Mistakes in Loan Guaranties
By Daniel Wheeler,
There are several common
mistakes made in the structuring, documenting and enforcement of guaranties.
Some are minor (and even debatable), like confusing the term “guaranty,”
which refers to the document and the term “guarantee” which refers to the
act of the guarantor under the guaranty. Other mistakes can have serious
sometimes fail to obtain supporting guaranties from subsidiary, parent
and sister entities simply because an entity was overlooked.
Personal. A lender
may obtain the guaranty of the principal owner of a business but fail to
realize that the individual actually holds very few assets in his or her
name because the individual has transferred all material assets to one
or more trusts. If those
trusts are irrevocable trusts, then the lender will have little recourse
against the assets.
and guarantor status. Generally, if a party is directly or indirectly
receiving the proceeds of a loan and should be subject to the loan
covenants, a lender should make that party a co-borrower. If a party is not
receiving the proceeds of the loan, even indirectly, then the party is best
suited for guarantor status (if allowed under a fraudulent transfer
transfer risks. Lenders must document the solvency of each guarantor and
the value each guarantor receives from supporting the loan in order to
defend against potential fraudulent transfer claims in bankruptcy. For this
reason, it is sometimes best to limit the guarantor’s liability
appropriately. Given the difficulty in documenting “equivalent value”
received by subsidiaries and sister entities, lenders should carefully
consider the alternative of taking the stock in the entity as collateral,
obtain a covenant preventing pledge of the subsidiary’s assets and filing
UCC notice of that negative covenant.
alternative letter of credit structure. Frequently, a lender can obtain
the same legal and underwriting result with fewer risks by obtaining a
letter of credit from the party that would otherwise be a guarantor. Such an
approach can entirely avoid the bias in the law in favor of guarantors and
instead take advantage of letter of credit law that is biased in favor of
beneficiaries. In litigation, a letter of credit is more likely to be
resolved on a motion for summary judgment whereas a disputed guaranty is
more likely to go to trial.
Failing to secure the
guaranty. Too often, lenders fail to consider whether a guaranty should
be secured or not.
Lenders sometimes forget that they may not take spousal guaranties as a
matter of course. In loans where a spousal guaranty is necessary to ensure
recourse against collateral, or where the lender’s analysis indicates that
no other suitable guarantor is available, then spousal guaranties are
Failure to include
requisite waivers. Many states have in place extensive statutory and
common law protections of guarantors. However, most of these protections can
be waived if the requisite waiver language is included in the guaranty.
Errors related to waivers arise in the following situations:
The lender uses a
form from an unreliable source such as by copying a guaranty from
another transaction that may be based on another state’s law or may be
The lender modifies a
standard guaranty form inappropriately, such as by making the guaranty a
guaranty of collection only.
The lender uses a
shortened form of guaranty in an effort to reduce a perceived
documentation burden on its customers. Such a form may contain the key
language of guaranty but omit crucial waivers needed to defend against
attacks on the enforceability of the guaranty. This problem commonly
arises in the consumer loan context where there is significant marketing
value in having a short document.
Failure to include
covenants in the guaranty. Many lenders require periodic financial
reporting from the guarantors but fail to include these covenants in the
guaranty. This means that the covenant could be inadvertently modified in
the course of negotiations with the borrower. There are also potential
weaknesses or delays in not having the guarantor expressly and directly
agree to such covenant in the guaranty.
the guaranty. Take the example of a guaranty of a $1 million loan that
says that the liability of the guarantor is limited to 1/3 of the debt. If
the loan is reduced to $300,000 after recourse against the borrower and sale
of collateral, the most the guarantor can be held liable for is $100,000
(1/3 of the remaining debt of $300,000). If the guaranty had instead
provided that the liability was limited to 1/3 of the debt when the loan was
made (plus any subsequent increases), then the guarantor could have been
made liable for the full $300,000. Another common limitation error is the
use of an expiration date that does not take into account extended
collection periods after the loan’s maturity date or contractual
extensions of the maturity date
No notarization. Guaranties
need not be notarized in California to be enforceable.
However, notarization can defeat the guarantor’s argument that he
or she did not actually sign the guaranty. Another helpful step is to
include the guarantor’s home address to facilitate service of process.
recourse against the guarantor. If a guaranty is secured by real
property in California, then the lender is subject to the various risks
presented by the “one form of action” rule, including the inability to
enforce the guaranty against anything other than the real property.
whether the guarantor’s consent should be obtained. Banks should
always carefully consider obtaining the written consent of the guarantors to
any loan modification to avoid litigating the argument that the modification
changed the guaranteed obligation beyond the guarantor’s legitimate
to October 2009 Lending & Credit Digest>
Wheeler is senior counsel at Buchalter Nemer and specializes in
representing independent banks. He can be reached at 415-227-3530
This article provides general information only and may not be construed as
legal advice to anyone.