A guarantee is a promise by a third party to be liable to a lender for the obligations of a debtor, if the debtor defaults on their obligations. These are serious undertakings as they can render a guarantor liable for the whole amount owed by the debtor. Guarantees become enforceable when the debtor has defaulted on their obligations. However, there are numerous reasons why a guarantee may be unenforceable.
Formalities of Contract
A guarantee is contract. Therefore, it will not be generally be enforceable unless all the formalities of a contract have been fulfilled. In addition, guarantees must be in writing and signed by the guarantors. Since a guarantee is a contract, it can be invalidated by the same reasons that invalidate other contracts such as misrepresentation, undue influence or duress.
Some states also have additional formal requirements for certain types of guarantees.
The principal obligation is not enforceable
A guarantor’s liability is ‘co-extensive’ with the debtor, meaning they are equally liable to the creditor for the obligation. In other words, the guarantor will only be liable to the creditor so long as the debtor is liable. Therefore, if the principal obligation of the debtor is discharged by repayment or is for some other reason unenforceable, the guarantor will also be off the hook.
A common way in which guarantees are rendered unenforceable is due to unconscionability. Generally this involves the guarantor having a special disadvantage of which the lender is aware and takes advantage of. Simply being careless is not enough. The special disadvantage of the guarantor must be due to something serious which prevents them from comprehending what they are getting involved in, such as age, mental incapacity, illiteracy, inability to speak the language, lack of education or business experience, lack of legal assistance or explanation where it is necessary or emotional dependency.
A common example is elderly, infirm or immigrant parents with little language skills guaranteeing loans for their beloved children without fully understanding what they have signed on for. Nowadays, lending institutions are especially careful to ensure at-risk guarantors know what they’re getting themselves into or have access to independent legal and financial advice.
Guarantees by wives
There is a controversial rule which was formulated in 1939 in a case called Yerkey v Jones, that presumes married women are at a special disadvantage when guaranteeing their husband’s business loans. Therefore, if a married woman guarantee’s her husband’s obligations without understanding the essential nature of the guarantee, receives no financial benefit and the lender made no attempt to explain the significance of her actions, the guarantee can be set aside.
Obviously this has come under heavy criticism over the last few decades. The presumption is regarded by many as sexist and by others as simply unnecessary, given the broad scope of unconscionability to assist any wives who are truly vulnerable to exploitation. However, the principle still operates, being affirmed as recently as 1998, where the High Court suggested it could operate in other situations which involve close relationships based on trust and confidence. The current status of the rule is unclear. Either way, lenders have become more proactive in ensuring guarantors who are volunteers, especially if they are close relations to the debtor, understand the purport and effect of their actions and gain independent advice.
If you are seeking to obtain a guarantee or become a guarantor, we would recommend you get independent legal advice. Please do not hesitate to contact us. Please be aware that this article was written in October 2014 and the law may have changed.