Payment of most commercial loans to small businesses is personally guarantied by the owners of the business. While there is no hard and fast rule as to when a commercial loan must be guarantied, most lenders ask for the owners to guaranty payment of credit extended to a corporate or limited liability company (“LLC”) borrower. There are several good reasons for getting the guaranty.
First, taking a personal guaranty generally allows the Bank to get around the limited liability that a corporation or an LLC gives to a business. Small businesses are often incorporated or conducted by an LLC. The idea is for the owner of the business to avoid personal liability for the debts and obligations of the company. Typically, trade debt owed by a company to suppliers and rental obligations are among the many debts of a corporation or LLC for which an owner wants to avoid personal liability. The easiest way to do so is to incorporate the business or put it into an LLC.
Without a guaranty, the lender can generally look only to the assets of the corporate or LLC borrower. Unless the Bank can enforce its loan directly against the owner of the borrower, so long as the company is not insolvent, the owner can transfer money and property out of the corporation or LLC to himself, his family or another wholly-owned corporation and generally put those assets out of the reach of the creditor. Often, these transfers are not intended to shield the borrower’s assets from the Bank, but that is the practical result.
Even so, small businesses are often conducted informally, paying only the necessary lip service to the requirements of corporate formality. For instance, as a business is failing, the owner continues to take substantial distributions or a high salary to fund his living expenses. Once distributed out of the borrower to the individual owner, without a guaranty, that money is not easily reachable by the Bank to be applied to pay off the loan.
For many years, commercial lenders have required the owners of corporate or LLC borrowers to personally guaranty payment of the loan. A guaranty of payment is an independent agreement by a person or an entity to pay the loan when it goes into default. Even if the borrower is unable or unwilling to pay back the loan, the Bank can require the guarantor to pay it back.
The personal guaranty has a way of keeping the owners interested in their company and in paying back the loan, even if the company is doing poorly. The owners of a corporation quickly understand that they will be better off if the borrower pays back the loan using its assets, because the alternative is that the Bank will require the owners to personally repay the loan under the guaranty using the personal assets of the owner. Workout professionals often refer to this process as keeping the owners’ “feet to the fire.”
There are several rules that apply to guaranties and most of them are favorable to the guarantors. The good news for lenders is that many of these rules can be waived, and those waivers are fairly standard in most commercial loan documentation. For our purposes, the waivers are so commonplace that there is little need to discuss them in this blog.
Most guaranties are called “Commercial Guaranty” or “General Continuing Guaranty” or something similar. The term “Continuing Guaranty” has an important legal meaning because a Continuing Guaranty is different from a guaranty of one specific obligation. The guaranties in most commercial loan transactions are continuing guaranties.
Since it was enacted back in the year 1872, section 2814 of the California Civil Code has defined a continuing guaranty.
A guaranty relating to a future liability of the principal, under successive transactions, which either continue his liability or from time to time renew it after it has been satisfied, is called a continuing guaranty.
This is pretty straightforward language for legalese, and it means what it says. A continuing guaranty is an agreement by the guarantor to be liable for the obligations of someone else to the lender, even if there are several different obligations that are made, renewed or repaid over time.
In contrast, a specific guaranty is limited only to one individual transaction.
A guarantor can get out of a continuing guaranty for transactions that have not yet occurred very easily. All the guarantor must do is to revoke the guaranty in writing. For example, the Bank extends a $1,000,000 line of credit to ABC Corp. Mr. C is an owner and guaranties payment of the debt. Mr. C has a falling out with Ms. A and Mr. B, the other owners. Mr. C can send a notice to the Bank revoking his continuing guaranty as to future advances, but Mr. C is still liable for the advances made by the Bank to ABC Corp as of the date of the revocation. Of course, it is an Event of Default under most loan documents for a guarantor to revoke a continuing guaranty. Once the Bank receives notice that a continuing guarantor has revoked, the Bank usually freezes the line of credit, stops all further advances and sends out a formal Notice of Default. Depending upon the situation, the Bank may take other steps to protect itself.
