1. Introduction
Updates and background for this project (Digest)
1.1 This Report marks the final stage of the Commission’s investigation of the law relating to the guarantee by one person of a loan to another person. This situation typically involves a loan made by a financial institution, such as a bank, to a person who is in a family relationship with the guarantor. For example, the guarantor may be the borrower’s parent or spouse. Typically too, the loan will be made to support the business activities of the borrower. The Commission and the Faculty of Law at the University of Sydney conducted the first comprehensive empirical study in Australia into this situation between 2000 and 2003.1 Drawing on this study as well as on submissions made to this reference, the Report contains recommendations for the reform of the law. For reasons explained in Chapter 4, reform of this area of financial law can only sensibly be undertaken as a uniform initiative involving all Australian jurisdictions.
1.2 This chapter discusses the legal nature of the contract of guarantee, the purposes it serves and its incidence. It also explores why contracts of guarantee are so problematic for the law.
NATURE AND CONTEXT OF GUARANTEES
Definition
1.3 A guarantee is a contract in which the guarantor promises to answer to the person in whose favour the guarantee is given (“the creditor”) for a debt or obligation of a principal debtor if the debtor defaults.2
1.4 Guarantees may be used to support a variety of obligations other than the payment of a debt. This reference is concerned only with guarantees in the context of loans. The principal debtor (“the borrower”) borrows money from a creditor (“the lender”). The borrowing results in a contractual relationship between the borrower and the lender. The lender may also enter into a further contract, known as a contract of guarantee, with a person other than the borrower who guarantees that he or she will repay the loan if the borrower cannot or will not do so.
1.5 Guarantors are also sometimes referred to as “third party guarantors”. The latter expression is used because the guarantor is not a party to the loan contract between the borrower and the lender.
1.6 Guarantors usually do not benefit from the loan. They may, however, provide a mortgage or charge over property as security for the guarantee.
A secondary obligation
1.7 The essential distinguishing feature of a contract of guarantee is the secondary, or ancillary, nature of the obligation that the guarantor assumes.3 The guarantor’s liability is secondary in the sense that it depends upon the principal debtor’s continuing liability and, ultimately, the debtor’s default.4 The guarantor is not liable unless and until the principal debtor has failed to perform his or her obligations.5
1.8 At common law, the secondary liability of the guarantor does not prevent the creditor from enforcing the guarantee before instituting proceedings against the principal debtor. In other words, subject to legislative or contractual provision to the contrary, once the principal debtor is in default, the creditor may sue the guarantor instead of the debtor for the amount owed.6
Functions
1.9 Guarantees are used in a broad range of situations. For example:
- The borrower has no substantial credit record, such as where the borrower is a young person or a recently formed company.
- The borrower, although credit-worthy, does not have sufficient assets to use as security for the loan.
- The borrower is a company and the lender needs security to meet the potential risks not only in the company’s business but also those associated with the use of a corporate structure to operate the business. For example, to avoid its financial obligations to lenders, a company may divert funds and assets to its shareholders, related companies or beneficiaries. In the case of a company with a small paid-up capital, the lender may require its directors to give a personal guarantee as a security in case the limited liability of the company has the effect of it not meeting its financial obligations.
- A group of companies borrow from one financial institution. Each may be required to give a guarantee covering the debts of the others. This achieves group liability even though each company is a separate legal entity with potentially limited liability.
- The borrower has jointly owned property, which he or she wants to use as security. A guarantee from the co-owners coupled by a mortgage over the entire property in support of the guarantee relieves the lender of the need to ascertain the proportion of the property to which the debtor is entitled.7
1.10 Lenders use guarantees as a risk-minimisation device. They protect the lender’s money in cases where the borrower does not have good credit or enough assets to use as security. Guarantees are also useful in loans made to businesses that are considered risky. By reducing lenders’ exposure to risk, as well as the lenders’ costs associated with risk assessments, they assist in making credit reasonably accessible and less costly. Without guarantees, many businesses may not be able to obtain credit. Additionally, credit would be more expensive since lenders impose higher interest rates and charges as the price for insufficient security for credit risks.8
Incidence
1.11 There are no reliable or comprehensive statistics on the incidence of third party guarantees in Australia. Some financial institutions provided estimates of such guarantees to the empirical inquiry conducted by the Commission and the Faculty of Law at the University of Sydney.9 These estimates relate to guarantees in the context of business loans. Lenders claimed that this type of guarantee is far more common than guarantees in support of consumer borrowing. They attribute this to the fact that businesses are often undercapitalised and do not have sufficient assets to provide security in their own right, which leads them to obtain guarantees and other forms of security quite frequently. The lenders also speculated that the requirements imposed by the Consumer Credit (New South Wales) Code on guarantees related to consumer loans might explain, in part, the infrequent use of this type of guarantee.10
1.12 One bank estimated that 75% of its small business loans are supported by a guarantee. This is consistent with one peak lending body’s estimate that in business lending, guarantees are required in more than 70% of cases. Submissions asserted that most smaller lenders in the business finance market require guarantees from directors in relation to company loans. One small lender said that it required guarantees in 39% of its small business loans. However, another estimated that it requires a guarantee in only approximately 5% of small business loans.11
WHAT MAKES CONTRACTS OF GUARANTEE SO PROBLEMATIC?
