Undue Influence and Personal Guarantees

This article explores the circumstances in which the law relating to undue influence might assist a victim of fraud who has provided a personal guarantee in respect of a loan provided to a third party.

By understanding how the law might protect a victim of undue influence, and the factors that would need to be present for undue influence to be established, individuals can better understand whether they are able to avoid liability for personal guarantees they have been unfairly pressured into signing.

What is a Personal Guarantee?

A personal guarantee is a contractual agreement between the guarantor (which can be an individual or a company) and a lender pursuant to which the guarantor accepts responsibility to pay the borrower’s debt if the borrower fails to pay it to the lender. It is increasingly common for lenders to ask a third party to guarantee that the borrower will repay the lender as this reduces the risk to the lender of it not being repaid.

What is undue influence?

Undue influence is an improper pressure or coercion by which a person (i.e. in this case the guarantor) is induced to act in a particular manner that is not of their own free will and decision.

Undue influence can arise in two ways:

1. Actual undue influence arises from the direct action from a party (i.e. overt acts of pressure, coercion or threats). The burden of proving actual undue influence would be on the guarantor who must establish that:
   1. The guarantor’s consent to provide the guarantee to the lender was not given of the guarantor’s own free will; and
   2. There was improper conduct by a third party that led the guarantor to provide the personal guarantee.

2. Presumed undue influence arises within the context of certain relationships. For example, family relationships, teacher/pupil, religious leader/follower, doctor/patient, solicitor/client etc. In order to prove presumed undue influence, the guarantor would have to establish that:

1. 1. There was a pre-existing relationship of influence between the parties; and
   2. The transaction in question calls for explanation.

If the guarantor is able to establish the above, there is a rebuttable presumption that undue influence exists.

Can you avoid liability under a personal guarantee if undue influence is established?

It may often be the case that the guarantor states it was some third party exerting the undue influence as opposed to the lender. However, if the lender is affected by the third party’s undue influence, it may still be possible to avoid liability under the personal guarantee.

The leading case on undue influence in the context of financial transactions is Royal Bank of Scotland v Etridge (No 2) [2001].  The Court held that a lender is “affected” by the third party’s undue influence if the lender is “on notice”.  Notice can be:

1. Actual (in which the lender is unable to enforce the guarantee); OR
2. Constructive (where a lender is put “on inquiry” of the risk of undue influence within the context of the provision of the guarantee and therefore the lender may be unable to enforce the guarantee unless it can show it has taken particular steps in light of this).

In Etridge, it was confirmed that a lender is put on inquiry in every guarantee transaction where the relationship between the guarantor and the borrower is non-commercial. The case of Etridge involved eight appeal cases (in which 3 were dismissed and 5 were allowed) all involving a husband and wife relationship. The wife had agreed to a charge on the matrimonial homes as security for the husband’s loan for the husband’s business. The wife had no direct benefit. The business failed and the lender wanted to repossess the home. The wife claimed that she had been under undue influence by the husband to sign the security agreement and therefore the agreements should be declared void and the homes not be repossessed.  The Court held that in a relationship of this type and particularly where security is given over a joint matrimonial home but the loan will only benefit one of the parties, the lender is put on inquiry that there may be the risk of undue influence.

If a lender is put on inquiry, it must take reasonable steps to make it clear to the guarantor the risks and consequences of providing the guarantee and it must ensure that the guarantor has obtained independent legal advice (in the case of husband and wife each should give fully informed consent, which might involve each meeting a solicitor separately). If the lender fails to take reasonable steps, the lender may be considered to have constructive notice of the undue influence and the personal guarantee may be set aside by the court.

However, in a commercial relationship (e.g. where a sole director and shareholder provides a personal guarantee on behalf of a loan advanced to his own company), it is likely to be much harder to establish that a lender has any notice of the undue influence.

Conclusion

In certain circumstances, it may be possible to avoid liability under a personal guarantee even when the lender is not the party responsible for exerting the undue influence. However, careful consideration would need to be given in determining a) whether undue influence can be established and b) whether the lender is deemed to have notice of the undue influence.

It is always advisable to seek independent legal advice if you are being asked to give a personal guarantee. Lawyers have specialist knowledge of the relevant regulations, legislation and law and are best placed in helping you understand the implications, risks and potential financial consequences you may face in signing a personal guarantee.

Tenet has experience of helping victims of fraud and other guarantors who find themselves being held liable by lenders under the terms of the personal guarantee that they have given. If you would like to discuss any issues in relation to fraud, undue influence or personal guarantees, please feel free to contact us at hello@tenelaw.co.uk