What Legal Risks Should Businesses Consider Before Giving Corporate Guarantees?
When entering into a corporate guarantee you may feel like yourâre just signing another piece of corporate paperwork. This is normally because a company (usually a parent company) wants to support a subsidiary company, group company or business associate so they can secure finance. Donât be fooled. When you sign that corporate guarantee you are putting your company at potential legal and financial risk.
What does a corporate guarantee entail?
Simply. A corporate guarantee will consist of one company becoming liable for certain obligations of a second party. If the second party defaults under the underlying loan facility or obligation, the guarantor becomes liable to the extent provided for within the guarantee. The extent of that liability will depend on; the terms of the guarantee, the underlying obligation and the parties involved. Subject to the three previous factors, legislation may also have an impact.
Due to the serious nature of providing a guarantee, company directors, promoters and business owners should approach the decision to provide a guarantee as they would any other corporate decision. Seek legal advice. One of the first things company directors should do when asked to provide a guarantee is instruct a lawyer. By allowing a lawyer to review the guarantee, the company will understand what it is getting itself into prior to being contractually bound.
Consider the underlying transaction. When asked to provide a guarantee, a company should look at not only the guarantee but the underlying transaction. A guarantee should be closely reviewed to uncover any provisions regarding liability, default and invocation, term and duration, indemnity, security and termination. Many companies look at the underlying transaction and see the benefit of obtaining a loan or entering into a transaction. They however, fail to consider the risks of providing a guarantee.
Pressure to provide a guarantee.
This is fair enough. If a bank wont provide a loan unless they receive a guarantee what choice does the company have. Or maybe your subsidiary company requires financial support to complete a deal. There are many instances where pressure will be applied to sign a guarantee. Even though there is pressure to sign, a company should always ask itself what would happen if the original party defaults on the underlying loan.
Can a Corporate Guarantee Affect a Company's Financial Position?
Yes. Even though no cash outflow may be necessary under a corporate guarantee, they can still create a contingent liability for the company.
Letâs assume that an entity decides to provide a guarantee for a significant loan taken out by a related party. The debtor may have no problem meeting each repayment when it becomes due. However, their circumstances may change and they may struggle to meet their repayment obligations. The guarantor now faces a potential claim against it for the amount of the guarantee.
This would impact budgeting, cashflows, discussions with financiers and the commercial reputation of the company in general.
That is why management should review the credit worthiness of the primary debtor and their ability to withstand such a claim.
Just because the debtor is related or a trusted business partner does not mean that providing a guarantee will be risk free.
Why Should Businesses Take Legal Advice Before Giving a Corporate Guarantee?
Simply because somebody else's assets stand behind the repayment of the debt. Just because the supply of a guarantee commits the guarantor to be responsible for the debt incurred in a transaction to which it has not itself been a party.
A Company may be asked to provide a guarantee in favour of a lender by another company because of a group structure, longstanding commercial relationship, investment opportunity or at the demand of the lender as a condition of funding. Commercial circumstances do not detract from the legal consequences of providing a guarantee.
Ideally, prior to execution the company should know :
- the nature of the primary obligation being guaranteed.
- the extent of the exposure.
- when the guarantee can be invoked by the beneficiary.
- whether the guarantee is for a fixed amount or a continuing guarantee .
- the consequences of default by the principal borrower.
- whether the guarantee is indemnified/reimbursed.
- whether any internal authorisation is required.
- whether the transaction is permitted under the companyâ s articles of association.
What Corporate Approvals May Be Relevant?
Corporate guarantees generally require statutory and internal approvals. Depending on facts the requirements would differ. Depending upon the nature of the transaction, relationship of parties, amount of consideration, provisions included, corporate structure etc. any or all of the following would apply: â
Companies Act, 2013 has various provisions relating to loans, guarantees and investments by companies. Section 186 would apply to certain corporate guarantees and similar transactions. Section 185 would apply to certain transactions with directors and related parties.
