Previously published by Law360 on November 10, 2011.
Law360, New York (November 10, 2011, 5:06 PM ET) -- Many lenders routinely require the principals of their small business borrowers to personally guarantee the payment of a loan. Guarantees are also commonplace in commercial real estate loans. Normally, guarantors agree to the obligations because they are excited about the deal that is being financed and want the loan to go through. This was certainly the case throughout much of the previous decade when businesses borrowed freely, companies expanded rapidly and developers raced to break ground on the next big development.
Then the markets collapsed and those same companies defaulted on loans one after the other. Some lenders successfully foreclosed on the collateral; but, some found that unless they obtained the collateral quickly and easily, the expense of foreclosing seemed to increase at an inverse proportion to the amount of time expended. When there was a deficiency or the collateral had no realizable value, lenders looked to the guarantors to make them whole. Some guarantors, however, refused to go down quietly.
When the guaranty is your last and only source of meaningful recovery, you may find that enforcing the guaranty is more difficult than you originally thought and may not yield as much recovery as you had hoped. While there is no specific language that will make a personal guaranty foolproof, all lenders should keep certain things in mind. This article will cover what lenders should consider ahead of time when crafting a personal guaranty and things to consider when collecting on one.
Personal Guarantees: An Enforceable Contract
Guarantees are contracts and are generally enforceable, especially against sophisticated borrowers and guarantors. Unsophisticated guarantors, on the other hand, may garner sympathy from a judge who scrutinizes the terms and conditions of the guaranty. All guaranty contracts, regardless of the guarantor's level of sophistication, must be supported by adequate consideration. This is not an issue when the guaranty is executed as part of the original loan, but separate consideration must accompany any guaranty that is executed after the loan transaction. This consideration can come in the form of new credit or a modification to the loan that benefits the borrower and guarantor.
Dealing Successfully with Loan Modifications
Loan modifications are frequently the central issue in disputes between lenders and guarantors. If the parties to the lending relationship want to keep open the option of modifying the loan, the lender should make that point explicit in the guaranty. The general rule is that modifying loans in ways that materially increase the guarantor's exposure without prior consent can have the effect of discharging the guarantor's obligations. In fact, if the guarantor is a gratuitous surety (as opposed to a compensated surety), any material modification — regardless of risk exposure — may result in a complete discharge.
One way to deal with this situation, especially if the loan was extended years ago and the guaranty did not include prior consent, is to require the guarantor to sign a consent or a new guaranty each time the loan is modified. However, this does not address a situation where there are multiple guarantors and some are unavailable, or perhaps even deceased. Therefore, it is best to obtain prior consent and include specific language in the original guaranty highlighting that the guarantor's obligations apply not just to the existing loan but to all other obligations that may arise in the future.
The language typically used to capture this obligation is "all amounts now or hereafter owing" or "whether now existing or arising hereafter." While these phrases are commonly accepted, it may be easier to use "all obligations and indebtedness now existing or arising in the future." The "in the future" language is much easier for a judge to pick out when analyzing a guaranty. This should be followed by an acknowledgment that the lender and borrower have the unrestricted right to renegotiate and materially modify the loan in ways that may increase the guarantor's risk without his or her consent. In at least one jurisdiction — Pennsylvania — it is important to specify that the guarantor gives prior consent to "material modifications that may increase his risk." It is not enough to obtain prior consent to material modifications that "vary" the risk; the essential term is "increase" the risk.
When a guaranty includes prior consent to future modifications, it is not necessary for lenders to obtain consent from the guarantor each time the loan is modified. However, out of an abundance of caution, some lenders do this anyway. If a lender decides to obtain consent to the first modification, it is recommended that the lender obtain consent to each and every subsequent modification. Otherwise, the guarantor has a basis (albeit a weak one) to argue that he did not consent to the latest modification despite his prior consent. This argument, depending on the inclinations of the court hearing the dispute, may be enough to survive your motion for summary judgment.
