Loan Guarantees: Nothing Is Guaranteed – Article
When a business borrower defaults, sometimes lenders cannot collect all of the debt by liquidating the business. As a result, they often look to guarantors – both natural persons and affiliated entities – in order to collect additional amounts. These guarantors can often be important sources of recovery.
However, guarantees always come with pitfalls for lenders, especially when lenders do not understand them, document them in rushed training situations, or exercise their rights inappropriately.
Types of guarantees
Warranties come in all shapes and sizes. As a first step, guarantees can be made by the principals of a borrower, a parent company or by subsidiaries or affiliated entities.
As for the guarantees themselves, a guarantee can be a payment guarantee, which obliges the guarantor to pay the debt in the event of default by the borrower, whether or not the lender makes a demand on the borrower. Alternatively, a less powerful form of collateral is a collection collateral, which only binds the guarantor if the lender cannot collect the amount owed after filing a lawsuit and exhausting its remedies against the borrower.
In addition, guarantees can be absolute, limited or conditional. Limited warranties may be limited by the amount of liability or made conditional on the occurrence of a possible event, such as the guarantor engaging in particular “bad boy” conduct specified in the warranty.
Since collateral is usually an important part of a lender’s collateral package that goes into an underwriting decision, lenders need to know what type of collateral they are getting and make sure they understand the “fine print”.
Consideration is always required
A guarantee without consideration is simply an unenforceable promise. It is therefore not surprising that guarantors frequently claim that they have not received any consideration in exchange for their deposit. While the courts routinely consider the credit given to the borrower to be sufficient consideration to back up a collateral, there are still pitfalls.
For example, guarantees must be executed at the same time as the underlying loan documents are executed. In a recent case in Illinois, a guarantor avoided liability on his personal collateral because the lender inserted an incorrect closing date into the collateral. Although the mistake was inadvertently made, the courts will usually bend over backwards to protect a guarantor since warranties are interpreted strictly in favor of a guarantor.
If a guarantee is signed after the granting of a loan, additional consideration must be provided, such as forbearance from pursuing remedies in the event of default or an increase in the amount of the loan. If a guarantee is taken after the granting of a loan, without additional consideration, the guarantee risks being invalidated by a court.
Always provide guarantors with a notice of default
When a bank sends a letter of default to a corporate borrower, it must also send a copy of the default to all guarantors. Failure to do so may compromise the bank’s ability to sue the guarantor. Loan documents may explicitly state that there is no obligation to notify a guarantor and that notice does not need to be given to a guarantor. However, without such language (and arguably, even with such language), banks would have to give guarantors notices of default to avoid the issue of notice in future litigation.
Intercompany guarantees and the risk of fraudulent transfers
It is common in debt repurchases and other lending transactions for a borrower’s subsidiaries to provide collateral for the borrower’s debts. In a downstream guarantee, a parent company will guarantee the obligations of its subsidiary. On the other hand, a guarantee by a subsidiary of the obligations of its parent company is an upstream guarantee. However, upstream guarantees in particular can expose lenders to the risk of lawsuits for fraudulent transfers.
Most lenders are sued under an implied fraud theory. Upstream guarantees benefit borrowers and lenders as they allow borrowers to obtain better loan terms and enable banks to include additional assets in their collateral base. Nonetheless, lenders should be aware of certain pitfalls when documenting an upstream collateral, especially when an upstream guarantor will not receive the loan proceeds directly. Potential risks include the avoidance of an upstream collateral due to lack of consideration or a determination that the collateral has been fraudulently conveyed in the event the guarantor files for bankruptcy.
With regard to the counterparty, if the counterparty does not pass directly between a lender and an upstream guarantor, an upstream guarantor (or its creditors) may argue that the loan guarantee is inapplicable for lack of counterparty if the loan does not provide not a direct benefit to the subsidiary. Thus, one way to at least minimize this risk is to document in the recitals of the collateral the benefits that the guarantor will receive from the loan. In addition, banks should ensure that they document that the loan was conditional on the execution of the upstream guarantee, and that this guarantee was a material incentive to make the loan.
In addition to counterparty issues, fraudulent transfer issues arise when the guarantor is insolvent or without sufficient capital at the time he executed the collateral, and the upstream guarantor has not received an equivalent value for the collateral provided. This is more common in practice or forbearance scenarios, but can happen at any time. If the guarantor was insolvent when he granted the upstream guarantee, the guarantee can be canceled in the event of bankruptcy. In addition, under bankruptcy law, upstream guarantees can be considered fraudulent by construction if they are enforced (1) within two years of the date on which the bankruptcy was filed, (2) for a less than “reasonably equivalent value”, and (3) where the guarantor was insolvent, or generally in a bad financial position. Therefore, even if an upstream guarantor is creditworthy when granting an upstream guarantee, the upstream guarantee can constructively be considered fraudulent on the basis of these factors.
The issue of fraudulent transfers in the context of intercompany guarantees is a complex issue that many courts and authors have addressed at length. For the purposes of this document, suffice it to say that banks seeking intercompany collateral under a loan facility should seek legal advice regarding these risks.
If a loan has gone bad and a personal guarantor may decide to file for bankruptcy in order to obtain a discharge from the collateral obligation. In fact, the guarantor can get such a discharge in a Chapter 7 case. However, lenders should consider certain exceptions to the discharge that are set out in the Bankruptcy Code.
Under section 523 (a) (2) (B) of the Bankruptcy Code, a lender may exempt the guarantor from indebtedness to it if it can establish that the guarantee obligation was based on a false document concerning the financial position of the guarantor and that the lender reasonably relied on the false entry. For example, such a writing could be the financial statement of a guarantor presented to a lender in support of a loan. Since verbal statements are not enough, lenders should always require signed financial certifications from guarantors attesting to their personal finances.
Guarantees can be an important part of a package of guarantees that allow lenders to provide loans on good terms. However, they should never be taken for granted and should always be carefully considered to ensure that they can be validly applied if necessary.