Guarantees in Loan Transactions: Associated Risks and the Importance of Independent Legal Advice

Written by Sarah Olley

Guarantees are commonly required in loan transactions where a lender seeks additional comfort beyond the borrower’s balance sheet. They are frequently provided by directors, shareholders, spouses or other individual/corporate entities related to the borrower in some way.

While guarantees could be regarded as routine when entering into loan transactions, the legal landscape surrounding guarantees is complex and the importance of obtaining independent legal advice cannot be overstated. Australian courts have consistently demonstrated that a guarantee that has been provided can give rise to significant legal risk if called upon, particularly if not explained and correctly documented at the onset.

This article covers how guarantees operate in practice, the key risks and considerations involved for both guarantors and lenders, along with the critical role of independent legal advice.

What is a Guarantee?

A guarantee is a promise by one party (the guarantor) to undertake to fulfil the obligations of another party (the borrower) if the borrower defaults. In commercial lending, guarantees are often taken in conjunction with other security such as mortgages or general security deeds, forming part of an overall risk-mitigation strategy.

Most guarantees are drafted broadly in that they typically secure all present and future liabilities of the borrower, including principal, interest (including default interest), fees, indemnities and enforcement costs. Many are expressed to be “continuing guarantees”, meaning they remain in force until expressly released by the lender, even if facilities are amended, extended or refinanced.

Modern finance documents frequently combine a guarantee with an indemnity. This distinction is critical as a guarantee is a secondary obligation that is dependent on the borrower’s liability. An indemnity, by contrast, creates a primary obligation and may be enforceable even where the borrower’s liability is compromised.

Legal Framework

The National Credit Code (NCC), as part of the National Consumer Credit Protection Act 2009 (Cth), governs guarantees in certain consumer credit transactions, provided the guarantor is a natural person or a strata corporation. Certain guarantees are excluded from the scope of the NCC, including guarantees provided by suppliers under tied loan contracts or tied continuing credit contracts. Additionally, guarantees that secure obligations under credit contracts involving corporate borrowers or loans for business purposes are not regulated by the NCC. This distinction is significant as guarantees not regulated by the NCC are not bound by the form, content, and disclosure requirements outlined in the NCC, such as the need for the guarantee to be in writing, signed by the guarantor, and accompanied by prescribed warnings and disclosures (Bendigo and Adelaide Bank Ltd v Brackenridge [2020] SASC 114).

Risks Associated

Guarantors face significant financial risks when providing guarantees as they may be held liable for the full amount of the borrower’s debt if the borrower defaults. This risk is exacerbated when guarantors lack a clear understanding of the terms and implications of the guarantee.

One of the most significant cases is Commercial Bank of Australia Ltd v Amadio [1983] HCA 14. In that case, elderly migrant parents guaranteed their son’s company debts, and the High Court set aside the guarantee on the basis of unconscionable conduct. It was found that the other party exploited the parents’ special disadvantage and limited understanding, failing to ensure the transaction was properly explained.

Another landmark decision is Garcia v National Australia Bank Ltd [1998] HCA 48 where the High Court confirmed that a spouse who guarantees their partner’s business debts may be entitled to relief where they do not understand the transaction, receive no real benefit, and where the lender fails to take reasonable steps to explain the guarantee or ensure independent legal advice is obtained. This principle continues to influence how lenders approach guarantees provided in family or domestic contexts.

Earlier authority such as Yerkey v Jones (1939) 63 CLR 649 laid the foundation for this approach. This case recognised that guarantees given by wives for their husbands’ debts may be set aside where the nature and effect of the transaction was not understood. While later refined in Garcia v National Australia Bank Ltd as above, the underlying concern with informed consent remains central, in which parties such as this require independent legal advice or adequate steps by the lender to ensure understanding.

These cases do not suggest guarantees are inherently unenforceable. Rather, they demonstrate that courts will closely examine the circumstances in which a guarantee is given, particularly where there is a clear imbalance of knowledge, power or benefit.

The Role of Independent Legal Advice

Independent legal advice serves as a safeguard for guarantors, ensuring they understand the legal and practical implications of the guarantee. It also protects lenders by mitigating the risk of claims of unconscionability or undue influence. It ensures the guarantor understands:

• the scope of the guarantee and any indemnity;
• whether liability is capped or unlimited;
• the circumstances in which the lender may enforce;
• that the lender may pursue the guarantor without first enforcing against the borrower; and
• the potential impact on personal assets.

From a lender’s perspective, requiring independent legal advice is a key risk-management mechanism. Courts have repeatedly indicated that where a lender is aware a guarantor is assuming significant obligations for another party’s debt, reasonable steps must be taken to ensure informed consent. A solicitor’s certificate confirming independent legal advice is now standard practice in many transactions and can be decisive in defending later challenges.

Conclusion

Guarantees in loan transactions remain a powerful and widely used tool in Australian banking, however they carry significant risks for guarantors, particularly those who may be in a position of vulnerability or lack financial literacy.

Independent legal advice is central to ensuring guarantors fully understand their obligations and the potential consequences of default, along with the guarantee being entered into with informed consent to remain enforceable. For lenders, it is a critical safeguard to mitigate the risk of claims of unconscionable conduct or undue influence.

Guarantees should never be treated as standard form or “tick-box” documents. Careful drafting, transparent processes and early legal engagement are essential to protecting all parties involved.