Simple Financial Positions: Guarantees

Introduction:

In a previous note, guarantees were cited as a type of a simple financial position. In this note, we delve deeper into the meaning of guarantees and their general features; examine how they differ from indemnity; identify the parties to a guarantee; consider debt as the foundation of guarantees; and discuss the rights and liabilities of a guarantor under a guarantee. The note concludes with the credit risks associated with guarantees.

Meaning and Overview:

In Black’s Law Dictionary, 9^th ed., guarantee is defined as:

1. To assume a suretyship obligation; to agree to answer for a debt or default.
2. To promise that a contract or legal act will be duly carried out.
3. To give security to.

Similarly, Joanna Benjamin (supra), on page 51, characterised guarantees as contracts of suretyship. She then defines suretyship as a generic term given to contracts

…by which one person (the surety) agrees to answer for some existing or future liability of another (the principal) to a third person (the creditor), and by which the surety’s liability is in addition to, and not in substitution for, that of the principal.

Subsequently, on page 54, the learned author adds that:

…a contract of guarantee is a contract to answer for the debt, default or miscarriage of another who is to be primarily liable on the promise.

Under a guarantee, a person known as the guarantor assumes an obligation to ensure that another person, such as a debtor, fulfils their obligations to another person, such as a creditor. For example, if X takes out a loan from Y Bank, Z may guarantee X's repayment of the loan.

Parties in a Guarantee:

The following three parties are usually present in a guarantee:

1. Creditor: The party that gives the loan or advances credit.
2. Principal Debtor: The party to whom the loan is given.
3. Guarantor: The party who assumes the obligation to ensure that the principal debtor fulfils his obligations, and who becomes liable to fulfil the obligation in the event of the principal debtor’s default.

General Features of a Guarantee:

1. It may be bipartite or tripartite: A guarantee is bipartite when it consists of only the creditor and the guarantor. A guarantee is tripartite when it consists of the creditor, the guarantor, and the principal debtor.
2. A guarantee may be discrete or continuing: A discrete guarantee applies to a single debt, while a continuing guarantee applies to a series of distinct transactions and remains in effect until explicitly revoked by the guarantor. More elaborately, in a discrete guarantee, the principal debtor's obligation is identified, and the guarantor undertakes to ensure that the principal debtor discharges that obligation. Once the principal debtor performs the obligation, or the guaranteed obligation is otherwise discharged, the guarantor's liability is exhausted. For example, if X borrows GH¢100,000 from Y and Z guarantees repayment of the loan, Z's liability ends once X repays it. The guarantee does not extend to any future loans or advances made by Y to X. In contrast, a continuing guarantee covers a series of transactions or successive advances between the creditor and the principal debtor. The guarantor undertakes to answer for the principal debtor's default in respect of those transactions for as long as the guarantee remains in force. Consequently, repayment of a single loan or advance does not extinguish the guarantor's liability, as the guarantee continues to apply to subsequent transactions until it is revoked or otherwise terminated in accordance with its terms.

Difference between a Guarantee and an Indemnity:

Both a guarantee and an indemnity are contracts for suretyship. However, the two concepts are not the same.

In the case of Yeoman Credit Ltd. v. Latter [1961] 1 W.L.R., the two were distinguished as follows:

An indemnity is a contract by one party to keep the other harmless against loss, but a contract of guarantee is a contract to answer for the debt, default or miscarriage of another who is to be primarily liable to the promisee.

The following differences are apparent:

1. Coverage: In an indemnity, one party undertakes to keep another party harmless against loss. For example, if X promises to indemnify Y against any losses, X is obliged to compensate Y for the actual loss suffered. Thus, if Y suffers a loss of GH¢100,000, X must indemnify Y for GH¢100,000. If Y suffers no loss, X is generally under no obligation to pay anything. On the other hand, in a guarantee, the guarantor promises that the principal debtor will perform his obligations (pay his debt). If the principal debtor defaults, the guarantor undertakes to answer for that default by paying the debt or performing the obligation.
2. Trigger: An indemnity is triggered by a loss, whereas a guarantee is triggered by the principal debtor's default.
3. Nature of Liability: Under an indemnity, the surety's liability is primary. Once the loss occurs, the surety is liable to make good the loss. By contrast, under a guarantee, the guarantor's liability is secondary and co-extensive. The guarantor is not primarily obliged to pay the sum of money to the creditor.
4. Requirement of Writing: Unlike a guarantee, an indemnity need not be in writing.

When there can be a Guarantee -The Foundations of a Guarantee:

There can be no guarantee without a principal debt or obligation. A guarantee is a secondary obligation that depends on the existence of a valid and enforceable obligation owed by a principal debtor to a creditor. The guarantor undertakes to answer for the debt, default, or failure of the principal debtor if the principal debtor fails to perform the obligation. Without a principal debt or obligation, there is nothing for the guarantor to undertake to answer for.

Nature of the Liability Incurred by the Guarantor Under a Guarantee:

The liability of a guarantor under a guarantee has the following characteristics:

1. It is a secondary liability: The guarantor is not obliged to pay the sum of money to the creditor; rather, the guarantor is obliged to ensure that the debtor pays the sum of money to the creditor. The protection buyer or debtor is the person with the primary liability under a guarantee.
2. The guarantor’s liability to pay the sum of money to the creditor arises only if the principal defaults: That is, while the general position is that the guarantor’s liability is secondary, the guarantor can become liable to pay the debt to the creditor if the principal or debtor defaults.
3. The liability of the guarantor is co-extensive with that of the principal. That is, where the principal is not obligated to repay the debt, the guarantor is not obligated to repay it. For instance, if the principal debt is illegal, void, or discharged by set-off, the creditor cannot recover the debt from the guarantor.
4. Where the guarantor comes under an obligation to pay a debt, the amount to be paid is limited to the amount owed by the debtor.

Rights of a Guarantor – How the Law Protects the Guarantor:

Once a guarantor has paid off a debt, he usually has the following implied rights:

1. Right of Contribution from other Guarantors: There are instances where multiple persons may agree to act as guarantors for a single principal debtor. Where that is the case, and one guarantor is made to pay the debt following the principal debtor’s default, the guarantor is generally entitled to contribution from other guarantors.
2. Right of Indemnity from the Principal: Where the principal debtor defaults and the guarantor pays the debt, he is entitled to recover the amount paid from the principal debtor. Here, the principal debtor is obligated to fully repay the guarantor for the amount paid to the creditor.
3. Right to be Discharged: There are instances where the guarantor is discharged of his secondary liability. For instance, where the principal is discharged, the guarantor is discharged. Also, the guarantor may be discharged where there was a failure to disclose unusual facts.
4. Right of Subrogation to Any Security: This right entitles the guarantor who has paid off a debt to step into the shoes of the creditor. For instance, if the creditor had a right to realise any security offered by the principal debtor, the guarantor acquires that right after paying off the debt.
5. Interpretation of Contracts of Guarantee: Contracts of guarantee are interpreted strictly and in favour of the guarantor.

For this reason, the guarantor's liability is described as secondary; it is not a liability to pay the debt, but a liability to ensure that the debtor pays the debt.

Credit Risks Associated with Guarantees:

As with insurance, guarantees carry credit risk. For the guaranteed creditor, there is an initial risk that the principal debtor will fail to repay the debt. The guarantor's undertaking serves to reduce that risk. However, a new risk arises: the guarantor may fail to honour the guarantee if the principal debtor defaults. This new risk is the credit risk associated with the guarantee.