What Is a Guaranty Agreement
When it comes to legal and financial transactions, one such important element is the guaranty agreement. In legal terms, a guaranty agreement is a written contract in which one party agrees to assume responsibility for the debt or obligation of another party in the event that debtor or obligor party is unable to make such payment or perform such obligation.
In a practical sense, guaranty agreements are typically used in real estate or commercial transactions in which a bank extends credit to a borrower in order to purchase real estate or a business and the bank requires that someone (often a shareholder or principal of the company that is the borrower) provides a personal guaranty of the debt of the borrower in favor of the bank . For example, if a corporation wants to borrow $100,000 to buy a factory site for a manufacturing business, the bank will extend the loan to the company and require that the company’s principal, Mr. Smith (a guarantor), sign a guaranty in which Mr. Smith guarantees that if the corporation "does not make its payments" to the bank for whatever reason, Mr. Smith will pay the debt owed to the bank personally.
The Components of a Guaranty Agreement
At the heart of every guaranty agreement are three key elements: the parties who enter into the contract, the obligation that is guaranteed, and the conditions under which the guarantor must perform its obligations. Although many guaranty agreements may look similar, there are often nuances between agreements that need to be considered in assessing the risk to the party relying on the guaranty.
First, who are the parties? The parties to the guarantee must be identified. The following are various parties that may be involved: the guarantor, the lender, the borrower, the seller, and the rated entity. The specific roles of each party should be stated in the guaranty agreement as well.
Second, what obligation is guaranteed by the guarantor? There are three general types of obligations that can be guaranteed:
Third, when must the guarantor perform its obligation? The conditions under which a guarantor must perform its obligation may be the most important part of a guaranty agreement for the lender or purchaser that is relying on the guaranty. The three major categories of performance conditions are:
Many times, depending upon the risk tolerance and financial condition of the borrower, a lesser standard of performance will be agreed to by the lender and the guarantor.
Forms of Guaranty Agreements
Even if the Bank holds a guarantee, that does not mean that they can collect on it regardless of the type of guarantee. In the case of a corporate guaranty, the Bank will not be able to collect on the guarantee if the corporation itself is not liable on the debt, either because the corporation is not really liable on the debt (the lender relied on the guarantee of the principle and not the corporation) or the corporation has not defaulted. The same is true if the Guarantor is an individual. If a Guarantor is a personal guarantor of the debts of a company, for example, and the company itself is not liable on the debt, or the company has not defaulted, the Bank cannot collect on the guarantee from the principal because he is not liable.
In addition to these types of guarantees, there are various types of guarantees:
- (1) Personal Guaranty: Personal guarantees are guaranteed, of course by individual persons. Small loans and debtors of small amounts may only require a personal guarantee. On a larger loan, the lender may require a personal guarantee in addition to a corporate guarantee. As long as personal assets would be available to satisfy the debt, a personal guarantee separate from the corporation’s guarantee is generally relatively easy to get.
- (2) Corporate Guaranty: Corporate guarantees are guaranteed by corporations. The lender may not want to extend credit to a corporation without adding a layer of security in the way of a corporate guarantee. They may want to name a parent company as a guarantor for the corporation if the parent company is stronger than the corporate borrower. Even if the corporate borrower is financially strong, the lender may require a corporate guaranty to satisfy any additional concerns they have about the corporate borrower. A corporate guarantor might be:
- Parent corporation of the corporate borrower;
- Company that owns the parent corporation, or
- Company that owns both the corporate borrowers and the parent corporation.
- (3) Conditional Guaranty: A conditional guaranty is a guarantee that is conditional on certain events. The conditional guaranty may be based on certain triggers such as net worth or income triggers. In fact, most commercial guarantees are conditional, because the Guarantor is free to back out of the deal if the conditions are not satisfied or the lender has not satisfied the conditions. A conditional guaranty only imposes personal liability on the Guarantor when the conditions are met.
- (4) Unconditional Guaranty: Unconditional guarantees are the opposite. Unconditional guarantees are backed by a Guarantor that has a high likelihood of being made liable for the obligations. They are unconditional guarantees that do not have conditions to its future obligation. Unconditional guarantees are "unconditional" until an event triggers the guarantee, usually something that the Guarantor has no control over.
