Scope of Rules Concerning Personal Guarantee Agreements (Report of Workshops (4))
Kazutoshi Sugimura *, Masaru Itatani, Masaki Bessho (Bank of Japan)
Research LAB No.17-E-4, March 17, 2017
Keywords: personal guarantee; cumulative assumption of obligations
JEL Classification: D86, K12
Contact: firstname.lastname@example.org (Masaru Itatani)
- Currently the Ministry of Finance.
The draft legislation revising the Law of Obligations (the Civil Code) introduces a number of new rules which impose procedural requirements on the personal guarantee agreement formation process.
These new rules are desirable as people becoming guarantors without adequately considering the risks involved has been a major social problem in Japan. However, there are a number of other forms of contractual arrangements which have similar legal functions to personal guarantees. The Report of the Workshops on "Contemporary Financial Transactions and Their Regulatory Treatment" (2016) (the "Report") discusses the appropriate scope of the new requirements when parties employ forms of contractual arrangements other than personal guarantee agreements in order to achieve a similar legal function. The Report uses an analytical framework from the economics literature as a point of reference for legal discussions.
The draft legislation revising the Law of Obligations (the Civil Code) (hereinafter referred to as the "Obligation Law reform") introduces a number of new rules which impose procedural requirements on the personal guarantee agreement formation process. For example, in order to form personal guarantee agreements for business loans, the agreements should be executed as notarized deeds.
In addition, the Obligation Law reform is aimed at imposing a new requirement on obligors to disclose information to the guarantors when they call for personal guarantees with respect to business loans. Personal guarantee agreements that violate the rules are void or can be annulled.
Do these new rules apply to other contractual arrangements? A number of contractual arrangements serve similar functions to those of personal guarantees. These arrangements in essence enhance the creditworthiness of obligors by relying on third parties' personal creditworthiness. Often cited examples include a "cumulative assumption of obligations" and guaranty insurance, for which the Civil Code does not impose particular requirements. It may also be possible to purchase types of insurance such as credit insurance or to use credit default swaps ("CDS"). Similar functions can be realized by "pre-contracts for loan sales exercisable by one party" or by using put options on loans.
If the new rules are applied to other forms of contractual arrangements that serve similar functions to personal guarantees, the notarized deed requirement or the obligation to disclose information may become a substantial burden on the contracting parties. If there is uncertainty about the scope of the new rules, it may have chilling effects on the development of innovative financial transactions.
Tightening of rules concerning personal guarantees
Personal guarantees have long been a major cause of social problems. Many people have had their lives ruined because of personal guarantee obligations assumed out of a sense of pity or ignorance of the risks involved.
In order to protect personal guarantors, the 2004 revision of the Civil Code introduced a new procedural safeguard stipulating that personal guarantee agreements are generally null and void unless executed in writing. With regard to contracts for "revolving guarantees on loans," the 2004 revision stipulated that they were void unless the maximum amount of the guarantee obligation was specified in a contract. It also stipulated the statutory duration of such contracts.
The Obligation Law reform further proposes to tighten the rules in order to protect personal guarantors.
First, the proposed rule stipulates that as a general rule, personal guarantee agreements are to be executed as notarized deeds when third party guarantors who are not proprietors of the business are called for in order to supplement a business loan contract. Personal guarantee agreements are void unless "those who become guarantors have expressed the intention to assume obligations in notarized deeds created within one month before conclusion of the agreement." The reason for the new requirements is to secure a means to verify the said intention. The drafting document for the Obligation Law reform explains that personal guarantee agreements should be void unless "the third party guarantor has made a sound and autonomous judgment to provide a guarantee."
Second, a new disclosure requirement is being introduced for personal guarantees. Specifically, when principal obligors ask third party individuals for personal guarantees for principal obligors' business obligations, they are obliged to make to such individuals disclosures of (i) their personal assets, revenue and expenditure; (ii) their obligations other than the principal obligation, including their amounts and performance status; and (iii) encumbered assets for the principal obligation. If principal obligors violate the disclosure obligation and obligees know or should have known about the undisclosed facts, said guarantors may cancel the guarantee agreement. The drafting document explains the reason for the new requirement as follows: "In some cases, guarantors unexpectedly have to perform guarantee obligations. Even in such cases, guarantors are rarely able to invoke the legal defense of 'mistake in an element of the juristic act' or 'fraud.' Personal guarantors should be protected through the proper disclosure mechanism."
Intent and purpose of personal guarantee regulation
The economics literature provides two cases in which personal guarantees are efficient:
The first case is when the level of risk appetite differs between obligees and guarantors. When the risk aversion level of a guarantor is lower than that of an obligee, it is more efficient to allocate risk to the guarantor. This type of analysis provides a good explanation of the economic foundations of guarantees assumed by surety companies or credit guarantee associations. A similar analysis also applies to insurance and CDS.
