In business, limited liability laws applicable to corporate entities usually protect business owners from personal liability for a company’s debts. For this reason, before granting credit to a business entity, a creditor such as a bank or landlord routinely requires the individual business owners to sign as surety for the underlying obligation.
For example, a business owner is likely to be required to sign surety for the company’s overdraft or equipment or vehicle finance, or when applying for credit facilities from a supplier or when renting premises.
A similar situation usually applies to trusts. Trustees who run the trust are not necessarily personally liable for its debts. Thus the creditor of a trust will usually require one or more of the trustees to stand surety before advancing funds. When a family trust applies for a mortgage bond to finance the purchase of a property, for example, it is likely that the bank will require a number of the trustees to sign as surety for the trust’s debt.
Potential lenders usually also request sureties in situations where the debtor cannot alone provide adequate security for the debt, or where the debtor lacks a regular income sufficient to cover the repayment terms. A spouse is often requested to stand surety for their “other half’s” debts, for example on home loan, or a parent will need to provide a surety for a loan made to a child.
Making sure: law of suretyship 101
A contract of suretyship is entered into when a person (called the “surety”) agrees with the creditor of another person or entity (called the “principal debtor”) to be liable for any part of the obligation (called the “principal debt”) that the principal debtor does not fulfil. A distinguishing feature of the contract of suretyship is that it creates a separate but ancillary obligation: the surety’s obligation, while independent from that of the debtor, only exists if there is a valid underlying principal debt. If the principal debt is extinguished (such as by payment in full by the principal debtor) then the surety’s obligation is likewise extinguished.
A surety can undertake liability for the full principal debt (an “unlimited surety”), or may place a limit on his or her exposure. The surety could even commit to a “continuing suretyship” by agreeing to stand good for whatever amount is owed by the debtor from time to time, including indebtedness incurred after the suretyship is given. Generally, provided the legal requirements for a valid suretyship are met (for example it must be in writing and signed by the surety), the surety is bound to make good any failure by the debtor to pay the debt. And although having paid the debt, the surety can call on the principal debtor to reimburse him or her, this right is often useless owing to the principal debtor’s inability to pay.
Signing on the dotted line: advice for the potential surety
The best advice to give a person asked to sign a suretyship may simply be …. don’t!
The reality though is that often the creditor’s and debtor’s bargaining positions are unequal; the creditor’s demand for a surety is usually a prerequisite to obtain credit. If you feel compelled to sign as a surety, the following guidelines might help:
- understand the terms of the suretyship contract, especially the creepy Latin stuff – get advice from a lawyer if necessary
- accurately describe (and restrict) the nature of the debt for which you intend standing surety – e.g. all indebtedness or just a home loan, overdraft, rental, future legal costs etc
- put a maximum limit on your liability if possible
- don’t leave blank spaces in the contract – it might be impossible to prove later that the final document was not what you signed
- request the principal debtor to obtain co- sureties; if you later have to pay the full debt as surety, you can call on co- sureties to reimburse you pro rata
- understand that so long as the principal debt exists, the creditor may call on you to pay – even years after you signed the contract; ask for regular reports on the status of the debt
- ensure you get written proof from the creditor if they agree to release you from the suretyship – for example, if you sell your business and the new owner agrees to “procure your release from sureties” you have undertaken for the business, get proof from the creditor that this has been done seek legal advice before paying up as surety – you should ascertain your rights against the creditor, principal debtor and co-sureties protect your estate by requiring the principal debtor to put “contingent liability assurance” in place (see below).
The death of a surety: contingent liability assurance
A surety’s death does not release his or her estate from the clutches of a suretyship contract. When a surety dies, the creditor must be persuaded to release the surety’s estate from its potential future (called “contingent” obligations before the surety’s estate can be properly wound-up and the deceased’s surety’s assets passed to his or her heirs.
In that situation, the creditor may demand that the principal debt be settled, or that an appropriate sum in the surety’s estate be set aside to cover the payment of the debt in due course. This could have serious repercussions for the winding-up of the surety’s estate, causing lengthy delays and leading to a cash shortage in the estate. Business owners in particular need to address this problem as they have often signed sureties for suppliers, banks and landlords.
Life assurance can provide an affordable and simple solution to the problem. When a director of a company or trustee of a trust agrees to stand surety for underlying debts of the company or trust, it is recommended that the debtor company or trust takes out a life policy on the surety. The arrangement should be backed by a legal agreement in which the company or trust binds itself that the policy proceeds must be used to settle the principal debt on the surety’s death. This will enable the surety’s estate to be easily released from its obligations. This structure is commonly called a “contingent (or personal liability plan)”.