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Suretyship and uncertainty
- DBN Communication Manager Jerome Mutumba talks about the value and the need for proper management of suretyship for collateral

During the normal course of banking business, applicants for loans will be required to provide security for their loans. In response to this requirement, most SMEs applicants usually pledge residential dwellings as collateral for their loans, in cases where collateral is needed. Unfortunately as it turns out, many of the bonds come in forms of third party suretyship, be it limited or unlimited surety. This situation presents unpleasant encounters at recovery stage when the loan applicant defaults.

Recently, uncertainty and concerns surrounding the use of homes as collateral has thrown the issue of collateral and recovery of capital into the banking spotlight once more.

Moral and legal arguments are being advanced cautioning lenders against what could appear like reckless lending, particularly in instances where the third party surety was signed by a member of a vulnerable group of society, such as pensioners and women.

From the point of view of banking operations, and DBN is no exception, use of collateral is a requirement in order to share risk with the entrepreneurs and to ensure recovery of capital in the event of a default. Collateral often helps to align the borrower and the lender's interest and to aid in recovering capital so that development finance can be reassigned to other enterprises in the event of a default.

As many previously disadvantaged entrepreneurs and emerging entrepreneurs lack collateral, third party suretyship is a highly valued tool. Third party surety is simply some form of security which is provided by someone, often a relative or friend, other than the borrower or owner of the business. Suretyship allows a willing third party to provide the necessary collateral to a second party in the absence of assets for collateralisation on the part of the entrepreneur.

In the experience of DBN, third party suretyship is often offered on the basis of friendship and trust, not on a considered business basis. This makes it difficult for those signing surety to assess the business risks and by extension risks to their pledged assets. In many instances, where recovery of capital is required from a third party, DBN has found that the provider of surety is unaware of the implications of the guarantee and will contest the matter.

This leads to questions about management of suretyship and how disputes can be avoided. Although the dispute should be handled between the third party and the defaulter, there are several steps that can be taken to reduce the risk for all parties. In the first place, absolute clarity must be given to the third party of the implications of suretyship. Although the third party may sign the cession, with the clause on understanding, the implications may still not be understood, so the financier may choose to provide council and understanding to the third party.

If absolute clarity is provided before signature of the cession documentation, the risk of a legal contest will be reduced. If the third party withdraws before providing suretyship, this may also reduce the risk of default for all parties.

In the second place, a contract governing suretyship should be encouraged between the second and third party. The primary motive of the bank should be to recover capital from the defaulter, not from the third party. Although bank's see recovery as an operational matter, the broader moral principles of governance should consider the well-being of all parties to the transaction, so this second contract will also help to ensure the interests of the third party.

In the third place, the third party should be encouraged to participate in the business and understand the administration of the business as well as have an overview of the loan repayments. If the viability of the enterprise is in doubt, the third party should have the ability to take corrective action if he or she has the skills to do so. A share in the enterprise is advisable as this allows the third party greater say and the ability to ensure his or her own interests are guarded with managerial intervention.

DBN mitigates its risks not only through collateral but also through approval of business plans that have the highest likelihood of success in the considered opinion of the Bank. With greater awareness on the part of third parties, as well as the ability of third parties to intervene, it is possible that the Bank will find further means to mitigate its risks, and enhance the long-term viability of the businesses that it finances.


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