Restructuring & Insolvency analysis: Following the decision in Wagner v White, Ashfords LLP, look at how the courts have been dealing with bankruptcy petitions which lenders have presented against guarantors when the principal borrower fails to repay the loan. We also consider the ways in which guarantors have tried to have the lender’s statutory demand set aside.
Wagner v White  EWHC 2882 (Ch),  All ER (D) 16 (Nov)
What is behind the use of personal guarantees in loan agreements and why do bankruptcy proceedings often follow such guarantees?
For a company in need of borrowing, which also has few assets or an exhausted lending capacity, the only way to secure funding is commonly by way of an individual—usually a director of the company—guaranteeing repayment in the event of the company’s default.
By their very nature, then, personal guarantees expose both lender and guarantor to a considerable degree of risk—guarantors become responsible for debts they did not incur but if they have no means to pay, lenders will be out of pocket with little prospect of recovering the debt in full.
What remedies are available to lenders in this unfortunate scenario? A claim for damages could involve lengthy and expensive litigation—the cost of which, if the guarantor has no assets against which the lender could enforce, would be wasted. The nature of personal guarantees allows lenders to initiate bankruptcy proceedings which, conducted on a swifter timescale and for comparatively lower cost, is a far more appealing option.
So how have the courts treated personal guarantees in the context of bankruptcy proceedings?
What procedure must be followed to petition for bankruptcy?
The statutory demand
Before considering guarantees, it is helpful to review the requirements for creditors’ bankruptcy petitions under the Insolvency Act 1986 (IA 1986). Under IA 1986, s 267, to petition for bankruptcy, a creditor must satisfy the court that the debtor is unable to pay the debt due. One of the two ways to do this is to serve a statutory demand on the debtor in respect of the outstanding debt. The debt must be based on a liquidated sum (ie a determined amount which parties to a contract have agreed to paying in advance) which exceeds £5,000. If the debt remains unpaid or unsecured, or if the statutory demand has not been set aside after three weeks, then a creditor may present a bankruptcy petition.
Debtors who have been served with a statutory demand can apply to have the demand set aside under rule 10.5(5) of the Insolvency (England and Wales) Rules 2016, SI 2016/1024 on any of the following grounds:
- the debtor has a counterclaim, set-off or cross-demand equal to the debt
- the debt is disputed on substantial grounds
- the creditor holds sufficient security over the debt
- there are some other grounds upon which the court may set the demand aside
It is important to emphasise, with regard to SI 2016/1024, r 10.5(5)(b), that all that need be shown is that a dispute exists. Actual liability need not be proven either way, which places a far lower burden of proof on debtors seeking to set demands aside than in ordinary litigation.
Liquidated sums—‘see to it’ obligation or conditional payment obligation
The bankruptcy process cannot be used as a way of expediting litigation for damages. The debt claimed must be for a liquidated sum of money. The important distinction might be said to be between whether the sum claimed is for a debt or for damages. If the court views the sum claimed as the latter, the demand may be set aside.
The starting point for interpreting whether a personal guarantee creates a liquidated sum is to examine the type of obligation the guarantee creates. Personal guarantees may create primary and secondary obligations—the difference being that a primary obligation creates a direct liability between guarantor and lender whereas a secondary obligation will be dependent on the actions (or inaction) of the principal borrower.
In Norwich and Peterborough Building Society v McGuinness  EWCA Civ 1286,  2 All ER (Comm) 265, Patten LJ distinguished the several types of liability imposed on a guarantor as follows:
- an indemnity
- a ‘see to it’ obligation, ie an undertaking by the guarantor that the principal borrower will fulfil the contract with the lender
- a conditional payment obligation, ie a promise by the guarantor to pay the lender the amount owed if the principal debtor fails to pay it
- a concurrent primary liability with the borrower for what is due under the loan
While an indemnity may create a primary obligation on the guarantor, it has long been established that indemnities must be remedied by a claim in damages and, as such, cannot be considered a debt for the purposes of a statutory demand.
Patten LJ also held that this was the case for ‘see to it’ obligations—the issue was whether ‘the liability of the guarantor can be treated as one which is reduced to a specified and agreed sum by the guarantee itself’ – in other words, to be considered a liquidated sum, the guarantee must contain a promise by the guarantor to pay a determined amount to the lender if the borrower fails to do so.
