Enforcement Issues in the New Wave of Loan Defaults – Common Pitfalls

By Tony Toranto

In the new wave of loans gone bad, lenders are already stumbling into some common pitfalls as they attempt to enforce their rights. This article is the first in a series of four that will highlight challenges the banking industry has not needed to worry about in boom times, but which are coming home to roost in the recent downturn.

Consider the following increasingly common hypothetical: You are a lender with a newly defaulted real estate loan. As you consider your alternatives, you go back through the loan documentation and see a guaranty made by the borrower’s revocable trust. When the loan was first made, maybe the guaranty was an important part of the underwriting, or maybe it was an afterthought that just seemed nice to have. Now, however, your real estate collateral may be worth less than the debt, but the guarantor has other assets. Can you enforce your guaranty and make up the difference?

There is a good chance the answer is no. At issue is a problem commonly called the “purported guarantor.” The problem arises anytime a person purports to incur liability as a guarantor for an obligation under which that person or its property is already liable. In California , the assets of the revocable trust in the example above would already be on the hook for the debt. Another common situation involves a loan made to a partnership with a guaranty executed by the partnership’s general partner. Other examples are not always obvious because the characterization in the loan documents of whether or not something is a guaranty may not be controlling. For instance, where multiple parties execute a promissory note ostensibly as co-borrowers, a court may find that some of them are in fact guarantors, or even that all of them are borrowers with respect to portions of the obligation and are guarantors with respect to other portions.

So what are the practical implications for our hypothetical lender of its purported guarantor problem? Simply put, the purported guarantor may be treated as a primary obligor that is entitled to all of the rights and defenses otherwise available to the borrower, and the purported guaranty may even be considered null and void altogether. Continuing with the example of California , if the hypothetical lender foreclosed on the borrower’s real estate collateral through a non-judicial foreclosure, the lender could not then sue the borrower to recover a deficiency if the proceeds at the foreclosure sale were less than the debt. Though the lender would have been able to sue a “good” guarantor for the deficiency, a purported guarantor is entitled to the same defenses as the borrower and is immune from a deficiency suit.

Of course, the best time to think about avoiding the purported guarantor problem is before the loan is made. But what can a lender do about the purported guaranty that is already on the books? The lender’s best alternative is to use the workout context to add other credit enhancements or collateral to the loan in exchange for some accommodation or forbearance.  Negotiating this is difficult, but workout discussions are often the only remaining opportunity for the lender to exercise some leverage. Of course, many lenders would be thinking about how to obtain additional security or credit enhancements even without a purported guarantor problem.  However, the lender who knows at the outset of a workout that its guaranty may be unenforceable will be better informed and therefore better prepared to make the most out of a difficult situation.

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