Guarantee or Guaranty Definition
A Guaranty/ Guarantee is a legally binding agreement in which a person (first party) agrees to be answerable for another person (second party), who wishes to obtain trust or credit from someone/institution (third party), and promises to fulfill the specified obligation of the other person (Second party) in case of default.
In international law, it may designate an agreement (treaty), usually in writing, between states or groups in which claims, territorial rights as well as possessions of goods are secured.
A guarantee produces both legal and economic effect and should be differentiated and not to be confused with;
- Warranty – a promise by a manufacturer that in case of product defect, they will repair or replace the product at their expenses. It is usually limited to a specified period.
- Security – an asset which can be part of the guaranty contract, to be charged and forfeited in case of default.
- “Personal guarantee” – a colloquial term that refers to an assurance by word of mouth made by one person to another that a specific promise will be kept or fulfilled.
A Little more on What is a Guarantor
Parties who constitute a Guarantee contract are usually referred to as follows;
- Guarantor or Surety – The person who promises to take responsibility for another person’s performance or obligation in case of default.
- Principal debtor or obligor -The person whose performance to an obligation or undertaking has been secured by a surety or guarantor.
- The creditor or obligee-The person or institution whom the guarantor promises to fulfill the performance or requirement of the principal debtor in case of default.
Suretyship can be viewed or classified in three distinct categories;
- Where the relationship between the principal debtor and the surety is formed through an agreement and the creditor is party to the contract.
- Where the relationship between the surety and the principal debtor has been similarly constituted by way of an agreement, but the creditor is not a party to such.
- Where there is no constituted contract to establish a relationship between parties, however, there is a primary and secondary liability expressed for a debt. Should the person with the primary obligation default and the person with the secondary responsibility is forced to make payments, reimbursement of the same from the primary obligor can be sought.
Various civil jurisdictions have different civil codes that guide the performance of a suretyship but with notable similarities:
As a general rule, personal incapacity of the principal debtor, and therefore, failure to pay value consideration is secured through a surety. However, when the specified performance cannot be measured in terms of monetary value, the suretyship becomes null and void.
In addition, minors are absolved from a guarantee of any credit advanced to them on the grounds of personal incapacity in some countries.
Nevertheless, some countries sanction guarantees that are entered to expressly recognize a minor as a principal debtor, for instance, Egypt. whereas, in the case of Portugal, all liability in such scenarios lies with the surety unless revoked by a court of law.
Types of Sureties
Sureties can be divided into context such as being either;
- Gratuitous and;
Expressed vs. implied suretyship
A surety is a contractual obligation and can be expressed – clearly stated in writing or made verbally. For instance, Germany requires the surety to be shown in writing only, whereas Portugal, on the other hand, accepts both expressed mode as proof of Guarantee.
If a surety is expressed verbally, and there is a considerable amount of funds involved, most civil codes require the presence of a witnesses.
Also, a surety can be implied, that is, naturally suggested or presumed to be in existence, however, some countries, for example, Belgium and France require an expressed surety and not an implied or assumed one.
A guarantee is similar to any other legally binding contract and therefore has all the elements and requirements that are enforceable by law.
For a guarantee to be legally binding during formation the following common law elements of a contract must be adhered to;
- Mutual consent of all parties involved.
- Invitation to offer and acceptance.
- Parties must be of sound and sane mind.
- The form and content of the guarantee has to be legally correct
- And a valuable consideration.
It should be noted, however, in some countries, for example, Scotland, a consideration not regarded as an essential element and in the absence, a contract may still be binding.
Type of Consideration
A guarantee consideration can be either Entire or Fragmentary.
An Entire consideration – for example,when a surety is given for a lease, the guarantee will be in existence during the whole lease period and cannot be revoked; therefore the surety is answerable to the performance of the lessee to the covenants in the lease.
In contrast, a fragmentary consideration is when the surety is provided from time to time, for example, to secure the account balance for supplied goods periodically. Unless otherwise expressed, the guarantee can be revoked by the Guarantor at any time.
Vitiating Factors (validity)
The validity of a guarantee is put to question when obtained by fraudulent means such as;
- Concealment of risk undertaken by a guarantor.
- Misrepresentation- the making of false facts about the guarantee.
- Incapacity – Intoxication or insanity of the guarantor.
The legal obligation of a surety in a guarantee contract cannot exceed that of the principal debtor and may not be the same also to the principal debt but depends on the expressed terms in the agreement. Besides, in some countries like India, the surety is liable to the whole principal debt unless otherwise stated.
The surety can only be made liable if a loss is occasioned to the creditor in case of default by the principal debtor. The limit of the guarantor should always be clearly stated in writing and such evidence produced in case of a dispute for fair interpretation of what was inferred during execution.
A Principal debt that cannot be enforced due to incapacity absolves the surety. Nevertheless, in the instance where directors to a company guarantee specific performance which their company is unable to fulfill, they are held personally liable since they have acted beyond their authority.