Articles of Association, board powers, shareholder approvals, existing borrowing agreements, financial covenants are some other areas which would need to be reviewed depending on facts.
One cannot assume that a transaction just requires the authorized directorâs signature.
Why Is the Underlying Agreement Important?
Corporate guarantee should not be read in isolation.
If its a loan facility being guarantied by the company, the facility/financing agreement would have terms like borrowers covenants, events of default, repayment obligations, security for loan, interest rate etc.
Reading the underlying agreement would help you understand precisely what is it that the guarantor is guarantying.
Another example. If the company is being asked to provide a commercial guarantee in connection with supply commitments, performance obligations, leases, project finance etc., reading only the guarantee will not give you the full picture about the commercial risk being undertaken by the company. That shall be clear only on reading the underlying agreements along with the guarantee and in context.
Does the Relationship Between Companies Matter?
Guarantor and principal obligor can be connected.
A parent company can give guarantee in respect of the debts of its subsidiary. One group company can give security to another group company to enable it to raise funds. Commercial parties can give comfort to each other in a multi-party transaction.
But there is a danger in giving a guarantee where there is a corporate relationship between the guarantor and the party guaranteed for.
Diligence should be performed on behalf of the guarantor to investigate the financial position of the party to be guaranteed, the commercial rationale for the transaction, the capacity of the principal obligor to refinance, existing indebtedness and liabilities and potential impact of default.
What Documents Should Be Reviewed Before Giving a Corporate Guarantee?
To know exactly what you are signing it can sometimes be helpful to read the following documents:
Depending on the deal structure this can consist of:
- draft corp guarantee
- loan/facility agreement
- sanction letter
- security documents
- board minutes
- memorandum and Articles of Association
- outstanding facilities
- outstanding guarantees
- financial statements
- corporate minute book
- any correspondence with lender/beneficiary
Anything else specifically referred to in relation to the main borrower.
List of documents is dependent on the specific facts.
Also companies should maintain minutes detailing why the guarantee was given, what authorizations were received and what obligations are specifically guaranteed.
What Happens If the Principal Borrower Defaults?
Guarantees operate only when the maker of the principal promise is unable to perform his liability. Only the guarantor or the person for whom the guarantee has been made can sue on guarantee and law.
Company's reply would solely be based on the terms of the said document, the liability it guarantees, nature of demand, any defenses available contractually and the facts.
That is why a guarantor should not treat any demand as some petty office document. Demand letter needs to be analysed at the very earliest to understand what exactly is being demanded and what is your position on such demand under the contract.
Can Businesses Negotiate Corporate Guarantee Terms Before Signing?
Parties can even bargain over some provisions after signing depending on the bargaining power of each party and the deal they are trying to enter.
At minimum the company should know where it ends; i.e. limitation of liability? How long does the provision last? What does it apply to? What release is required? What invocation is needed? Etc.
You are going to lose on some issues. Some requests just arenât commercially reasonable to the promise. Remember when reviewing a contract from a legal standpoint you want to walk away with a clear understanding of what you are getting yourself into. You shouldnât think you can or should strike everything.
BK Singh Advocate can assist you in determining what terms are worth your while when you bargain over a contract.
When Should a Business Consult a Corporate Lawyer?
Legal review should ideally be obtained before the corporate guarantee is executed.
Obviously, there are many times other than at execution that legal review of a corporate guarantee should be obtained by the company. For example:
A lender requests it.
The company is asked to guarantee the obligations of another member of the group. (e.g., parent guarantees subsidiary's debt.) Group members frequently support each other's financial obligations.
- Another member of the group asks the company to support its financial obligations.
- The exposure the company potentially faces under the guarantee is substantial.
- The guarantee imposes continuing obligations on the company.
- The company has suffered losses with prior guarantees.
- The company receives an advanced copy of an invocation/demand.
- The company is asked to extend or modify a guarantee.
Helping before a party "signs" an obligation will almost always be more effective.
How Can a Corporate Law Firm Help?
BK Singh Advocate is a Corporate Lawyer and primarily works with businesses on their corporate documents,commercial contracts, reviewing guarantees, compliance issues and business transactions.
