There have been numerous major reports referring to the problem of relationship debt in recent years, as concern about guarantee transactions has grown. Our project is the first comprehensive Australian empirical research into the law and practices governing third party guarantees.

This project was carried out in partnership between the Faculty of Law at the University of Sydney and the New South Wales Law Reform Commission between 2000 and 2003 with funding made available by an Australian Research Council Strategic Partnerships in Industry, Research and Training grant.

Our research was directed to finding out more about the experiences of the people who agree to guarantee the loans of others. Why do they sign on, how do they get into trouble in those transactions and what might have assisted them in avoiding such difficulties?

While we learn some things about guarantee transactions from reported judgments of cases that are litigated when things “go wrong”, these cases are not necessarily helpful in gaining an understanding of what is occurring more broadly. Litigated cases represent a very small percentage of disputed matters, the vast majority of which settle prior to, or during, litigation. Drawing information only from cases that proceed to litigation may be misleading when policy-makers and researchers are trying to determine what the key issues are in guarantee transactions.

There is clearly a paucity of data about the prevalence and practice of third party guarantees. This study sought to address that absence, and to provide reliable data so that lenders, borrowers, guarantors, litigants and legislators alike could assess the situation with more clarity.

This report is divided into chapters that follow the inception, life and death of a guarantee transaction, beginning with the original loan and following it through to the resolution of disputes about the guarantee of the loan.

WHAT WE FOUND

Many of our findings confirmed existing suppositions drawn from anecdotal reports and litigated cases. For example we found a high proportion of female guarantors supporting the borrowing of male partners who were engaged in small business.

Some of our findings were surprising. For instance we did not expect to find such a high proportion of older guarantors, many of whom were supporting the borrowing of adult children. We were also surprised to find that a relatively small proportion of guarantors received legal advice prior to the transaction, and of the guarantors who did receive advice, they reported a high level of poor practice on the part of solicitors. A high level of reported poor practice on the part of lenders was also unexpected, given how many inquiries and reforms have been undertaken in this area in recent years.

We were interested to discover that in many ways the data we drew from our survey of guarantors did reflect that found in the available litigated cases. Our guarantor respondents were very similar to litigants in the case law pool we examined in areas such as: their gender, non-English speaking background, relationship with the borrower, and likelihood of having signed the guarantee documentation in the presence of the borrower.

We were unable to determine the age of all litigants, but noted that many of them were guarantors for the loans of adult children; suggesting an age range of over 50, which correlated fairly closely with the large proportion of guarantor respondents over the age of 50.

The areas in which guarantor respondents and litigants in case law differed are also noteworthy. We found that compared to litigants, our guarantors were supporting loans for smaller sums of money, were more likely to sign the documents in informal circumstances and were half as likely to have received legal advice prior to signing the guarantee. Litigants were more likely than our guarantor respondents to be supporting a business loan, to have mortgaged the family home as part of the guarantee, and to have signed an “all moneys” clause as part of the guarantee.

More detailed findings set out in each chapter are summarised below.

Chapter 2. Securing family business borrowing: why guarantee transactions take place

The vast majority of third party guarantees are undertaken to support small business borrowing, primarily family business. These businesses are typically owned and run by men. While a female partner may be listed as a shareholder or director, she is rarely in a position of any real control over the company.

Over one third of guarantors who responded to our survey reported that the borrowing was undertaken to expand an existing business; a quarter of loans were directed to starting a new business and around one fifth of loans were required to help an already ailing business.

Most guarantors were in a close relationship with the borrower.

The majority of guarantees were for loans in excess of $100,000.

Because most guarantees have been undertaken to support a business loan, they are not covered by safeguards provided in the Consumer Credit Code. The Code is enacted in legislation in each Australian state and requires lenders to provide plain language documents, cooling off periods, warnings and information to prospective guarantors for consumer loans.

Chapter 3. Who are guarantors and why do they sign?

We found that a very high proportion of guarantors were women.

Women principally undertake guarantees as the wives or de facto partners of male borrowers. Very few men guarantee the debts of a spouse, and those men who were guarantors were most likely to have guaranteed the loan of an adult child.

