(Part 3 On the series on lending)
What is a guarantee?
A guarantee is a contractual obligation by a guarantor to ensure that a third party (a borrower) will fulfil their payment obligation and an undertaking to pay any amounts owed by the borrower should they fail to pay. It acts as a secondary obligation to the lender as it is anchored on the payment obligation of the borrower.
A contract of guarantee is an accessory contract, by which the surety undertakes to ensure that the principal performs the principal obligations. It has been described as a contract to indemnify the creditor upon the happening of a contingency, namely the default of the principal to perform the principal obligation.
The surety is therefore under a secondary obligation which is dependent upon the default of the principal and which does not arise until that point.
The Law of Contract Act, defines a guarantee as a written promise by the guarantor to be responsible for a debtor’s obligations.
Legal Framework Governing Guarantees in Kenya
Under Kenyan law, guarantees are governed by the general principles of contract law. For a guarantee to be valid and enforceable, it must meet all the essential elements of a contract, namely:
- Offer;
- Acceptance;
- capacity to enter into a binding agreement;
- intention to create legal relations; and
- consideration.
In addition, the law requires that a guarantee must be in writing and signed by the guarantor or a person duly authorized by the guarantor pursuant to Section 3(1) of the Law of Contract Act. Further, it must be stamped within 30 days of execution in accordance with Section 6(1) of the Stamp Duty Act.
The Law of Guarantees – by Geraldine Andrews & Richard Millet 2nd Edition, at page 156:
“A contract of guarantee is an accessory contract, by which the surety undertakes to ensure that the principal performs the principal obligations. It has been described as a contract to indemnify the Creditor upon the happening of a contingency namely the default of the principal to perform the principal obligation. The surety is therefore under a secondary obligation which is dependent upon the default of the principal and which does not arise until that point.
The nature of a guarantor’s obligation is also articulated in Halsbury’s Laws of England 4th Edition Vol 20 Paragraph 194, which states:
“On the default of the principal debtor causing loss to the creditor, the guarantor is, apart from special stipulation, immediately liable to the full extent to his obligation, without being entitled to require either notice of the default or previous recourse against the principal….”
This position underscores the seriousness of a guarantee. Once default occurs, the guarantor’s liability crystallizes immediately, unless the guarantee provides otherwise.
Types of Guarantees: Personal and Corporate
Guarantees generally fall into two broad categories: personal guarantees and corporate guarantees.
Personal guarantees are made by individuals who undertake to use their personal assets to secure a loan facility. A common example is where a director guarantees a loan taken by a company. In such cases, the director’s personal property may be at risk if the company defaults. In addition, the obligations under the guarantee are not extinguished by resignation from the directorship of the company. This was the finding in Southern Credit Banking Corporation Limited v Raja & 3 others (Civil Suit 159 of 2004) where the court held made a finding that a guarantee is a continuing obligation unless revoked or discharged in accordance with its terms a guarantor’s liability is not terminated merely because they cease to be a director or shareholder of the principal debtor. The 2nd and 4th Defendants’ argument that they sold their share and left the company cannot, on its own, extinguish liability under a duly executed guarantee unless the guarantee expressly provides for such release or the creditor consents in writing.
Corporate guarantees, on the other hand, are issued by companies or other legal entities. Since a company has a separate legal personality from its shareholders and directors, it assumes liability in its own right. For instance, one company may guarantee the obligations of another company.
Corporate guarantees, however, require additional considerations. A company must have the capacity under its constitutive documents such as its articles of association to issue a guarantee and must generally obtain the necessary approvals, such as a board or shareholder resolution.
Nonetheless, even where such approvals are not properly documented, a lender dealing with the company in good faith may still be protected under the indoor management rule. In practice, lenders must also undertake due diligence to assess the financial standing of the corporate guarantor.
Limited and Unlimited Guarantees
Guarantees may either be limited or unlimited in scope. A limited guarantee restricts the guarantor’s liability to a specified portion of the debt. In contrast, an unlimited guarantee exposes the guarantor to the full amount of the debt, including interest and associated costs.
In some cases, guarantees may also be tied to specific assets, while in others, lenders may pursue any of the guarantor’s personal assets in the event of default.
When does a Guarantor’s Liability Arise?
The obligation of a guarantor arises upon default by the principal debtor. This position has been affirmed in several judicial decisions.
In Ebony Development Company Ltd vs. Standard Chartered Bank Ltd, the court stated that the guarantor becomes liable upon the default of the principal debtor.
Where a guarantee contains terms such as “payable on demand” or “normal bankers’ demand rights,” the lender is entitled to demand repayment at any time.
In Lalji Karsan Rabadia & 2 Others V. Commercial Bank of Africa Ltd (2015) eKLR, it was held that there was no misconduct on the part of the bank for demandingrepayment of the facilities as the bank was guided by the contract documents stipulating that the provision for repayment of the loan in the long term was subject to demand provisions set out in the contract instruments.
Whether a Creditor must first Pursue the Borrower
A common misconception is that a lender must first pursue the principal debtor before proceeding against the guarantor. The law, however, does not impose such an obligation on the creditor.
