Setting Aside Personal Guarantees – Grounds of Invalidity

Setting Aside Personal Guarantees – Grounds of Invalidity

Personal guarantees are binding promises provided by a third party who agrees to be personally liable for the obligations of the contracting party, such as a company. Such guarantees are enforceable in the event of that contracting party defaulting.

Personal guarantees are most commonly provided in relation to the payment of a debt, however other contractual obligations can also be guaranteed.

The usual principles relating to the creation of contracts also apply to the creation of personal guarantees, which means that like any other contract, personal guarantees are liable to be deemed invalid and set aside under certain circumstances.

Special grounds of invalidity apply to spouses who personally guarantee their partner’s company debts.

Grounds of invalidity

The two grounds of invalidity of particular importance for spouses are:

  1. Unconscionability; and
  2. The rule in Yerkey v Jones.

Unconscionability

A guarantor can seek relief from the Courts for unconscionability under principles of equitable relief or pursuant to statutory provisions contained in the Contracts Review Act 1980 (NSW).

In order to obtain equitable relief and have an unconscionable guarantee set aside, a guarantor must establish the following two elements:

  1. At the time of providing the guarantee the guarantor was under a special disadvantage, such as age, sickness, mental incapacity, illiteracy, emotional dependence or lack of business acumen; and
  2. the creditor had knowledge of the guarantor’s special disadvantage.

If the guarantor successfully establishes these two elements, then the onus of proof passes to the creditor to show that the transaction was fair, just and reasonable and that the guarantee should be upheld.

In terms of statutory provisions which provide guarantors with relief from unconscionability, section 7 of the Contract Review Act 1980 enables a Court to set aside, declare void, or vary in whole or in part any provision of a guarantee if the Court is satisfied that in the circumstances of the case it would be unfair and unjust to enforce the guarantee.

Section 9(2) of the Contracts Review Act 1980 provides a complete list of matters to be considered by the Court in determining whether a guarantee was unjust in the circumstances relating to the guarantee at the time it was made. The list of matters to be considered focus on:

  1. whether there was material inequality in bargaining power between the parties;
  2. the relative economic circumstances, educational background and literacy of the parties;
  3. whether independent legal or other expert advice was obtained by the party seeking relief; and
  4. whether any undue influence, unfair pressure or unfair tactics were used on the party seeking relief.

The rule in Yerkey v Jones – the special common law rule protecting spouses

The Courts have held that there is a special rule in equity which applies to the execution of guarantees by spouses[1]. The rule in Yerkey v Jones provides that if a spouse’s consent to become a guarantor for the debts of her/his partner’s business is procured by the partner in circumstances where the spouse does not understand the “essential elements” of the guarantee and the creditor accepts the guarantee without dealing directly with the spouse personally, the spouse has a prima facie right to have the guarantee set aside.

The Yerkey v Jones rule encompasses two limbs: the first limb is where the guarantee was given by the spouse as a result of actual undue influence by the partner, whereupon the spouse obtains a prima facie right to have that transaction set aside unless the creditor can demonstrate that the spouse obtained independent legal advice. The second limb is where the spouse misunderstood the purport and effect of the guarantee which she/he gave, upon which the spouse will acquire the same prima facie right unless the creditor took all reasonable steps to inform the spouse of the particulars of the transaction and, additionally, the creditor reasonably believed that the spouse knew what she/he was engaged in. The reasonableness aspect, if proven to have succeeded, will discharge the creditor of its duties to separately inform the spouse.

The “essential elements” of the rule which need to be established by the spouse are as follows:

  1. The rule applies to a spouse who provides a guarantee for the debts of their partner’s business;
  2. The spouse is a volunteer in the sense that they derive no tangible benefit from the transaction;
  3. The guarantee is procured by the partner without any direct dealings between the spouse and the creditor;
  4. The spouse does not understand the guarantee in “essential respects”; and
  5. The spouse does not receive a proper explanation of the guarantee from an independent witness.

If the above conditions are satisfied the Court may set aside the guarantee even if there is no evidence of any misleading or deceptive conduct or misrepresentation by the partner. The rule is an equitable principle and relief may be denied on discretionary grounds. However, even if the Court finds that the rule does apply and that the guarantee should be set aside, the Court may in its discretion limit the relief granted to the spouse/guarantor.

In order to avoid having a personal guarantee set aside, creditor’s should take steps to ensure that parties providing guarantees understand the consequences of entering into the guarantee and are provided with the opportunity to obtain independent legal advice.

If you believe you have provided a personal guarantee in unfair and unjust circumstances or require any assistance please contact our office for further information.

 

Author: Kathleen Faulkner, Associate

Published: July 2015

 

[1] Yerkey v Jones (1939) 63 CLR 649; endorsed in Garcia v National Australia Bank Ltd (1998) 194 CLR 395.

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