Banks are under considerable pressure to reduce risk and improve profitability. One effect of the banking crisis of 2008 is that banks now increasingly require personal guarantees from borrowers – and in particular SME (small and medium-sized enterprise) borrowers. This gives a fallback recovery option in the case of default, shielding banks from some of the risk of lending. Banks are often quick to call such guarantees.
This has led to a steep rise in bank guarantee litigation, but interestingly has also seen a considerable number of successful challenges to personal guarantee claims from guarantors. This article reviews some of the defences that may be available to business owners who find that they have given personal guarantees and whose assets are now ‘at risk’.
What is a personal guarantee?
As the name suggests, a guarantee is a contractual promise to pay the liabilities of another. The guarantor is typically a shareholder, director or group company with assets. The debtor is typically the guarantor’s company. A guarantee can be an obligation either to pay the liabilities of the company or to ensure that the company performs its obligations to the lender.
A guarantee is therefore essentially a contract and in particular a contract of ‘suretyship’. Because the surety (guarantor) may not necessarily be directly involved in the primary relationship between the borrower (company) and the lender (bank), the law of suretyship, through principles of equity, has developed to permit additional defences to guarantors in certain circumstances.
If you find that you are facing a demand on a personal guarantee, then you need to analyse the situation systematically to see how best to respond to the bank or other creditor making the demand.
Although the law does afford specific additional protection to a guarantor, the starting point should always be to examine the position in accordance with the principles of English contract law. English contract law has evolved over centuries and provides a series of complex rules governing all contracts. Certain breaches of these contractual principles will cause the relevant contract (in this case the personal guarantee) to be void and/or unenforceable.
All guarantees must be given for ‘consideration’
For any contract (as opposed to a deed) to be binding, there must be consideration. Consideration is the legal term for the benefit of the contract. The most common form of consideration is the payment (in kind or in cash) for the subject matter of the contract, whether it be rights, goods, services or otherwise. In the case of a guarantee, the consideration is usually the agreement of a bank to lend, or to continue to lend, to a third party (the business). Courts do not assess the adequacy of consideration, only its sufficiency (Chappel v Nestle
 AC 97). This means that even if the loan being given in exchange for a guarantee does not seem objectively favourable, it will generally be treated as valid consideration.
However, if the loan is already in existence at the time of granting the guarantee, or if the bank is obliged to continue lending because it has no legal basis to call in the loan at that time, there may be no consideration and accordingly no liability. Eastwood v Kenyon
(1840) 11 Ad&E 438 is long-established authority for the rule that ‘past consideration is no consideration’.
All guarantees must be in writing
A guarantee has to be in writing and signed by the guarantor or some party authorised by the guarantor (Statute of Frauds 1677). It is often thought that more formality is required, but in fact the formal requirements are few.
Indeed, the courts have even shown flexibility in their interpretation of the 1677 legislation. Golden Ocean Group v Salgaocar Mining Industries PVT
 EWCA Civ 265 confirmed that a series of documents, in this case a chain of emails, could together be construed as a valid guarantee.
The demand made must be in accordance with the terms of the guarantee
It is necessary to ask whether the demand being made is one that properly falls within the scope of the contract. Where the business undertaking is reasonably substantial there will, over the life of the business, inevitably be a number of different facilities. A bank may seek to rely on a guarantee that is quite old and was understood to relate to a particular facility that has since expired. This may not be immediately clear from the wording of the guarantee itself. It is well established in English law that contracts are to be construed with reference to the surrounding circumstances and the relative positions of the parties at the time that the contract was made.
Lord Roskill said in Hyundai Shipbuilding & Heavy Industries Co Ltd v Pournaras
 2 Lloyd’s Rep 502 that the guarantee should be construed as a whole against “the factual matrix of the background”. So where the bank’s demand comes as a surprise because the guarantor considered that it related only to a particular facility that has since expired, the guarantee will need to be construed in the context of all the contemporaneous circumstances and other contractual documentation before liability is accepted.
There are two types of guarantee: those creating a primary obligation and those creating a secondary obligation. A primary obligation imposes an obligation on the guarantor actually to pay in the event of a default by the guaranteed party under the primary contract. A secondary obligation instead imposes an obligation to ensure that the guaranteed party will honour its obligations in the loan facility. This was considered in the case of Moschi v Lep Air Services Ltd
 AC 331.
Secondary obligations of this nature are sometimes called a ‘see to’ guarantee, that is, that the guarantor will ‘see to it’ that the debtor performs. The important difference here is that guarantees which impose a primary obligation oblige the guarantor to pay money. Failure to pay that money entitles the bank to sue the guarantor for that fixed sum of money. In the case of the ‘see to’ obligation, the bank is only entitled to sue for damages for breach of that obligation by the guarantor. Any party suing for damages is subject to the normal principles of having to mitigate loss, and therefore some enquiry of what loss the bank has actually suffered is necessary before accepting liability for the sum demanded. It is worth noting that the courts require unambiguous language in order to find that a primary rather than secondary obligation has been established, per Ultrabulk A/S v Jagatramka
 EWHC 2792 (Comm).
