable
There are a number of key risks that might cause a guarantee to be unenforceable by a Court, such as:
- The principal contract with the debtor is either discharged or varied.
- The guarantee is put at risk by waivers or extensions of time granted to the principal debtor.
- There is a deficiency with the execution of the guarantee document.
- The terms of trade between the creditor and the debtor are changed.
- One guarantor is released from the guarantee but not the other.
- The creditor company is in fundamental breach of the contract with the debtor.
At law, a personal guarantee may be discharged upon the occurrence of one of the following events:
- Variation of the principal contract may discharge the guarantee if the variation could prejudice the guarantor. However this does not apply if the contract includes a clause excluding this.
- Discharge of the principal debtor will also discharge the guarantor.
- If it is a condition of the guarantee that there are co-guarantors (where there is more than one personal guarantor), the release of a co-guarantor will release all co-guarantors from liability under the guarantee.
Further, if the creditor breaches any provision of the principal contract or the guarantee that is a condition or essential term of the contract, the guarantor will be discharged from liability.
- Improve standard documents and include an indemnity and charging clause
Often if a guarantee is incorporated into a credit application form the form incorporates both a guarantee and indemnity.
An indemnity is a principal obligation whereby the indemnifier makes a promise to be responsible to a creditor for any loss suffered by the creditor if the debtor fails to perform its obligation under a contract.
A contract of indemnity is a primary liability on the part of the indemnifier and is generally unaffected by some of the problems that may affect a guarantee, such as issues with the validity or enforceability of the principal contract, because it is not contingent upon the principal debtor’s obligation. An indemnity may be considered to be a more sophisticated and encompassing personal guarantee and in some cases a guarantee may combine both a guarantee and an indemnity.
- Personal guarantee checklist
When preparing a personal guarantee if your intention is to protect a principal creditor’s interests against a debtor’s failure to pay all monies owing under a contract, the following should occur:
- The guarantee should be contained in the company’s new credit application or if the creditor and debtor are not entering into a new credit application relationship the guarantee should be executed in the form of a deed with witnesses;
- The guarantee should be in writing and be executed by the proposed guarantors;
- The guarantee should use a form of words that includes “continuing and irrevocable” and “all monies”;
- If you are providing consumer credit, legal advice should be sought; and
- A credit check should be undertaken of the debtor and the personal guarantor(s) to ensure the identities of all parties and that the guarantor(s) are not bankrupt.