How Guaranty Agreements Function
Guaranty agreements are commonly written as part of larger loan or credit agreements. Financial institutions often require borrowers to personally sign guaranty agreements in order to secure the debt associated with a particular loan. Guaranty agreements can also be made in order to secure financing for a business. The financial institution may require owners or investors with a certain level of ownership to personally sign and/or guarantee a particular loan for a corporation, LLC, etc. Guarantor(s) of a guaranty agreement are often required to cross-collateralize credit lines and assets in order for a guaranty agreement to take effect. This is another step in the process that provides extra security to the financial institution.
Once a borrower has agreed to the guaranty agreement, the guaranty agreement is often recorded at the land records (if the guaranty is real estate based) and executed in front of a notary public. If the guaranty agreement involves ownership or investment of a business, the guaranty agreement is then often provided to the corporation as an amendment to its bylaws. Thereafter, the guaranty agreement is binding on all parties listed in the guarantees.
Advantages and Disadvantages of Guaranty Agreements
Guaranty agreements can prove advantageous for both guarantors and beneficiaries. Whether or not these benefits are realized, however, may depend on the specific terms and the overall economic environment. For the guarantor, the benefit of a guaranty agreement is that it can create an economic opportunity and provide financing in circumstances in which the guarantor might not otherwise be allowed to borrow. The guarantor ensures that an investor can receive financing on the investment in the company. As a result, the company itself benefits because it can increase the amount of its investment (i.e., the amount invested by the investor) and the rate of return on that investment (i.e., by either borrowing more money, allowing the investor to invest more, or both).
Guaranty agreements can pose certain risks to the guarantor. The most immediate risk to the guarantor is that the guarantor’s personal assets could be subject to levy or garnishment in order to satisfy the terms of the guaranty. In addition, the guarantor grants the beneficiary a security interest in some or all of the guarantor’s assets with the execution and delivery of the guaranty. Although the guarantor provides the beneficiary with the authority to garnish or levy against his or her assets to enforce the guaranty agreement, enforcement of the guaranty agreement in accordance with its terms is dependent on the default of the underlying obligation (i.e., the investment in the company).
Guaranty agreements can be beneficial to the beneficiaries of the guaranty agreement as well . These benefits include broader collateralization to the investor and, therefore, a greater likelihood that the investor can fulfill its obligation on the underlying debt. Guaranty agreements can also provide the benefit of enhanced security. For instance, when an investor is considering an investment, it may want to secure the investment with the guarantor’s personal assets, or a portion of them. The enhanced security benefits the investment in several ways. If, for instance, the company has to liquidate due to insolvency, the assets pledged as security could increase the level of financing available for the asset. In addition, if the company defaults on the investment, the beneficiary can recover on the guarantor’s personal assets. Both scenarios create an opportunity for the beneficiary to recover any funding that may be lost in the liquidation or default of the investment. In addition, in the event the company files a Chapter 7 bankruptcy petition, the guaranty agreement is an asset of the guarantor that becomes part of the guarantor’s bankruptcy estate. The rights of the guarantor with respect to the guaranty agreement would be determined, among other things, by the provisions contained in the guaranty agreement and the applicable bankruptcy law.
The risks to the beneficiaries of a guaranty agreement are that it may be forced to incur costs in enforcing the guaranty agreement and may not achieve the recovery on the investment that it anticipates.
Legal Implications and Responsibilities
A guaranty agreement creates complex legal relationships between borrowers/debtors, lenders/creditors, and guarantors, and a number of important legal obligations for the guarantor that become binding when the guarantor signs the agreement. These obligations include that the guarantor must pay the secured parties’ fees, and attorneys’ fees in the event that default occurs and it is necessary to pursue a judgment to collect.
If a judgment is obtained, the secured party can pursue all of the remedies available to it under the law, such as enforcement of the security agreement, a possible charging order against a borrower, and/or a claim against the guarantor. In most cases, once default occurs and the guarantor is required to pay, the guarantor can pursue a claim against the borrower/debtor for reimbursement.
