30/10/2008

The events of the last few months in the international finance sector suggest that credit may be scarce in the foreseeable future and loan conditions tougher. 

 

Super funds wanting to borrow under s.67(4A) of the SIS Act might be faced with a requirement from their lender that the Fund arrange a third party personal guarantee to support the security for the loan.  Of course that guarantee will most likely be given by a member of the Fund.

 

How will the Fund handle this in light of the ATO’s Taxpayer Alert 2008/5 which, among other things, casts doubt on the compliance issues surrounding the giving of such personal guarantees?

 

The ATO states in the Alert:

 

“a personal guarantee [given by a third party, particularly … a member or a related party of the SMSF] may result in recourse being made to the assets of the SMSF other than the [secured] asset in the event that the guarantee is enforced against the trustee as the principal debtor contrary to the intent that the exception in subsection 67(4A) … only applies to limited recourse borrowings.”

 

Apparently (it is not stated in the Alert) the ATO’s argument is that the guarantor would have an indemnity from the trustee of the borrowing SMSF and may also be subrogated to the rights of the lender against the trustee of the borrowing SMSF, which in both cases would make all the fund’s assets available to repay the loan, which is at least a breach in spirit of s.67(4A)(d) of the SIS Act which requires that

 

“the rights of the lender … for default on the borrowing … [be] limited to rights relating to the original asset …”

 

A contract of guarantee is (subject to any qualifications made by the particular instrument) generally a promise by person A (‘guarantor’) to pay the debt of person B (‘borrower’) to person C (‘lender’) if person B defaults.

 

The terms ‘guarantee’ and ‘indemnity’ are often used interchangeably but are in fact not quite the same.  An indemnity is a promise by the person A that they will keep person C harmless against loss as a result of C making a loan to person B. Almost invariably a personal guarantee document required by a main stream lender will be both a guarantee and an indemnity.

 

What are the rights of the guarantor if the debtor defaults on repayment of the loan and the guarantor has to pay an amount to the lender pursuant to the guarantee?

 

Firstly, unless the written guarantee document says otherwise, the guarantor has a right to be indemnified by the principal debtor for the amount paid by the guarantor to the lender under the guarantee. The courts will imply such a right as a term of the guarantee. A guarantor may claim an indemnity once payment has been made on behalf of the debtor.

 

Secondly is the concept of “subrogation” which is sometimes described as allowing one party to ‘stand in the shoes’ of another and to exercise rights which are or were available to that other person.

 

A guarantor is therefore entitled, when it pays the lender the guaranteed debt, to be “subrogated to” (ie stand in the shoes of) the lender’s rights against the borrower.  As part of that right the guarantor has access to the security that the lender holds in respect of the debt.

 

Again, this right may be excluded by agreement.

 

But there’s a catch which the ATO Alert doesn’t mention.  The cases demonstrate that a guarantor inherits the same rights to a security interest that the lender had at the time the guarantor paid the borrower’s indebtedness to the lender.  As a result, if the lender’s security was limited in some way (eg a limited recourse loan) then so too will be the guarantor’s rights when they inherit the security.

 

In the context of a borrowing by a super fund, because the lender is only entitled to access the secured property (the ‘limited recourse’ loan) the guarantor, in being entitled to take over the lender’s rights, is similarly only entitled to have access to the secured property.

 

So is the ATO’s concern legitimate?  As the guarantor’s right to subrogation can only ever be as good as the lender’s original rights against the borrower, the guarantor cannot have access to all the fund’s assets but only to the same assets as the lender had, namely the secured property.

 

Unlike the right of subrogation, however, the guarantor’s right of indemnity is not limited.  It therefore entitles the guarantor to have access to the fund’s assets.

 

So is it possible to grant a third party guarantee without running foul of the issues raised in the Alert?  To provide a personal guarantee that does not breach the SIS Act requirements and meets the concerns expressed by the ATO it is necessary to ensure that

 

- the right of the indemnity is excluded so the trustees of the borrowing fund have an agreement (written and signed) with the guarantor that the guarantor has no right of indemnity

 

- the right of subrogation is excluded so the trustees of the borrowing fund have an agreement (written and signed) with the guarantor that the guarantor has no right of subrogation to the rights of the creditor

 

- the guarantee agreement specifically excludes any right the lender might otherwise have to recover on default by the guarantor against the guarantor’s interest in the super fund whether direct as member or indirect as trustee of the fund; and

- the loan agreement between the borrowing fund and the lender makes clear that the lender’s only recourse on default vis-à-vis the borrower is the mortgage over the secured property.

 

Please contact Townsends Business & Corporate Lawyers on (02) 8296 6222 for more information.