In Ecobank Kenya Ltd vs. Francis Tole Mwakidedi (2018) eKLR, the Court stated:
“The Debtor has no luxury nor right of choosing for the Creditor who amongst the Debtor, to pursue and failure to pursue all Debtors at once is not fatal to the Creditor’s petition”
Similarly, in Kenindia Assurance Company Limited v First National Finance Bank Limited, the court affirmed that a creditor is free to choose which debtor to pursue. Furthermore, in Peter Munga vs. African Seed Investment Fund LLC (2017) eKLR, the Court held:
“As a Secured Creditor with multiple remedies, the Creditor was entitled to elect which to enforce, at what time, in what order and in the way it chose… The liability of a Guarantor is generally co-extensive with that of the Principal Debtor…”
In Rose Chepkirui Mibei v Jared Mokua Nyariki & 2 others eKLR, the Court emphasized:
“Once there is default and notice is given to the guarantor, his obligation under the guarantee must take effect immediately… the creditor is under no obligation to first pursue the principal debtor…”
Extent and Effect of a Guarantor’s Liability
The effect of a guarantee is significant. A guarantee creates personal liability on the part of the guarantor and this liability is not limited to any charged property. This means that a guarantor’s personal assets may be attached and sold in order to recover the debt.
This position was affirmed in CRDB Bank Ltd v. Issack B Mwamasika & 2 Others Civil Appeal of Tanzania No. 139 of 2017, where the court held that a bank may pursue the personal assets of a guarantor upon default and that guarantors cannot escape the legal consequences of such obligations.
Where there are multiple guarantors, their liability is typically joint and several, meaning that the lender may pursue any one guarantor for the full amount of the debt.
Rights of a Guarantor
Despite the strict nature of guarantees, guarantors are entitled to certain rights.
- Right to demand payment from the principal debtor: A guarantor has the right to require the principal debtor to settle the guaranteed debt, particularly where the guarantor has been called upon to make payment.
- Right to information: A guarantor is entitled to be informed of material changes affecting the loan or the terms of the contract. In Reid vs. National Bank of Commerce (1971), the court affirmed the guarantor’s right to be informed of changes to the contract.
- Right to indemnity: A guarantor is generally entitled to be indemnified by the principal debtor for any payments made under the guarantee. However, this right may be limited or excluded by the terms of the guarantee agreement.
Defences Available to a Guarantor
Although guarantees impose strict obligations, the law recognizes several defences that a guarantor may rely on to avoid liability in appropriate circumstances.
- Extension of time without consent: A guarantor may be discharged where the creditor extends time to the principal debtor without the guarantor’s consent.
- Variation of the loan contract: Where the terms of the loan agreement are varied in a manner that affects the guarantor’s obligations without their consent, the guarantor may be released from liability.
- Release of security: A guarantor may be discharged where the creditor releases or fails to preserve security held in respect of the debt.
- Lack of consideration: In the case of corporate guarantees, a guarantor may rely on lack of consideration where no commercial benefit is derived from issuing the guarantee.
- Duress, undue influence, misrepresentation and Non Est Factum: A guarantee may be set aside where it is procured through duress, undue influence, misrepresentation or where the guarantor did not understand the nature of the document signed. In National Bank of Kenya Ltd v. Pipeplastic Samkolit (K) Ltd [2002] 2 EA 503, the court stated: “A court of law cannot rewrite a contract… unless coercion, fraud or undue influence are pleaded and proved.”
- Bad faith: A guarantor may be discharged where the creditor acts in bad faith or in a manner that prejudices the guarantor’s position. In Martin Kirima Baithambu vs. Jeremiah Miriti [2017], the importance of good faith was emphasized.
- Repudiatory breach by the creditor: Where the creditor commits a repudiatory breach of the principal contract, thereby entitling the principal debtor to treat the contract as terminated, the guarantor may also be discharged.
- Prejudicial dealings without consent: Where the creditor and the principal debtor engage in dealings that are prejudicial to the guarantor without the guarantor’s consent, the guarantor may be released from liability.
Key Considerations Before Giving a Guarantee
Given the significant risks involved, it is important for both individuals and companies to exercise caution before executing a guarantee.
One important consideration is whether the guarantee creates a continuing obligation. A continuing guarantee may cover not only existing debts but also future advances, thereby exposing the guarantor to ongoing liability without a clear termination point.
It is also essential to ensure compliance with the legal requirements of a valid contract and to confirm that the guarantor has the necessary capacity to enter into the agreement. For corporate guarantees, this includes ensuring proper authorization through board or shareholder resolutions.
Guarantors should also seek independent legal advice before executing a guarantee. This helps to ensure that they fully understand the implications of the agreement and reduces the risk of disputes arising from claims of undue influence or misrepresentation.
Finally, it is advisable for guarantors to secure an indemnity from the principal debtor to protect themselves in the event that they are called upon to satisfy the debt.
Conclusion
Personal and corporate guarantees are powerful legal tools that provide lenders with enhanced security in financial transactions.
However, they also impose serious obligations on guarantors, often exposing them to substantial financial risk.
The law is clear that once a borrower defaults, a guarantor may be called upon immediately and may be pursued independently of the borrower.
As such, anyone considering acting as a guarantor must fully understand the legal implications, carefully assess the risks involved and seek professional advice before entering into such an arrangement.
Disclaimer: The information provided in this article is for general informational purposes only and does not constitute legal advice. The author/website is not responsible for any errors or omissions and a party desiring legal advise should get in touch with the authors