1.13 Guarantees have generated an enormous volume of litigation in the past 20 years. Unsurprisingly, they have formed the subject of a number of investigations, including a report published in 1996 by the Expert Group on Family Financial Vulnerability.12
1.14 Guarantees are highly susceptible to unfair dealings for a number of reasons. They are generally not well understood in the community. Some guarantors, for example, sign a guarantee in the belief that that they are acting simply as a referee for the borrower.13 Even when they know of their potential liability, many guarantors think they will never be called on to repay the loan. Many believe guarantees pose little or no financial risk.14
1.15 A recurring and highly significant theme in guarantee transactions is the personal relationship between the borrower and guarantor. Many guarantors are spouses (usually wives),15 parents, other relatives or close friends of the borrower. If the borrower is in default, the creditor will usually attempt to recover the money from the guarantor. Hence, this phenomenon has been called “sexually transmitted debt”, “emotionally transmitted debt”16 or “relationship debt”.17
1.16 On the one hand, the emotional relationship between the borrower and guarantor means the guarantor is vulnerable to unfair conduct on the part of the borrower and/or lender. A significant number of guarantors have reported that they did not understand what they were doing at the time of the transaction.18 Many do not engage in the usual inquiries that a person entering a business arrangement would undertake. Quite often, they do not receive information needed to understand the nature of the transaction and the risks involved.
1.17 On the other hand, many guarantors in a close relationship to the borrower agree to guarantee the borrower’s indebtedness even where they fully comprehend the nature of the risks associated with the transaction into which they are entering. They do so simply because they do not want to damage their relationship with the borrower by refusing to act as a guarantor, viewing themselves as having no real choice about providing security for the underlying loan.19 Speaking of the vulnerability of parents as guarantors for the debts of their children, Chief Justice Higgins and Justice Crispin recently said:
[T]he real vulnerability of parents usually stems not from a failure to comprehend the nature of the transactions in which they have been asked to participate or from insufficient information concerning their implications. It stems from the love of their children. Their desire to help and protect them, to advance their interests, to maintain a close relationship, to avoid causing disappointment, hurt or distress, to maintain the relationship may all make it difficult to say “no”.20
1.18 Regardless of the guarantor’s motives for entering into the contract, it is important to remember that guarantees are contracts with significant legal and financial implications. The financial risks can be great because a guarantee is usually accompanied by a mortgage over property, commonly the guarantor’s family home.21 Guarantors therefore undertake huge risks, including the possibility of losing their family home, without necessarily obtaining any financial benefit from the loan taken out by the borrower. It is apparent, therefore, that the legal system needs to protect guarantors as far as it reasonably can, especially from unfair conduct by lenders and borrowers.
1.19 That protection must, however, recognise that guarantees are an essential tool in facilitating access to credit. Reform measures intended to protect guarantors must, therefore, take into account the interests of lenders and borrowers and ensure that the utility and convenience of guarantees as a credit risk-minimising device remain largely undiminished.
FOOTNOTES
1. J Lovric and J Millbank, Darling, please sign this form: a report on the practice of third party guarantees in New South Wales (NSW Law Reform Commission and University of Sydney, Research Report 11, 2003) (“Lovric and Millbank”).
2. See Sunbird Plaza Pty Ltd v Maloney (1988) 166 CLR 245 at 254 (Mason CJ); Direct Acceptance Finance Ltd v Cumberland Furnishing Pty Ltd [1965] NSWR 1504 at 1509 (Walsh J); Total Oil Products (Aust) Pty Ltd v Robinson [1970] 1 NSWR 701 at 703 (Asprey JA).
3. See McDonald v Dennys Lascelles Ltd (1933) 48 CLR 457 at 479-80 (Dixon J) (suretyship).
4. Commercial Banking Co of Sydney Ltd v Patrick Intermediate Acceptances Ltd (in liq) (1978) 52 ALJR 404 at 406 (Lord Diplock); Guild & Co v Conrad [1894] 2 QB 885 at 895 (Lopes LJ), 896 (Davey LJ).
