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In a transaction, a party (often the seller) may require some form of guarantee in case the other party fails to make payment or is a limited company and its creditworthiness is unknown. The party who provides the guarantee is the “guarantor”, also known as “surety” of the transactions.
Hong Kong does not have a specific set of rules or ordinance governing the operation of a guarantee. Parties are generally free to agree using a guarantee agreement and the general rules of contract interpretation apply when deciding the meaning of the guarantee contract.
Terminology
Creditor – party taking benefit of guarantee
Debtor – party whose obligations are being guaranteed
Guarantor (or surety) – the party guaranteeing the obligations of the debtor
Personal guarantee
A personal guarantee means that a guarantor promises to repay the loan taken out by another individual or a company (the debtor). To simply put, when the debtor for any reason fails to repay the loan, the guarantor will assume responsibility to pay whatever is due.
Example
Co. A (Debtor) has taken out a 1 million loan from Bank B (Creditor). Because Co. A is a limited company, even when Co. A fails to repay the loan, the directors and the shareholders will not be personally liable for the debt of the company. Because of that, Bank B requires Mr. C, (being the director of Co. A) (Guarantor) to sign a personal guarantee of payment.
So if Co. A fails to pay the 1 million plus interest in full at maturity, Mr. C will assume personal liability to pay the outstanding amount.
Please be reminded that, as a personal guarantor, it will be difficult for you to avoid liability from the guarantee unless you have solid evidence proving that you were forced or misled to sign the guarantee document.
Using the same logic, if a start-up director gives personal guarantee to repay the business’s debt, the creditor can chase after him/her if the start-up does not repay the loan.
Bank Guarantee
A bank guarantee means the bank will ensure that the liabilities of the debtor will be met. To simply put, if the debtor fails to pay a debt, the bank will cover it.
An SME can apply for a bank guarantee if it wants to purchase materials, equipment or services. Due to the high risk nature of dealing with a SME, sellers sometimes also require SMEs to provide a bank guarantee to cover payments before they ship the goods.
Here are the pros and cons of getting a bank guarantee:
Advantages:
- Bank guarantee lowers the financial risk in the transaction
- Banks generally charge low fees for guarantees, which is beneficial to small businesses
- Business credibility and business opportunities will increase as banks certify its financial stability
- Few documents are needed
- Short Application process
Disadvantage:
- Banks can be rigid in assessing the financial ability of the business and complicate things
- Banks will require collateral security to grant the guarantee
Example
Co. A (Debtor) is a new gym that wants to buy $1 million in gym equipment. Co. B (Creditor) who is the equipment seller knows nothing about the financial ability of Co. A, therefore, Co. B requires Co. A to provide a bank guarantee to cover payments before they ship the gym equipment to Co. A. As a result, Co. A requests a guarantee from Bank C (Guarantor) and makes Bank C to co-sign the contract.
So if Co. A fails to pay the 1 million by the time the gym equipment is shipped, Bank C will cover the outstanding amount owing to Co. B.
In exchange for a bank guarantee, Co. A might have to pay a fee. Also, it might as well be the case that Bank C might require Mr. D (the director/the shareholder of Co. A) to sign a personal guarantee, so that Bank C can seek compensation from Mr. D if the bank makes any payment pursuant to the bank guarantee.
Guarantee Agreement
A Guarantee Agreement should be entered into by the creditor and the guarantor when a guarantee is created. A legally binding and enforceable guarantee agreement is important as it sets out the obligation and protections of the guarantor. In the guarantor’s perspective, a well drafted agreement should limit the scope of the guarantee and provide enough protections for the guarantor.
As mentioned above, the guarantee contract is the only thing the court will look at when trying to solve disputes between the parties. That is why a written guarantee agreement has to be entered into and parties must draft them carefully so it can eliminate unnecessary dispute and uncertainty.
Here are some of the most important clauses that should be included in a guarantee agreement:
- Scope of the guarantee: This is usually the biggest concern of guarantors as a guarantee agreement should clearly set out which specific loan(s) between the debtor and the creditor should the guarantee cover. (i.e. the potential liability of the guarantor)
- Law protective of guarantors: Parties should be careful of whether a guarantee agreement excludes or includes the important rights of the guarantor under the law. E.g. if the debtor and creditor agree on a material variation of the loan agreement without the guarantor’s consent, then the guarantor should be discharged of all the guarantee obligation.
- Right of guarantor against debtor: A guarantee agreement should include whether a guarantor will have the right to claim against the debtor for the loan that has been paid off by the guarantor to the creditor.
- Jurisdiction and choice of law: Parties should check whether the agreement is subject to Hong Kong Law or laws of other countries, as that could make huge differences on defining parties’ obligations if there is uncertainty or dispute.
You must scrutinize ALL the terms and conditions before signing any guarantee document. You are also recommended to seek advice from a lawyer beforehand.
Key takeaway
- A personal guarantee means that an individual promises to repay the loan taken out by a company, whereas a bank guarantee means the bank will ensure that the liabilities of a borrower will be met.
- Parties should carefully observe the terms under a guarantee agreement as they are strictly bound by them once signed.
