Why Should Companies Seek Legal Advice Before Providing Corporate Guarantees?
BK Singh Advocate has written.When you sign a corporate guarantee you may feel that you are just signing another piece of business paperwork. This is often because one company (possibly a parent company) wants to support a subsidiary, group company or business associate in order for them to obtain finance. The reality could not be further from this. By signing a corporate guarantee you are willingly putting your company in potential legal and financial jeopardy.
What is a corporate guarantee?
Broadly speaking, a corporate guarantee will involve one company agreeing to be liable for certain obligations of a second party. If that second party defaults under the underlying transaction or obligation, the guarantor will be liable to the extent specified in the guarantee. The exact nature of that liability will depend on the terms of the guarantee, the underlying obligation and the parties involved. Subject to the three aforementioned factors, legal provisions may also play a key role.
Because of the potential implications of giving a guarantee, directors, promoters and business owners should consider giving a guarantee as they would any other corporate decision. One of the first steps in the decision making process should be to obtain legal advice. By instructing a lawyer before giving a guarantee, the company will have a better understanding of its exposure before it is contractually obligated.
It is recommended that when approached to give a guarantee, a company should consider not only the guarantee but also the underlying transaction. Close review of a guarantee can unearth provisions dealing with liability, default and invocation, term and duration, indemnity, security and termination. Many companies only see the benefit of the underlying transaction and sign the guarantee without considering the potential repercussions.
Commercial pressure to sign
This is understandable. If a lender needs a guarantee before it will approve a loan, what option does the company have but to provide one? Or maybe your group company needs financial support in order to complete a transaction. Pressure to sign a guarantee can come from all angles. However, the company providing the guarantee should always consider what would happen if the original borrower defaults on the underlying obligation.
Can a Corporate Guarantee Affect a Company's Financial Position?
Yes. Even if no cash outflow is required under a corporate guarantee it can still represent a contingent liability.
For example, let's say that an organisation provides a guarantee for a substantial loan borrowed by a related party. The borrower may well be able to meet each repayment as it falls due. However, circumstances can change and the borrower may find themselves in financial difficulty. The guarantor may face a significant claim against it if the guarantee is called upon.
This could affect budgeting, cashflows, negotiations with financiers and the commercial standing of the company as a whole.
That is why it is wise for management to assess the credit worthiness of the primary debtor and their own ability to withstand such a claim.
Just because the borrower is a related party or trusted business partner doesn't mean a guarantee is without risk.
Why Should Businesses Take Legal Advice Before Giving a Corporate Guarantee?
Simply because …. the supply of a guarantee commits the guarantor to debt arising from a transaction to which it has not itself been a party.
An entity may give a guarantee on behalf of the company because of a group structure, longstanding commercial relationship, investment opportunity or at the insistence of a lender. Commercial reasons for giving a guarantee do not override the legal implications of the instrument.
Before signing, the company should know :
- the nature of the obligation being guaranteed.
- the extent of the exposure.
- when the guarantee may be invoked by the beneficiary.
- if the guarantee is for a limited amount or a continuing guarantee.
- the consequences of default by the principal borrower.
- if the guarantee is subject to indemnity/reimbursement.
- whether any internal authorization is required.
- if the transaction is permitted under the company’ articles of association.
BK Singh Advocate navigates you through these concerns before you make any commitment.
What Corporate Approvals May Be Relevant?
Corporate guarantees typically require statutory and internal approvals. The requirements would vary depending on facts. Depending on the nature of the transaction, relationship between parties, consideration amount, provisions involved, corporate structure etc. some or all of the following might apply:
The Companies Act, 2013 contains various provisions relating to loans, guarantees and investments by companies. Section 186 applies to certain corporate guarantees and similar transactions. Section 185 would apply to certain transactions with directors and related persons.
Articles of Association, powers of the board, shareholder approvals, existing borrowing agreements, financial covenants are some other areas which would need to be considered depending on facts.
One should not assume that a transaction simply requires a signature from a director authorized to do so.
