A Guaranties & Collateral agreement is a document in which one party (the Guarantor) is agreeing to assume responsibility for the debts of another party (the principal). This is particularly useful for any businesses that have small lines of credit but need to borrow more money. Instead of having to prove their creditworthiness again, the Guarantor agrees to take on the liability if something goes wrong. Therefore, it is used in commercial transactions where there is a need for an extra level of protection beyond creditworthiness and reputation. It is a legally binding agreement between two parties where one party, the Guarantor, promises to pay a debt owed by another party, the debtor.
For example, let’s say you signed up for a loan through your bank to start a new business. If you default on the loan (that is, if you don’t make your payments on time), then the bank can come after one of your personal assets—like your house—to cover its loss. This is known as collateral. It’s essentially an insurance policy for the bank: if something goes wrong with your business and you’re unable to cover your debt, then the bank can recoup its losses in another way.
As a result of this agreement, the lender (the bank) will have greater confidence in extending credit to you because it knows that it has some sort of security against non-payment by the borrower (you).
There are two basic types of Guaranties & Collateral agreements: personal property and real property. Personal property can include tangible items like cars, boats, furniture, computers, and clothing as well as intangible items like bank accounts and stock certificates. Real property refers to land, buildings, and other permanent structures that are attached to land.
In practice, financial institutions often use standard templates for drafting guarantees and collateral security agreements. This is true regardless of whether such instruments are used in domestic or international transactions. Below are some ideas on how these agreements are being drafted.
Guarantors
The Guarantor is the person who guarantees the performance of the debtor. The nature of this guarantor-guarantee relationship is defined in the contract between the Guarantor and the creditor.
It is important to carefully draft this agreement in order to achieve clarity on all points, so that there are no uncertainties in what has been agreed. At its simplest, the agreement should provide that the Guarantor’s obligation arises only if and when there has been a default by the debtor.
Two main points you should consider when you review such an agreement:
Whether the obligation will continue after a payment made by the Guarantor; and whether the creditor has the right to enforce against the Guarantor without first having exhausted remedies against the debtor.
Obligations Guaranteed
The “Obligations Guaranteed” clause is the body of a guarantee agreement. It defines what obligations are being guaranteed, who the Guarantor is and who the beneficiary is. It may also include rights and remedies of the beneficiary, which are enforceable against the Guarantor.
The “Obligations Guaranteed” clause should be drafted broadly so that it encompasses all of the obligations that the Guarantor wishes to guarantee, whether those obligations exist at the time of execution of the guarantee or arise after execution. The clause should not involve any conditions for liability other than an event of default under one or more agreements to which the parties agree that the Guarantor will become liable.
Releases
The Releases clause will state how the bank or lender will release the collateral for a particular loan if there is an event of default. It is used to protect the lender if the borrower is unable to make a payment due to default or bankruptcy. By virtue of this clause, the lender will have first access to the collateral stated in this clause.
Subrogation
Subrogation means “the substitution of one person for another.”
The Subrogation clause states that the Guarantor is expressly subrogated to all of the secured party’s rights and remedies against the lender in respect of any obligation or liability of such person (including, without limitation, rights and remedies in respect of any guarantee or indemnity) and may exercise such rights and pursue such remedies as if it were the secured party.
In other words, this clause states that if the Guarantor of a loan pays the debt of the borrower, then that Guarantor can recover from the borrower what he paid, i.e., the Guarantor will step into the shoes of the lender and enforce his rights against the principal debtor. Also, he will have the right to step into the shoes of the borrower against the lender.
The purpose of subrogation is to prevent double payments by obligating anyone who pays off a debt to do so as a substitute for the creditor, not as an additional payment.
Subrogation is a common clause in loan agreements and is one of the most critical clauses in a guarantee agreement.
Furthermore, there are other elements also are considered in drafting a Guaranties & Collateral agreement, such as:
Guaranty: Sets out the maximum amount of the guarantee;
Event of Default: Details the actions which will constitute an event of default on the part of the debtor;
Collateral: Lists all items that are considered collateral;
Default and Remedies: Outlines what happens if there is a default under this Guaranties & Collateral agreement;
Jurisdiction and Governing Law: Sets out which laws will govern this Guaranties & Collateral agreement.
Most importantly, before you sign such a Guaranties & Collateral agreement, it is essential that you read every part of it to see if anything in it will put you at risk. This document is usually dozens of pages long, and it can be very complicated. You may need to hire a lawyer to help you decipher it.
In the end, there is no substitute for careful reading before putting your signature on anything. It can save your business a lot of money, time, and trouble if you take the time to do the reading at the right time.
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