Considerations as a Corporate Guaranty in California
August 21, 2017
1. INTRODUCTION – Where a corporation, limited partnership or limited liability company
[1] is making a business or real estate loan or entering into an equipment or real estate lease, the principals of the entity are often required to execute a guaranty. This article focuses on whether a Guaranty Agreement is enforceable and the different types of guaranty agreements that might be negotiated.
2. RIGHTS OF A CREDITOR TO PURSUE A GUARANTOR – Rights of a creditor to enforce a guaranty are generally governed by State Law. California has adopted the “independence principle”. Under this principle, a creditor can pursue claims under a guaranty before pursuing rights against the underlying borrower/lessee or exercising any rights in collateral. Many other states require a creditor to exhaust its remedies against the borrower/lessee and/or pledged collateral before asserting any claims against a guarantor. As a general rule, the filing of a bankruptcy by a borrower/lessee does not stay a creditor enforcing its rights under a guaranty agreement.
3. REQUIREMENTS AS TO AN ENFORCEABLE GUARANTY – For a creditor to enforce rights under a guaranty, the creditor must establish that certain predicate facts exist. In most instances, these requirements are referenced in the written guaranty.
a. IS THE GUARANTY IN WRITING – As a general rule a guaranty agreement must be in a writing signed by the guarantor. With some exceptions, the writing must also state all terms and conditions of the guaranty.
b. CONSIDERATION – As a general rule, the creditor must have given consideration to the guarantor for the guaranty agreement to be enforced. The court will not generally be concerned as to the sufficiency of the consideration. Historically, the extension of credit to a borrower/lessee in reliance on a third party guaranty was considered sufficient consideration. While not yet developed, there is a possibility that courts may in the future require that the guarantor receive some independent consideration, even if in a small amount.
c. DOES THE WRITING CONFORM WITH THE UNDERSTANDING BETWEEN THE GUARANTOR AND THE CREDITOR – Recent case law has allowed parties to a contract to challenge the enforceability of the contract under a theory of “promissory estoppel” by claiming that through fraud or mutual mistake the writing does not reflect the actual understanding of the parties.
d. IS THE GUARANTY AGREEMENT A “SHAM” – Where an individual applies for a loan or wishes to enter into a lease and the creditor requires the individual to form an entity to be the borrower or lessee and to then have the individual guaranty the performance of the underlying agreement, the guarantor may argue that the guaranty was a “sham” and challenge the enforceability of the guaranty agreement. While there is historical precedent for this position to be asserted, it does not appear to currently be a favored position in commercial transactions.
4. DIFFERENT FORMS OF GUARANTY – A guaranty agreement will normally take one of two forms (a) an unconditional and absolute guaranty agreement of all borrower/lessee obligations and additional covenants in the guaranty or (b) a “limited”, “bad boy” or “carve out” guaranty that limits the guarantor’s risk and obligations. Consideration as to the form and terms of a guaranty must be understood and considered in all transactions where a guaranty agreement is mandated.
a. THE ABSOLUTE AND UNCONDITIONAL GUARANTY – Where the guaranty agreement is unconditional and absolute, breaches by other guarantors or the borrower/lessee can result in the loan being accelerated and liability to each guarantor for the entire outstanding loan or lease balance. If any of the loan/lease or guaranty terms are not met, depending on the terms of the guaranty agreement, each guarantor may be declared in default by the lender/lessor and in California the lender/lessor can, as a general rule, pursue claims against all or any guarantors independent of the collateral or others who may share liability. Even where an unconditional guaranty is required, terms such as notice and cure periods and priority of enforcement may still be subject to negotiations.
b. THE CARVE OUT, “BAD BOY” OR LIMITED GUARANTY – A guaranty is defined and limited by its contractual terms. The obligations under a limited, bad boy or carve out guaranty will depend on the terms negotiated with the proposed lender/lessor. The carve out or limited guaranty may limit a guarantor’s risks by (1) limiting the dollar amount of the guaranty (2) limiting the term of the guaranty to a limited period of time or limiting the events that constitute a default under the terms of the guaranty (see below) (3) requiring notice to the guarantors and a cure period before a default can be declared or (4) requiring the lender/lessor to first exhaust other claims or foreclose on pledged collateral.
The events under which a lender/lessor can declare a default and pursue remedies under a bad boy guaranty will vary depending on the concerns and focus of both the lender/lessor and guarantors as follows:
i. False Financial Information and Documents – A limited guaranty usually will include a provision that any misrepresentations by a borrower/lessee or any guarantor will negate all limitations and also allow the lender/lessor in its sole discretion to declare a default and accelerate the loan balance. The guarantor will want to limit this to only “material” misrepresentations and only by the guarantor executing the guaranty agreement not the borrower/lessee or other guarantors and also provide for a notice and cure period.
ii. Environmental and Toxic Waste – Carve outs in limited guaranty agreements usually allow the creditor to declare a default and accelerate the loan balance and pursue all claims if an environmental condition is discovered on the pledged real property. The guarantors will want a provision requiring notice and a reasonable cure period and to exclude items commonly used on the type of property/business in question in the geographic area where property is located.
