Guarantees And Indemnities PDF

T O (N SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO GUARANTEES AND INDEMNITIES ) CHAPTER 11 11-1 GUARANTEES AND INDEMNITIES 11. GUARANTEES AND INDEMNITIES Learning Outcome At the end of the chapter, you will be able to: Key Topics FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE in...

T O (N SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO GUARANTEES AND INDEMNITIES ) CHAPTER 11 11-1 GUARANTEES AND INDEMNITIES 11. GUARANTEES AND INDEMNITIES Learning Outcome At the end of the chapter, you will be able to: Key Topics FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE instruments and the law relating to documentation and enforcement. ) Summarise the purpose of guarantees and indemnities as credit support In this chapter, you will be able to read about: Guarantees Enforcement of Guarantees An Indemnity Assessment Criteria During the exam, you will be expected to: Describe the purpose and law for guarantees and indemnities. Discuss the documentation process of guarantees and indemnities. 11.1 GUARANTEES (N O T The bank may require the borrower to provide one or more guarantors to support the repayment of the loan granted. These represent additional personal obligations in support of the principal debtor and collectively deemed as continuing support. A guarantee is defined as a legally binding contract under Section 79 of the Contracts Act 1950 as at 1 July 1974. In a lending situation, it is an agreement by the guarantor to settle the outstanding loan in the event the borrower fails to repay. 11.1.1 Foreign Guarantees A guarantee is considered ‘foreign’ when issued by a party outside the jurisdiction of the beneficiary’s country. The main concern for the credit officer of the beneficiary bank is the enforceability of such guarantees. The guarantor may be worthy but there is a risk of a legal challenge when the beneficiary bank attempts to enforce it. This is a possibility especially when a dispute has arisen for whatever reason between the guarantor and the guaranteed party. CERTIFICATE IN CREDIT GUARANTEES AND INDEMNITIES 11-2 The other concern is the enforceability of the guarantee in the courts of the country of origin. Should the need arise in enforcing the foreign guarantee, knowledge of the law and procedures might be imposing and expensive. SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO preferred option to that of normal bank guarantees. ) There is a preference for international bank guarantees instead of company guarantees. However, for the same foregoing reasons, an issue of a standby letter of credit under the UCP 600 rules of the International Chamber of Commerce (ICC) and the International Standby Practices (ISP) 98 is the 11.1.2 Important Characteristics of a Guarantee A contract of guarantee involves the existence of three parties, namely, the guarantor, the bank, and the borrower. The three parties must co-exist before the guarantee to be valid. The guarantor’s liability to pay is only secondary. The borrower shall at all times remain primarily responsible, since the liability of the guarantor is invoked only when the borrower has failed. a. A borrower cannot personally guarantee the repayment of his own loan, since he is already primarily liable to pay. Moreover, there are clearly no three parties involved in the transaction. Accordingly, the guarantee in this case is invalid, even though the borrower remains liable to repay as a borrower. b. A loan that is granted to a sole proprietorship or a partnership and guaranteed by the sole proprietor or the partners personally presents some of the common problems confronted by certain banks. In law, a loan granted to a sole proprietorship, or a partnership constitutes a T loan granted to the sole proprietor or the partners themselves. Both the sole O proprietor and the partners are the actual borrowers. In the event of default, (N they remain personally liable. The sole proprietorship and partnership are not recognised as separate legal entities, unlike a company registered under the Companies Act 2016. Since the sole proprietor and the partners are the actual borrowers, they certainly cannot act as guarantors at the same time. Such guarantees are invalid and unenforceable even though the sole proprietor and partners remain liable as borrowers. This was decided in the case of I.A.C. (Singapore) Pte Ltd. v Koh Meng Wan 2 MLJ 9. However, some lenders may opine for revolving credits, it is appropriate for guarantees to be taken to cover circumstances where a particular partner leaves the partnership either by death or withdrawal, as their liability may terminate from the date of leaving the partnership. With the guarantee, they remain liable for drawdown even after departure. CERTIFICATE IN CREDIT GUARANTEES AND INDEMNITIES 11.1.3 Considerations on the Need for a Guarantee as a Necessary Credit Support Some considerations on the need for a guarantee to provide credit support are as follows: client’s debt servicing ratio is assessed to be beyond the lender’s