Guarantee

A form of credit support where one chap agrees to make good the obligations of another chap to a third party, if the second chap can’t or won’t.

Types of guarantee

There's a saying in legal circles: anus matronae parvae malas leges faciunt: little old ladies make bad law. In the history of the common law, more little old ladies than you’d expect seem to have given guarantees.The common law is therefore littered with well-meaning judgments applying (and, frankly, making up) idiosyncratic, counter-intuitive and at times plainly stupid rules just to let little old lady-guarantors off the hook.

This means it is a minefield for lawyers. You know what you find in mines: GOLD. So a guarantee is a place, like no other, where you need magic words.

Continuing guarantee

A continuing guarantee is one where the guarantor assumes liability for all the debtor’s past, present and future obligations to a creditor. Even where the amount owing has been paid in full, the guarantor can still be liable under the same facility if there is a subsequent indebtedness. This is useful for revolving credit facilities and other forms of indebtedness with a “now you see it, now you don’t” sort of a flavour to them.

This is to overcome a principle articulated in Devaynes v Noble that payments are presumed reduce debts in the order in which the debts are incurred.

Demand guarantee

A demand guarantee is a guarantee that the guarantor must honour upon the beneficiary’s demand. The beneficiary is not required to first make a claim or take any action against the obligor of the obligation that the guarantee supports. A demand guarantee is enforceable notwithstanding any deficiencies in the enforceability of the underlying obligation.

Guarantee vs Indemnity

Not, strictly speaking, a guarantee at all, but a contractual obligation having a similar economic effect is the indemnity. Note the statute of frauds doesn’t apply to an indemnity - which is why it’s traditionally seen as a useful thing to attach to a guarantee.

Negotiation points

Assignment of a Guarantor’s rights

A Guarantor has certain rights it acquires at law, even where it executes as a deed (such as the right of subrogation), and there is a risk that a guarantor who assigns these rights might somehow mysteriously compromise a beneficiary’s rights under the guarantee. So, to be sure, limit that right of assignment.

Guarantees and the ISDA Master Agreement: why Transaction-specific guarantees don’t work

Should a client request a {{{{{1}}}|transaction}}-specific parental {{{{{1}}}|guarantee}} (or letter of credit) for a {{{{{1}}}|Transaction}} under an ISDA Master Agreement instead of the usual “all obligations” guarantee of all the counterparty’s obligations under the ISDA Master Agreement, hit the alarm button.

You should never agree to the {{{{{1}}}|guarantee}} of individual {{{{{1}}}|Transaction}}s (nor accept a letter of credit with respect to individual {{{{{1}}}|Transactions}}) under an ISDA Master Agreement. If you do, because of the way ISDA Master Agreements are closed out under Section {{{{{1}}}|6(e)}} — or rather, aren’t closed out, you might find that just when you want your guarantee to pay, the {{{{{1}}}|Transaction}} it is guaranteeing isn’t there anymore:

On a close-out, each {{{{{1}}}|Transaction}} is terminated, the individual close-out amounts are determined, they’re aggregated up to a single net sum (i.e. negative exposures are netted off against positive ones) and a single {{{{{1}}}|Close Out Amount}} is payable with respect to all terminated {{{{{1}}}|Transactions}} under {{{{{1}}}|6(e)}} ({{{{{1}}}|Payments on Early Termination}}) of the ISDA Master Agreement.

That is to say, payments following termination of a {{{{{1}}}|Transaction}} are not payable under the {{{{{1}}}|Transaction}} at all - they are payable under the ISDA Master Agreement itself. Therefore, if the guarantee relates to the single {{{{{1}}}|Transaction}}, at the point you wish to rely on it (i.e., upon the party’s default), it will have gone, with no payment required. Vanished, like tears in the rain.

Termination rights

A related point: be careful about allowing the guarantor a termination right, even if amounts owing before termination are meant to remain guaranteed. For a mark-to- market exposure under a master agreement, whither the guaranteed obligation ? The mark-to-market exposure isn't, of itself, an obligation, at least not until until the contract has been closed out. Until then it is an emergent property of all the live transactions under the master agreement. Nor are those transactions "existing obligations" in whole: each will comprise future obligations, which may be contingent, and in any case are not yet due.

Consider providing for a lengthy notice period in such a termination period, which allows the beneficiary to adjust initial margin and precipitate a failure to pay (or rebase its credit support into tangible collateral). Alternatively make the termination of the master agreement a condition precedent to terminating the guarantee.

See also

• Credit Support Document
• Guarantees of the ISDA
• full title guarantee
• Limited title guarantee
• Indemnity
• Subrogation