A director signs a personal guarantee for the company's overdraft. Six years later the company fails, and the bank sues the director for the whole balance — plus mark-up — and attaches the family home.

At that point the question is what the document said and what the bank did. Both questions are decided long before anyone is sued.

Guarantee or indemnity — they are not the same

Guarantee. A promise to answer for another's default. It is secondary: the guarantor's liability depends on the principal debtor's. If the principal obligation is void or discharged, the guarantee is generally affected too.

Indemnity. A promise to make good a loss. It is primary and independent — the indemnifier's liability does not depend on anyone else's default, and it survives circumstances that would discharge a guarantee.

Banks and sophisticated counterparties draft documents as "guarantee and indemnity" precisely so that the defences available to a surety do not help. Read the title, and then read the operative clause, because the label is not decisive.

Chapter VIII of the Contract Act 1872 governs indemnity and guarantee, and it contains most of the protection a guarantor has.

The defences a guarantor actually has

Under the Contract Act, a surety may be discharged in defined circumstances, including:

Variance in the terms of the principal contract, made without the surety's consent — a rescheduled facility, an increased limit, changed terms.

Release or discharge of the principal debtor, by the creditor's act or agreement.

Any contract between the creditor and the principal debtor by which the debtor is released, or the creditor promises not to sue, or gives time to the debtor, without the surety's consent.

Creditor's act or omission impairing the surety's eventual remedy — for example losing or releasing security the surety expected to be able to look to.

Loss of security held by the creditor: the surety is discharged to the extent of the value of that security.

Two things follow. First, these defences are real and are argued successfully. Second, well-drafted bank documentation attempts to exclude every one of them by consent in advance — clauses permitting variation, indulgence and release of security without affecting the guarantor's liability. Whether such clauses answer a particular set of facts is itself frequently the fight.

A surety who pays is also entitled to be subrogated to the creditor's rights against the principal debtor and the securities held — worth remembering, because it is often the guarantor's only route to recovery.

Before you sign a personal guarantee

  • How much? Is it capped, or "all monies" — every present and future liability, without limit?
  • How long? Is it continuing, and can you terminate it for future advances?
  • Joint and several? If you and two co-directors sign, the bank can pursue you alone for the whole amount, and you then chase the others
  • What is secured besides the guarantee, and are you relying on that security?
  • Does it cover mark-up, costs and enforcement expenses?
  • What happens if you resign as a director — nothing, unless the document or a release says otherwise
  • Is there a counter-indemnity from the other shareholders, sharing the burden proportionally? There should be
  • Has your spouse been asked to sign or to charge jointly-held property, and do they understand it? Independent advice matters here

Do not sign in blank, and do not sign a document you have not been given a copy of. Ask for the executed copy and keep it — guarantors are routinely unable to produce the document they are being sued on.

Getting released

On sale of the business or your shares. Release of personal guarantees should be a condition precedent to completion, not a promise to arrange it afterwards. Sellers who complete on a promise are still guaranteeing a business someone else now runs. See buying a business: share or asset purchase.

On resignation. Write to the lender, ask for release, and if release is refused, at minimum give notice terminating the guarantee for future advances in the manner the document requires. Keep proof of service.

On refinancing. The moment of maximum leverage — negotiate the guarantee down or out as part of the new facility.

By substitution. Offer alternative security in place of the personal guarantee.

Whatever is agreed, get the release in writing from the lender. A relationship manager's assurance is not a release.

When the bank sues

Defending a claim on a guarantee is a distinct exercise from defending the underlying debt, and both may be available:

  • Was the guarantee validly executed, and by a person with authority?
  • Was there variation, indulgence or release without consent — and do the document's exclusion clauses actually cover what happened?
  • Has security been lost or released by the lender?
  • Is the amount claimed correct — mark-up computation, charges, and appropriation of payments are frequently wrong
  • Has the lender complied with the procedural requirements of the recovery regime?
  • Is the claim time-barred? See limitation and the deadlines that end claims

See defending a bank recovery suit and frozen accounts and attached assets.

Indemnities in commercial contracts

The same word appears in every supply, services and distribution agreement, and it is frequently the largest exposure in the document — larger than the contract value, because indemnities usually sit outside the liability cap.

Negotiate:

  • Scope — confine it to identified risks (IP infringement, breach of confidentiality, personal injury), not "any and all losses arising in connection with this agreement"
  • A cap, or at least a super-cap
  • Exclusion of indirect and consequential loss, and of losses caused by the indemnified party's own acts
  • Conduct of claims — you should control the defence of a claim you are paying for, or at least be consulted
  • Mitigation and notice requirements

See the contracts every business should have, dealership and distribution agreements and software development and SaaS agreements.

Bank guarantees are a different instrument

A bank guarantee or standby letter of credit — performance, advance payment, bid security — is an independent undertaking by a bank, payable on demand according to its terms, largely regardless of the underlying dispute. Restraining a call on one is difficult and requires established grounds. See bank guarantees and letters of credit.

How the firm can help

We review guarantees and indemnities before signature and negotiate their scope, obtain releases on sale, resignation or refinancing, defend claims brought against guarantors, and act in disputes over calls on bank guarantees.

See banking and finance, or contact the firm — before signing, if at all possible.