The guarantor will pay
Recent case law on guarantees provides an example of a guarantor finding himself in a financially unforgiving situation. In Cancian v Carters, Mr Cancian believed he was guaranteeing a $50,000 credit account, which turned out to be a $1,078,668.23 personal liability (a multiple of over 21x). The court had no sympathy for the guarantor. So what can we take away from this case?
This update covers:
Guarantees generally.
The Cancian v Carters case.
Tips when negotiating a guarantee.
Guarantees
In the business world, guarantees are a familiar topic. Under a guarantee, a guarantor is obliged to answer to another person for the debt, default or liability of a third person. This is typically seen in lending situations, where a creditor would require a guarantor to answer for the payment and other obligations of a debtor, who is typically a limited liability company. In this way, creditors reduce the risk of non-payment and ensure personal commitment from the directors (or shareholders) of a fictitious company personality.
Guarantees are not limited to lending. They are also widely used in commercial leases, supplier agreements, as well as in business purchase agreements where the purchaser is a special purpose, shell, vehicle. In theory, they can be used in any other situation where a party believes that there is a (substantial) risk of default by the counterparty, without adequate security in place. In this way, guarantees are a useful commercial tool that helps parties to allocate default and credit risks, and facilitates transactions.
The law on guarantee seems straightforward. Property Law Act 2007 requires contracts of guarantee to be in writing and signed by the guarantor. Standard principles for the formation of contracts also apply – for example, there should be clear intention between the parties to form a legal relationship, the terms must be certain, and there must be a consideration (a quid pro quo) given for the guarantee. The consideration for the guarantee does not need to be in writing and is not needed at all if the guarantee is in a deed form, which is the standard practice. Otherwise, each guarantee will turn on its wording, as negotiated between the parties.
Case law also dictates the nuances and interpretation of guarantees.
Cancian v Carters
The Bella Vista subdivision in Tauranga. Photo: RNZ / Andrew McRae
Here, a question arose whether a guarantee must be discharged if there is a material variation to the underlying contract. Here’s what happened:
Mr Cancian was the sole director and the sole shareholder of Bella Vista Homes (“BVH”), a building company.
BVH wanted to buy supplies from Carters on credit. To do this, BVH completed a credit application, which confirmed that it was entering into Carters’ standard supply terms (“BVH Agreement”). As part of the application, Mr Cancian also executed a deed of guarantee. Under it, he guaranteed the payment and other legal obligations of BVH under the BVH Agreement.
BVH initially requested a $700,000 credit and said it would spend approximately $400,000 in monthly purchases with Carters.
Carters accepted the credit application. It told BVH that it will initially provide a $50,000 credit.
Over the next few months, BVH bought supplies from Carters, and Carters increased the credit limit for BVH to $800,000. Carters did not notify BVH or Mr Cancian about the credit increase.
BVH ran into trading difficulties and was put into liquidation. At that time, BVH owed Carters $1,078,668.23.
Carters called Mr Cancian on the guarantee to pay for BVH’s outstanding amount.
Mr Cancian said the guarantee could not be enforced. He argued that altering the credit limit was a variation to the BVH Agreement such as to discharge Mr Cancian from any liability. This is an accepted legal principle because it would be unfair to hold to account a guarantor for an obligation that they did not originally agree to take on.
This argument failed.
The Court referred to the BVH Agreement which permitted Carters to impose a credit on BVH and alter it without notice. That power prevailed over any credit limit set at any time. So, a subsequent change to the credit limit could not be seen as a variation to the BVH Agreement.
The Court then made two further comments. First, even if increasing the credit limit was a variation to the contract, the guarantee contained an “anti-discharge” clause (set out below). An anti-discharge clause is an express acknowledgement by the guarantor that an underlying agreement may be varied including without notice to the guarantor. The guarantor would remain liable.
Secondly, there was a discussion around the applicability of the purview doctrine. This doctrine says that where a variation is so fundamental that it could not properly be described to be a variation at all, it will fall outside the general purview - in the sense of reasonable contemplation - of the guarantee and it will not be covered by an anti-discharge provision. Going back to Mr Cancian, initially, his guaranteed obligation was for a credit limit of $50,000. That limit was increased to over $800,000 without any express notice to him, which ended up in a $1,078,668.23 personal liability. Could it really be that such an increase was within the general purview of the original guarantee?
Apparently, yes. The Court said that it is a matter of construction for each case and that a very substantial increase in the credit limit without notice to BVH or Mr Cancian was within the general purview of the guarantee. Relevant factors were Mr Cancian being the sole director who attended the meeting with Carters to set up the credit account and signing the legal documents, and BVH initially requesting $700,000 credit itself. Mr Cancian essentially controlled the company, as its alter ego. This is a tough outcome, especially as the latest in the Bella Vista Homes legal saga.
So what can be learned?
When negotiating a guarantee: suggestions
We set out a few non-exhaustive suggestions for creditors and guarantors - with the benefit of the Cancian v Carters case, but also more generally. From a creditor’s point of view:
Ensure you have strong anti-discharge provisions. These are relatively standard provisions, and examples can be found online (e.g. UDC, Kiwibank).
Where a variation to the underlying agreement is material, consider a process where you get a guarantor buy-in, e.g. at least with a notification of the change.
Ensure that the guarantor obtains independent legal advice or waives the right to seek such advice.
A different set of considerations will apply to consumer lenders who take personal guarantees and also arguably where SMEs are involved. These are layers under the Credit Contracts and Consumer Finance Act and also the Fair Trading Act.
Negotiating a guarantee will be practically more difficult for a guarantor. But, there should be an attempt given its significance. From the guarantor’s point of view, and assuming that the guarantee document contains standard anti-discharge and other creditor-friendly clauses:
Limit the guarantee by asking for a total liability amount.
Set an expiry date for the guarantee – for example, one year from the date of contract provided that there is no breach under the underlying agreement.
Require the guarantor to be CC’ed in all correspondence between the creditor and the debtor.
Require the guarantor’s prior written consent to all variations to the underlying agreement.
The above suggestions help a guarantor to limit, delete or have more control over what they are signing.
Ultimately, a sole director, who controls a limited liability company and enters into contracts on its behalf (including guarantees), will find it very difficult to get out of personal guarantees on technical grounds. But what if the guarantor was someone related to the director, such as a shareholder who is not involved in the day-to-day operations. What if the initial credit application was for $50k, instead of $700k? Or if the credit limit was increased to $5 million being the amount of the guarantee called upon? These hypotheticals could call for harder case law, but really do not need to come before the courts. Parties, with foresight, can avoid these issues by ensuring that a guarantee is properly considered and negotiated at the outset.
Disclaimer
This publication should not be construed as legal advice. It is necessarily brief and general in nature. Please seek professional advice before taking any action in relation to the matters discussed in this publication.