Almost two thirds of guarantors were over the age of 50.

A disproportionate number of guarantors were from non-English speaking backgrounds and 40% of the guarantors who responded to our survey were overseas born. Guarantors from non-English speaking backgrounds appear to be least likely to receive legal advice prior to entering into the transaction.

Guarantors generally agree to the transaction for emotional rather than financial reasons, with a significant proportion of guarantors reporting that they agreed to the transaction because they did not want to damage their relationship with the borrower by refusing. Many reported that they had misgivings about the transaction from the start, but went ahead regardless.

Guarantors gave a range of reasons for signing. These included: trust in the borrower, optimism, misunderstanding or misinformation about the transaction, individual pressure from the borrower ranging from emotional pressure to threats or coercion, and more general pressures such as cultural and family pressure to support a borrower. It was clear that many guarantors signed because they felt that they had no choice but to sign, especially in situations of economic dependence on the borrower.

In addition, in some instances guarantors signed because they simply had no idea of the gravity of the consequences, did not understand the agreement or had been mislead about the transaction.

Chapter 4. The lenders

We were unable to ascertain the number or proportion of guarantees that are called upon in any given period, or that result in the repossession of security such as residential homes, as lenders were unable or unwilling to disclose this information.

Nor could we discover the number or proportion of debts which are disputed by guarantors.

There was some evidence suggestive of the fact that some lenders had engaged in asset based lending, where they assess the risk of the loan by reference to the value of the security rather than on the ability of either the borrower or the guarantor to repay the loan.

While there are a wide range of common law and legislative avenues available to challenge unjust transactions after the event, there is relatively little external regulation of the conduct of the finance industry in taking guarantees. The Consumer Credit Code proves a range of protections for borrowers, but it is limited in its application to “consumer” transactions. Most guarantees are given to support small business borrowing and so are not currently covered by the Consumer Credit Code.

The finance industry’s conduct in taking guarantees is therefore largely self-regulated. The Code of Banking Practice is the main self-regulation mechanism. However, this Code only applies to banks that adopt it.

Banks who are part of the Code agree to investigate disputes internally, which can also be referred to the Australian Banking Industry Ombudsman. While the Code was originally limited to consumer guarantees, following a comprehensive review, guarantees of small business loans are included in the scheme from August 2003. The revised Code of Banking Practice contains far more wide-reaching constraints on the taking of guarantees than have existed to date.

Chapter 5. The guarantee transaction

Guarantors often had little or no knowledge of the financial situation of the borrower or the borrower’s business.

There was a widespread lack of understanding among guarantors about the obligations that they had undertaken. Very few guarantors were aware of the commercial or legal implications of the transaction when they executed the guarantee.

We found that guarantee documentation is lengthy and complex, often involving a bundle of several interrelated documents that combine to create legal liability which is not apparent on the face of any one document separately.

“All moneys” clauses extend the liability of a guarantor to future as well as present loans up to an unlimited amount. Such clauses are still in common use despite widespread concern about their potential to cause unfairness and lender assertions that their use is rare. The revised Code of Banking Practice, which applies from August 2003 prohibits the taking of “all moneys” guarantees in a wider variety of circumstances than it previously did.

We found a trend towards a restructuring of guarantee transactions to place the guarantor on paper as a borrower or co-borrower in order to conceal the reality of the situation and avoid regulation or legal liability.

Our survey of guarantors revealed that over one quarter of them entered into the transaction in informal circumstances, with one fifth of them executing the guarantee in their own home. A lesser, but still significant, proportion of guarantors in the litigated cases we reviewed also signed at home.

Given the potential for influence or pressure to be brought to bear in these situations, we were disturbed to find that almost half of guarantors who responded to our survey reported that the borrower was present when they signed, while nearly a quarter reported that both the borrower and the lender were present. This was also reflected in the litigated cases.

Many guarantors reported that they did not have time to consider the contract. Over half felt that the provision of a “cooling off” period prior to the contract coming into effect would have helped them, while a third did not think such a provision would have made any difference to their situation.

