Guarantees are commonly encountered in real estate finance arrangements where the loan-to-value requirements of a lender are not satisfied solely by the assets of the borrower. However, the taking of a guarantee – whether from an arm’s-length third party or from a company within the same group as a borrower – is not without potential pitfalls. If the guarantee is called in by the lender and consequently scrutinised, these pitfalls may jeopardise the position of both the lender and the directors of the company giving the guarantee.
Initial considerations
Conceptually, guarantees are not difficult to understand; they constitute a promise by the guarantor to pay a lender if a borrower fails to do so. The guarantor’s obligation to pay – the guarantee – is therefore dependent on the validity of the borrower’s primary obligation to pay the lender. Where that primary obligation to pay is, for any reason, unenforceable, there is nothing for the guarantor to guarantee. To address this risk to the lender, almost all guarantees will contain an indemnity.
The practical effect of the indemnity is that the guarantor remains liable to the lender if the primary obligation of the borrower is void for any reason. In this context, indemnities are always drafted as widely as possible to include any and all loss and costs incurred by a lender in relation to the non-performance by the borrower of its primary obligations.
Guarantees are either confined to specific liabilities of the borrower or are “all monies”, that is to say they extend to all of the liabilities of the borrower to the lender on any account. Depending on the circumstances, a guarantor may be able to negotiate a quantified limit on the principal amount recoverable by a lender under a guarantee.
The guarantor’s constitutional documents (ie its memorandum/articles of association) must not contain any prohibition on guaranteeing the obligations of third parties. In most situations, this will not apply to companies incorporated after 1 October 2009. For older companies, where restrictive objects clauses are more typical, it may be necessary to amend the guarantor’s articles to remove any restriction.
If the proposed guarantor is party to existing finance arrangements the finance documents should be checked to ensure that there is no prohibition on the grant of security – a so-called negative pledge. This is a covenant in favour of an existing lender not to create any other forms of security without its consent. The grant of a guarantee is likely to amount to a breach of the negative pledge and may be an “event of default”, which would allow the lender to accelerate the loan and enforce its security.
Commercial benefit
It has long been the case that companies cannot act in any manner they choose. Directors have a statutory duty – now codified in the Companies Act 2006 – to consider the commercial benefit for the company and its members when entering into any transaction. It is not always apparent – even when guarantor and borrower are members of the same group – that there is a benefit to a company in guaranteeing the payment obligations of another.
When a parent company guarantees the obligations of its subsidiary – a “downstream” guarantee – the benefit to the parent in giving the guarantee is not difficult to project. For example, if the guarantee enables the subsidiary to obtain finance, the subsidiary obtains working capital. The working capital will enable the subsidiary to pursue its business objectives, which might be expected to result in profits, which will eventually be paid to the parent as dividends.
An “upstream” guarantee occurs where a subsidiary guarantees the obligations of its parent company. The commercial benefit to the guarantor company here is far from obvious – the success of the parent will on the face of it benefit the parent’s shareholders and not its subsidiary. Less obvious still is a guarantee of the obligations of a sister company or of a company without the group of the guarantor.
In determining the adequacy of commercial benefit, directors of a guarantor company should ensure that the benefit to the company is proportionate with the risk of the guarantee being called on by the lender, ie the likelihood, extent and consequences of borrower default (see flow chart).
Where commercial benefit cannot be easily ascertained, a lender may require the members of the guarantor company to approve its entry into the guarantee by way of ordinary resolution. Such approval is intended to prevent the members of the guarantor challenging the validity of the guarantee, by pursuing a derivative claim at a later date.
Reviewable transactions
If a guarantor goes into administration or liquidation within two years of granting the guarantee, the guarantee can be subject to review as a “transaction at an undervalue” under section 238 of the Insolvency Act 1986 (the 1986 Act). For section 238 to apply, the guarantor must have received either no or significantly less consideration than it provided and the guarantor must have been insolvent when the guarantee was granted or have become insolvent as a result of its grant.
Where these conditions are satisfied, the court may make any order it thinks fit to restore the position of the guarantor to that which it would have been had it not entered into the transaction.
An insolvency practitioner of a guarantor can also apply to the court to set aside any guarantee that is deemed to be a preference (section 239 of the 1986 Act). A preference is a transaction that intentionally benefits a creditor by enhancing its position in the event of the insolvency of the guarantor. For section 239 to apply, as is the case with transactions at an undervalue, the guarantor must have been insolvent when the guarantee was granted or have become insolvent as a result of its grant. Additionally, the guarantee must have been granted within the six months prior to the onset of insolvency (extended to two years where the preferred party is connected to the guarantor).
It is common for lenders to seek confirmation of solvency in respect of a guarantor, as solvency will prevent any guarantee being set aside under sections 238-239 of the 1986 Act. Typically the directors or auditors of the guarantor will be asked to certify its solvency; while this will not of itself improve the position of the lender, if the guarantor is actually insolvent, it may provide the lender with certain rights against the directors or the auditors.
Enforcement of guarantee
If a guarantee contains an indemnity, the lender does not have to demand payment from the borrower or give notice of the default to the guarantor, before proceeding against the guarantor. This means that the guarantor’s liability arises immediately on grant of the guarantee and the lender does not need to take enforcement action against the borrower before pursuing the guarantor for full payment.
Where a guarantor discharges the liabilities of a borrower pursuant to a guarantee, it acquires the right of subrogation. This allows the guarantor to assume all of the rights of the lender, including any security, against the borrower.
Case study: corporate benefit
Brian Boru Ltd and Conmael Ltd are SPV developers and subsidiaries of Fergal Ltd.
- Brian Boru has a loan facility with Cruachan Ltd, which has a remaining unexpired term of one year. Brian Boru has pre-paid part of its loan and, on the sale of three more residential units from a development, is on track to redeem the loan early.
- Conmael has entered into negotiations with Cruachan for a similar facility in relation to a development.
- Cruachan has requested a guarantee from both Brian Boru and Conmael guaranteeing the performance of the others’ obligations to Cruachan.
What could the corporate benefit be?
Answer: Each company is providing credit support to the other which, on the face of it, ticks the cross stream corporate benefit box. However, Brian Boru’s development would appear to have been successful – it is on track to redeem its loan early – whereas Conmael has not yet begun its development. Bearing in mind the likelihood of Brian Boru’s default, and the relative likelihood of Conmael’s default, the directors of Brian Boru are bound to conclude that a lower degree of corporate benefit attaches to the grant of its guarantee, than are the directors of Conmael.
George de Stacpoole is a solicitor in the corporate department at Seddons