Because the nature of a contract of guarantee is that of a contract of suretyship, there are also rules of interpretation developed by the courts that afford special protection to guarantors. For example, the courts invariably hold that if certain legal or equitable rights usually available to a guarantor are to be excluded in the contract of guarantee, then very clear words must be used (Trafalgar House Construction v General Surety & Guarantee
 AC 199). Where wording is ambiguous, the ‘contra proferentem’ rule may be used to interpret in favour of the guarantor and against the bank.
Encouragingly, the courts are not slow in applying business common sense to questions of interpretation. Rainy Sky v Kookmin Bank
 UKSC 50 establishes that courts can turn to commercial common sense whenever
the plain text of a contract admits of more than one possible reading. This has been qualified slightly by Wood v Capita
 UKSC 24, which clarified that both textualism and contextualism are tools to reach the same goal of finding the objective meaning of a contract – but considerations of commercial common sense are certainly not off-limits.
Guarantors must not be induced to enter into a guarantee by a misrepresentation
A surety (guarantor) is not bound by his contract if it was induced by any misrepresentation by the creditor (bank) of any fact known to it and which was material to the surety, whether the misrepresentation was fraudulent or not (London General Omnibus Co v Holloway
 2 KB 720).
On the face of it, this is a potentially powerful protection for guarantors. However, its scope was construed somewhat narrowly in North Shore Ventures Ltd v Anstead Holdings Inc & Ors
 EWCA Civ 11. This case held that there is no duty to disclose features that are not unusual in a creditor/debtor relationship, even since the London General Omnibus
Nonetheless, certain types of misrepresentation will enable the guarantor to have the guarantee set aside and any security pledged thereunder returned. There are a number of types of misrepresentation that will be relevant:
- A misrepresentation as to the state of indebtedness between the bank and the company at the time the guarantee is given
Suppose a director and business owner is called in to the bank’s offices to discuss the state of the company’s facilities and it is represented by the bank that if it is to continue to support the business, additional security, including a personal guarantee, is required. This constitutes a representation by the bank that the state of the account between it and the business is at a level that legally entities it to call in the loan facilities. There are a number of reasons why this may not be the case (see my earlier article entitled “Undue Bank Pressure”). For example, the balance owing to the bank may have been simply overstated by the unlawful application of incorrect interest charges. In this case, the bank claims that the balance is such as to put the business in default under the terms of the relevant loan facility. If interest, properly calculated, would mean no default had occurred, then the misrepresentation of the balance could be a material misrepresentation as to the state of the account. This would entitle the guarantor to have the guarantee set aside.
- A misrepresentation as to what was being guaranteed
In the case of a guarantor who was led to believe that he was simply guaranteeing a bank loan, but the guarantee as a matter of fact extended to “all debts and liabilities direct or indirect” of the principal debtor, the bank was prevented from recovering in respect of “indirect liabilities” (Royal Bank of Canada v Hale
 30 DLR (2d) 138).
Where there is a matter of particular concern to an intending guarantor who makes a specific enquiry of the bank, he must be given a true, honest and accurate answer to his enquiry.
Guarantors must freely decide to provide a guarantee
One of the key elements in any contract is the intention of the parties to be bound by it. Where a party is subject to undue influence from a third party, then this can mean that party did not have the requisite intention to contract. There are many possible types of undue influence or duress that potentially impact upon contractual obligations in general and guarantees in particular. The most common scenario in this context is where a third party (often a husband or wife of the business owner) is made a party to the guarantee of the business’s liabilities to the bank. The law has changed in recent years in relation to these situations, and is now wholly encompassed within the doctrine of “Presumed Undue Influence”.
Presumed Undue Influence arises in cases where the relationship between the parties is such as to raise a presumption that one party has exerted undue influence over the other. Certain relationships give rise to such a presumption as a matter of law. These relationships are, amongst others, husband and wife, parent and child, and doctor and patient. Otherwise, it will be determined on the facts, with a court examining the extent to which undue influence is relevant. In these cases, where there is no predefined relationship of influence, it falls upon the guarantor to prove influence on the facts. However, the ‘undue’ element still need not be proven; once a relationship of influence is shown, the presumption of undue influence arises.
If, therefore, a bank requires a guarantee to be given by a business owner and his/her spouse (who is not involved in the day-to-day management of the business), then it is to be presumed by the bank that the signature on the guarantee by the spouse has been procured by the exercise of undue influence. This is known as constructive notice, a doctrine firmly established in Barclays Bank v O’Brien
 1 AC 180. Unless the bank has satisfied itself that the spouse has entered into the guarantee of his/her own free will, then the spouse’s guarantee could be set aside. To avoid this, the bank will typically require the spouse to receive independent legal advice (RBS v Etridge (No. 2)
 UKHL 44). Usually banks now take the appropriate steps in these circumstances to ensure that such a party is properly advised but, surprisingly, not always!
