Guaranties

A friend was asked to guarantee repayment of a business loan being made to a company in which he is a substantial shareholder but not part of the management team. The proposed guaranty looked like this.

For value, I (the "Guarantor") unconditionally (1) guarantee payment and performance when due, and not merely collection, of all present and future debts, liabilities, and obligations of the Company to the Lender (the "guaranteed obligations"), (2) consent to extensions of time, material modifications, impairment of collateral, waivers, and forbearance without notice to or consent from the Guarantor, (3) waive notice of default and/or dishonor, presentment, claims in recoupment, rights of recourse (including reimbursement, contribution, and subrogation), and defenses based on illegality of the transaction giving rise to the guaranteed obligations or this guaranty (duress, lack of legal capacity, fraud, etc.), and defenses based on suretyship or impairment of collateral, and (4) agree to reimburse the Lender for all fees and costs incurred in enforcing the guaranteed obligations and this guaranty, including reasonable attorney fees, whether or not any civil action, arbitration proceeding, or bankruptcy claim or proceeding is filed, tried, or appealed.

I had the following discussion with my friend about the guaranty, which may also help you in your own thinking about whether or not to ask for or give a guaranty.

A guaranty, like any other contract, requires consideration (something of value) to be enforceable. However, unlike other contracts, a guaranty is enforceable even if the Guarantor does not receive any direct benefit. As long as the Company (the "principal obligor") receives consideration, in this case the loan, the guaranty will be binding and enforceable against the Guarantor. Obviously, my friend was willing to sign the guaranty only because he is a substantial shareholder in the Company and will receive indirect benefit from the guaranty.

The guaranty is of "payment" and not merely "collection." What this means is that the Lender can demand payment from the Guarantor immediately upon a default by the Company. The Company is not obligated to first try to collect from the Company or to foreclose against the collateral. A collection guaranty is very different. The Lender first would have to repossess and sell the collateral, sue the Company for the deficiency, and have the judgment returned partially unsatisfied before the Lender could collect from the Guarantor.

The guaranty covers all present and future debts, liabilities, and obligations of the Company to the Lender. Since my friend is not a member of the management team and is therefore unfamiliar with the daytoday operations and working capital needs of the Company, I recommended that he try to limit the guaranty either to a specific dollar amount or to repayment of the specific loan, including principal, interest, fees, and collection costs. If the Lender were willing to agree to such a limit, the Lender probably would also want the Guarantor to guarantee performance of the Company’s covenants relating to the collateral and the Lender’s security interest, such as payment of taxes and insurance.

I recommended to my friend that he ask for a new clause requiring the Lender to give him notice of any default by the Company and an opportunity for ten days or so to cure (or to cause the Company to cure) the default before the Lender could accelerate the due date of the loan or exercise any other right or remedy. That right will give the Guarantor an opportunity to avoid acceleration of the due date of the loan by curing the default and the opportunity to work out what problems caused the default in the first place. While such a clause appears to restrict the Lender’s rights and remedies on a superficial level, it can be attractive to the Lender because it helps the Lender report the loan as current rather than past due. Most lenders would prefer to see their loans paid "as agreed" as opposed to having to sue and/or foreclose after a default.

The guaranty includes the Guarantor’s consent to extensions of time, material modifications of the guaranteed obligations, and impairment of collateral, and a waiver of defenses based on suretyship or impairment of collateral without notice or consent. I recommend that my friend delete "material modifications of the guaranteed obligations, and impairment of collateral" from the consent clause and the phrase "and a waiver of defenses based on suretyship or impairment of collateral." With those changes, the Lender can still grant the Company extensions of time without discharging the Guarantor from liability but must get the Guarantor’s consent before making material modifications to the note or security agreement or releasing or impairing collateral. This assures the Guarantor that he will have a "seat at the table" if a workout is necessary. The change protects the Guarantor’s recourse rights.

I recommend to my friend that he also delete the waiver of defenses based on illegality of the underlying transaction (things like duress, fraud, lack of capacity, or violation of some other law). My reasoning is that the Guarantor’s liability, which is secondary, should be discharged if the Company’s liability, which is primary, is released by operation of law.

The guaranty also waives presentment and notice of default. For the reasons stated above, I want my friend to receive notice of any default and to have the opportunity to cure that default before the Lender can accelerate the due date of the guaranteed obligations. That requires deleting "and notice of default." To waive presentment means that my friend is waiving the right to require the Lender to show him the guaranty before it can be enforced.

Lastly, I recommend to my friend that he delete the waiver of rights of recourse. Why? Because the rights of recourse are the fundamental rights of a surety or guarantor. What are these rights? Basically, the Guarantor has the right to recover what he has paid to the Lender under his guaranty from the Company and the collateral. For almost ten years, creditors have been saying that it is necessary for a guarantor to waive his recourse rights to avoid a trustee’s avoidance powers because of the holding in the DePrizio case. The waiver language and lender position have lived on, unfortunately, long after Congress overruled the DePrizio case by 1994 amendments to Section 547 of the Bankruptcy Code.

The guaranty requires the Guarantor to reimburse the Lender for the attorney fees and costs that the creditor incurs in enforcing the guaranty whether or not a civil action or bankruptcy proceeding is filed, tried, or appealed. The Lender clearly doesn’t want its recovery discounted by the costs it incurs in collection. If a civil action or bankruptcy proceeding is commenced or appealed and the Guarantor prevails (wins), ORS 20.096 authorizes recovery of attorney fees and costs by the Guarantor even though the guaranty appears to allow only the Lender to recover such fees and costs. However, if the guaranty is enforced by negotiation or other nonjudicial means, only the Lender will be entitled to its attorney fees and costs.