BK Singh Advocate helps clients with their corporate guarantee issues. This includes reviewing the proposed guarantee and transaction/business documents. The focus is on what exactly the business is agreeing to do, what risk is it exposing itself to and what documents should be executed to protect its position.
There are numerous circumstances where a business may need to have its guarantee provisions reviewed. Examples include contractual disputes, corporate approval issues or issues resulting from an invocation or proposed enforcement.
Each situation is fact specific. This means it depends on the underlying documents, parties involved, transaction structure, specific provisions and the facts.
You can meet with BK Singh Advocate prior to issuing a guarantee. This allows you to understand the obligation your business is entering into, from a legal and commercial standpoint
Frequently Asked Questions
1. What is a corporate guarantee?
A corporate guarantee is a promise made by a company on behalf of certain obligations of another party. The scope and enforceability of such guarantee would depend on the terms of the guarantee and the governing law.
2. Why should a company take legal advice prior to executing a corporate guarantee?
Taking legal advice would make sure that the company understands the liability it is entering into, when the guarantee can be invoked, period of guarantee, what approvals need to be taken, indemnities and other risks involved before signing a guarantee.
3. Can a parent company execute a guarantee on behalf of its subsidiary?
A parent company can execute a guarantee in favour of lender for its subsidiary subject to applicable law, corporate approvals required to be obtained, transaction requirements and companyâs constitutional and statutory provisions.
4. Is Section 186 of Companies Act applicable to corporate guarantees?
Section 186 has certain provisions relating to loans, guarantees and investments made by companies. Applicability of section to a transaction would depend on facts involved, whether any statutory conditions/limits are required to be complied with and if any exceptions are available.
5. Can a corporate guarantee expose a company to financial liability?
Yes. Guarantees are usually invoked on default of underlying obligation. On invocation of guarantee, guarantor would become liable to pay as per terms of guarantee and applicable law.
6. What should be reviewed before signing a guarantee?
Before signing, a company needs to check the specific duties it's guaranteeing, the maximum liability involved, how the guarantee can be called upon, its duration, any indemnities provided to the guarantor, events triggering the need for advance consent, and the core transaction agreements.
7. Should the underlying loan agreement be reviewed?
Yes. Reviewing underlying agreement would help you understand the obligations which are guaranteed, events of default under agreement, repayment obligations etc.
8. Can you negotiate terms of a corporate guarantee?
Contractual terms are always negotiable prior to executing the agreement subject to nature of transaction and bargaining position of parties. Legal review would help you understand provisions which require clarification/negotiation.
9. What should a company do upon receiving a guarantee invocation?
Company should review guarantee, underlying transaction, demand and all related documents quickly upon receiving an invocation. Taking legal advice would help you understand legal position of company and responses available to you.
10. How can BK Singh Advocate assist you with respect to corporate guarantees?
BK Singh Advocate can review your guarantee and related contracts, check for corporate compliances which are required to be met prior to signing the guarantee, identify any contractual issues and advise you on the legal position of the company.
Final Thoughts
Execution of a corporate guarantee can enable a transaction to occur. Execution can also expose the guarantor company to tremendous liability. The commercial benefit of enabling another partyâs transaction should be weighed against financial and legal exposure.
A company should understand what it is guaranteeing, the terms of the underlying transaction, events of default and guarantee call provisions, the duration of the obligation, indemnification obligations and other corporate considerations before signing a guarantee.
Because timing is of the essence in legal reviews, a company will usually have more negotiating power to work out favorable terms by identifying issues if it has retained an attorney prior to signing an agreement.
BK Singh Advocate can help companies review corporate guarantees, related commercial agreements, secure necessary corporate authorizations and work through legal issues resulting from operations under a guarantee.
If your company is ever requested to operate under a corporate guarantee, consult with Advocate BK Singh before executing the guarantee. A thorough review specifically tailored to your situation can help you understand your legal risks and make an informed commercial decision.