5. Lakeman v Mountstephen (1874) LR 7 HL 17 at 24 (Lord Selbourne); Guild & Co v Conrad [1894] 2 QB 885 at 895 (Lopes LJ); Sampson v Burton (1820) 129 ER 891at 894 (Burrough J).
6. Yeoman Credit Ltd v Latter [1961] 1 WLR 828 at 830-831 (Pearce LJ); Sunbird Plaza Pty Ltd v Maloney (1988) 166 CLR 245 at 255 (Mason CJ); Jackson v Digby (1854) 2 WR 540; Moschi v Lep Air Services Ltd [1973] AC 331 at 348 (Lord Diplock). Section 82 of the Consumer Credit (New South Wales) Code 1995 (NSW) has modified this common law principle with respect to guarantees that relate to consumer loans: see para 10.24-10.25.
7. A J Duggan, The Law of Guarantee in Australia (4th edition, Australian Finance Conference Limited and Australian Equipment Lessors Association Inc, Sydney, 1998) at para 1.1; Australia, Expert Group on Family Financial Vulnerability, Good Relations, High Risks: Financial Transactions Within Families and Between Friends (Report, 1996) at 13; R Jukic, Till Debt us do Part (Consumer Credit Legal Service, Melbourne, 1994) at 13.
8. See Australia, Trade Practices Commission, Guarantors: Problems and Perspectives (Discussion Paper, 1992) at 16-18.
9. Lovric and Millbank at para 4.48.
10. Lovric and Millbank at para 4.51.
11. Lovric and Millbank at para 4.49-4.50.
12. Australia, Expert Group on Family Financial Vulnerability, Good Relations, High Risks: Financial Transactions Within Families and Between Friends (Report, 1996). Other reports on guarantees include: Australia, Trade Practices Commission, Guarantors: Problems and Perspectives (Discussion Paper, 1992); Australia, House of Representatives Standing Committee on Finance and Public Administration, A Pocket Full of Change: Banking and Deregulation (AGPS, Canberra, 1991); Australian Law Reform Commission, Equality Before the Law: Women’s Equality (Report 69, Part 2, 1994); R Jukic, Till Debt do us Part (Consumer Credit Legal Service, Melbourne, 1994); S Singh, For Love Not Money: Women, Information and the Family Business (Consumer Advocacy and Financial Counselling Association of Victoria Inc, Melbourne, 1995).
13. A J Duggan, The Law of Guarantee in Australia (4th edition, Australian Finance Conference Limited and Australian Equipment Lessors Association Inc, Sydney, 1998) at para 1.1; Lovric and Millbank at para 3.71-3.73.
14. Lovric and Millbank at para 3.44-3.49.
15. Third party guarantees impact on women more significantly than on men: Australian Law Reform Commission, Equality Before the Law: Women’s Equality (Report 69, Part 2, 1994) at 239. See also Garcia v National Australia Bank Ltd (1998) 194 CLR 395 at 403-404 (Gaudron, McHugh, Gummow and Hayne JJ); Barclays Bank plc v O’Brien [1994] 1 AC 180 at 188 (Lord Browne-Wilkinson).
16. Australian Law Reform Commission, Equality Before the Law: Women’s Equality (Report 69, 1994) at 240 – drawing upon Paula Baron’s coining of that term: see P Baron “The Free Exercise of Her Will: Women and Emotionally Transmitted Debt” (1995) 13 Law in Context 23.
17. Australian Banking Industry Ombudsman Ltd, Report on Relationship Debt (Bulletin No 22, 1999).
18. Lovric and Millbank at para 3.36.
19. Lovric and Millbank at para 2.8-2.12.
20. Watt v State Bank of New South Wales [2003] ACTCA 7 at para 22.
21. Title to the family home is increasingly jointly held by husbands and wives and, as the main significant asset of the parties, it is often used as security for a loan for a business over which the husband has the predominant control: B Fehlberg, Sexually Transmitted Debt: Surety Experience and English Law (Clarendon Press, Oxford, 1997) at 9-10. Equity in owner-occupied housing accounts for more than 50 per cent of women’s total wealth in Australia and New Zealand, notably more than for men: Yann Campbell Hoare Wheeler, Women’s Economic Status: “Equal Worth” – Final Report: Output 4 (Job No 32056, for the Australian Commonwealth/State and New Zealand Standing Committee of Advisers for the Status of Women, 1999) at ch 1; Executive Summary at 27.