BK Singh Advocate can review the transaction and corporate records to determine what approvals and documents would be applicable.
Why Is the Underlying Agreement Important?
Corporate guarantee should not be read in vacuum.
If the company is guarantying a loan facility, the facility/financing agreement would normally contain the borrowers covenants, events of default, repayment obligations, security for the loan, interest rate and other important terms.
Reading the underlying agreement will help you understand exactly what it is that the guarantor is guaranteeing.
On a similar note, if the company is asked to give a commercial guarantee in connection with supply commitments, performance obligations, leases, project finance etc. reading only the guarantee will not give you a clear picture about the commercial risk involved. That shall be clear only on reading the underlying agreements along with the guarantee in context.
Just as BK Singh Advocate has advised, read the underlying agreements before the company agree to give a guarantee.
Does the Relationship Between Companies Matter?
Guarantor and principal obligor could be connected.
The parent company could guarantee the debts of its subsidiary company. A fellow group company could support another group company by providing security to enable it to obtain funding. Commercial parties could provide mutual commercial comfort in a larger transaction.
However, there can still be a risk with a guarantee if there is a corporate relationship between the guarantor and the beneficiary of the guarantee.
Due diligence should be undertaken on behalf of the guarantor to review the financial position of the beneficiary of the guarantee, the purpose of the transaction, the ability of the principal obligor to repay, existing indebtedness, and the consequences of a default.
BK Singh Advocate can assist companies in understanding the commercial and legal consequences of giving a guarantee.
What Documents Should Be Reviewed Before Giving a Corporate Guarantee?
It is sometimes beneficial to read through the documents to understand what you are signing up to.
Depending on the transaction, this can include:
- draft corporate guarantee
- loan or facility agreement
- sanction letter
- security documents
- board resolutions
- memorandum and Articles of Association
- existing borrowing facilities
- existing guarantees
- financial statements
- corporate records
- correspondence with lender/beneficiary
- anything else that is mentioned in regard to the principal borrower
The types of documents will depend on the facts of the transaction.
Companies should also keep detailed records why the guarantee was given, what approvals were obtained and what obligations are guaranteed.
What Happens If the Principal Borrower Defaults?
Guarantee becomes alive only when principal debtor fails to discharge his obligation. Guarantor or the party benefiting under the guarantee can make a demand under the guarantee and law.
Company's position would depend on the terms of the document, the obligation it secures, nature of demand made, any contractual defenses available and the facts.
That is why a guarantor should not treat any demand as some typical office paper. The demand letter should be reviewed immediately to understand what is being demanded and what is the contract position.
BK Singh Advocate can review such demand made under a guarantee (or any similar legal letter) and explain you the legal position.
Can Businesses Negotiate Corporate Guarantee Terms Before Signing?
The parties may even bargain over certain contractual provisions prior to execution depending on the relative bargaining power of the parties and the transaction at hand.
The company needs to know where it ends; ie. what is the limit of liability? How long does it last? What obligations does it apply to? What release does it require? What invocation is necessary? Etc.
You will not win on every issue. Some demands just aren’t commercially reasonable to the promisee. Remember when doing a legal review you want to walk away with knowing what you are getting yourself into, not think that everything can or should be struck.
BK Singh Advocate can help you identify which terms deserve your attention when bargaining over contract.
When Should a Business Consult a Corporate Lawyer?
Legal review should ideally occur prior to execution of the corporate guarantee.
Legal review of a corporate guarantee should be obtained by the company any time:
- It is requested by a lender.
- The company is asked to guarantee the obligations of another group member (such as a parent guaranteeing a subsidiary). Group members often provide financial support to one another.
- Another group member is seeking financial support from the company.
- The potential exposure under the guarantee is significant.
- The guarantee contains continuing obligations.
- Prior guarantees have resulted in the company incurring financial losses.
- The company receives an advance copy of an invocation/demand.
- The company is asked to extend or modify an existing guarantee.
Helping before a party "signs" an obligation is usually much more effective.
How Can a Corporate Law Firm Help?
