WHEN A GUARANTEE BITES BACK! PRACTICAL TIPS TO REDUCE THE RISK. By Atticus Legal, Business & Property Lawyers Hamilton

Posted September 11, 2016

In Atticus Legal Information Sheets, General Articles

Banks lending to companies will always require a personal guarantee from the directors and/or shareholders. But bank guarantees from parents in favour of their children are also quite common in the residential property context as well. With the property market as it is, the amounts being borrowed by home buyers are much greater than they used to be. Add to this the loan-to-value ratios (deposit levels) now required by banks, and it is more difficult than ever for first home buyers to get onto the property ladder.

Parents are sometimes being asked to step in by giving a guarantee to the bank or by making a gift or loan to their kids to help raise their deposit to the required level. And given the price of residential properties these days, the amounts guaranteed (or lent or gifted) are substantial. The level of risk to those parents, and the consequences of default, are significant.

This article focuses on guarantees in the above-mentioned context. For comment on the alternatives of parents lending or gifting to their kids, see our article ‘Helping your kids onto the property ladder – A guarantee, loan or gift?’ on our website at https://atticuslegal.co.nz/helping-your-kids-onto-the-property-ladder-a-guarantee-loan-or-gift-it-really-does-make-a-difference-atticus-legal-property-lawyers-hamilton/

What is a guarantee? What is the effect of a guarantee?

A guarantee is a promise to the bank by one person or by say, a family trust (the guarantor) to be responsible for the obligations of another person (the borrower) if that other person defaults. The guarantor is as legally liable to the bank as if he/she were the borrower. In the context of this article, often the guarantee will relate to your child and his/her spouse or partner.

Each bank has their own form of guarantee document, but they all follow along more or less the same lines.

Things you might not know about guarantees

The guarantee document itself is a ‘paper promise’. The bank wants more than that so it will insist on having a security from the guarantor. In the case of a guarantee by parents, that security will usually be a mortgage security over the guarantor’s home (whether it’s an existing mortgage security or a new mortgage to be put in place).

So the bank will have two securities. A mortgage over the property being purchased by the child as well as a mortgage over the parents’ home securing the guarantee liability.

If there is a default on the child’s loan, the bank is not required to exhaust its remedies against the child, or their mortgaged property, before it calls up the guarantee and exercises its rights against the guarantors (eg. by mortgagee sale of the parent’s home, if they can’t pay).

The guarantee and the mortgage securities will be ‘all obligations’ meaning that, in the absence of any limitation agreed in writing by the bank, the parents’ guarantee (and the mortgage over their home) will not only secure any existing borrowing by the child and their spouse/partner but also any future borrowing by them or either of them from the bank. Without limit. And the bank does not need the parents’ consent before lending more to the guaranteed person.

Also relevant is whether the guaranteed persons, or either of them, have business borrowing with the same bank. Whether borrowing in their own names or in the name of a company that they have guaranteed. If so, the ‘all obligations’ nature of your guarantee will mean that you are guaranteeing their business borrowing as well.

Low hanging fruit

But wait, there’s more. The fine print of all bank guarantees includes a ‘right of set off’. This means that the bank can, without consent or prior notice to the guarantor, at any time dip into the guarantor’s deposit accounts with the bank to satisfy any guaranteed obligation. This can be done even before the bank has attempted to exercise its remedies against the borrower. As mentioned above, the guarantor is equally as liable to the bank as the borrower and the bank is not required to exercise its remedies in any particular order. The bank will often go for the ‘low hanging fruit’ first – eg. a guarantor’s deposit account, which is ripe fruit and very tempting to the bank. Yum! Believe me, I’ve seen this happen before.

Banks regard guarantees as very important. So they want to make sure they are enforceable against the guarantors (and their home). That’s why banks usually require guarantors to take advice on the guarantee from their lawyer before they sign. Gives the bank someone else to sue if there is a problem with the guarantee!

That’s also why lawyers are (or should be) careful when advising on a guarantee to ensure that the significance of it is fully explained to the guarantor. At Atticus Legal, we’ve advised on many a guarantee over the last 25 years. We know them inside-out. We also know some practical tips to help minimise a guarantor’s exposure. We share those tips with you below, some of which you should take up with the bank before it prepares the guarantee document.

Some ways to help minimise the guarantee risk

Ask the bank to agree, and to specify in the guarantee document, a maximum limit the guaranteed amount. Otherwise the guarantee will have no dollar limit.
Ask the bank to limit the guarantee to a specified loan account – ie. to counter the effect of what would otherwise be an ‘all obligations’ guarantee (see above).
If you the guarantor have more than one property mortgaged to the bank, ask the bank to limit its recovery remedies on your guarantee to one or more of those properties only (this will depend on the level of equity in each property).
At the outset a guarantor should shift their deposit accounts to another bank (see above comment on low-hanging fruit). I mean another bank, not just another branch. This doesn’t reduce your legal guarantee liability to the bank, but may help avoid your money doing a vanishing act.
Make a careful assessment of the borrowers’ ability to meet their loan obligations and related risks. Do they have any safety margin in their finances? Are they borrowing up to the hilt? What if circumstances change? – eg. if interest rates increase by 2 or 3% or more. How stable is their income? Are their jobs secure? Do they have other debts or obligations (bank or non-bank) that could put them under financial pressure? Are they good with their finances or reckless? Could you afford to help with the borrower’s mortgage payments, at least for a while, if they got into financial trouble and defaulted on their loans? What would be the effect on your financial situation if the guarantee was called up? Would you have to sell your home? Do the guaranteed persons also have business borrowing with the same bank (see above comment on the ‘all obligations’ nature of your guarantee)? Actually, all of these aspects should probably be your first consideration.
Continue your assessment of the borrower’s finances while you remain a guarantor. Where the borrower relies on business income, ask for annual financial statements and regular management accounts. If you don’t understand them get advice from someone who does.
As a very minimum, ask the bank to copy to you (with the borrower’s authority) monthly statements of the loan account balance and the borrower’s payment instalments so you can promptly find out if there is a default. Guarantors are entitled to ask the bank for ‘request disclosure’, but getting these monthly statements is better.
As soon as the borrower is in a position to ‘refinance’ with the bank in the sense that your guarantee is no longer required by the bank (eg. the loan balance has reduced sufficiently), ask the bank to discharge your guarantee in writing. Review from time to time whether the borrower has yet reached this position. Note that guarantees don’t have a ‘term’ and do not automatically expire after a certain period or when the borrower has repaid their loan (what if they then borrow more?). The guarantee only terminates when the bank issues a written discharge of it.
If circumstances change and you are no longer comfortable with the guarantee consider giving written notice to the bank ‘withdrawing’ your guarantee. This crystallises the level of your guarantee liability as at that date – ie. your guarantee won’t cover any subsequent increased borrowing. But be aware that if you do this the bank may call up the guaranteed borrowing and may call up your guarantee and exercise its mortgage securities (including the mortgage over your home). This is therefore not a step taken lightly and you should definitely take legal advice before doing this.

Oh I do love a happy ending! Still forewarned is forearmed, as they say.

WANT TO KNOW MORE? Just ask Atticus Legal, Business & Property Lawyers Hamilton

CALL ANDREW SMITH, the owner of Atticus Legal, for expert professional advice on any of the matters referred to in this information sheet.

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Disclaimer: The information contained in this information sheet is, of necessity, of a general nature only. It should not be relied upon without appropriate legal advice specific to your particular circumstances.