Few guarantors received independent legal advice prior to entering into the guarantee. While legal advice had been given in 29% of the litigated cases, only 14% of surveyed guarantors reported that they had received legal advice prior to entering into the transaction. Moreover only 20% of guarantors reported that anyone, including the lender, suggested that they obtain such advice prior to signing.

Of those few guarantors who did receive legal advice, most did not find it adequate, nor did it have any significant impact upon their decision to enter into the transaction. Advice was often cursory, and usually took place shortly before the documents were signed.

The fact that in many instances the legal advice was organised by the borrower and sometimes was given in the presence of the lender or the borrower raised issues about the independence of the advice and, in some cases, about conflict of interest.

Most solicitors reported that their role was to explain the effect of the documents and give advice on the legal risks of the transaction such as the nature and extent of liability. While a quarter of solicitors saw their role as ensuring that a guarantor understood the transaction, and a few saw themselves as protecting the guarantor’s interests, none saw their role as ensuring that the guarantee was freely entered into.

Legal advice does not include advice on the financial implications of the transaction, or an assessment of risks. This is beyond the role of solicitors, and in any event, in most cases there was insufficient information on the borrower’s finances to enable such an assessment.

While independent legal advice ought to ensure a guarantor is better able to understand the transaction, many lawyers also remarked upon the fact that such advice really works to protect the interests of lenders, by making disputed transactions much harder to challenge.

Lawyers were very concerned about what they saw as a rising tide of claims against them in the context of third party guarantees. Many perceived independent legal advice as a risk shifting exercise, rendering solicitors responsible for the loss that ought rightly to rest with borrowers or lenders. In fact we found very few claims against lawyers, and no instances in our pool of cases in which lawyers were held liable for a guarantor’s or lender’s loss.

Chapter 6. When the loan went wrong

Most guarantors reported that they received no information about the loan until their guarantee was called upon.

When the guarantee was called upon the vast majority of guarantors were shocked to find that they were wholly liable for the debt. Most were taken by surprise by the amount of the debt, which included interest and other charges. Several guarantors reported that this was the first time they discovered their guarantee extended to cover “all moneys”.

Many lawyers and judges expressed the view that litigation was expensive, complex and inefficient for the resolution of guarantee disputes and expressed a preference for more accessible dispute resolution mechanisms such as mediation, industry resolution or tribunal processes. Yet of the few such processes in existence, we found that they were very little used.

The Australian Banking Industry Ombudsman was approached by only 7% of surveyed guarantors. The ABIO’s own figures show that guarantee matters form a very low percentage of its closed complaints. There are several limitations to the jurisdiction of the ABIO, including monetary limits and the fact that commencement of litigation ousts its jurisdiction. These may account for such under-use.

The Consumer, Trader and Tenancy Tribunal was also very little used, and likewise this appears to be related to its limited jurisdiction, which by virtue of the Consumer Credit Code does not include guarantees that support loans for business purposes.

While the majority of disputes about guarantees settled, we found that it was quite common for settlement to occur only once litigation was already underway. So in a sense litigation could still be regarded as a, if not the, primary dispute resolution process in this area.

Of matters that settled, the majority were on terms that were more favourable to the lender than the guarantor.

Chapter 7. Litigation

Litigation is marked by a complex maze of claims and cross claims on a variety of common law and statutory bases. We found that it was common for three or more grounds of defence to be relied upon in any single matter and late amendments to pleadings were a regular event.

The views of lawyers about the conduct and efficiency of litigation were coloured by whether they acted predominantly for guarantors or lenders. Lawyers who acted for lenders tended to think that the law provided too many avenues to challenge guarantees. These lawyers and several judges, suggested that guarantors often raised a desperately wide raft of barely arguable claims that simply delayed the inevitable. Lawyers who acted for guarantors were of the view that lenders unconscionably increased their own costs, were quick to move for default judgment and used procedural manoeuvres to prevent claims being properly heard.

Legal costs are obviously high. The high cost of legal services impacts disproportionately on guarantors as they have both fewer financial resources and less experience compared to lenders. We were unable to determine clearly how many guarantors were proceeding to litigation without legal representation, although several judges stated that they saw a significant portion of unrepresented litigants.

