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Focus: Drafting of guarantees after the Bofinger case – some thoughts

30 October 2009

In brief: Partner Diccon Loxton (view CV) looks at the drafting of guarantees in the light of the recent High Court decision concerning guarantors' subrogation rights.

How does it affect you?

  • The traditional wide boilerplate language of guarantees will be interpreted strictly.
  • Lenders will need to look at the drafting of their guarantee documents, particularly the no-competition clause, the clause which is designed to stop guarantors claiming subrogation and other rights against the debtor in competition with the creditor.

The High Court's interpretation

The mortgagees argued that the terms of the guarantees given to the second mortgagee excluded the right of subrogation.

The High Court said that in this case the drafting of the guarantee was not sufficient to exclude it.

The court said that the settled principle in the interpretation of contracts of guarantee and indemnity is that any doubt in their construction should be resolved in favour of the surety. They said doubt may arise not only from the uncertain meaning of a particular expression, but also 'from its apparent width of possible application' – a worry, when guarantees are drafted as widely as possible.

The mortgagees relied on a number of clauses, two in particular:

  • A clause containing an express waiver by the guarantor of its rights as surety – It was held this only applied to its rights as surety to the second mortgagee, and not in relation to the guarantee given to the first mortgagee.
  • The no-competition clause, which was in traditional form – It forbade the guarantors from competing with the relevant creditor in relation to the borrower and other parties. However, that clause was interpreted only to refer to the exercise of its rights arising in relation to the guarantee given to the second mortgagee, not to the guarantee given to the first mortgagee.

The relevant no-competition clause had three sub-paragraphs.

In two sub-paragraphs, this conclusion was inevitable, because the sub-paragraphs referred to security, etc, taken by the lender (that is, the second mortgagee) and the guarantors' liability under that particular guarantee.

The remaining sub-paragraph said that the guarantors may not 'make a claim or enforce a right against any other Obligated Person (defined to include the Borrower) or against the estate or any of the property of any of them (except for the benefit of the Lender)'. This would seem at first sight to be of the widest import, and to cover rights as against the borrower for any reason. Nevertheless, the High Court held it only applied to matters relating to the guarantee of the second mortgage.

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The drafting of no-competition clauses in guarantees

Guarantees are normally drafted quite widely to make sure that the surety's rights are contractually excluded. The High Court's remarks mean that the wider the effect on the guarantor, the more care will need to be taken that the guarantee is clear.

In particular, the lenders should have a close look at the drafting of no-competition clauses in guarantees to make sure they cover the type of situation that occurred in this case. That is, they cover a wider class of subrogation than merely that arising out of the particular guarantee.

A simple and instinctive reaction would be to alter the clause so that it prevents the guarantor exercising any rights of any nature arising in any way against the debtor, so it is not limited to the rights arising as surety, and effectively subordinates all debt owed by the debtor to the guarantor. Some drafters approach the clause in that way.

However, there does need to be some thought as to whether that wider approach is appropriate:

  • In a number of scenarios, it could be against the creditor's interest. In particular, if the creditor is unsecured, and it would have a higher percentage payout as a creditor of the guarantor in the insolvency of the guarantor than it would as a creditor in the insolvency of the debtor, then it would be in the creditor's interest for the guarantor to be able to make its claim in the insolvency of the debtor. Within corporate groups, this may often be the case.
  • From the point of view of the guarantor, a wide clause can also be harsh if the result is to stop the guarantor exercising any right against the borrower so long as any loan is current, whether or not there has been any default, or any claim on the guarantee.

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Turnover trusts

A number of drafters add to this clause a turnover trust, so that if the guarantor does receive anything from the borrower, it has to hold it on trust for the creditor. This raises some difficulties. Although under current law, it is not a security interest, such a turnover trust will breach many negative pledges, as it would be a 'Security Interest' or 'Encumbrance' when those terms are given an expanded definition in negative pledge clauses. Under the new Personal Property Securities Bill 2009, turnover trusts may be regarded as security interests.

Finally, if the guarantor signs a number of guarantees, each containing a turnover trust, only the first turnover trust signed can be assured to be effective. Being equitable interests, the trusts will rank in order of creation, so that all the assets that might be subject to the turnover trust will go to the first creditor who has such a clause in its document, in priority to any other creditors who subsequently have the clause in their documents.

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Conclusion

The High Court has given clear warning that guarantee boilerplate needs to be drafted with great care.

Footnotes
  1. Bofinger v Kingsway Group Limited [2009] HCA 44.

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