There are two kinds of guaranties: payment and performance. Most guaranties given in conjunction with commercial loans are guaranties of payment. In other words, the guarantor agrees to pay the loan back if the borrower does not pay.
Guaranties of performance may require payment, but they are more typically found where performance of an act is essential to the deal. For instance, commercial real estate lenders usually require developers or general contractors to guaranty performance of their construction contract, i.e., to guaranty that they will complete the project if the borrower does not do so.
Despite popular belief to the contrary, there is no requirement that a guaranty have a maximum limit or be limited in amount in any way. We at the JMBM Special Assets Team™ strongly recommend to our lender clients to avoid limiting the amount of a guaranty of payment. There is simply no good reason to include a limit other than to create either confusion or unexpected consequences years later.
The guarantor’s obligation to pay if always limited to the amount that is owed by the borrower, whether or not that amount is included in the guaranty. If there is no maximum limit in the continuing guaranty, the Bank can make additional advances to the borrower without the need to amend the guaranty or make any other changes to it. If there is a maximum limit, the Bank may not be able to quickly make that needed advance without first amending the guaranty to increase the limit. Usually, commercial guaranties of payment that do contain a maximum limit provide that the maximum only applies to the principal sum of the loan, and that interest, collection costs and fees in excess of the limit are still covered by the guaranty. I’ve seen a Bank limit a guaranty, lend more than the limit and then find out that the language of the guaranty is faulty and does not provide that the guaranty also covers unpaid interest and collection costs in excess of the limit. This is not a pretty picture and makes our job of collecting the loan nearly impossible.
Guaranties are an integral part of the commercial lending process. As a matter of good practice, nearly every commercial loan that is made to a corporation or LLC should be guarantied by its owners. A well-drafted continuing guaranty will help the owners of a troubled borrower focus on retiring the Bank debt as soon as possible using the borrower’s assets, for the good of both the Bank and the guarantor.
This is Dick Rogan, bank lawyer and author of www.SpecialAssetsLawyer.com, signing off for now. Join us again soon to check out what’s new in the World of Workouts.
Year after year, day after day, workout professionals in the know rely on JMBM’s Special Assets Team™ to handle problem commercial and real estate loans. Whatever problem loans you have, chances are, we’ve seen it. Give us a call.
Our Perspective. JMBM represents commercial banks, special servicers, private lenders, asset-based lenders, hard money lenders and factors. We help lender clients throughout the United States craft business and legal solutions to their commercial and real estate troubled loans. For more information, please contact Dick Rogan at RRogan@JMBM.com, or (415) 398-8080.
Richard A. Rogan is Chair of the JMBM Special Assets Team™. He also serves as the co-managing partner of JMBM’s San Francisco office and co-chair of its Bankruptcy Practice Group.
JMBM’s Special Assets Team™ has represented hundreds of lenders in California and throughout the United States. We regularly appear in bankruptcy courts, district courts and superior courts. We are proud to serve as trusted counsel and advisors who look for a business solution and try to help lenders find the best possible resolution for each troubled loan. Whether a loan is being newly documented, restructured or litigated, JMBM’s Special Assets Team™ has the skill, know-how and experience to solve your problem in a practical no-nonsense way.
NOTE TO CONSUMERS: As a matter of Firm policy, JMBM does not represent individual consumers who have disputes with their lenders. Many lenders have specialized consumer workout professionals who have the time to help consumer borrowers. There are many fine attorneys who specialize in representing consumers. Individuals with consumer lending problems should contact a lawyer or law firm who specializes in consumer insolvency and bankruptcy in their local area. When in doubt, we suggest you contact your local bar association’s Lawyer Referral Service. [For example, see Bar Association of SF or LA County Bar Association Lawyer Referral Services]
JMBM does not provide legal advice to consumers, and cannot respond to consumer inquiries.