Following the ruling in McGuinness, prudent lenders have been at pains to ensure that their personal guarantees contain unambiguous conditional payment obligations. Conversely, guarantors have gone to some lengths to argue that their personal guarantees create ‘see to it’ obligations or indemnities. In Dunbar Assets plc v Fowler  Lexis Citation 108,  BPIR 46,  All ER (D) 02 (Jan), a director who had provided a personal guarantee over loans which his company had made to a bank attempted to argue that the guarantee was a ‘see to it’ obligation. The relevant clause read:
‘The guarantor hereby (a) guarantees the payment or discharge to the Bank and undertakes that it will on first demand…pay or discharge…all monies and liabilities which shall for the time being be due…and (b) agrees as primary obligor and not merely as surety to indemnify the bank…from and against all losses incurred by the bank as a result of the principal debtor failing to perform any obligation…’
The guarantor attempted to argue that the two clauses—the first of which was a conditional payment obligation and the second of which was an indemnity—were dependent on each other and so as the second sub-clause was an indemnity, the obligation was for unliquidated damages.
Chief Registrar Baister disagreed with this interpretation, holding that the clauses were ‘separate but cumulative’. There was no ambiguity in the drafting of the first sub-clause, of which he said:
‘One asks two questions—who pays and what does he pay? If the answers are "the guarantor pays" and "he pays the principal debtor’s debt", the guarantee is a conditional payment obligation.’
As there was no question as to who was liable, and for what, the guarantor was clearly subject to a conditional payment obligation. The fact the guarantor was also subject to an additional indemnity obligation was irrelevant.
This lender-friendly approach was continued in Lombard North Central plc v Blower  EWHC 2267 (Ch),  BPIR 1501 which again involved a director attempting to argue that the guarantee he had provided was not a liquidated sum. The relevant clause read as follows:
‘I/we…(1) guarantee payment to you on demand…of all sums that become payable to you by the customer under the agreement…(2) hereby indemnify you against any failure by the customer under the agreement and agree to pay you on demand any sums which the customer has agreed to pay to you under the agreement and any sums which may become payable to you as a consequence of the customer’s said failure.’
It was agreed that sub-clause (1) was a ‘see to it’ obligation and that the first part of sub-clause (2) was an indemnity. However, the guarantor sought to argue that the final part was a further ‘see to it’ obligation.
Tipples QC, sitting as a High Court judge, was not convinced. She held that the drafting of the final line clearly created a conditional payment obligation—there being a key difference between sums that become payable (the ‘see to it’ element) and sums which have been agreed to be paid (the conditional payment obligation).
What is clear from both Dunbar and Lombard is that courts will usually treat conditional payment obligations—to the extent that they are relatively unambiguous—in isolation from surrounding clauses. The recent case law has generally favoured lenders over borrowers on interpretations of this particular point, though this is no doubt due to the attention lenders have given to drafting personal guarantees since McGuinness.
However, a recent case which found in favour of the guarantor on the ‘liquidated sum’ point was that of Dowling v Promontoria (Arrow) Ltd  Lexis Citation 292,  BPIR 1477,  All ER (D) 82 (Sep). The secondary obligations included in the personal guarantee in question contained both ‘see to it’ and conditional payment obligations—but both were, for the purposes of SI 2016/1024, r 10.5(5) at least, held to be statute-barred. It was therefore necessary for the lender to show that the clause creating a primary obligation was a conditional payment obligation and not an indemnity. The relevant clause read:
‘The guarantors hereby agree…that their liability…shall not merely be as surety and that all monies not recoverable from the guarantors on the footing of a guarantee for any reason or circumstance whatsoever…shall nevertheless be recoverable (on a full indemnity basis) from the guarantors as principal debtor and shall be repaid by the guarantors on demand.’
The lender argued that this clause gave rise to a concurrent liability (as per McGuinness) which was a liquidated sum. Registrar Barber (as she then was) rejected this argument, holding that the obligation the guarantee created was an indemnity. She held that the construction of the clause implied a loss against which the lender was to be indemnified by the guarantor and that ‘if a concurrent liability was intended, one could simply make the party under the guarantee a joint obligor in the facility letter’. Again, this was a decision which turned on the construction of the relevant guarantee clause.
In what circumstances can personal guarantees be set aside?
It would appear that the liquidated nature of guarantee obligations is now relatively settled law. But this is only one aspect upon which guarantors may seek to have a statutory demand served upon them set aside. The recent, high-profile case of Wagner provides a useful example of the other grounds upon which it is frequently argued statutory demands based on personal guarantees should be set aside.
In brief, the case involved a technology start-up which entered financial difficulty in around 2015. The founder of the company—the appellant—sought bridging finance from the respondent, a successful entrepreneur and investor, along with several others. The appellant ultimately guaranteed around $4m of his company’s borrowing.
