Risks in execution of a contract of guarantee

Companies generally require their counterparties to provide security for a better guarantee of creditor’s rights and lower business risks during transactions. Security can be provided by means of guarantee, mortgage, pledge, lien and security deposit, as provided in the Security Law.

Subject examination

When a company enters into a contract of guarantee, it should first check whether the guarantor is the subject eligible for providing a guarantee. It is provided in the Security Law that non-profit public institutions such as schools, kindergartens, hospitals, social organizations and corporate functional departments are prohibited from providing guarantees, but branches of eligible entities may provide guarantees within the scope of authorization. In addition, a company should pay attention to the following:

The guarantor is a business entity. In order to prevent losses to the company and damages to the interests of minority shareholders because the legal representative provides security to others at will on behalf of the company, the Company Law provides that the acts of providing security should not be decided solely by the legal representative. If a legal representative of a company is to provide security for other companies, the board of directors or shareholders’ meeting of the company should make resolutions in this regard, pursuant to its articles of association as the basis and source of authorization.

If the legal representative acts in excess of its authority, the validity of the contract of guarantee will be decided based on whether the creditor enters into the contract in good faith. If yes, then the contract is valid, and vice versa.

Before the issuance of the Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts, courts had different opinions regarding how to determine a bona fide creditor in practice.

The mainstream view is that, even though the act of the legal representative does violate the provisions of articles of association, the effectiveness of such an act will not be impaired unless the company can prove that the creditor knows, or should have known, that the legal representative is not duly authorized. Otherwise, the court should decide that the creditor is a bona fide counterparty as provided in the Contract Law.

The minutes clarify that a creditor will be deemed bona fide only when it proves that it has reviewed the board resolution, or resolution of the shareholders’ meeting, and the quorum voting for the resolutions and signatories complies with the provisions of the articles of association when it enters into a contract of guarantee.

For this reason, when a company and a guarantor enter into a contract of guarantee, it should request the guarantor to produce its articles of association and effective board resolution, or resolution of the shareholders’ meeting, made as per the articles of association.

The guarantor is a natural person. When the guarantor provides security to the creditor, the creditor’s right may be realized by disposition of the guarantor’s assets, which may be difficult to enforce generally because of the existence of co-owners. It is provided, in the Judicial Interpretation of the Supreme People’s Court on Issues Concerning Application of Laws in Trial of Cases Involving Marital Debt Disputes, that the liability assumed by either a husband or a wife in excess of necessary liabilities incurred from family life during the period in which they are under relationship of marriage does not constitute marital joint debt. For this reason, if a natural person provides security in his/her own name for others, such security obviously exceeds the liability incurred from his/her family life. Such security can hardly be determined to be marital joint debt.

If the guarantor is a natural person, the parties concerned should first learn about the asset status and marital status of the guarantor. If the guarantor is married, his/her spouse may be required to sign the contract of guarantee as a co-guarantor, so as to ensure enforceability of the contract on the guarantor’s properties.

Contents examination

If the principal debtor is not the guarantor, change to the principal contract will have an impact on the liability for guarantee. The Security Law stipulates that the creditor and the guarantor can otherwise agree that the creditor and the debtor may amend the principal contract without the consent of the guarantor. The guarantor will assume its liability for guarantee as per the amended agreement.

The Judicial Interpretation of the Security Law, however, made some changes in this regard. The mainstream judicial view determined that rulings should be made in line with the provisions of the Judicial Interpretation of the Security Law. In the event of changes to the principal contract, the guarantor will not be responsible for additional liability for guarantee if the guarantor does not give its consent to such changes, and the changes exceed the scope of promised guarantee of the guarantor.

Therefore, the authors suggest that if a company and its debtor are to change and modify the principal contract, they should request the guarantor to re-issue a written commitment, or sign a supplemental agreement, to clarify that the guarantor will continue to assume liability for guarantee for the changed contents.

Dependency of guarantee. It is stipulated in the Security Law that the parties concerned may agree on the validity of accessory contract after invalidation of the principal contract. In judicial practice, however, the mainstream view deems dependency as the most obvious legal feature of the contract of guarantee.

If the principal contract becomes invalid, the object of guarantee as agreed in the contract of guarantee does not exist. Therefore, invalidation of the principal contract will invalidate the contract of guarantee. The minutes also invalidate the agreements between the parties concerned that exclude the dependency of guarantee.

The authors suggest that, in addition to the clause of “independent validity of contract of guarantee”, it should also be agreed that the guarantor will assume joint and several liability for the liability of recovery, liability for default, and liability for damages incurred from invalidation or cancellation of the principal contract.

In the meantime, based on the dependency of the contract of guarantee, the guaranteed principal creditor’s right should be the agreed creditor’s right. If the amount of creditor’s right in the principal contract is to be determined, or to be created, when the contract of guarantee is signed, the authors suggest that security be provided in the maximum amount.

In addition to these risks in execution of a contract of guarantee, the parties should also pay attention to the means of guarantee, scope of security, and period of guarantee. Therefore, a company should be discreet when it enters into a contract of guarantee to ensure legitimacy and effectiveness of the contract, and strong guarantee of the creditor’s right.

Li Weiming is a partner and Xiong Xiaorong is an associate at Tiantai Law Firm

Tiantai Law Firm
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xiongxiaorong@tiantailaw.com
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