There is a perception among some commentators that there has been an explosion in successful litigation by guarantors and as a result, the law has gone “too far”, such that commercial certainty in this area has been undermined. This concern was not borne out by our research. While guarantors were partially or fully successful in 35% of the litigated cases we reviewed, these cases represent only a small fraction of the overall pool of disputed transactions. Most disputed cases settled, and of those we found that the majority were on terms that favour lenders. Solicitors reported that even in disputed transactions, the most common result for their clients was that they repaid the loan with interest, with only a very small portion being partially or wholly released from the debt.

We also examined the impact of the Contracts Review Act 1980 (NSW) and the High Court decision of Garcia v National Australia Bank (1998) 194 CLR 395, both of which are perceived as providing fairly generous avenues of relief for guarantors.

In our analysis of litigated cases we confirmed that the Contracts Review Act does indeed provide a broader and more flexible approach to assessing unfair dealing than common law doctrines. However we also noted that the Act was applied with considerable inconsistency. We also confirmed a trend noted by other researchers, towards partial rather than complete relief under the Act.

The 1998 High Court decision of Garcia revived a “special protection” for volunteer wives even in the absence of unfair dealing. This rule holds that if a wife is a volunteer to a transaction, and does not understand its effects in essential respects, she may be able to have it set aside, even in the absence of unfair dealing, if the lender did not take steps to explain the transaction or to recommend legal advice be sought. While Garcia was raised in 58% of litigated cases we analysed, litigants were successful in only around a quarter of these cases. Solicitors and barristers did not think the decision had a large impact upon the law.

We found considerable uncertainty about the scope and application of the principle. While some decisions have applied the principle to de facto spouses, others held that only formal marriages are covered by the principle. There has been similar division over whether the principle extends to elderly parents, while the claims of in-laws, clients who relied upon their trust in solicitors, and close friends have all been denied in the cases reviewed.

We found even greater variation over courts’ interpretation and application of the Garcia requirement that the claimant be a “volunteer” to the transaction in order to be entitled to relief.

Other issues explored in this Chapter include: the very slight consideration of violence as an issue in litigated cases, the use of lenders “usual practice” as evidence, the importance of determinations of credibility in determining outcomes in litigation, and the role of gender and cultural stereotyping.

Chapter 8. Implications of this report

This chapter outlines some of the implications of this research in two areas: firstly, pre-transaction conduct, and secondly, dispute resolution once a guarantee is disputed.

The objectives of law and policy reform in this area involve a tension between the need to protect guarantors, secure finance for small business, and provide some measure of certainty in procedure, practice and outcome for all parties concerned. This report does not suggest particular reform measures. Rather, it highlights key findings of our research and suggests how these findings need to be considered by, and may impact upon, future developments in law and policy.

A. Signing

Guarantors in positions of vulnerability. The evidence from this report clearly shows that women, elderly people and those from non-English speaking backgrounds are disproportionately affected by third party guarantees. This highlights the need to consider these groups as the prime demographic of guarantors and to target them specifically in any reform or education measures.

Many guarantors we surveyed were in positions of vulnerability, either because of their emotional connection with the borrower or because of structural inequalities. These findings suggest that there are significant issues of power imbalance in guarantor/borrower and guarantor/lender relationships that may not necessarily be resolved by the provision of more or better information.

Guarantor relationships and gender. Men and women’s experiences of guarantee transactions appear to be quite different, and any reform and education measures need to be careful to identify guarantor needs and experiences by gender.

Informational disparity. It appears common for guarantors to sign in situations where they have little information or are misinformed about key aspects of the transaction. Guarantors rarely have any information about the borrower’s loan or about the health of the business they are supporting and so are unable to assess the risk they are taking. Such information is clearly necessary to enable even the possibility of an informed choice about the transaction.

Guarantee documentation is lengthy, complex and on occasion incomprehensible even to the legally trained. While plain language documentation may not prevent guarantors from entering into improvident transactions, it would, like the provision of other information and advice, assist in giving at least the opportunity for some real choice to be exercised.

