"Going Guarantor" - The Misunderstood Risks
Because of the personal relationships that are often involved, many people will provide a guarantee or indemnity without taking the time to understand the legal and financial risks they may be taking on.
Guarantees and indemnities are a form of security given by a person in favour of another person/entity, to give commercial comfort that legal obligations of a third party (such as a bank or a landlord) will be met.
Examples of when guarantees and indemnities are commonly required are when someone is:
- borrowing money from a bank; or
- taking a lease of premises.
Consider the following example:
Jessica is 20 years of age and wants to open her first small business. To operate the small business, Jessica requires a shop premises, so Jessica negotiates a lease with a Landlord. The Lease is for a three year lease with a three year option. The Landlord, being wary of Jessica’s age, lack of financial assets, and the vagaries of small business, requires Jessica’s mother Sue to provide a guarantee and indemnity in favour of the Landlord.
What is a guarantee and what is an indemnity, and how are they different?
A guarantee is a contract to assume another person’s liability. In the example above, Sue assumes Jessica’s liability pursuant to the contractual terms of the lease.
An indemnity is a promise to keep a third party harmless for loss, which can extend beyond the contractual obligations. In the example above, the Landlord may be entitled (under the terms of the lease) to reasonable legal costs from Jessica in the event of Jessica’s default. However, with an indemnity the Landlord could pursue Sue for all costs, not just those which are reasonable.
Quite often, guarantees and indemnities are required of a person (in their capacity as an individual), when that person’s company or trust is the principal contracting entity. Generally part of the purpose of a company or trust structure is to quarantine risk from the individual, so a guarantee and indemnity will typically negate this benefit.
Common misunderstandings with guarantees and indemnities
Guarantors often labour under the misunderstanding that:
- they will be claimed against as a last resort. Most guarantees and indemnities will permit the guaranteed party to claim against the guarantor straight away. In the example above, the Landlord could typically claim against Sue without first claiming against Jessica; and
- once the principal contract is terminated, then they will be released. Liability can continue to accrue irrespective of whether the contract is terminated. This means that a specific release is required.
Guarantees and indemnities are often presented as a necessary but non-negotiable pro-forma document after the terms of the principal agreement are agreed. You should, however, feel free to negotiate the terms of the guarantee and indemnity.
In the example above, Sue could attempt to negotiate for better terms for the guarantee and indemnity as follows:
- a guarantee only;
- a ‘capped’ upper limit on the amount that Sue is liable to the Landlord for, such as $30,000.00;
- ensuring the guarantee and indemnity expires at the completion of the first three year term. Guarantees and indemnities are often extended unilaterally when a tenant exercises an option term. Therefore if Jessica exercises the option term, then Sue is liable for three or more years liability without any say in the matter; or
- providing a large cash bond instead of a guarantee and indemnity.
If you are considering entering into a guarantee and indemnity, you should carefully consider the terms of the document and the consequences. Please do not hesitate to contact the CGL Commercial + Property team to discuss further.