The second case is when there is asymmetry of information about principal obligor's credit risk between obligees and guarantors. When an obligee cannot precisely evaluate the credit risk of a principal obligor, he/she will resort to guarantee contracts instead of raising lending rates. Guarantee contracts have a screening or signaling function, while increasing lending rates may end up attracting only high-risk borrowers through adverse selection. Guarantors have an incentive to monitor the principal obligor, because guarantors have to perform the guarantee obligation if the principal obligor defaults on the underlying obligations. If guarantors can effectively perform monitoring activities at a lower cost than can obligees, personal guarantees may lead to greater efficiency.
For such monitoring to be carried out successfully, the social ties between principal obligors and guarantors must be close. Furthermore, guarantors should be able to obtain information on principal obligors that cannot be obtained by obligees (or can only be obtained at a high cost). If social ties are now becoming weaker in Japan (probably a universal phenomenon in developed countries), there are presumably fewer cases in which personal guarantees effectively and efficiently mitigate the asymmetry of information problem. As mentioned above, people becoming guarantors without adequately considering the risks involved and eventually having their lives ruined have been a major social problem in Japan. Evidently, the harmful impacts of personal guarantees have been more prevalent than their benefit (i.e. improving efficiency by addressing information asymmetry). One source of motivation for the recent series of Obligation Law reforms to add procedural requirements on the personal guarantee agreement formation process is the desire to address the cause of this social problem. The proposed rules (e.g. a requirement for notarized deeds and an obligation to disclose information when a personal guarantee is called for) are aimed at least at deterring people from the irrational execution of personal guarantee agreements.
Scope of rules
With respect to the rules concerning personal guarantees, it has been pointed out that they could be evaded by using "cumulative assumption of obligations" and other forms of legal arrangements. Careful attention was paid to this issue during the Obligation Law reform drafting process, but its legislative resolution was ultimately shelved.
If a transaction described as a "cumulative assumption of obligations" is executed but is characterized as a "personal guarantee" based on its substance, a guarantee obligation, rather than a joint and several obligation (which arises out of a true "cumulative assumption of obligations"), may arise. The word "characterization" refers to a procedure whereby legal acts such as contracts are classified into existing legal categories with a unique set of applicable rules. For example, even if the contracting parties' intention is to form a "cumulative assumption of obligations" but the parties' main purpose is to provide guarantees, it is appropriate to apply the personal guarantee rules.
Some guaranty insurance is used as a type of personal guarantee. If that is the case, the personal guarantee rules should also be applied.
In addition to arrangements characterized as personal guarantees, other forms of legal arrangements could also be subject to the personal guarantee rules. For example, if a person provides a personal guarantee with a nominal share of an obligation, it may be difficult to characterize it as a guarantee obligation. Such a guarantee is more akin to a joint and several obligation. However, if the parties' intention is to evade the personal guarantee rules, application by analogy of such rules is preferable.
On the other hand, it is not necessary to apply the personal guarantee rules to CDS. Financial instrument business operators, who usually act as counterparties to CDS transactions, are subject to solicitation requirements contained in the Financial Instruments and Transaction Law (Act No. 25 of 2011). They are obliged not to solicit in a manner considered inappropriate given the customer's intentions, knowledge, experience, property status, etc. (a narrower definition of the suitability rule). As long as financial instrument business operators comply with said requirements, overlapping application of the personal guarantee rules may not be necessary.
Personal guarantees are efficient when (i) the level of risk appetite differs between obligees and guarantors; or (ii) asymmetry of information exists with regard to the credit risk of principal obligors. Corporate guarantees, insurance and CDS presumably belong to category (i) above. Personal guarantees have previously belonged to category (ii) above, but they may have become less efficient because of changes in the social environment.
The Obligation Law reform is aimed at introducing new requirements for personal guarantees, whereby such guarantees must be executed as notarized deeds and obligors must disclose information to guarantors in order to prevent people from irrationally concluding personal guarantee agreements. If transactions labeled as a "cumulative assumption of obligations" or "guaranty insurance" are executed to evade the application of these rules, the personal guarantee rules should be directly applied to such transactions, at least to the extent that they are characterized as personal guarantees. Even if they cannot be characterized as personal guarantees, the personal guarantee rules may be applied more broadly in some cases.
- Report of Workshops on "Contemporary Financial Transactions and Their Regulatory Treatment" (2016), to be included in Kin'yu Kenkyu (Monetary and Economic Studies), Institute for Monetary and Economic Studies, Bank of Japan (forthcoming 2017) (in Japanese).
The views expressed herein are those of the authors and do not necessarily reflect those of the Bank of Japan.