Corporate Lawyer mainly deals with companies regarding their corporate documents, commercial contracts, guarantee reviews, compliance matters and business transactions.
BK Singh Advocate assist businesses regarding their corporate guarantee issues. This includes reviewing the proposed guarantee and transaction/corporate documents. The emphasis is placed on what the business is actually committing to do, what it is exposing itself to and what documents should be put in place to protect its position.
Some situations that may require a review of guarantee provisions include contractual issues, corporate approval issues and issues arising from an invocation or proposed enforcement.
Every situation regarding corporate guarantees is fact specific. This means it depends on the documents, parties, structure of the transaction, specific provisions and the facts.
You have the option of meeting with BK Singh Advocate before issuing a corporate guarantee. This allows the business to understand the obligation both legally and commercially.
Frequently Asked Questions
1. What is a corporate guarantee?
A corporate guarantee is a commitment given by a company regarding certain obligations of another party. The extent and enforceability of such guarantee would depend on the terms of the guarantee and the governing law.
2. Why should a company take legal advice prior to executing a corporate guarantee?
Legal advice would ensure that the company fully understands the liability being taken, when the guarantee can be invoked, the period of the guarantee, approvals required to be taken, indemnities and other risks associated before signing the guarantee.
3. Can a parent company execute a guarantee on behalf of its subsidiary?
A parent company can execute a guarantee in favour of its subsidiary subject to the applicable law, corporate approvals required to be obtained, transaction requirements and the constitutional and statutory provisions of the company.
4. Is Section 186 of Companies Act applicable to corporate guarantees?
Section 186 contains provisions relating to loans, guarantees and investments by companies. The application of the section to a particular transaction would depend on the facts involved, whether any statutory conditions/limits need to be complied with and exceptions that may be available.
5. Can a corporate guarantee result in financial liability?
Yes. Guarantees generally become enforceable on non-performance of the underlying obligation. On invocation of the guarantee, the guarantor would become liable as per the terms of the guarantee and applicable law.
6. What should be reviewed before a company signs a guarantee?
Company should review – the obligations which are being guaranteed, any limits on liability, invocation provisions, period of guarantee, indemnities provided to the guarantor, any defaults or events which require approvals to be obtained and underlying transaction documents.
7. Should the underlying loan agreement be reviewed?
Yes. Review of underlying agreement would allow the guarantor to understand the obligations guaranteed, events of default under the agreement, repayment obligations etc.
8. Can the terms of a corporate guarantee be negotiated?
Contractual terms can always be negotiated prior to executing the agreement subject to the nature of transaction and bargaining position. Legal review would help you identify the specific provisions requiring clarification/negotiation.
9. What should a company do upon receipt of a guarantee invocation?
Company should quickly review the guarantee, underlying transaction, demand and all related documents upon receipt of a guarantee invocation. Taking legal advice would help you understand the legal position of the company and responses available.
10. How can BK Singh Advocate help you with respect to corporate guarantees?
BK Singh Advocate can review your guarantee and related contracts, check for corporate compliances required, identify contractual issues and advise you on the legal position.
Final Thoughts
Signing a corporate guarantee can allow a transaction to proceed. It can also subject the guarantor company to vast liabilities. The commercial benefits of facilitating another party’s transaction should be balanced against financial and legal risk.
Before signing a guarantee, a company should know what it is guaranteeing, the details of the underlying transaction, events of default and guarantee call mechanisms, the length of the obligation, indemnification responsibilities and other corporate issues.
Since timing is critical in reviewing legal documents, retaining an attorney before executing an agreement will usually allow the company more leverage to negotiate favorable terms by identifying potential problems.
BK Singh Advocate can assist companies with reviewing corporate guarantees, associated commercial agreements, obtaining necessary corporate authorizations and working through legal issues created by operations under a guarantee.
If your company is ever asked to operate under a corporate guarantee, please seek advice from Advocate BK Singh before signing the document. A review tailored to your specific situation can help you understand your legal obligations and make an educated commercial decision.
