Commercial Property Focus - May 2010

Can You Guarantee It?  -  A Warning to Lenders

In the present economic climate, lenders are increasingly reliant on guarantees as a means to recover debts from borrowers but due to this increased reliance, lenders need to be aware of the pitfalls of inadvertently releasing the guarantor through a variation of the underlying contract.

The law states that any major variation to a guaranteed contract will automatically discharge the guarantor; a guarantor should not be expected to increase its liability due to amendments made to the guaranteed contract which it wasn’t aware of or did not consent to.

Standard form bank guarantees usually contain provisions stating that the underlying contract, usually the facility letter or loan agreement, can be varied without affecting the liability of the guarantor. But how effective is such a provision?

As long ago as 1878, the court held that a guarantor should be consulted and his consent obtained to any amendment to the guaranteed contract, and if he does not consent then he should be discharged unless the amendment is evidently insubstantial or not prejudicial to the guarantor.

The 2005 case of Triodos Bank v Dobbs highlighted the problem, in which the court held that a guarantor was released from liability where the bank had ‘rescheduled’ the borrower’s loans covered by the guarantee.  The loans were replaced by further agreements with materially different terms relating to the ranking of securities and the repayments due from the borrower.  Although described by the bank as ‘rescheduling’, the court felt they amounted to considerably more than a simple variation of the principal loan and accordingly the guarantor’s liability was discharged. 

Although the guarantee had anticipated certain variations to the principal loan and the guarantor had consented in advance to those changes in the Triodos Bank case, the amendments were too material to have been envisaged by the original guarantee.  Accordingly, the guarantor’s further consent had to be given to the amendments.

In that case the guarantee was given by a director of the borrower company who also signed the increased facility letter on behalf of the company. The court felt that his signature on the facility letter was insufficient to amount to consent. A separate memorandum of consent was required by the director in his capacity as guarantor, even if it may have been obvious to him when signing for the increased facilities that his liability as guarantor may also increase. Other cases have demonstrated that guarantors do not have to sign a separate consent document but instead the only requirement is that there is some unequivocal evidence of consent to ensure they are bound by the revised terms.

Guarantors can remain liable for subsequent variations to a contract where those variations are immaterial or have been expressly provided for in the guarantee and are “within the scope of contemplation” when the guarantee was prepared. However if the variations are material or prejudicial to the guarantor then they amount to an unauthorised departure from the terms of the original contract, resulting in the guarantor being discharged.

The effect of a material variation that isn’t specifically envisaged by a guarantee is to discharge the guarantor altogether. If a facility agreement has been materially varied, the original contract is legally terminated and a new one is created in its place. As the guaranteed contract no longer exists, there is nothing for the guarantor to guarantee and the whole of his liability falls away.  It has been argued that this effect amounts to a fundamental flaw in the English legal system relating to guarantees.  The argument that it would be commercially sensible for the law to require a guarantor to remain liable but only to the extent of his original obligations, has a certain logic and would strike a fair balance between the interests of lenders and guarantors.

For lenders’ protection, guarantees should be drafted to secure all debts at any time due from the borrower to the lender on any account and whether past, present or future.  Such guarantees are known as “all moneys” guarantees and are characterised by the fact that they are not linked to a specific facility letter.

This way, there is no issue of principal contracts being varied or otherwise.  The guarantor is simply liable for everything owed by the borrower to the bank on any account whatsoever at any time.  However, careful wording is required in the guarantee to ensure that the bank is protected. For example, a guarantee stated to cover ‘future advances’ only may not cover a new loan taken out at a higher rate of interest where no further advance was involved. Without clear legal advice on the position, the safest position for lenders is to arrange for the guarantor to sign any facility amendment by way of consent in order to put the matter beyond doubt and avoid any challenges under the guarantee in the future.

Lenders can no longer rely on wording to the effect that the guarantor gives advance consent to any subsequent variations to the facility letter or loan agreement if they want to put themselves in a strong legal position. If subsequent variations are deemed to be material or prejudicial to the guarantor then case law demonstrates that unless the variation is something expressly anticipated and catered for in the original documentation, the lender will not be protected and the guarantor will be released.

The best advice for lenders wishing to avoid this is to follow set procedures and keep track of all paperwork to ensure their security is not inadvertently discharged through the actions of other departments who may agree a variation several years later. Therefore in the absence of an “all moneys” guarantee expressed to cover all future advances to the borrower on any account or facility whatsoever, the safest course for lenders is to obtain the guarantor’s consent to anything other than the most minor variation of the principal contract.

David Tabinor is a Partner in the Commercial Property team at Weightmans LLP, David.tabinor@weightmans.com

This article first appeared in the Estates Review and also in Business Money.