The responsibility of a guarantor ends depending on the nature of the guarantee and the underlying principle. For instance, in a continuing guarantee, the surety is answerable to a series of future transaction. In such a case, death can terminate the liability, or the surety can elect not to renew a promise after successive transactions. A surety bond for good conduct during employment is an example of a continuing guarantee.
In the case of a Conditional guarantee, the liability of the surety ends only, after the contract has been enforced on the principal debtor and the debt fully recovered, otherwise the surety obligation stands. In contrast, an absolute guarantee is unconditional, and in default, the surety is always liable without any contingency plan for recovering debt from the principal debtor; therefore the liability only ends if performance to the creditor is fulfilled.
References for Guarantee or Guaranty
Academic Research on Guarantee or Guaranty
- Guaranty funds and risk-taking evidence from the insurance industry, Lee, S. J., Mayers, D., & Smith Jr, C. W. (1997). Journal of Financial Economics, 44(1), 3-24. The paper asserts that the enforcement of state enactments dating back to 1969 and 1981 on guaranty funds increases the risk of an insurer asset portfolio especially for stock insurers.
- Risk‐based premiums for insurance guaranty funds, Cummins, J. D. (1988). The Journal of Finance, 43(4), 823-839. The article suggests that the insurance guarantee fund should adopt a risk premium rate charges on policyholders to encourage insurance company to adopt high-risk strategies. The report further presents three formulas and makes a comparison for premium assessment rates.
- Petty Federal Offenses and the Constitutional Guaranty of Trial by Jury, Frankfurter, F., & Corcoran, T. G. (1925). Harv. L. Rev., 39, 917. The article looks at petty offenders and their constitutional Guaranty to be heard, and cases determined by a trial jury as enshrined in the constitution.
- Monitoring, ownership, and risk-taking: the impact of guaranty funds, Downs, D. H., & Sommer, D. W. (1999). Journal of Risk and Insurance, 477-497. The paper presents evidence based on studies on the effects of insurance guaranty funds and the relationship to risk-taking, monitoring, and ownership interest. The article further looks at supporting evidence for a risk subsidy hypothesis.
- Bank Solvency and Guaranty Letters of Credit, Verkuil, P. R. (1972). Bank Solvency and Guaranty Letters of Credit. Stan. L. Rev., 25, 716. The paper looks at the importance of guarantee letters of credit in ensuring continuity of a financial institution solvency. The article focuses the impact of credit letters in relation to bank solvency.
- A financial-economic evaluation of insurance guaranty fund system: An agency cost perspective, Han, L. M., Lai, G. C., & Witt, R. C. (1997). Journal of Banking & Finance, 21(8), 1107-1129. The paper proposes a way to ensure that the insurance guaranty fund adequately protects policyholders in case an insurance company is in financial distress.
- The value of pension benefit guaranty corporation insurance, Pennacchi, G. G., & Lewis, C. M. (1994). Journal of Money, Credit and Banking, 26(3), 735-753. The paper suggests models that can be adopted by the Pension Benefit Guaranty Corporation (PBGC) insurance to ensure consistency in relation to its liability to running pension funds and their economic value.
- An economic analysis of the guaranty contract, Katz, A. W. (1999). The University of Chicago Law Review, 47-116. The paper tries to outline the reasons behind the adoption of guaranty contracts and provides analysis from an economic perspective. The risk factor of a surety is also discussed and whether it is enough to guarantee default.
- What the pension benefit guaranty corporation can learn from the federal savings and loan insurance corporation, Bodie, Z. (1996). Journal of Financial Services Research, 10(1), 83-100. The article makes a comparison between two government bodies tasked protecting funds, that is, the Pension Benefit Guaranty Corporation (PBGC) and the Federal Savings and Loan Insurance Corporation (FSLIC), and what lessons the PBGC can effectively adopt from FSLIC. The issue of underfunding, financial strength and the market risk exposure of PBGC are discussed and legislative reforms to address such.
- Guaranteed trouble: the economic effects of the pension benefit guaranty corporation, Brown, J. R. (2008). Journal of Economic Perspectives, 22(1), 177-198. The paper looks at how the Pension Benefit Guaranty Corporation (PBGC) ended up facing financial distress from the year 2000 stock market decline which affected pension assets. The article further proposes ways to ensure such a scenario never happens again since the enactment of the Pension Protection Act of 2006 that revived the PBGC program.
- Fair insurance guaranty premia in the presence of risk-based capital regulations, stochastic interest rate and catastrophe risk, Duan, J. C., & Yu, M. T. (2005). Journal of Banking & Finance, 29(10), 2435-2454. The paper looks at the Fair insurance guaranty premium and statistically examines the presence of models such as risk-based capital regulations, stochastic interest rate, and catastrophe risk, and presents their impact to a guaranty contract.