Overview
It is not possible for every business to always have the adequate means to assure lenders regarding repayment of credit facilities they avail themselves of. This is where a corporate guarantee comes into the picture. Corporate Guarantees are used by businesses to banks and financial institutions as a form of assurance of repayment against business loans. Read on to find out more.
Corporate Guarantee – How does it work?
It is also known as a Guarantee from a third-party guarantee or guaranteed loan. A Corporate Guarantee is a legally binding agreement in pursuance of which a third person known as a guarantor consents for the fulfillment of the debt obligation where the debtor fails to repay loan repayments to the concerned creditor. Corporate Guarantees offer assurance to lenders for repayment of loans in the event of default on the one hand, whereas the debtor feels more relaxed and confident to avail of the credit facilities minimizing the default risk.
In general business practice, corporate guarantees can be executed between any number of parties, however, generally, such guarantors and borrowers are closely related in business. For instance, for a corporation that is the legitimate beneficiary of a commercial credit line, the credit facilities could be availed by business owners.
Corporate Guarantee – All You Need to Know
Parties Involved in a Corporate Guarantee
Generally, there are two main parties to a standardized corporate guarantee agreement –
- Individual or Business entity agreeing to repay the debt obligation in the event the borrower fails to meet the debt obligation.
- Lender, who has given loans or extended credit facilities and the debt liability.
- Debtor, who has received money and is primarily responsible for repaying loan obligation.
Types of Corporate Guarantee
Subject to the readiness of the organization to take on the risks and commit to a certain level, corporate guarantees could come in different types. Some of the typical categories of Corporate Guarantees are-
Limited Guarantee:
Limited Guarantees are guarantees under which the guarantor wishes to put a certain ceiling to the total financial obligation. Such obligations are limited to a certain sum which a guarantor could legally be obliged to pay. For example, when a business entity takes a sum of Rs. 2 cr as loan while the business owners agree to a limited guarantee of Rs. 50L. Thus, the guarantor cannot be obligated to pay back more than 25L in any case.
Unlimited Guarantee:
Unlimited Guarantee is a guarantee where the guarantor agrees to be fully liable for the debt obligation of the borrower. An Unlimited Guarantee offers assures the lender of repayment of the total sum to the lender whereas a considerable risk for the guarantor.
Conditional Guarantee:
A conditional guarantee becomes enforceable upon certain conditions being met, for instance if the borrower breaches a specific condition or fails to satisfy specific financial standards.
Continuing Guarantee:
A continuing guarantee extends protection for an agreed period for multiple agreements or several types of loans or agreements. The guarantee is effective until it is revoked by the guarantor.
Cross Guarantee:
When two or more businesses within the same business group mutually agree to act as guarantors for each other’s debt obligations, it is also known as Cross Guarantee. Cross Guarantees are generally practiced in large conglomerate entities.
Multiple Guarantors:
Normally, commercial lenders have to deal with instances where a business is owned by several business owners and thus a business loan can be availed based on their risk-taking ability and the credit structure of the organization which will act as joint guarantors or multiple guarantors. Thus, their guarantee-related obligations could be divided equally in the same way as their ownership or negotiate guarantees independently, or could one guarantee “jointly and severally.”
Need for Corporate Guarantee
- Better Access to Credit Facilities – Corporate Guarantee ensures seamless access to finance while reassuring the lender of repayment of loans.
- Enhanced Trust and Credibility – A Corporate Guarantee is a business entity that helps to exhibit financial stability as well as commitment and gain the trust of its stakeholders. Such enhanced trust might have positive effects on business relationships with suppliers, customers and other business partners possibly leading to potential business opportunities and collaborations.
- Encourages Joint Ventures and Collaborations-Corporate Guarantees encourage business partnerships, joint ventures, and collaborations allowing it to scale its operations.
- Risk Mitigation – Corporate guarantees enable protection to parties including towards any risk of loan default. Since the assurance is effective in the case where the borrower fails to make repayment, the guarantor will honor debt obligations encouraging suppliers to extend credit facilities and deliver goods or services without any unnecessary delay.
- International Trade and Commerce – Corporate Guarantee is significant in trade and commerce in global transactions which can be uncertain sometimes due to unversed legalities involved, currency, or business practices.
- Acts as an additional layer of security – Corporate Guarantee acts as an additional layer of security reducing the risk with respect to extending loan facilities.
