UK: Maintaining The Validity Of Guarantees

Last Updated: 17 September 2009
Article by Edward Davis and Sue Millar

In Bank of Scotland Plc v (1) Constantine Makris (2) Ben O'Sullivan (2009) (Ch D), the Court considered the validity of a guarantee in light of a variation to the underlying facility agreement between the bank and the borrower company in the form of a reduction in the amount of the facility.

Bank of Scotland Plc (the "Bank") sought to recover a sum due under a guarantee provided in relation to a facility agreement between the Bank and the borrower company after the borrower company entered into creditors' voluntary liquidation.

Background

The borrower company was the vehicle for a joint business venture between three men, Mr Constantine Makris, Mr Ben O'Sullivan and Mr Vincenzo Spano. The facility agreement initially provided for an overdraft facility for the company of up to £250,000. The advance of the overdraft facility was conditional on the provision of security as follows:

1 A fixed and floating charge, and a legal charge over the borrower company's leasehold interest in its premises.

2 A guarantee by Mr Spano in the sum of £250,000 supported by a legal charge over his home (the "Property").

3 An unsecured guarantee limited to £50,000 from Mr Makris and Mr O'Sullivan expressed to be joint and several.

The facility agreement was signed on behalf of the company by Mr Spano and Mr Makris. The guarantee for £50,000 was duly signed by Mr Makris and Mr O'Sullivan.

A complication arose in respect of Mr Spano's guarantee. The Bank discovered that Mr Spano was not the sole owner of the Property. It was in fact registered in the joint names of him and his mother. Although Mr Spano's mother joined with her son in executing the guarantee and charge in favour of the Bank, the Bank regarded the security as weakened by the mother's involvement. As a result, the Bank was only prepared to advance an overdraft facility to the company of up to £230,000. A revised facility agreement for this amount was issued by the Bank and the facility agreement was signed on behalf of the company, as before, by Mr Spano and Mr Makris. These two defendants subsequently disputed their liability to meet the guarantee, on separate grounds, and a dispute arose in respect of whether the guarantee was valid.

Variation of principal contract

Mr Makris argued that the reduction of the overdraft facility from £250,000 to £230,000 was a material variation of the principal contract (between the Bank and the borrower company) and thus discharged the guarantee.

The Court accepted that a material variation of a principal contract may discharge a guarantee if the variation occurs without the consent of the guarantor (the rule in Holme v Brunskill (1878) 3 QBD 495). The Court found however that the principle did not apply in this case for the following reasons:

1 The change in the amount of the overdraft facility was not a variation of the contract. The change arose as a result of the fact that one of the conditions to which the initial facility had been subject (the provision of a charge by Mr Spano over his property) had not been met. Thus, the revised facility offered to the borrower company by the Bank represented a fresh offer of a lesser amount on different conditions. The wording of the guarantee was wide enough to cover the liability under this new facility.

2 Mr Makris co-signed the revised facility agreement on behalf of the borrower company. This was seen by the Court as a manifestation of his consent to the reduced amount of the facility.

3 Clause 9.9 of the guarantee precluded reliance on a variation to reduce or discharge the guarantee.

The Court therefore could not see a legitimate basis upon which Mr Makris could show that the reduction in the borrower company's overdraft facility was a material variation in the facility agreement between the Bank and the borrower company, sufficient to discharge the guarantee.

Undue influence

The case advanced by Mr O'Sullivan was that his signature on the guarantee had been procured by the undue influence of Mr Spano.

The Judge applied the leading case of Royal Bank of Scotland v Etridge (No.2) [2002] 2 AC 773. In order to establish undue influence, Mr O'Sullivan first needed to establish the presence of the "necessary relationship" between himself and Mr Spano which was capable of being abused by Mr Spano to override the free will of Mr O'Sullivan. This relationship was described as "trust and confidence, reliance, dependence or vulnerability on the one hand and ascendancy, domination or control on the other".

The Court found that Mr O'Sullivan had not come anywhere near establishing that the "necessary relationship" existed, despite accepting that the two men were close friends and part of a team. The Court further held that the Bank was not put on enquiry as to the existence of a "necessary relationship" so as to require it to take further steps in this regard, known as the sanitation process (a process by which a bank, having been put on enquiry as to the existence of a "necessary relationship", should take certain steps culminating in a certificate from an independent solicitor stating that the guarantor has received independent legal advice). The relationship between the guarantor (Mr O'Sullivan) and the debtor (the borrower company) was a commercial relationship and the Court rejected any concept of a hybrid relationship (part commercial and part non-commercial) – Etridge had envisaged that relationships would be strictly either commercial, or non-commercial, with only the latter requiring a bank to invoke the sanitation process.

Practical implications

Although this case turned on its own particular facts, it is a useful reminder that lenders should ensure that, where they do not have the benefit of an all-monies guarantee, and there is what could be viewed as a material variation in the terms of a loan agreement, the consent of any guarantor(s) is obtained to the variation so that the validity of the guarantee is maintained. Lenders should also continue to bear in mind that where a guarantee is to be provided by a guarantor who has a non-commercial relationship with the borrower, the lender will be put on enquiry as to the possibility of undue influence and must follow the sanitation process as set down in the Etridge case.

This article was originally written for Stephenson Harwood's quarterly publication, Finance Litigation Legal Eye. If you would like to receive this publication, please contact Stephenson Harwood ( www.shlegal.com).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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