This same logic applies if the lender decides to obtain contemporaneous consents from multiple guarantors to each subsequent modification. There is a risk associated with this decision because if one of them is unable to sign subsequent consents the lender is then left in a difficult position. Further, if a dispute arises years later, the guarantor who did not sign the consent can argue that he should be discharged because the lender "chose" to only obtain consents from other guarantors but not him. Similar to the previous example, this argument should not prevail under the law, but may be enough to survive summary judgment.
Insist on a Confession of Judgment Clause — If Available in Your Jurisdiction
In addition to obtaining prior consent, lenders should insist on a confession of judgment clause if such a procedure is recognized in the governing jurisdiction. This clause allows lenders to skip the entire process of a trial and obtain a judgment against the guarantor "by confession." While not all states recognize this procedure, a lender may want to include choice of law and consent to jurisdiction clauses that require the application and jurisdiction of a state that recognizes confessions of judgment, assuming the transaction has sufficient contacts with the state selected
Without a confession of judgment clause, you must commence a lawsuit to enforce the guaranty. Even if you think your case is strong, the lawsuit will move at the mercy of the pretrial scheduling order and you will need to go through the usual phases of litigation. Meanwhile, because you do not have a judgment yet, the guarantor could attempt to shift or transfer assets, forcing you to consider whether the guarantor engaged in actionable fraudulent transfers.
A confession of judgment clause is not a perfect safety net for lenders, however. Even if a guaranty includes an enforceable confession of judgment clause, a lender should be aware that enforcing the guaranty is not as simple as filing a few documents with the court and obtaining an immediate judgment. An obstinate guarantor is likely to file a petition to strike or open the judgment, and he has an outside chance of prevailing because courts impose stringent standards upon judgments entered by confession. As a lender, if you find yourself in an unsympathetic venue, you may end up in front of a judge who will read the guaranty line by line looking for any possible defect to justify his or her inclination to strike or open the judgment. Once opened or stricken, you will need to proceed on the complaint to justify your judgment or file a new complaint.
Executing on the Guarantor's Assets
After a lender obtains a final judgment against the guarantor, the next step is to attempt to execute on the guarantor's assets. This is not a complicated process, but it takes time. If the guarantor has significant assets, a lender can takes steps to attach those assets. If the lender is a bank, and the guarantor maintains a sufficient deposit account with the lender, then the lender can offset those funds.
There is a chance that a judgment against a guarantor may trigger defaults on the guarantor's other transactions and the guarantor will be eager to strike a deal. But if the guarantor has no significant assets, or if the guarantor's greatest asset was an ownership interest in the defaulted borrower and/or the guarantor used most of his liquid assets to support his struggling business activities, a lender may have no immediate or clear path to relief. Other times, the guarantor's assets are beyond the lender's reach, such as marital assets and partnership interests.
While it would be ideal at the outset to require a co-guaranty from the spouse and a collateral pledge of the guarantor's other business interests, neither may be realistic in practice. Regulation B of the Equal Credit Opportunity Act prohibits creditors from requiring the signature of a guarantor's spouse so long as the guarantor meets the lender's standards for creditworthiness (known as the "spousal signature rule"). Even if one of the exceptions to this rule applied, marital property may not make the most stable collateral because the couple could divorce. Partnership interests and shareholder interests in unrelated businesses may also not be the best collateral to secure a guaranty because a pledge of these assets may require consent from the other partners or shareholders.
Perhaps the best way to increase the likelihood that the guarantor will have attachable assets in the event of a default is to (1) require annual financial statements from the guarantor to gain a better understanding of what assets are solely and jointly owned, (2) require the guarantor to maintain a certain amount of solely-owned liquidable assets at all times, and (3) require a pledge of those assets as security for the guaranty. When the lender is a bank, the guarantor should be required to maintain a minimum balance on deposit. If none of these conditions can be achieved, lenders must be prepared for the possibility that there may not be sufficient recovery from the guarantors. In summary, the majority of guarantees are upheld by the courts, but it may take some effort to ultimately convince a trial judge to enforce the guaranty, especially if the borrower is unsophisticated or can offer some form of defense. The best way to address this issue is to strengthen the guaranty from the outset and take measures to ensure that the guarantor has sufficient executable assets in the event of a default by the borrower. Otherwise, there may be no point in requiring a guaranty at all.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.