Guarantees: The Pitfalls of being a Co-Guarantor Revisited
We have written previously on the dangers for guarantors who, to the exclusion of another co-guarantor, negotiate a settlement directly with a creditor, including the potential exposure to a future claim by the other co-guarantor for contribution under the guarantee despite that settlement.
It is worth exploring in more detail the significant legal effect any settlement between a creditor and principal debtor, or between a creditor and one co-guarantor, can potentially have on the liability of guarantors, or on another co-guarantor to the creditor under that same guarantee.
A recent decision of the Queensland Court of Appeal in Horsburgh v Emerald Rock Pty Ltd  QCA 47 considered that situation in detail.
What are the Rules?
Before delving into the specifics of the Horsburgh case, it is worthwhile mentioning the main legal principles applicable to guarantees.
Where there is any ambiguity, a contract of guarantee is to be construed strictly, and generally in favour of the guarantor (given the onerous obligations imposed on the guarantor). Over time, the Courts have developed a set of rules, modifying the usual rules of contractual construction, which are specifically applicable to guarantees.
These specific rules include, relevantly, that:
- A guarantor will be discharged from liability under a guarantee if one or more co-guarantors are released without his or her consent;
- A release of the principal debtor can extinguish the underlying debt (and obligation of the principal debtor), and, since there is then no debt unsatisfied in respect of which the guarantor can be liable, the creditor will lose any recourse or remedy against the guarantor under the guarantee; and
- Alteration or variation of the principal debtor’s obligations (and hence an alteration of the nature of the guarantor’s obligations) to the guarantor’s prejudice, and without the consent of the guarantor) will be sufficient to discharge the guarantor, unless the alteration or variation is insubstantial.
It is important to remember that these rules can be contractually excluded by the parties, if both the creditor and guarantor agree, as is highlighted in the Horsburgh case.
The Horsburgh case
The appellant and another party had co-guaranteed the performance by a lessee of a lease of property, and which lease had been granted by the lessor (who was respondent to the appeal) for a term of 10 years, with two six-year options.
About eight years into the lease, the lessee was in arrears under the lease to the tune of approximately $340,000, at which time the lessor and lessee agreed to a surrender of the lease on terms which included an acknowledgement by the lessee that it was indebted to the respondent lessor. This arrangement was documented in a Deed of Surrender.
When the lessee failed to pay the debt owing, the respondent lessor commenced legal action against both the appellant and his co-guarantor under the guarantee they provided in an attempt to recover the sum owing by the lessee.
While one co-guarantor negotiated a settlement with the respondent lessor, pursuant to which that co-guarantor agreed to pay $125,000 to the respondent lessor in full and final satisfaction of the dispute between them, the other co-guarantor (the appellant) and respondent lessor did not reach an agreement to settle the claim.
Ultimately, the District Court entered judgment against the appellant, and in favour of the respondent lessor, for a sum exceeding $300,000.
On appeal before the Court of Appeal, the appellant argued that:
- The Deed of Surrender of the lease between the lessee and respondent lessor operated to release the lessee from its payment obligations under the lease and replaced them with a new obligation to pay the acknowledged debt – that being a new debt which was not caught by the appellant’s original guarantee;
- The guarantee that had been granted by the appellant was discharged by the Deed of Surrender of lease, because it varied the lessee’s obligations under the lease (and so also the appellant’s obligations under the guarantee) to the prejudice of the appellant, without his consent; and
- The appellant’s guarantee was discharged by the Deed of Settlement between the respondent lessor and the other co-guarantor because that Deed operated to release the co-guarantor (because a release of one guarantor can, under the law of guarantees, operate to release all co-guarantors from liability).
The Court of Appeal, in rejecting each of those arguments put forward by the appellant, held that:
In respect of the first of the appellant’s argument:
- while the Deed of Surrender did release the lessee from its payment obligations under the lease, this did not affect the appellant’s liability which had accrued under the guarantee well before the Deed of Surrender was entered into; and
- the terms of the guarantee, which specifically provided that the guarantor waived all “rules of law or equity relating to contracts of guarantee which would have the effect of re-drawing or extinguishing rights of action by the Lessor against the Guarantor under this Guarantee”, meant that the appellant was precluded from relying on the usual rule of guarantees that a release of a debtor (in this case, the lessee) effectively extinguished both the principal debt and so the guaranteed obligation;
- As to the second argument, the terms of the written guarantee expressly provided that any variation of the terms of the lease would not extinguish or diminish the enforceability of the guarantee, which, read together with the waiver noted above, precluded the appellant from relying on the usual principle that an alteration of the principal obligation to the prejudice of a guarantor, and without the guarantor’s consent, will discharge the guarantor; and
- As to the final argument, given that the effect of the rule would have the outcome of extinguishing the respondent lessor’s accrued right of action against the appellant, the terms of the guarantee (the waiver mentioned above) expressly precluded the operation of the rule; moreover, the operation of the rule depended on the terms of the Deed of Settlement which the Court found was a covenant not to sue, rather than a release, and specifically showed an intention not to release the appellant as joint and several guarantors.
Accordingly, the Court of Appeal dismissed the appeal.
Take Home Points
This case highlights the significant importance which specific terms of a guarantee will have in determining the impact on a guarantor of any settlement by a principal debtor, or by a co-guarantor, with a creditor directly.
Ideally, where a debt or other obligation has been guaranteed, any settlement negotiated with a creditor will be entered into by all co-guarantors (as well as the principal debtor, as the case may be) and resolve entirely all claims by the creditor against them.
If there is, or has been, a claim made or threatened against you under a guarantee, and there is any doubt about the effect of such guarantee you have given, especially where a settlement may be contemplated, you should seek specialist legal advice prior to entering into any settlement.
It is always recommended that specific legal advice be sought prior to signing a guarantee, and also in respect to any settlement or resolution of claims or disputes under a guarantee, and especially in relation to the documenting of a settlement.
If you do not, you may be left out in the cold as the appellant was in the Horsburgh case.
This publication has been carefully prepared, but it has been written in general terms and should be viewed as broad guidance only. It does not purport to be comprehensive or to render advice. No one should rely on the information contained in this publication without first obtaining professional advice relevant to their own specific situation.