The legal obligations and rights are not always totally clear and are the subject of constant interpretation of the terms of the guaranty and the underlying loan document (the C&I loan agreement or other agreement subject to the guaranty). In some instances, the guarantor may obtain additional protections if the guarantor is an entity. Some Lenders will provide that a specific personality of entity is necessary for the Guarantor to be granted capacity to enter into a guaranty, but not any of its affiliates, and such affiliates can be protected on an entity basis. And for that reason, sometimes "problematic" entities of the same parent entity are included in the same Guaranty in different sections (with different covenants, representations and warranties, covenants and restrictions) and with different guarantee amounts.
Guarantors should understand whether they have any additional protections in the guaranty signed and delivered by them. It is advisable for a guarantor, prior to signing a guaranty, to explore whether a more protective guaranty could be negotiated. Sometimes the Lender may be willing to make concessions on the guaranty form to add various provisions that would make the guarantor’s position more secure in the event that certain default events occur. In light of the recent financial crisis, including many historic revisions to existing legal arrangements, courts will interpret any guaranty in context and in light of all other agreements between the parties.
Drafting a Guaranty Agreement
The drafting of a guaranty agreement requires forethought and attention to detail to limit the buyer’s and any guarantor’s liability, ensure that the agreement meets the expectations of the lender, and understand the objectives of the transaction and the parties’ respective roles. The steps outlined below are intended as an overview only. A more detailed discussion of the topic of guaranty agreements will follow in subsequent posts. First, consider whether the guarantee should be limited to a finite period or it should be related to a specific event. For example, is the guarantor’s liability limited to the extent that the buyer is in default on the loan agreement? If so, the guaranty document should state that (or words to that effect) so there is no confusion about what events would trigger the guarantor’s liability. Second, consider whether the guaranty will have a limit or a cap on the amount that can be recovered from the guarantor, or whether the guaranty should extend to cover amounts in excess of any such limit. Third, review the guaranty document to determine whether it provides for a remedy in the event that the transaction does not close. Consider that if the guaranty is unconditional the lender could sue the guarantor and recover immediately upon the buyer’s default without waiting for a sale of the collateral or entry of a judgment against the buyer. Fourth, consider whether the guaranty should be "joint and several" such that each guarantor can be sued individually regardless of whether the other parties to the guaranty are sued. Alternatively, the guaranty can be "non-joint and several" in that the guarantor may limit its liability to an amount proportionate to its ownership share of the buyer. Cash equity investors are typically included within the definition of guarantors and therefore should be wary of joint and several liability in lending arrangements. Fifth, be careful regarding treatment of certain individuals as guarantors or parties to a guaranty. For example, officers, directors, and shareholders of a corporate buyer may also be parties to a guaranty, but care should be taken to ensure that any liability of persons involved in both roles is clear. Depending on how the parties are referenced, a court could be called upon at some future date to decide a fact question as to whether a person was acting in its capacity as a shareholder, director, officer, manager, or principal of the company. This fact question could lead to liability for all parties involved. Finally, be sure to discuss any unique situations with your attorney. Always have your attorney review your contract(s) to ensure they conform to your state’s laws and that the form is acceptable to your lender.
Examples and Case Analysis
To fully grasp the significance of a guaranty provision in a commercial lease, it helps to consider some real-world examples.
Case Study 1: The Co-Signing Roommate
In a case out of the New York Court of Appeals, a female college student signed a lease along with her boyfriend. When her boyfriend stopped paying rent, the landlord sought to enforce the lease against the guarantors, who were her mother and brother.
The question before the court was the extent to which the guarantor was obligated for damages above and beyond unpaid rent.
The court held that the guarantor was liable not only for unpaid rent, but for consequential damages arising out of the landlord’s efforts to evict. The court also held that consequential damages, which significantly increased the basic rent, were unforeseen and thus not recoverable under the terms of the guaranty provision.
Case Study 2: Real Estate Contracts
The guarantor of a real estate contract was named , but never signed. The real estate association sued the guarantor and assigned the matter to arbitration based on the contract, even though the guarantors never signed the contract.
The court ruled that the guaranty agreement was broad enough to include the obligation to submit to arbitration, since the guarantor agreed to submit to any obligations required by the contract. The court noted that this was not strictly speaking an Arbitration Clause. Rather, it was a catch-all provision.
Guarantor Peer Review
No matter how simple your situation seems, it is a good idea to vet your guarantor through the following process:
A leasing lawyer or real estate attorney can guide you through this process step by step and identify disadvantages or potential liabilities that are unique to your situation.