Limited Guarantee: a Worked Example

An unlimited guarantee covers everything the borrower owes the lender, now and later. That suits a sole owner-director who controls the business and its borrowing. It suits less well a minority shareholder, an investor, a parent or a director who does not set the company's limits, and each of them has reason to ask for a ceiling. The lender's reason to agree is that a guarantee is usually there to cover a gap: the part of the debt the business's own security does not reach. A cap sized to that gap gives the lender what it needs and the guarantor a risk it can measure.

In Australia, the industry's Banking Code of Practice makes the limit a requirement for the guarantees it covers, those given by individuals for loans to individuals or small businesses: the guarantee must be limited to a specific amount or category of amounts, such as everything owing under a named loan, or to the value of a specified property under a mortgage. Elsewhere, and for guarantees the Code does not cover, a cap is a matter for negotiation.

Three drafting choices sit behind the figure. The first is what the cap includes. Some caps include everything; many are stated as a sum plus interest from the date of demand and the lender's enforcement costs, so the guarantor's total can exceed the headline.

The second is what the guarantor is guaranteeing. A guarantee of the whole debt, with recovery limited to the cap, leaves the guarantor answerable for every dollar but collectable only up to the limit. A guarantee of part of the debt, such as a stated sum or a share, makes the guarantor answerable for that part alone. The difference shows after payment. Under the general law of suretyship, a guarantor of the whole debt who pays the cap generally cannot prove in the borrower's insolvency or take over the lender's security until the lender is paid in full, because the lender is already proving for the whole debt and one debt is not proved twice. A guarantor of part who pays that part can generally prove for it. Guarantees commonly contain clauses deferring the guarantor's rights in either case, so the document is read before the rule.

The third is how guarantees stack. A new limited guarantee may add to an older one rather than replace it, so a guarantor who signed for US$250,000 and later for US$500,000 can owe both unless the first was released.

A wholesaler, constructed for this page, goes into liquidation owing its bank US$2.0m, with no security left to realise. Its director has guaranteed US$500,000. The liquidator expects to pay unsecured creditors 30 cents in the dollar; the rate is the example's. The director pays after the liquidation begins, so the bank's claim at that date is the full US$2.0m. Two wordings of the same cap:

The total proved in the liquidation is US$2.0m either way, so the dividend rate is unchanged. What moves is who receives the dividend on the guaranteed slice: US$150,000 goes to the bank under the first wording and to the director under the second.

Interest and costs move it again. If the cap reads US$500,000 plus interest from demand and enforcement costs, and the bank's demand goes unpaid for eight months at the example's default rate of 9% a year, the director owes about US$30,000 of interest (500,000 × 9% × 8 ÷ 12) and, say, US$15,000 of costs: US$545,000 against a guarantee the director remembers as US$500,000.

An unlimited guarantee has no ceiling, and if it is written all-monies it covers facilities added after it was signed. A limited guarantee can still be all-monies within its cap: the guaranteed money is whatever the borrower owes, and the cap limits only what the lender may collect. So a guarantor whose limit is US$500,000 may find that the debt behind it has grown from a term loan to a term loan, an overdraft and a bond line, all inside the same cap.

A different kind of limit ties the guarantor's exposure to an asset rather than a sum: a guarantee limited to the value of a named property, which in practice works like a third-party mortgage.

DEFINED IN ONE PARAGRAPH → · PERSONAL GUARANTEES → · THE ALL-MONIES CLAUSE →

The cap is negotiated when the facility is set up and tested when it fails. At approval, the credit paper records what the guarantee is meant to cover, usually the shortfall between the debt and the security, and checks that the cap and the guarantor's means both reach it. A cap no one could pay is a number in a document.

During the facility, the cap is reopened at each change. A request to increase the facility raises the question of whether the guarantee still covers the gap; a guarantor asking to reduce the cap is asking the lender to carry more unsecured risk. The Banking Code lets a guarantor it covers ask in writing to limit the guarantee further, and lets the bank decline where the new limit would not cover the borrower's existing liability. At a refinance or a sale, the question becomes release: whether the outgoing lender lets the guarantee go, and whether an older guarantee is still sitting underneath the new one.

WHAT YOUR BANK HOLDS AS SECURITY → · THE THIRD-PARTY MORTGAGE →