To Guarantee or not to Guarantee

A colleague at work approaches you with a brilliant idea to generate income. They have been saving up for some years and they have decided to get the ball rolling. You congratulate them, offer your support and wish them the best. A month later you are chit chatting and they somberly tell you that the Sacco will not extend them a loan because their security is insufficient. Your colleague is a friendly person, you have worked together for two years and see each other every other day. You agree to be their guarantor so they can get the loan.

Three years down the line, you receive a notice from your Sacco that your colleague has defaulted on the loan. The Sacco is enforcing the guarantee and you are required to pay the balance on the loan in 30 days or they start deducting sums from your savings. You frantically start looking for your colleague but he is evasive. They cancel plans to meet, are hardly ever at work and ignore your calls. Thirty days are up and the axe falls.

Walk into any workplace and at least 6 out of 10 people have been in similar situation more than once. This can be attributed to many things; either people are too gullible or too dishonest, perhaps they do not read/understand the implications of guarantees, perhaps lenders are lax in conducting due diligence and prefer to shift the risk to unsuspecting third parties, maybe there is inadequate protection of guarantors in the law. Whatever the case we can all agree that a lot of injustice has been occasioned from Guarantees.

In February 2019, a bill to amend the Law of Contract Act Cap 23 was introduced into Parliament. The amendment proposes a safeguard for guarantors by requiring creditors to exhaust the debtor’s security first before going after a guarantor. This article will advise on the ramifications of a guarantee, the rights of a guarantor and the implications of the Law of Contract (Amendment) Bill, 2019. Hopefully, at the end you will be more discerning when giving a guarantee and adept at avoiding sticky situations.

What is a Guarantee?

A contract of guarantee is an accessory contract, by which the guarantor undertakes to ensure that the principal performs the principal obligations. It indemnifies the Creditor against the default of the principal to perform the principal obligation. The guarantor is therefore under a secondary obligation which is dependant upon the default of the principal.

As a general rule a Contract of Guarantee is Separate from the Principal’s agreement and the guarantor’s obligations do not arise until the Principal default. However, Creditors are shrewd when drafting guarantees in order to bind both the principal and guarantor as indistinguishable parties.

Look out for such/similar wording “the Guarantor shall be deemed under the foregoing agreement principal debtors and not merely guarantors…”  This was the situation in the case of Rajnikantkhetshi Shah v Habib Bank A.G. Zurich (2016) 2016 eKLR. The Courts found that it is permissible that a person may be designated as both. This poses greater risks on an unsuspecting Guarantor as it gives the Creditor lee-way to pursue you as though you were the beneficiary of the Loan. Courts have consistently held that they do not rewrite contracts between parties unless there has been a fraud, illegality or coercion. You would therefore be bound by such an agreement and the Creditor would not be faulted for pursuing you.

In the case of Lalji Karsan Rabadia & 2 others v Commercial Bank of Africa Limited [2015] eKLR there was a clause in the agreements providing that the Defendants could recall the loan before there was any default in payment of agreed installments by the Principal. The loan was recalled and the Principal was not able to pay the sums due and consequently the Defendants went after the Plaintiffs who were the Guarantors. The Guarantors argued that there was misconduct on the part of the Bank when they recalled the loan before there was default by the Principal. The court asserted that they do not overrule any clearly expressed intention of the parties in an instrument.It also found that there is no general principle that merely irregular conduct on the part of the creditor, even if it is prejudicial to the interest of the guarantor, discharges the guarantor.

What both these cases assert is that, notwithstanding the general practice of guarantees, parties may agree under contract to terms that deviate from the general practice and will be bound by those terms.

The key takeaways are therefore that:

  1.  As a general rule guarantees are secondary agreements and are not enforceable until there is default by the principal.
  2. A guarantor should therefore look out for expressions in the Guarantee that try to place the guarantor and the principal on equal standing in circumstances where the guarantor is not a beneficiary of the loan.
  3. Look out for expressions giving leeway for the creditor to recall the loan before there has been any default on the principal. This obviously exposes a guarantor to greater risk as the creditor will be left to pursue the guarantor when the principal is unable to pay the loan in full when called upon.
  4. Finally, Guarantees are contracts and courts are hesitant to remake or rewrite them where the intention of the parties is unequivocal and there is no evidence of duress, misrepresentation or coercion. Before signing a guarantee ensure to have it reviewed by a lawyer, your bank, Sacco representative, business/financial advisor or other person familiar with their practice to avoid assuming an unnecessary risk.

Rights of a guarantor

Guarantees are an effective largely because they caution the risk of a creditor and afford a debtor access to credit. Unfortunately, due to their nature a guarantor shoulders considerable risk. This is because contractually they have accepted liability yet they did not benefit from the transaction. There is also no legislation clearly outlining how guarantees should be dealt with. This notwithstanding, guarantors do have rights:

  1. Right to key information about the Guarantee and Credit Contract
    If you agree to be a guarantor you are entitled to have a copy of the Guarantee, and a copy of the key information pertaining the credit/loan contract.
    The Creditor must also provide you with certain information if you make a written request such as the amount required for full payment at any date.
  2. Right to Notice of Changes in the Credit/Loan contract
    If there is a change in the Credit/loan contract between the debtor and the creditor. The creditor is obliged to give you notice of the same. This is because a change in the credit contract could materially increase your risk as a guarantor and you are entitled to be informed so you can decide whether or not you will assume such a risk.
  3. Right to Notice of Default by the Principal
    You have a right to be informed as soon as the principal defaults. This is affords a guarantor time to make payment or pursue the principal for payment.
  4. Right to call upon the Principal Debtor
    In Martin Kirima Baithambu v Jeremiah Miriti [2017] eKLR the court held that upon receiving notice of the Principal’s default the guarantor has a right to call upon the principal to pay the debt.
  5. Right to subrogation
    The guarantor has a right recover from the debtor if the guarantor has paid the debtors debt. The guarantor becomes the debtor’s creditor and can pursue him for payment. They can also pursue bankruptcy or insolvency proceedings as creditors.
  6. Right to reimbursement
    The guarantor has a right to reimbursement of any costs incurred to pay the principal’s/debtor’s debt.
  7. Right to contribution
    Where there is more than one guarantor the contract must specify the percentage of each of their liability and if one guarantor pays more than his share he is required to recover from the other guarantors.
Defenses available to Guarantors for not paying off the debt
  1. Contract modification – if the credit/loan contract materially changes or if the guarantee is amended without the guarantor’s knowledge or signature the guarantor can refuse to pay the debt.
  2. Fraud, connivance, duress or bankruptcy – if a guarantor discovers that the guarantee was entered into under false pretenses or that the creditor and debtor are conspiring to fraudulently obtain payment under a guarantee, the guarantor may refuse to pay. A guarantor may also claim bankruptcy as a ground for failing to pay a debt.
  3. Debtor’s defenses – because a guarantee is founded on the credit contract, if the debtor alleges breach of contract on the part of the creditor the guarantor may assert the same defense for failure to pay under a guarantee.

The Law of Contract (Amendment) Bill, 2019

In February 2019 a bill was introduced in parliament to amend section 3 (1) of the Law of Contract Act cap 23 by introducing a new subsection 3(1A):
“(1A) Notwithstanding subsection (1), before a suit is brought against a defendant under subsection (1), the Plaintiff shall first realize the security of the principal.”
Section 3 (1) of the Law of Contract provides that a creditor cannot bring suit on a contract for guarantee unless the guarantee is in writing and signed by the guarantor. The amendment would provide further that, a creditor must realize the security of the principal before bringing a case against a guarantor for settlement under a guarantee.
In practice, when a debtor defaults on a debt the creditor has discretion to pursue either the guarantor, the creditor or both for recovery. This subsection would require the creditor to exhaust the principal’s security in order to merit pursuing the guarantor.
The rationale behind this amendment is that since the debtor is solely the one to benefit from credit all avenues to realize their security should be pursued. This avoids an unfair situation where a guarantor’s assets are taken over while the debtor still has realizable security.

What does realizing security mean?

Section 90 of the Land Act provides for remedies of a lender where a borrower has used land as security and defaulted:

  • Sue the chargor for any money due under the charge.
  • appoint a receiver of the income of the charged land.
  • ease the charged land, or if the charge is of a lease, sublease the land.
  • enter into possession of the charged land.
  • sell the charged land.

From these we can deduce that realizing the security of the principal first would mean exhausting the above remedies. The provisions of section 90 (3) of the Land Act apply to interests in land but the same/similar provisions would apply to other forms of security.
If a company defaults on a debenture for example; it would mean that a creditor would have to pursue insolvency proceedings for administration or liquidation of the company assets. This is a lengthy process and there is no assurance that the debt will be satisfied. Only after this process can they then pursue the guarantor. These are costly processes and take up a lot of time for both the courts and the creditors. When faced with a more expedient solution such as a guarantee courts may exercise their discretion in directing the creditor to pursue the guarantor.

Status of the Bill

During its second reading, the Bill received overwhelming support from the House with most Members stating that it would be a reprieve for many Kenyans who give guarantees in good faith only for them to be robbed of their hard earned investments. Members also stated that creditors need to conduct extensive due diligence to avoid a situation where a guarantees are enforced when the debtor has assets that can be realized. What is clear is that there needs to be a balance of rights between creditors, debtors and guarantors.
On the 18th September 2019, the Bill proceeded to the Third Reading and was passed by Parliament with an amendment deleting ‘security’ and replacing it with ‘assets’ and a declaration made that the amendment would not apply retroactively. The Bill is now awaiting presidential assent. We advise you keep checking LawyerWangu for updates.

Conclusion

Guarantees are evidently invaluable in business and when handled in a proper way they can be worthwhile. This requires good faith on all the parties’ involved and equitable treatment in case conflict arises. A guarantor should also have a clear understanding of their obligations under a guarantee. Resist the impulse to just sign a document! Consult a lawyer, a Sacco representative, your banker or a financial advisor. Some banks offer opinions for as little as KSh. 2,000. We suggest making an enquiry and seeking guidance and advice before you ink on the dotted line of a guarantee.

References
The Law of Guarantees by Geraldine Andrews & Richard Millet 2nd Edition.
Law of Contract Act Cap 23.
Law of contract (Amendment) Bill, 2019.
Land Act No. 6 of 2012.
Rajnikantkhetshi Shah v Habib Bank A.G. Zurich (2016) 2016 eKLR.
Lalji Karsan Rabadia & 2 others v Commercial Bank of Africa Limited [2015] eKLR.

Martin Kirima Baithambu v Jeremiah Miriti [2017] eKLR.
https://www.lawyerment.com/library/kb/Banking_and_Finance/Credit_and_Loans/1199.htm
https://www.legalmatch.com/law-library/article/guaranty-lawyers.html

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