An entrepreneur obtaining a commercial loan for a new business will often be required by the lender to sign a personal guaranty. It is very important to seek legal advice prior to signing one.
Although an entrepreneur would normally be insulated from personal liability for a business's debts due to the limited liability protection afforded by corporate, limited liability, or limited partnership laws, the entrepreneur will be "on the hook" personally if a personal guaranty is given. A guaranty is a contractual agreement in which a person (or an entity) agrees to pay the debts of another. The guarantor may not be otherwise involved in the loan between the lender and the borrower (or even personally benefit from it), but under the terms of a guaranty, the guarantor will be obligated to repay the loan. Lenders know that guarantors will make re-payment of business loans a priority if the guarantors' personal assets and income are at risk.
If the borrower makes its loan payments as required under the loan, there is no reason for the lender to pursue enforcement of the guaranty. However, if the borrower does not pay its debt, the lender can enforce the guaranty to proceed against the guarantor's personal assets and income for payment.
A guaranty must be in writing and signed by the guarantor or some party legally authorized by the guarantor. A potential guarantor should read any guaranty agreement carefully. There are several fairly standard guaranty clauses which need to be understood prior to execution of a guaranty:
A continuing guaranty means that the guarantor will be liable for all of the borrower's obligations to the lender, including current debts, future debts, and the renewal or extension of such debts. For example, a guaranty may state that the indebtedness guaranteed under the agreement includes "all of the principal amount outstanding from time to time and at any one or more times, accrued unpaid interest thereon and all collection costs and legal expenses related thereto permitted by law, attorneys' fees arising from any and all debts, liabilities, and obligations of every nature or form, now existing or hereafter arising or acquired that borrower individually or collectively or interchangeably with others, owes or will owe lender." This language makes the guarantor liable for: (i) the borrower's debts which existed prior to his guaranty, (ii) the borrower's loan which he is in the process of obtaining, and (iii) any future loans or debts between the borrower and the lender.
There is no termination date for a continuing guaranty unless the guarantor is prepared to pay the lender the full outstanding balance of the borrower's obligations to the lender. The guarantor can give the lender written notice to terminate the guaranty for additional obligations of the borrower arising after the termination, but will remain liable to the lender for the full outstanding balance of the then existing obligations including all interest and fees. In the absence of termination of the guaranty, even upon full payment of all obligations at issue, it will continue to serve as a guaranty of additional future debts.
An unlimited guaranty means that it is not limited to a particular time period or amount. In contrast, a limited guaranty limits the guarantor's obligation to debts incurred only over a certain period of time, to a stated maximum amount, or to only specified loans. For example, a limited guaranty may limit the guarantor's liability to a percentage of the borrower's obligations equal to the percentage of the ownership interest of the guarantor in the borrower, or the limitation can be as simple as a limitation to "no more than $____" (a stated amount).
Joint and Several Liability
A borrower's debts may be guaranteed by more than one guarantor. This does not mean, however, that each guarantor will be liable for only that guarantor's pro-rata share of the overall debt. Most guaranties provide that the guarantor's liability for the debt is "joint and several," which means that each co-guarantor is liable up to the full amount of the guaranteed debt and the lender can opt to pursue only one guarantor for the full amount of the guaranteed debt and ignore the other guarantors. If a co-guarantor dies or disappears or declares bankruptcy, the remaining guarantor will remain fully liable for the entire amount of the guaranteed debt. However, if one guarantor pays the debt in full and there are co-guarantors, the guarantor who pays may be able to recover from the co-guarantors their share of the total guaranteed amount by way of a claim for "contribution."
What may be more surprising to some is that some guaranty agreements provide that the guarantor will be directly and primarily liable for the obligation. That means the lender doesn't even have to wait for the borrower to default or demand that the borrower pay before going after the guarantor! The lender can just pursue the "guarantor" directly. In essence, such a "guaranty" actually makes the guarantor a borrower.
Lender's Right to Set-Off
A guaranty agreement that includes provisions for a lender's right to "set-off" allows the lender to take funds from any other account of the guarantor (with the exception of certain IRS or trust accounts for which set-off is prohibited) to satisfy the guarantor's obligations under the guaranty. For example, the guaranty may state that "lender reserves a right of set-off in all of guarantor's accounts with lender including all accounts guarantor may open in the future. Guarantor authorizes lender, to the extent permitted by applicable law, to hold these funds if there is a default and apply the funds in these accounts to pay what guarantor owes under the terms of this guaranty." The effect of such a provision is that the lender can demand repayment of the full amount of the guaranty upon default by the borrower and then set-off (that is, directly and unilaterally take) the guarantor's personal funds to pay the debt by withdrawing them from the guarantor's accounts and crediting the withdrawn funds to the lender's accounts.
Liability Continues After Death of a Guarantor
Most guaranties will survive the death of the guarantor and continue to be a liability of the guarantor's estate until the guaranteed obligations are paid in full or until the guaranty is released by the lender. The lender has no obligation to release a guarantor's estate from liability and typically a lender would do so only if a new guarantor, satisfactory to the lender, is willing to take the place of the deceased guarantor. Sometimes a lender will be willing to agree that if certain specific factors exist, it will release the estate of a guarantor, but such provisions are usually very detailed and require the assistance of an attorney or other professional to draft them.
Make sure you read and understand all the terms and conditions in a guaranty before signing one. Otherwise, you may be taking on more liability than you intend. Always obtain independent legal advice before giving a personal guaranty. Such legal advice will provide you with an opportunity to fully understand your obligations and potentially limit the extent of your liability through negotiation with the lender.
© 2016 Ward and Smith, P.A.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.