When the company entered administration in early 2016, the respondent issued a statutory demand over the appellant’s personal guarantee. The appellant sought to set aside the statutory demand on the grounds listed under SI 2016/1024, r 10.5(5). In particular, these were that both he and the company had counterclaims against the respondent in misfeasance, misrepresentation, breach of collateral contract and conspiracy (SI 2016/1024, rule 10.5(5)(a)), and as a result the debt was disputed on substantial grounds (SI 2016/1024, rule 10.5(5)(b) and (d)).
The appellant’s personal claims as guarantor are fact-specific and in that sense the legal principles are uncomplicated and relatively self-explanatory. If guarantors can demonstrate a triable reason—such as misrepresentation or breach of contract—as to why they should be discharged from their obligations under the guarantee, they may succeed in having a statutory demand set aside.
Two further arguments raised by the appellant are worthy of further consideration, however. These are the co-extensiveness principle and the Patel principle.
The co-extensiveness principle is well-established. It was first set out in Lakeman v Mountstephen (1874) LR 7 HL 17, [1874-80] All ER Rep Ext 1924, it was considered in more detail in Moschi v Lep Air Services Ltd and another  AC 331,  2 All ER 393 and, broadly, is authority for the proposition that a guarantor’s liability is a secondary obligation contingent on the principal borrower failing to perform its obligations under a loan facility (subject to the wording of the guarantee, as explained above).
The appellant in Wagner sought to rely on Remblance v Octagon Assets Ltd  EWCA Civ 581,  2 All ER 688, which confirmed that the co-extensiveness principle applied to situations where a statutory demand could be set aside if the principal debtor had an arguable counterclaim, set-off or cross-demand against the lender, ie if the principal debtor’s counterclaim will extend to the guarantor and allow him to avoid liability. Counsel for the respondent in Wagner argued that, as the decision in Remblancehad been based on a ‘see to it’ guarantee, the reasoning could not be extended to a conditional payment guarantee (as appellant’s was).
At first instance, the late Deputy Registrar Garwood found in favour of the respondent in Wagner. However, while the matter was argued on appeal, Nugee J found that, as no triable counterclaim existed in any event, it was not necessary to decide upon the point. While Remblance therefore remains good authority for the co-extensiveness principle extending to ‘see to it’ guarantees, the question remains somewhat open as to whether that extends to conditional payment obligations.
The Patel principle
The appellant in Wagner sought to assert that the respondent, as lender, had acted in bad faith and ‘caused or connived at’ the principal debtor’s default under the loan in order to call in the guarantee—and that as a result, he as guarantor should be discharged from his liability under the guarantee.
This principle was established in Bank of India v Trans Continental Commodity Merchants Ltd and Patel 2 Lloyd’s Rep 298 and was summed up by Bingham J at first instance, who stated that:
‘A surety is discharged if the creditor acts in bad faith towards him or is guilty of concealment amounting to misrepresentation or causes or connives at the default by the principal debtor in respect of which the guarantee is given or varies the terms of the contract between him and the principal debtor in a way which could prejudice the interests of the surety’.
Both he and Goff LJ were sure to point out, however, that ‘there is no general principle that “irregular” conduct on the part of the creditor, even if prejudicial to the interests of the surety, discharges the surety’.
Although its scope remains limited, subsequent cases have broadened the circumstances in which the Patel principle might apply. In National Westminster Bank plc v Bowles  EWHC 182 (QB),  All ER (D) 226 (Feb), Clarke J stated that if the lender had simply ‘told untruths’ which had the consequence of the borrower defaulting, ‘he might well have a claim to be discharged from liability’. Hamblen J extended the reach of the principle further still in Dubai Islamic Bank PJSC v PSI Energy Holding Co BSC EWHC 2718 (Comm),  All ER (D) 225 (Oct), when he stated that the principle extended to situations in which a creditor ‘positively acts to as to prejudice the surety in an unfair way’.
What is clear, both from Patel itself and the subsequent authorities, is that the Patel principle is limited to circumstances where there is some positive action on the part of the lender to prejudice the guarantor in an unfair way. Such cases will, of course, always turn on their facts. In the case of the appellant in Wagner, all his claims were dismissed at both first instance and appeal without merit, which will no doubt come as welcome news for lenders.
Pursuing personal guarantees through the route of a statutory demand and bankruptcy petition can be a highly effective method of enforcement. However, lenders should be aware that the process comes with its own risks. Even if the demand itself is unambiguous, the low burden of proof required for a debtor to successfully set aside a statutory demand means the odds are to some extent inherently stacked against the creditor, and set-aside applications can also be costly and time-consuming. Ultimately, of course, all cases will turn on their facts—but lenders should ensure they have considered all potential disputes carefully before continuing with the process.
Interviewed by Robert Matthews.
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