guideline; client; FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO income reported by the client is of an unstable nature; or SE ) loan tenor requested may exceed the expected retirement age of the income reported by the client cannot be substantiated as there is no proper document for verification. The proposed guarantor must be assessed to determine if the guarantee can provide a meaningful financial support for the credit. In the assessment, the lender cannot combine the income of the client with the guarantor to justify the debt servicing ability for the credit. Generally, the guarantor should be in a healthier financial position than the borrower either in terms of income generated, stability of income, or lower existing debt obligations to service. To facilitate future recovery efforts against the guarantor (i.e., effecting a call on the guarantee) the lender may attempt to obtain a letter upfront from the guarantor, usually, simultaneously with the execution of the guarantee, agreeing to a deduction of a certain sum from his salary-credit or his account in the event of the borrower’s debt service default. T 11.1.4 Joint and Several Guarantee O A ‘joint’ guarantee requires the bank to institute legal proceedings against all the guarantors. There is no option for the lender to select which guarantor to (N 11-3 sue. On the other hand, if the liabilities of the guarantors are joint and several, the bank now has the luxury of either suing all of them jointly or choosing from amongst them, the guarantor(s) it wishes to sue. Note that under Section 91 of the Contracts Act 1950 as at 1 July 1974, the discharge of one guarantor will not discharge the others. CERTIFICATE IN CREDIT GUARANTEES AND INDEMNITIES 11-4 11.1.5 Past Consideration The consideration for a guarantee is always in respect of the loan to be granted to the borrower. A past consideration guarantee arises when the loan in question has already been granted and disbursed before the guarantee was given. This can happen in the following circumstances: ) a. A guarantee was not taken when the loan in question was first granted. In SE view of the unsatisfactory conduct of the loan, the bank now requests a guarantor. The past consideration is obvious. The loan has been disbursed FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO prior to the guarantee being executed. b. One or more of the guarantors may have served notice on the bank to discharge their guarantees. They may, on their own accord, request that new guarantors replace them. The bank may also make a similar request. The new guarantors will then execute either a fresh or supplementary guarantee. c. After the disbursement of the loan, the bank may request for different or additional guarantors. The legal position governing past consideration guarantees is explained under illustration (c) of Section 80 of the Contracts Act 1950 as at 1 July 1974: A sell and delivers goods to B. C afterwards, without consideration, agrees to pay for them in default of B. The agreement is void. In the scenario above, the agreement is void because there was no consideration provided to party C for its agreement to pay A for the goods should B default. T In a banking situation, the effect of such past consideration is as follows: (N O a. If the loan in question is an overdraft facility, the legality of the guarantee is not affected by past consideration. By its nature, an overdraft facility is continuing. It is past, present, and future in form. b. However, if the facility in question is either a term or fixed loan or a hire-purchase facility, the validity of the guarantee is affected by past consideration, since such a facility would have already been fully disbursed when the guarantee was executed. In the event that a request is made for any one or more of the guarantors to be substituted, the bank should be guided by the following consideration and procedures: a. There is no legal duty imposed on the bank to accommodate such request for substitution. It remains the prerogative of the bank to reject such a request if it is not in its interest to do so. CERTIFICATE IN CREDIT GUARANTEES AND INDEMNITIES b. If the bank is persuaded to accommodate the request, the most convenient procedure is to convert the term loan into an overdraft facility, if this is possible. 11.1.6 Documentation of Guarantees SE In general, it is an agreement and a binding contract. ) There is no standard form for guarantees. The form varies from bank to bank. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO A guarantee does not require attestation. However, the practice adopted by the lender is to ensure that a guarantee is properly witnessed. Since it is not compulsory to witness a guarantee, the law does not prescribe any requirements or qualifications for the witness. This explains why an officer of the bank or any unrelated person can witness a guarantee. The reason banks require a guarantee to be witnessed is to ensure there is no forgery. In the event an allegation of forgery is made, the role of the witness is to testify that the guarantor in question has actually executed the guarantee. It is imprudent on the bank’s part to allow the guarantee document to be taken out of its possession. The bank should discourage the practice of allowing the guarantee to be executed in the guarantor’s home or office. Without supervision, there is a risk that the guarantee may not be executed by the intended guarantor. In the event the guarantee was executed by someone else, the guarantee is deemed forged. A single forged signature will render the entire guarantee document void and unenforceable in a court of law. No proceedings can be instituted against any of the guarantors, including those whose signatures O T are genuine. The consequences of forgery are grave for the following reasons: (N 11-5 a. The entire recovery process is frustrated. Any attempts to enforce the guarantee will be resisted by the person who did not execute the guarantee. The bank may incur unnecessary legal costs in pursuing a fruitless litigation. b. A bank officer who had witnessed a forged signature may be subjected to disciplinary action. To witness a forged signature is a serious lapse of prudence. c. There is no criminal liability imposed on a witness who has not properly witnessed the signing of a guarantee. Solicitors who negligently witness a forged signature are liable for negligence. In response to an allegation of forgery by one or more of the guarantors, the bank can adopt the following course of action to ascertain whether such allegations are genuine or merely a ploy to avoid liability: CERTIFICATE IN CREDIT GUARANTEES AND INDEMNITIES 11-6 1. Forgery is a criminal offence. To facilitate police investigation, the person making an allegation of forgery is required to lodge a police report. 2. Experience has shown that if the guarantor in question is lying, he is not likely to lodge a police report. Providing false information in a police report constitutes an equally serious criminal offence. Any refusal or reluctance on his part to lodge a police report will create an adverse presumption ) against him. SE 3. In the event a police report is lodged, the bank should then withhold any FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO legal proceedings until the police complete the investigation. The alleged forgery will then be investigated and verified by handwriting experts appointed by the authorities. 4. In the event it is necessary to execute the guarantee outside the bank premises, the bank must ensure that one of its representatives will be present at the material time when the guarantee is signed. The identity of the intended guarantor must be verified. The risk of any forgery is thus eliminated. 5. The current practice of dating the guarantee only after all the guarantors have signed will not affect its validity. It is common knowledge that guarantors may sign the guarantee at different times. The date in the guarantee is deemed to be the date when the guarantee comes into force. In addition, the date is important for purposes of determining when the required stamp duty is to be paid. 11.1.7 Stamping of Guarantees Under the Stamp Act 1949 as at 1 July 2014, the amount of stamp duty to be O T paid under a guarantee is RM10 nominal for a personal guarantee. (N 11.1.8 Discharge of Guarantees A guarantee can be discharged under certain circumstances under the Contracts Act 1950 as at 1 July 1974. When a guarantee is discharged, the liability of the guarantors will similarly be discharged. Accordingly, the bank must ensure that circumstances do not occur which will discharge the guarantors. 11.2 ENFORCEMENT OF GUARANTEES The question arises whether the bank is required to exhaust all legal remedies against the borrower before having recourse against the guarantors. Bank Negara Malaysia has issued guidelines requiring, inter alia, that a bank must first have recourse against the borrower before any proceedings can be filed CERTIFICATE IN CREDIT GUARANTEES AND INDEMNITIES against the guarantor. It must be noted that these guidelines are issued pursuant to provisions of the Financial Services Act 2013. Financial institutions are required to comply with these requirements. However, these guidelines are not binding on all guarantees. They are binding only if: the guarantees are executed after 9 October 1995; ) the loan amount does not exceed RM250,000; to a company is not subjected to these guidelines; SE the loan is granted to an individual borrower. Loans of whatever amount granted and FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO the loan is granted to an individual borrower whose spouse is not the guarantor; the guarantor has not, in writing, voluntarily waived his rights provided under the guidelines. Under the provisions of these guidelines, the bank is required to comply with the following: use its best endeavour to recover the debt from the borrower; commence legal proceedings against the guarantor, if it wishes to, only after one year from the date of the initiation of any legal action against the borrower; and even if judgment has been obtained against the