COMMERCIAL FINANCE – PART 8: GUARANTEES
In the previous post of this Series, we wrapped up looking security agreements and the primary remedies afforded by the various security agreements and we left off with guarantees. In this installment we will look at guarantees.
Guarantees will either be personal or corporate guarantees and this deals only with whether the guarantor is an individual or a corporation and they will either be a collection guaranty or a payment and performance guaranty.
The collection guaranty is one where the lender first pursues the borrower business for payment and after exhausting their attempts to collect from the borrower, because the business no longer exists or it has filed bankruptcy or some other action seeking debt relief, then the lender turns to the guarantor to pay the unpaid amount. Because a collection guaranty requires a lender to pursue the borrower first, it has become a disfavored guaranty process and is rarely used in commercial lending transactions.
More common is the payment and performance guaranty. This is a guaranty where the guarantor covenants to perform with or without demand at any time the borrower defaults. This type of guaranty upon default allows the lender to pursue the guarantor and the borrower at the same time for payment on the loan without regard to the borrower’s ability to pay the debt. Because of the ease with which a lender can pursue a guarantor under this type of agreement, it has become the preferred type of guaranty.
In addition to the types of guaranty, the guarantor should know what is actually being guaranteed. Is the guaranty a full performance guaranty wherein any default can trigger guarantor liability or does the guaranty create some sort of carve-outs where certain defaults will not trigger guarantor liability? Most guarantees these days are full performance guarantees but you still see the standard “bad boy” carve-out guarantees related to established businesses. The “bad boy” carve out guaranty is a guaranty where the guarantor is only liable if the business defaults based upon certain bad acts which are generally limited to filing for bankruptcy, dissolving the business or some sort of fraud or misrepresentation in obtaining the loan. Under this type up carve out the guarantor would only be liable if the company defaults for one of those above identified reasons. However, if the borrower defaults simply because it could no longer pay the loan then payment default would not, in and of itself trigger the guarantor liability.
Guarantees much like promissory notes and loan agreements contain a number of affirmative covenants (things the guarantor must do) and a number of negative covenants (things the guarantor cannot do). The primary covenants that are used in guarantees are financial disclosures wherein the lender requires the guarantor to periodically provide financial information including tax returns and bank statements. In addition, there are liquidity requirements that require a guarantor to maintain a certain amount of liquid assets and attest and provide proof periodically of liquidity. Failure by the guarantor to comply with these requirements can also lead to a default under the loan terms. In some situations, lenders may even restrict a guarantor from guaranteeing any other obligations, which for a business owner can be problematic as you may have multiple business loans at one time all of which require your guaranty.
The last component to be aware of is the concept of a sham guaranty. A sham guaranty is an unenforceable obligation. The concept behind sham guarantees is that the guarantor is acting as a surety for the borrower, meaning that the guarantor is acting almost like the insurance in case a borrower fails to perform its obligations. However, what routinely happens is that a lender either (a) requires the borrower to obligate itself as a guarantor or (b) the lender requires the borrower to create an entity and then guaranty the obligation as well. California law states that a guarantor cannot guaranty an obligation they already have. If the borrower executes a note they cannot also be liable on a guaranty. Because you are already required to perform under an agreement you cannot be required to guaranty your own performance because you cannot insure your own performance. Likewise, if a lender requires you form a company and then requires a guaranty, because that lender dictated the business structure for the purposes of the loan they cannot reap the reward on the guaranty. In lending defaults this is where the hotbed of litigation arises. Is the guaranty enforceable or not based upon a set of alleged defaults and the liability can be high?
Lenders in commercial transactions have sophisticated lawyers putting together voluminous one-sided loan agreements to protect themselves in financing transactions. It is important for you the borrower to understand what it is that you are signing and what the liability could look like and what events actually could trigger a default. The stakes are high and if you are looking to obtain a commercial loan you should have an experienced commercial finance lawyer assisting you. The lawyers at BPE Law Group have significant experience representing lenders, investors and borrowers in all types of financing transactions and attorney Keith Dunnagan is a court qualified expert on financing matters. The attorneys at BPE Law would be happy to assist you in your legal needs related to commercial finance transactions.
BPE Law Senior Attorney and Co-Manager, Keith Dunnagan, practices exclusively in the area of commercial transactions and finance. If you have any questions, you can reach him at 916-966-2260 or firstname.lastname@example.org.
For over 20 years, the attorneys of BPE Law Group, P.C. have been advising and representing business and property owners and investors in dealing with their legal needs. Check us out on the Web at: www.bpelaw.com. If you would like a consultation with us, please call our office at (916) 966-2260 or e-mail Keith Dunnagan at the above link.
This article is not intended to be legal advice, lending advice, or a specific recommendation of any particular lender or company, and should not be taken as such advice.