Banking Guarantee Update December 2005 Contents 2. Introduction Validity 3. Discharge 5. Conclusion 6. Contacts
Introduction After a number of years of declining defaults by debtors, the occasions when banks have to rely on guarantees is on the increase again. Cases continue to show that, despite the best efforts of banks to make guarantees watertight through use of standard terms, there is still a real risk of inadvertent discharge of guarantees which may give rise to a valid defence to any claim on a guarantee. Banks have made substantial efforts to eliminate uncertainty and scope for error in taking guarantees. Principally, they have developed comprehensive standard form guarantee documentation. The purpose of this briefing paper is to highlight certain areas where risks to obtaining watertight guarantees still remain. Validity Given the prevalence of standard form guarantees in banking contracts, it might be thought that the validity of a guarantee is a given. However, this is not necessarily the case. Electronic signatures The formalities for the execution of a valid contract of guarantee are found in the Statute of Frauds 1677. A guarantee must either be contained in a written agreement signed by or on behalf of the guarantor or in a memorandum of the agreement (which may itself be oral) signed by the guarantor or his agent. Any failure to observe the formal requirement will render the guarantee unenforceable. In a modern banking context, the formalities should not present any problems as all banks have standard forms of guarantee and procedures for ensuring that the correct paperwork is signed by or on behalf of the correct parties. The 1677 Act was of course enacted before the advent of e-mail and electronic signatures. It is well established, however, that the signature of a guarantor is defined very widely. This would appear to include signature by means of a stamp or the printed heading of the guarantor s name on a document written by him. It seems sensible to suppose that this would equally apply to e-mails and online signatures. The use of electronic signatures, however, does not yet have the certainty required by banks. The Electronic Communications Act 2000 provides for the admissibility of electronic signatures in legal proceedings and also for regulations to be made by the Secretary of State to modify any enactment as he sees fit to facilitate the use of electronic communications. However, the Statute of Frauds has not been so modified. The current position is therefore uncertain. Electronic signatures are as a matter of policy approved but it is uncertain whether all types of electronic signature are effective and also whether a document stored only electronically satisfies the test for in writing. Until this uncertainty is resolved best practice remains to obtain a written signature. Duty of disclosure There is no general duty of disclosure or duty of utmost good faith in a contract of guarantee. As a general rule, it is for the guarantor to satisfy himself of the circumstances under which he enters into the guarantee. However, there are two scenarios in which there is a duty of disclosure on the bank. These are important because the failure to give disclosure in these circumstances may vitiate the guarantee, allowing the guarantor to avoid it. The first is the well-known decision of the House of Lords in Royal Bank of Scotland v Etridge (No 2) [2002] 2 AC 773. This decision was primarily concerned with undue influence cases. However, it also confirmed the existence of a duty to disclose any unusual feature of the contract between the creditor and debtor. The case law describes a raft of unusual features. Lord Nicholls summed the duty up well in saying a creditor is obliged to disclose to a guarantor any unusual feature of the contract between the creditor and debtor which makes it materially different in a potentially disadvantageous respect from what the guarantor might naturally expect. A good example is where an individual agreed to act as guarantor for the borrowings of a company which were also secured by way of a fixed and floating charge over the company s assets. The bank failed to disclose to the guarantor that an additional loan had been made by another lender, also secured by a fixed charge, and the bank had agreed that that security would rank ahead of its own charges. The guarantor would not have expected this and was disadvantaged as less of the pot was left over to discharge the guaranteed borrowings, leaving more for the guarantor to pay (Royal Bank of Scotland v Bennett [2002] 2 AC 773). The second situation is where the guarantor asks a direct question. The bank is under a duty to answer that question truthfully to the best of its ability 2
