02/08/2011

Guarantees are made to protect a lender in the event that a default occurs in repayment of a debt. Essentially, the lender loans to Jaclyn but Gavin promises to repay the lender if Jaclyn defaults. 

Indemnities are wider and seek to protect a party from any loss as a result of their loaning funds to another party. Essentially, the lender loans to Jaclyn but Gavin promises to not only repay the lender if Jaclyn defaults but also to pay any other losses that the lender may suffer such as legal fees, lost interest etc. 

For SMSFs which engage in limited recourse borrowing transactions the borrower is the trustee of the fund. Section 67A of the Superannuation Industry (Supervision) Act 1993 (Cth) requires that the lender’s rights or recourse are limited to the asset acquired with the loan.  

If Gavin has provided the bank with a guarantee to cover the SMSF’s default, and Gavin pays out the bank, he has the right to be indemnified (unless the guarantee document states otherwise) by the SMSF for the amount he had to pay the bank.

This is known as “subrogation”: the right to stand in the shoes of the other, as it were. Once Gavin has paid the bank to satisfy the SMSF’s debt, he can stand in the shoes of the lender (ie the bank) and require the SMSF repay him.  But, again unless the contract says otherwise, Gavin would only have the same rights against the SMSF as the bank had, ie limited to the acquired asset.

Despite this the ATO have expressed concern where guarantees are given by a member or related party of an SMSF (Taxpayer Alert 2008/5). 

If Gavin is a member of the fund then effectively his interest in the super fund is at risk if he can’t pay the bank under the guarantee. This is a back door way around the legislation and is not acceptable to the ATO.  They require that Gavin’s interest in the fund not be available to the bank under any circumstances.

More recently an additional issue has been raised in that a payment by a guarantor would be treated as a contribution where the guarantor forgoes the right of indemnity. This is where Gavin pays the bank, but does not seek to enforce the right of subrogation and recover the funds from the SMSF.

Ultimately, there are additional methods of recovery which raise a myriad of other issues, but when it’s narrowed down; when a guarantee for a limited recourse loan is honoured, providing that the guarantor exercises their rights of subrogation, in simple terms the rights of recovery will remain limited to the asset acquired. This is the same right as the bank originally had.

Indemnities are wider and not limited to the original rights of the bank which are of greater concern when signing in relation to limited recourse borrowing.

If you have any questions in regard to the above article, please contact TOWNSENDS BUSINESS & CORPORATE LAWYERS on (02) 8296 6222.