iii. Rents and Security Deposits – The lender/lessor typically includes a provision for the immediate turnover on demand or upon a default of all rents, reserves and security deposits. The borrower/lessee and guarantors want to limit this by including a notice and cure period before such a demand can be made. The failure by a borrower/lessee to comply with such a demand or the diversion of rents for non-approved purpose typically will allow a lender/lessor to accelerate the entire loan balance and pursue remedies against the guarantor.
iv. Waste or Damage to the Property – Waste, depletion of repair and improvement reserves and property damage are typically included in a guaranty agreement as giving rise to a right to accelerate and declare a default of the guaranty obligation. The borrower/lessee and guarantors typically propose that a default can only be called for waste or damage to the collateral caused or contributed to by the borrower/lessee or its agents. The fallback position for the proposed guarantor is to require notice and an opportunity to cure before a default or acceleration can be declared.
v. Taxes, Impositions and Insurance – The requirement that taxes and other impositions remain current or for a reserve account to be funded for this purpose, is commonly included in a carve-out guaranty agreement. The borrower/lessee and guarantor typically request a notice and cure period and a provision that if a payment arrangement is in effect with a governmental agency as to taxes or there is a good faith dispute as to taxes, no default will be declared so long as the borrower/lessee is current on payments under a tax plan or deposit further reserves with the Lender.
vi. Impairment of Borrower or Guarantors – A change in management or ownership of the borrower/lessee entity or in the ownership of the collateral is typically considered to be a default. Whether the guaranty agreement is absolute or limited, in nature the borrower/lessee and guarantors should insist that a change in ownership or management of the borrower/lessee entity as the result of death or incapacity is not an event of default as long as the substitute manager or ownership meets certain qualifications. There also should be negotiations as to the effect of a lawsuit or bankruptcy of one guarantor on the lender/lessor’s right to declare a default under the guarantees of other guarantors.
vii. Transferring or Encumbering Ownership of All or Any Part of the Collateral or a Lien against the Collateral – This is typically considered a default in a carve-out guaranty agreement. The borrower/lessee should attempt to include notice and cure provisions in the Guaranty and a right to substitute a guarantor’s obligation and interest in the borrower/lessee entity to a qualified substitute.
viii. Failure to Maintain the Collateral – Lenders/lessors typically require a provision that a failure to maintain the collateral in good repair or to make timely improvements to the loan collateral constitutes a default. Proposed guarantors want to limit these requirements as much as possible.
5. TORT LIABILITY – In addition to the contract claims referenced above, in certain instances the Guarantor may be exposed to tort damages for “bad acts”. This would include such things as waste, fraud and diversion of income or assets of the borrower/lessee pleaded as collateral. The significance of tort damages is twofold. First, in addition to its actual damage claims the lender/lessor may seek a punitive damage award over and above the lender/lessor’s actual damages to punish the guarantor for the bad acts. Secondly, if an intentional tort judgment is entered against a guarantor in civil court this judgment may not be dischargeable in bankruptcy court.
CONCLUSION – Too often borrower/lessee and counsel ignore the terms of the guaranty agreement when negotiating the loan documents and assume that the terms of the draft guaranty presented by the lender/lessor and its counsel are standard and non-negotiable. The guaranty is an essential part of the loan documentation and its terms should be negotiated wherever possible. In fact, efforts to limit the guaranty should start at the time the loan commitment or lease is being negotiated in conjunction with the negotiation of the other loan or lease terms. Once the loan closes or lease is entered into, the managers and guarantors need to understand the nature of the defaults the guarantors are personally responsible for and avoid these defaults wherever possible. Diversion of property income or other loan collateral is particularly risky and opens the guarantor up to significant potential exposure as well as the ire of the lender/landlord. It behooves the borrower/lessee and guarantors throughout the term of the guaranty agreement to maintain as good a relationship and as much credibility with the lender/lessor as possible. If a problem arises or is foreseen in the future, rather than attempt to hide this problem from the lender/lessor (which may in and of itself be a default under the loan documents) it may be beneficial for the guarantor to approach the lender/landlord at the early stages of the problem and attempt a work out rather than risk the wrath of the lender/landlord when it later discovers the problem through other means.
Questions About Commercial Guaranty in California?
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About FitzGerald Yap Kreditor: QUALITY LAWYERS MAKE A DIFFERENCE – FitzGerald Yap Kreditor is a full service business and real estate servicing clients throughout the State of California, www.fyklaw.com. Eric Dean is a partner in the Firm who has years of experience in all aspects of commercial real estate, hospitality and secured lending, both as to transactions and disputes.
Disclaimer: This article is solely intended to provide information for consideration only. It is not legal advice and is intended solely to raise broad and general possible topics of concern for further consideration, and therefore, should not be relied on. A reader who has concerns related to the topics addressed in this article should consult his/her own advisors and not otherwise act based on the content of this article.
[1] Guarantees of Loans to Trusts and General Partnerships present unique issues beyond the scope of this article.