(Hamilton v Watson [1845] 12 Cl. & Fin. 109). It is unclear how this sits with duties of confidentiality to the principal but it is submitted that duties of confidentiality should be observed. This is particularly the case in an environment where inadvertent disclosure of personal data can lead to regulatory censure and civil proceedings 1. If the bank is forced, because of confidentiality, to tell the guarantor that it cannot answer the questions, the guarantor may think again about acting as surety, unless the principal is prepared to answer the question itself or to authorise the bank to do so. Like a failure to satisfy the limited duty of disclosure, a misrepresentation by a bank may entitle the guarantor to rescind. Standard terms used by banks routinely seek to exclude liability for reliance on any representation. Such terms will be caught by the Unfair Contract Terms Act 1977 and the onus will be on the bank to show that such a term is reasonable 2. Discharge By far the most obvious means of discharge of a guarantee is the performance by the principal debtor of the guaranteed obligation. That is also usually the most desirable outcome for the creditor bank. However, there is a variety of circumstances in which the guarantee may be inadvertently discharged. Creditor banks should be alive to these potential pitfalls. The chief categories of inadvertent discharge are considered below. Variation of underlying contract It is well established that a guarantor is released from liability under a guarantee where the creditor and the principal debtor have entered into an agreement which has the effect of altering the contractual position between them to the disadvantage of the guarantor without his prior consent (Holme v Brunskill [1877] 3 QBD 494). The rule is common sense if nothing else. However, standard form guarantees used by banks now invariably include a clause providing that the guarantor s liability will not be reduced or discharged by any variation to the underling contract. The effect of this standard term is to displace the basic rule in Holme v Brunskill. In the absence of an effective term disapplying the rule in Holme v Brunskill, there is a real danger of inadvertent discharge of the guarantee through a variation to which the guarantor does not consent. Given that facilities made available to borrowers are often the subject of repeated restructuring, such a term is essential. However, even where a term disapplying the rule exists, inadvertent discharge is still a very real danger. Two differing cases which came before the Court of Appeal this year demonstrate the problem. Triodos Bank v Dobbs In Triodos Bank N.V. v Ashley Charles Dobbs [2005] EWCA CIV 630, the Court of Appeal considered whether a rescheduling of loans covered by a guarantee constituted a variation allowed by the standard form guarantee. The guarantor (D) had guaranteed the indebtedness to the bank (T) of a company in which he was a director under the T s standard terms. These included a term enabling T to grant time for payment or grant any other indulgence or agree to any amendment, variation, waiver or release in respect of an obligation of the company under the Loan Agreement. The principal loans were replaced by further agreements (described by T as rescheduling) with materially different terms. T argued that this rescheduling constituted an acceptable variation within its standard terms. Lord Justice Longmore chose to analyse the effect rather than strict wording of the replacement agreements. He found that an agreement describing itself as a replacement but simply rescheduling, as envisaged by its predecessor, was an amendment or variation of the predecessor permitted under the standard terms. However, agreements which altered terms relating to ranking of securities and the actual sums due he found to be considerably more than an amendment or variation of the existing agreements and therefore outside the scope of the standard term. Accordingly, D s liability under the guarantee was discharged (subject to possible further argument on an estoppel by convention point). It is worth pausing a moment to consider the basis on which Lord Justice Longmore reached this decision given that on the face of it the ability to vary was rather wide. He reviewed the authorities and made the following points: It is important to distinguish between a true variation of an existing obligation and the entering of what is in fact a different obligation even though it may purport to be no more than a variation; The courts are more likely to give a wide construction to variation where the standard clause contains provisions limiting the power to vary; 3