The inclusion of “all moneys” clauses is still apparently occurring in guarantee transactions. Such clauses in and of themselves enhance the likelihood that guarantors will be placed in an ill-informed and disadvantaged position in the guarantee process.

The circumstances of signing. It appears disturbingly common that guarantee transactions are carried out in informal surroundings and/or in the presence of the borrower. It was very common for our surveyed guarantors to have little time to consider the terms of the agreement. The guarantee transactions in our study almost always took place in the absence of adequate legal or financial advice. These factors contributed to guarantors’ poor understanding of their obligations and to depriving them of an opportunity of informed choice.

These findings contradict what is understood as good practice – and commonly assumed to be typical practice – in this area. Good lender practice, as set out in lenders’ own policy manuals, requires guarantors to sign at the lender’s premises in formal circumstances, in the absence of the borrower and following the receipt of independent legal advice.

Legal advice. There appears to be a sharp disparity between what courts, lenders and policy-makers understand to be the scope and content of independent legal advice and what is delivered in practice. “Independent legal advice” is in practice merely a “basic explanation” of the content of legal documents.

These findings have serious implications in terms of the development of guarantor protections, which until now, have contained a heavy focus upon independent legal advice as a cure for unfair dealing, a source of information or empowerment for the guarantor, and as a protection against lender liability. While the presence of legal advice may protect a lender from an action to have the transaction set aside, such advice as it is currently typically provided does not appear to offer the guarantor very much in terms of information on the loan, advice on the transaction, or empowerment to refuse or renegotiate the terms of the transaction.

Lack of regulation. The pre-transaction conduct of the taking of guarantees still appears largely unregulated and shows little evidence of what either the finance industry or consumer advocates would regard as best, or even adequate, practice.

There appears to be a need for clear and consistent standards of conduct across the entire lender industry.

B. Later disputes

Litigation is inadequate. If there is any dispute over the guarantee transaction, the available avenues for redress are clearly inadequate. Informal and accessible dispute resolution mechanisms that currently exist are very limited in their operation and utility. Litigation, with its associated expense and complexity, still remains the principal focus of dispute resolution in this area.

Litigation is complex, protracted, expensive and often poorly conducted. Litigation is fiercely and desperately fought in many matters, and may often add considerably to the final costs even when settlement is achieved at some stage in the process.

The costs of dispute resolution. The inclusion of “all reasonable costs of recovery” clauses is very common in guarantee transactions. These costs are in addition to the principal sum and interest, and include legal costs and the costs of pursing the borrower and the guarantor. They can amount to many tens of thousands of dollars before litigation has even commenced. These clauses transfer a significant portion of the risk of lending – the transaction costs of recovery – from lenders to guarantors.

Such clauses act as a powerful disincentive for lenders to negotiate, to settle claims or engage in lower cost forms of dispute resolution, as their legal costs and costs of recovery are contractually borne by the guarantor and can be automatically deducted from secured assets.

Need for certainty. The current array of common law and legislative avenues to challenge unfair transactions has contributed to the complexity of litigation.

The application of legal principles – particularly the Contracts Review Act 1980 (NSW) and the “special equity” for wives in Garcia – in decided cases has been inconsistent and further contributed to uncertainty. It appears that there are too many legal principles that are too uncertain in their application for any degree of predictability in this area.

Greater certainty in the operative law in this area could reduce litigation and provide both lenders and guarantors with a better sense of what conduct and factors will render a transaction unenforceable.

The need for accessible dispute resolution. While many matters settle in negotiation between lawyers, there are very few structured avenues of accessible or informal dispute resolution in this area.

The industry and tribunal level dispute resolution processes that do exist are very little used. This under-use appears to be principally caused by jurisdictional limits such as low monetary limits on the value of the dispute and limited application to “consumer” rather than “business” transactions. As a large portion of guarantees are secured by residential properties and are undertaken to support small business borrowing, the jurisdictional limits of current avenues render them virtually useless.

There is a clear need for a relatively even playing field in which disputed transactions can be heard and adjudicated, in addition to avenues for mediated or negotiated settlements.