Enforceability of Corporate Guarantee
Corporate Guarantees are especially relevant for business loans during the grant of loan or credit facilities. Signing a corporate guarantee allows the guarantor to bear the debtor’s responsibilities, including debt repayment. For instance, a holding company agreeing to be a guarantor for debt obligation given to one of its subsidiaries relieves the lender of repayment even if there is a certain degree of risk involved. At this point, you might be curious: are corporate guarantee agreements enforceable? In certain judicial precedents, the courts have upheld that in cases where a guarantor has agreed to honor debt obligations for someone else, the agreement is legally binding between the guarantor and lender and could be enforced legally.
However, it is to be noted that personal guarantees are easier to legally enforce particularly in cases where one party claims forgery, fraud, or any coercion which is not the case with Corporate Guarantees. Further, since diverse business entities have dissimilar structures with layers of people, with the Board of Directors, Stakeholders like Creditors or Shareholders, or Employees with very specific roles in the management and administration of the business affairs, thus the signatory person should not have the necessary authority to act on the behalf of the corporate entity making the process of enforcement more challenging.
In the case of P.J. Rajappan v. Associated Industries (1983) Case where the guarantor attempted to escape liability contending that since he had not signed the guarantee agreement and thus was a surety for the contract’s performance. However, the documents stated otherwise, stating that the guarantor was involved in the transaction and had committed to signing the contract at a later time.
Therefore, the Kerela High Court stated that since the contract of guarantee is a three-party agreement entered into between the lender, borrower, and the surety and where there is ample evidence to show that the guarantor has been involved in the transaction, then the fact that he had not signed the agreement shall not declare any evidence invalid which would otherwise have proved that he had consented to the execution of the contract of guarantee.
The Court also ruled that while deciding whether an individual or a business entity has agreed to act as a guarantor in pursuance of the agreement, all the transactional factors shall be taken into consideration.
This rule may clarify and lay stress on the enforceability of corporate guarantees, that will in turn affect the creditor’s claim against the guarantor in case the main party defaults.
Need for GST in Corporate Guarantee
Corporate Guarantees are provided by one related party to another with the intent to protect the investment into other related businesses allowing the borrower access to funds and improving its creditworthiness. However, in terms of GST law, the transaction of guarantee is deemed as a ‘Supply of Services. 28(2) of the CGST Act and Rules.
Under this, the Guarantor is a supplier of services, with the borrower being the beneficiary and the lender though is not a party to the supply transaction but is applicable in pursuance of GST rules regarding the guarantee. Accordingly, a corporate guarantee thus attracts GST at a rate of 18%, assessed on either 1% of the amount subject to the guarantee agreement or the actual consideration, with certain exceptions for the promoters or directors of the business entity.
For instance, directors availing credit facilities from markets are exempted from GST liability on Corporate Guarantees whereas GST applicable on guarantee agreements between parent companies, subsidiaries, and related parties is 18 percent.
Corporate Guarantee Vs Bank Guarantee
The basic difference lies in the fact that both guarantees are issued by different parties. Corporate Guarantee and Bank guarantee are two different terminologies, although they serve the same purpose of giving financial security to the lender in case the borrower defaults. In one case, a bank guarantees to cover losses in case of default, whereas in the other case a company promises to fulfil the obligations of the loan in case the borrower defaults.
It is already seen as a corporate guarantor, mostly in the case of its subsidiaries or group companies, promising to fulfil a borrower’s obligations in case of default. Whereas, Bank Guarantees are commonly used for LC, tenders or contracts in business operations. In both cases this adds to the credibility and borrowing capacity of the business as it is seen to have a solid backing.
Final Thoughts
Corporate guarantees play a significant role in enabling smooth business functions, encouraging ease of trade, and improving the creditworthiness of the borrower. Being a multifaceted financial instrument, they have a considerable impression on the financials of an enterprise. Apart from this, corporate guarantee also instils trust and confidence among the parties’ opening doors for new business opportunities and collaborations while creating a strong sense of security for the lenders to offer requisite financial support to the borrower entity.
Irrespective of where a corporate guarantee agreement may come across, as a joint business commitment or a contractual obligation, they are vital to enable risk mitigation and ensure sustained business growth. Though there are certain challenges to the enforcement of Corporate Guarantee agreements, it could be prevented through meticulousness of the agreement, its validity, and compliance of the terms.
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