Avoiding Mistakes in Loan Guaranties

By Daniel Wheeler, Buchalter Nemer

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 consequences.

Structuring Errors

• The overlooked guarantor. 
  

  • Corporate. Lenders 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. 
    

• Confusing co-borrower 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 analysis). 
  

• Ignoring fraudulent 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. 
  

• Not considering 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. 
  

• Regulation B. 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 permitted. 

Documentation Errors

• 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 outdated. 

  • 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.
  

• Improperly limiting 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.

Enforcement Errors  

• Inadvertently limiting 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.
  

• Not considering 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 expectations.

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