When a corporate borrower defaults, lenders sometimes cannot recover all of the outstanding debt by liquidating the company. As a result, they often look to guarantors — both individuals and affiliate entities— in order to collect additional amounts. Such guarantors often can be important sources of recovery.

However, guaranties still come with pitfalls for lenders, particularly when lenders do not understand them, document them in hurried workout situations, or exercise their rights inappropriately.

Types of Guaranties

Guaranties come in all shapes and sizes. As an initial matter, guaranties can be made by a borrower’s principals, a parent corporation, or by subsidiary or affiliate entities.

As for the guaranties themselves, a guaranty can be a payment guaranty, which obligates the guarantor to pay the debt upon occurrence of the borrower’s default, regardless of whether the lender makes a demand on the borrower. Alternatively, a less potent form of guaranty is a collection guaranty, which only obligates the guarantor if the lender cannot collect the amount owed after bringing a lawsuit and exhausting its remedies against the borrower.

Moreover, guaranties can be absolute, or limited or conditional. Limited guaranties can be limited by the amount of liability, or conditioned upon the occurrence of some contingent event, such as the guarantor engaging in particular “bad boy” conduct specified in the guaranty.

Since guaranties are commonly a significant part of a lender’s collateral package that goes into an underwriting decision, lenders should know what type of guaranty they’re getting, and ensure that they understand the “fine print.”

Consideration is Always Required

A guaranty without consideration is simply an unenforceable promise. It comes as no surprise, therefore, that guarantors frequently claim that they received no consideration in exchange for their guaranty. While courts regularly hold that credit extended to the borrower is adequate consideration to support a guaranty, there are still pitfalls.

For example, guaranties must be executed at the same time the underlying loan documents are executed. In a recent Illinois case, a guarantor avoided liability on his personal guaranty because the lender inserted an incorrect closing date in the guaranty. Although the error was inadvertent, courts commonly will bend over backwards to protect a guarantor since guaranties are strictly construed in favor of a guarantor.

If a guaranty is signed after a loan is made, there must be additional consideration provided, such as forbearance in pursuing default remedies, or an increase in the loan amount. If a guaranty is taken after a loan is made, without additional consideration, the guaranty is at risk of being invalidated by a court. 

Always Provide Guarantors With Notice of Default

When a bank sends a default letter to a corporate borrower, it should also send a copy of the default to all guarantors. Failing to so do can jeopardize the bank’s ability to pursue the guarantor. Loan documents may provide explicit notice that there is no duty to notify a guarantor and that notice need not be given to a guarantor. However, without such language (and arguably, even with such language), banks should give guarantors notices of default to avoid the notice issue in future litigation.

Intercorporate Guaranties and Fraudulent Transfer Risk

It is common in leveraged buyouts and other lending transactions for a borrower’s affiliates to provide a guaranty of the borrower’s debts. In a downstream guaranty, a parent corporation will guarantee the obligations of its subsidiary. In contrast, a guaranty by a subsidiary for the obligations of its parent corporation is an upstream guaranty. However, upstream guaranties in particular can expose lenders to risks of being sued for fraudulent transfers.

Most lenders are sued under a constructive fraud theory. Upstream guaranties benefit borrowers and lenders because they enable borrowers to obtain better loan terms and permit banks to include additional assets as part of its collateral base. Nonetheless, lenders must be aware of certain pitfalls when documenting any upstream guaranty, particularly when an upstream guarantor will not be directly receiving any of the loan proceeds. Potential risks include avoidance of an upstream guaranty due to lack of consideration or a determination that the guaranty was fraudulently conveyed in the event the guarantor files for bankruptcy.

With respect to consideration, if consideration does not move directly between a lender and an upstream guarantor, an upstream guarantor (or its creditors) may argue that the loan guaranty is unenforceable for lack of consideration if the loan does not provide a direct benefit to the subsidiary. Thus, one way to at least minimize this risk is to document in the recitals of the guaranty the benefits that the guarantor will receive from the loan. In addition, banks should make sure to document that the loan was conditioned on the execution of the upstream guaranty, and that such guaranty was a material inducement to make the loan.

In addition to the consideration issues, fraudulent conveyance issues arise when the guarantor is insolvent or without adequate capital at the time it executed the guaranty, and the upstream guarantor did not receive equivalent value for the guaranty provided. This is more common in workout or forbearance scenarios, but can occur at any time. If the guarantor was insolvent at the time it granted the upstream guaranty, the guaranty may be avoided in a bankruptcy case. Further, under bankruptcy law, upstream guaranties may be found to be constructively fraudulent if executed (1) within two years from the date the bankruptcy was filed, (2) for less than “reasonably equivalent value”, and (3) when the upstream guarantor was in insolvent, or generally in a poor financial condition. Therefore, even if an upstream guarantor is solvent when it grants an upstream guaranty, the upstream guaranty may be determined to be constructively fraudulent based on these factors.

The issue of fraudulent transfers in the context of intercorporate guaranties is a complex issue that many courts and authors have addressed at length. For present purposes, suffice it to say that banks seeking intercorporate guaranties as part of a loan facility should seek legal guidance regarding these risks.

Bankruptcy Dischargeability

If a loan has gone south and a personal guarantor may decide to file a bankruptcy case in order to obtain a discharge of the guaranty obligation. In fact, the guarantor may obtain such a discharge in a Chapter 7 case. However, lenders should consider certain exceptions to discharge that are set forth in the Bankruptcy Code.

Under section 523(a)(2)(B) of the Bankruptcy Code, a lender can have the guarantor’s debt to them excepted from discharge if it can establish that the guaranty obligation was based on a false writing relating to the guarantor’s financial condition and that the lender reasonably relied on the false writing. For example, such a writing can be a guarantor’s financial statement presented to a lender in support of a loan. Since verbal representations do not suffice, lenders should always require signed financial certifications from guarantors attesting to their personal finances.   

Conclusion

Guaranties can be important components of a collateral package that enable lenders to make loans on good terms. However, they should never be taken for granted, and should always be carefully considered in order to ensure they can be validly enforced if needed.