Defences based upon the conduct of the bank after the guarantee has been given
There are a number of important equitable principles that apply to the conduct of the bank and may again have the effect that the guarantee in question is voidable. These types of defence are based upon the fact that the guarantor is not a party to the contract between the bank and the debtor and has little, if any, control over the conduct of the bank, but at the same time is directly affected by the bank’s conduct and the operation of the facility agreement. In particular, as the guarantor has the benefit of certain rights, such as the right to indemnity from the debtor (business), then any conduct by the bank that actually or potentially prejudices these rights can operate to discharge all of the guarantor’s liability. There follow some examples of the more usual scenarios:
- The bank releases the debtor or gives the debtor time to pay
The ground upon which the guarantor is discharged in both cases is that the guarantor’s right at any time to pay the debt and sue the principal in the name of the creditor is interfered with. In practice, standard bank guarantees will often contain provisions attempting to exclude this rule, but clear language is required.
Even when a variation in the creditor/debtor agreement does not release the guarantor, it may still be the case on the facts that the guarantee becomes ineffective as a way of enforcing payment. In Investec Bank v Zulman
 EWCA Civ 536, the amounts owed to a bank by a confectionary company were reduced by an agreement involving the use of a previous deposit to write off some of the debt. However, no agreement to vary the guarantee was ever signed. The original guarantee precluded liability as long as the company’s indebtedness did not surpass £2 million, which in practice made the guarantee worthless to the bank once the debt had been reduced. Nonetheless, the court refused to artificially recognise a revised guarantee.
- There is an increase in the underlying loan
In the case of Triodos Bank NV v Dobbs
 EWCA Civ 630, the bank guarantee specifically contained a provision allowing the bank, “without reference to the guarantor”, to “agree to any amendment, variation, waiver or release in respect of an obligation of the company under the loan agreements”. The initial loan to the debtor was later increased substantially, following the original signature of a facility limited to £50,000. It was held by the court that the revision was so far outside the scope of the original facility that it effectively amounted to a new loan that was not covered by the guarantee. The guarantor successfully defended the bank’s claim and the court held that the guarantor was discharged.
Chadwick LJ stated that “the guarantor is not to be taken to have agreed that his liability under the guarantee would be increased or made more onerous by a subsequent agreement made between the lender and the borrower (to which he is not party) unless there are clear words in the guarantee which show that he did agree to be bound to a more onerous obligation in the future imposed without further reference to him”.
CIMC Raffles v Schahin
 EWCA Civ 644 even suggested that there may in fact be two (closely related) doctrines at play. One is a matter of pure construction, where a guarantor must have clearly consented to variations in order for the guarantee to stand following those variations. The other is a principle of law “reflecting … equitable concerns” – in other words, to protect guarantors from abusive alterations to the underlying loan.
In certain cases the guarantee will not be totally discharged but there will be a defence to any claim against the guarantor for additional sums lent (Wittman (UK) Ltd v Willdav Engineering S.A.
 EWCA Civ 824).
- Material change in the risk being guaranteed
In general, any type of conduct by a lender or creditor can have the effect of materially changing the balance of the risk that the guarantor had agreed to cover.
Holme v Brunskill
(1878) 3 QBD 495 is the origin of the rule that variations in the creditor/debtor agreement discharge the guarantor; a change in the agreement can cause a change in the risk, with the guarantor never having agreed to guarantee the new risk. The judgment of Cotton LJ explains this rationale: “If there is any agreement between the principals with reference to the contract guaranteed, the surety ought to be consulted, and that if he has not consented to the alteration … he will be discharged.” In North Shore v Anstead Holdings
(see above), it was established that alterations to the underlying agreement are a matter of objective fact; the court held that a variation had been made, even though both parties to the agreement gave evidence to the contrary.
Essentially, any fact or matter that is likely to increase the risk of default by the principal represents a material alteration of risk, so all matters need to be considered.
It is more common now than ever before for a guarantor to receive the unwelcome news from the bank that the guarantee is being called. The conduct of the bank and the wording of the suite of bank lending and security documents will be key in determining the rights the bank actually has as a matter of law. A careful reading of the documents is the first step a guarantor should take on hearing that a guarantee is being called, but even that will not be conclusive and valid arguments could well be available to guarantors to defend their assets from the reach of the bank.
Some of these arguments about contracts of suretyship that can be raised by a guarantor are very complex and this is especially so where there is more than one guarantor of the same liability. There are even certain situations where a debtor or guarantor can challenge the creditor/debtor agreement on the grounds that it creates an unfair relationship between the two parties. In specific circumstances, the court can effectively rewrite the underlying agreement under the terms of the Consumer Credit Act 1974; this may have the effect of wholly or partly relieving the guarantor.
The key factor is that those on whom such demands are made need to act quickly and obtain competent specialist professional advice at an early stage in order to ensure that legitimate substantive defences are not overlooked.