Can you guarantee it?

The commercial property sector needs an injection of funding to kick-start development projects that have been waylaid by the recession or to fund new projects. But the banks are still hesitant about handing money out, even to sound business propositions. Added to this is the fact that recent case law has thrown up a new problem for the banks when it comes to guarantees for loan agreements that could lose them a great deal of money because of a small mistake.

Lenders are increasingly reliant on guarantees as a means to recover debts from borrowers and particularly in the last couple of years, the banks have needed guarantors to stump up repayments where original property businesses have either gone into administration or fallen behind in their repayments because of the downward slide of the property market.

However, due to this increased reliance, lenders have so far not been fully aware of the pitfalls of inadvertently releasing the guarantor from his obligation 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.

Banks have traditionally got around this problem by issuing standard form bank guarantees that 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 for any amendment to the guaranteed contract. 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. While 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 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 does have a certain logic and would strike a fair balance between the interests of lenders and guarantors.

In the new economic world we find ourselves in after the recession, lenders will most likely be looking to protect themselves against losing funds this way by drafting guarantees to secure all debts due from the borrower to the lender at any time 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. The banks will carefully word the guarantees here to ensure that it 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. Lenders will therefore try to secure themselves the safest possible position by arranging 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.

So what will this mean for commercial property businesses and their guarantors looking to get a new loan or renew an existing one? In a way, the position of the borrower and its guarantor is stronger since 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 because of the results of recent case law. If the bank comes to a company and its guarantor with wording to that effect, then the guarantor may have a good chance of being discharged from its duty should the business fall behind on its repayments.

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.

Guarantors should keep an eye on the loan agreements that they have undertaken to guarantee and if the bank asks them for repayments, should check that the terms of that agreement are the same as the terms they originally complied with.

As a word of caution, guarantors should seek out legal advice as quickly as possible to ascertain the strength of their position. The banks will often set an interest rate from the day they demand repayment and guarantors could find themselves being forced to pay out a great deal more than they originally anticipated.

David Tabinor is a partner in the commercial property team at Weightmans LLP. Email: david.tabinor@weightmans.com