In its most basic form, the guaranty is an agreement (importantly it is the guarantor’s separate contract with lender) by one party to be responsible for the debt or obligations of someone else. We all know it and love it – it is the lender’s friend. But like so many friendships, when it is built on a fundamental misunderstanding or problem, a train wreck ensues and we feel the pain. Unfortunately, as of late, I have been seeing and hearing about more and more issues with guaranties (albeit I grant you that many are not as problematic as borrowers’ counsel argues.) Therefore, I thought it might be helpful to revisit this old friend by looking at key terms, concepts and some common defenses to a guaranty’s enforcement.
Absolute Guaranty Clause – The guaranty contains a clause in which the guarantor is promising that the guarantor will fully repay the obligation or perform, if the borrower fails to do so, regardless of certain events, such as material changes, release of collateral, etc. Better have it.
Conditional Guaranty – For the guarantor to become liable under this guaranty, in addition to default, something else must take place. An example, a Guaranty of Collection is a Conditional Guaranty, which is means that the obligations of the Guarantor only come into being after the lender has taken reasonable steps to recover from the borrower and has enforced its obligations in any collateral. These are not the norm and not recommended for a lender.
Continuing Guaranty – The guaranty is not limited to a certain note or event, but covers future transactions. Please note that a continuing guaranty can be revoked but the guarantor remains obligated to all then existing obligations. A lender should generally require the Unconditional and Continuing Guaranty.
Default – Most guaranties waive notice of Borrower’s default (and all guaranties should). Regardless of the waiver, it is best practice to notice (at least copy) all guarantors on any notices of borrower’s default. This is not only a pre-emptive strike against a guarantor’s defense but the guarantor may have more leverage than you do over a borrower and is required to get attorney’s fees from a guarantor.
Downstream Guaranty – It is a guaranty by the parent of a subsidiary entity. Reasonably equivalent value or consideration is generally inferred.
Hypothecate – One party pledging its property as collateral for the loan. This is not necessarily a guaranty but is only providing credit support essentially up to the value of that collateral.
Limited Guaranty – The guaranty is limited to a certain amount of the overall obligations of borrower. Please make sure that in this type of guaranty any limit does not include lender’s costs and expenses, legal and otherwise, which can still be sought in addition to the sum certain. These types of guaranties are sometimes useful in avoiding fraudulent conveyance issues.
Material Change in Debt or Borrower – This is another common defense to the enforcement of guaranties. Material changes include change in payment terms and maturity dates, increase in debt of borrower, and changes in identity of borrower. To address this defense, lender should require a guaranty absolute clause and obtain a reaffirmation of the guaranty in conjunction with the change.
Release of Co-Guarantor – This is another common defense to the enforcement of guarantors. Guaranties should allow for the release of a co-guarantor. If it does not, then the remaining co-guarantor has a defense to enforcement of the guaranty...even better is to also ask the remaining guarantor to reaffirm the guaranty at the time one guarantor is released.
Release or Impairment of Collateral – Yet another often heard defense to guaranties. To address this issue, the lender should ask the guarantor to reaffirm the guaranty.
Resolutions of Guarantor – Any corporate guarantor (including a limited liability company) should present the lender with a resolution approving and authorizing the guaranty. Failure to do this could result in a valid defense to enforcement because the guarantor could argue that there was no requisite corporate authority to enter into the guaranty. Additionally, the guarantor’s internal documents should be reviewed to confirm that the resolutions are properly ratified.
Spousal Guaranty – One spouse guarantees the debts or obligations of the other spouse. We all love spousal guaranties but please remember that you cannot require a spousal guaranty just on principal. Guarantors’ defense (or sword) du jour is that the lender by seeking and receiving a spousal guaranty has violated the federal Equal Credit Opportunity Act (ECOA). In other words, you cannot require a spousal guaranty when the applicant guarantor satisfies the lending requirements based on his or her individual assets. The ECOA is not intended to be a bar to requiring spousal guaranties, and in my opinion is being misused presently. It is something a lender should be cognizant of. The lender should be able to show that it analyzed and found the individual’s financials lacking under its standards before it required a spousal guaranty. Furthermore, the bank should be able to articulate in substantive terms why it is requiring the spousal guaranty, then document, document and document the file.
Upstream Guaranty – Guaranty by a subsidiary of a parental entity’s obligation. Reasonably equivalent value is not inferred in this type.
In Writing – Make sure that any guaranty is in writing and signed. Otherwise it is worthless...do not laugh at this one.
I recognize that these topics, terms and issues are old-hat to many of you. Regardless, I believe that they are of fundamental importance to understanding guaranties and working to ensure that each remains in effect in spite of the numerous attacks against their enforceability.
Timothy R. Moore is a member of the law firm of Spilman Thomas & Battle, PLLC. He heads the firm’s Community Banking Practice Group, Winston-Salem’s Corporate Department and was named a “Rising Star” by Superlawyers magazine in Banking and Finance in 2011.
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