guarantor, the bank cannot execute such judgment unless all legal remedies against the borrower have been exhausted, such as the writ of seizure and sale, prohibitory or garnishee orders, and bankruptcy proceedings. However, these requirements are not absolute. They will not apply under the following circumstances: proceedings against the guarantors can commence immediately, where such T action, if not taken, would be time-barred; and O if the borrower cannot be traced, or is since deceased, or has already been adjudged a bankrupt. (N 11-7 Even if legal proceedings are instituted against the guarantors, a lender is advised to consider the following factors: The legal process of recovery is often a long and winding one. Suing the guarantor to obtain a judgement constitutes only the first part of the process. A judgement by itself is not enough to compel the guarantors to pay. Further steps must be taken to enforce the judgement. Such steps may include the attachment of goods belonging to the guarantors by way of a writ of seizure and sale; attachment of land by a prohibitory order; garnishee proceedings; judgement debtor summons, bankruptcy, or winding-up proceedings as appropriate. The Insolvency Act 1967 as at 1 November 2017, absolutely prohibits commencement of any bankruptcy action against a social guarantor. A social guarantor is one who does not profit and essentially provides a guarantee for an education loan, CERTIFICATE IN CREDIT GUARANTEES AND INDEMNITIES 11-8 hire purchase transaction for personal or non-business use, or a housing loan for personal dwelling. There is also an added protection for other types of guarantors. A creditor will need to obtain permission from the court before commencing bankruptcy proceedings against other guarantors. The creditor would have to demonstrate he has exhausted all modes of execution and enforcement to recover from the debtor first. ) Delay is inevitable. The courts are burdened with a huge backlog of cases. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO litigated. SE Postponements are common. The whole process can be protracted for years, if In addition, the question of legal cost has to be considered. The legal fees charged by the bank’s solicitors have to be paid whether or not the bank eventually recovers from the guarantors. These fees are payable to the solicitors even if the bank’s claim against the guarantors is dismissed by the court. Whether the bank can actually recover from the guarantors the outstanding loan together with interest and legal costs, depends almost entirely on whether the guarantors have the financial means, or sufficient assets, to pay. For instance, even if a guarantor has been adjudged a bankrupt by the bank and considerable expenses have been incurred in the process, it is highly unlikely that the bank can recover either a part or the whole of the outstanding debt, unless substantial assets belonging to the bankrupt are surrendered to the Official Assignee. These assets can then be realised and the proceeds distributed not only to the bank that has commenced the bankruptcy proceedings, but to all other creditors who have filed their respective proof of debt against the bankrupt guarantor. 11.3 AN INDEMNITY T An indemnity is defined under Section 77 of the Contracts Act 1950 as at 1 July O 1974. Unlike a guarantee, an indemnity is an undertaking by the person giving the (N indemnity to pay the bank. This undertaking to pay is not dependent on default by the borrower. It constitutes a primary obligation on the Indemnifier’s part to repay the loan when demanded by the bank. EXAMPLE: Difference between a guarantee and indemnity X says to the bank: “Grant B the loan. If he does not pay you, I shall pay.” This is a guarantee. X says to the bank: “Grant B the loan. I shall pay you.” This is an indemnity. An indemnity, similar to a guarantee, must be given by a third party who is not the borrower. CERTIFICATE IN CREDIT 11-9 GUARANTEES AND INDEMNITIES 11.3.1 Undertaking An undertaking is an assumption of duty or responsibility by a party. In contractual terms this is not necessarily a financial contract nor one that is enforceable in court. The term has been used generally both with and without legal intent. An undertaking without legal intent might not constitute a contract enforceable by law. For any undertaking to be a contract, including a SE ) financial undertaking, it must be constructed as a legally binding agreement with the following elements: FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO there is an offer and acceptance; there is consideration for the contract; and there are parties that have the legal capacity to contract. PRACTICE QUESTIONS (INDICATIVE ANSWERS CAN BE FOUND IN THE TOPICS LISTED FOR THE RESPECTIVE QUESTIONS) 1. Explain the working of a guarantee as a credit support document for a loan. (11.1.3 & 11.2) 2. Discuss the differences between a guarantee and an indemnity. (11.1, 11.1.2, 11.1.3 & 11.3.1) KEY TERMS Guarantors Contract of guarantee Indemnity Undertaking (N O T Attestation CERTIFICATE IN CREDIT