Any variation, in order to be permissible, must be within the purview of the original loan agreement. Lloyds TSB Bank v Hayward In Lloyds TSB Bank v Norman Hayward [2005] EWCA CIV 466, the case again involved a dispute over the liability of a director who had guaranteed his company s indebtedness to a bank. The guarantee contained a standard form of wording permitting variation of the underlying loan without discharging the guarantee. In fact, the form of wording went even further in that it permitted variation to the potential disadvantage of the guarantor without his prior consent. Again, new terms were agreed between the bank and principal debtor which were detrimental to the guarantor. In particular, a term was agreed whose effect was to bring forward the guarantor s liability by a year. This variation would have been acceptable under the standard guarantee terms but not under the rule in Holme v Brunskill. In this case, as is often the situation, there was a wealth of correspondence and negotiation. It was alleged that, in the course of that correspondence, a side agreement was made whose effect was to reinstate the rule in Holme v Brunskill. On the evidence, the Court of Appeal found that the side agreement had been made, the rule in Holme v Brunskill applied and the guarantee was accordingly discharged. It seems that any consistency between what was agreed with the guarantor and what was agreed with the principal debtor was lost in the volume of correspondence. Both of these cases demonstrate how, in complicated transactions involving guarantees, it is important for banks to follow set procedures and track paperwork to avoid inadvertent discharge. In Dobbs, the failure was either to comply with standard terms or obtain consent to a variation to the guarantee when varying the underlying loan. In Hayward, the problem was inconsistency in dealings between bank and debtor on the one hand and bank and creditor on the other. The bottom line in each case was that the bank was unable to recover significant sums under the guarantee. It is submitted that best practice is always to obtain the guarantor s written consent to any variation to the underlying contract between the principal debtor and the bank. Discharge due to acts of creditor Two categories to be considered here which may give rise to a discharge essentially involve conduct on the part of the creditor bank which is at least approaching dishonesty. First, where a creditor materially alters the terms of the guarantee after signature, the guarantee will be completely discharged. One might have thought that, rather than a complete discharge, the original terms would still apply. However, the Courts have applied the rule in Master v Miller [1791] 4 t. r. 320 that no man shall be permitted to take the chance of committing a fraud, without running any risk of losing by the event, when it is detected. It is not the case that all alternations will discharge the guarantor. A guarantor availing himself of the rule must show potential for prejudice 3 as a result of the alteration. However, this rule is good reason for banks to have in place procedures to avoid annotating any guarantee document after signature. Second, it is worth mentioning a pending case on discharge of a guarantee due to fraud or conduct unfair to a guarantor. This category is rare and its full extent yet to be delineated. However, the case of National Westminster Bank plc v Philip Joseph Bowles [2005] EWHC 182 (QB) gives an example of the possible application of the principle, which was set out clearly in Bank of India v Patel [1982] 1 Lloyds Rep 507. The facts in National Westminster Bank plc v Bowles are complex to say the least. In simple terms, W, an employee of the bank (N) was alleged to have lied to the Court in administration proceedings, effectively bringing about the downfall of the debtor company. As a result the guarantee was called upon, but was not paid and default judgment entered. The decision was given in the context of an application by the guarantor (B) to set aside default judgment. Albeit at a preliminary stage and dependent on outcome at trial, Mr Justice Christopher Clarke found that the arguments had a real prospect of success. The Bowles case is notable for two reasons: It shows that the application of principle in Master v Miller, if rare, is still relevant; It has clarified the principle. Mr Justice Christopher Clarke found that the unfair conduct need not be toward the guarantor for the principle to apply. In this case the effect of the conduct is alleged to be conniving at the default of the principal debtor. The guarantor is in fact disadvantaged by conduct towards the principal. 4
Conclusion The relevance of these cases relating to inadvertent discharge is not confined to the particular facts of the cases. They show that carelessness (and sometimes recklessness) on the part of employees of creditor banks can have disastrous consequences. Banks are well advised to err on the side of caution in taking and managing guarantees. Even where seemingly comprehensive standard terms are in place best practice remains to obtain written consent to any variation. This article was first published in the Journal of International Banking Law and Regulation Vol 20, Issue 12. 5
Contacts Andrew Lafferty t: +44 (0)20 7861 4044 e: andrew.lafferty@ffw.com Colin Gibson t: +44 (0)20 7861 4123 e: colin.gibson@ffw.com 6
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