Guarantees are often an after-thought in commercial loan transactions: Lenders tend to focus more on the collateral, and borrowers tend to assume that the form of guarantee is non-negotiable.
As a result, no one pays much attention to the guarantee agreement – until the loan is in trouble, that is, at which point everyone suddenly becomes very interested in whatever recourse against the guarantors was agreed to back on that sunny, optimistic day when the loan was made. However, the guarantee agreement deserves a more thoughtful, flexible consideration than that. Bankers would be better served not to treat the guarantee as another document in the stack, but as an important agreement that ought to be of equal concern to all parties. There is a whole menagerie of specialized types of guarantees that can be useful to the commercial loan officer. What follows is a sampling of some of the most useful – and the some of the most inventively-named:
Full or Limited Payment/Duration
Obviously, the lender prefers a guarantee of the entire debt – every red farthing – the primary obligor owes. Also called a “hell-or-high-water” guarantee, this agreement assures the obligee that the guarantor will pay all the obligations of the debtor, no matter how or when they arise, and without any conditions. Most of the form loan guarantees banks use are of this ilk. Sometimes, however, a guarantor will negotiate for a limit on the amount he is willing to stand for. For example, with accruals of interest, default interest, late fees and attorneys’ fees, the guarantor may want certainty on the top side of his obligation to the lender. Sometimes the guarantor is simply not inclined to guarantee the totality of the primary obligor’s debt, or wants to limit his obligation to a single credit transaction. Then, a limited guarantee can be used. For example, a limited guarantee can guarantee only a specified amount or percentage of the obligation; only the principal of the debt; only the debtor’s operating expenses or the debt service; only costs of collection, or a deficiency; or only for a limited period of time. Where the guarantee is limited as to time, care must be taken to ensure that obligation’s termination point is clearly delineated, that is, the limited duration guarantee should say that the oblige must send a claim or file a lawsuit against the guarantor within six calendar months after the primary obligor fails to pay or respond to a judgment and only at that point does the time period begin to run.
Reducing, or “Burn-Down,” Guarantees
This type of guarantee provides that the guarantor’s potential liability will be reduced (or will disappear entirely) upon the occurrence of something other than the mere passage of time. For example, the guarantee could reduce in amount or proportion, if and when the borrower reaches certain revenue goals, sells a certain asset, perfects a patent, or some other occurrence. For purposes of drafting, it is imperative that the extraneous condition reducing the guarantee obligation be objective and relatively easy to ascertain, to avoid a dispute over whether the triggering event has actually taken place and the obligation has thus been reduced. Reducing guarantees are not uncommon in those construction loans where the lender is willing to look only to the primary obligor’s credit and the value of the real property collateral, once the realty has been improved by the completion of construction. Until then, the lender wants the guarantor to have plenty of incentive to see to it that the project is finished and the collateral has been enhanced. Thus, the guarantee should specify that the guarantor’s obligation will not be reduced until the improvements are substantially complete in accordance with plans and specifications approved by the lender; a certificate of occupancy has been issued; or, a certain proportion of net leasable space has actually been leased.
Joint, or Joint and Several
Occasionally, a guarantor will bargain for only joint liability with a co-guarantor, as contrasted with joint and several liability. Where the guaranteed obligation is a “joint” obligation, the obligee must join all co-guarantors in a single lawsuit if he hopes to recover from them all. On the other hand, where the obligation is joint and several, the lender can proceed against less then all of the co-guarantors (or only one) for recovery of the entire guaranteed obligation.
“Springing” or “Exploding” Guarantee
Related to the “reducing” guarantee is the “exploding” guarantee, one where the guarantee of the entire debt (or some agreed-upon amount) becomes effective if the primary obligor breaches certain specific covenants or takes or allows someone else to take certain actions. These covenants usually involve a falsity of the borrower’s warranties and representations made in connection with the lender’s credit extension or the bankruptcy of the primary obligor. Obviously, the “exploding” guarantee is most useful where the guarantor controls the primary obligor; it is designed to motivate the guarantor to intercede for the lender’s benefit.
A “carve-out” guarantee (sometimes called a “bad-boy” guarantee) is used where the loan is made as non-recourse except on occurrence of the specified events the lender wishes to discourage – such as bankruptcy, false representations or financial reporting, the wrongful transfer of collateral, or misappropriation of rents, security deposits, reserve accounts or insurance proceeds – in which event the guarantor’s obligation becomes concurrent with the primary obligor’s. Most commercial banks and insurance companies do not make
Non-recourse loans, but carve-out guarantees are frequently used in securitized secured loans to single-asset/single-purpose entities, which typically have few assets besides the loan collateral. Where there is no recourse, the lender’s chief concern is that the borrower properly maintain the collateral and preserve its value, and refrain from bad acts such as fraudulent statements to the lender, misappropriation of insurance proceeds, failure to pay taxes, etc.
A perennial concern of lenders is that the repossession and disposition of the collateral be quick and painless. This worry can be abated by using a variation called a “good-guy” guarantee, where the guarantor is automatically released if and when the borrower transfers clear title to the collateral to the lender.
Once a guarantee has terminated and the guarantor is released, a “snap-back” agreement reinstates the guarantee if certain conditions or occurrences arise. For example, “snap-back” provisions can be used to resurrect a guarantee obligation that has been released by payment, if the lender is subsequently required to disgorge payments received to a bankruptcy trustee exercising the avoidance powers of 11 U.S.C. § 365.
“Upstream” guarantees are the guarantees of a subsidiary’s obligations by a parent entity, and “downstream” guarantees are the reverse. A “cross-stream” guarantee is one affiliate’s guarantee of the debt of another affiliate of the same parent entity. The draftsman should carefully examine whether there is consideration for these kinds of guarantees as well as the potential ramification of the primary obligor’s bankruptcy. Because the parent entity’s equity interest in the subsidiary increases with payment of the subsidiary’s debts, “downstream” guarantees offer less risk to the lender than either “upstream” or “cross-stream” guarantees.
The guarantee agreement deserves more attention than it often gets in the commercial loan transaction, where it can be effectively tailored to meet the desires of the guarantor while still ensuring that the lender has a guarantee that will meet its needs quickly and without protracted litigation.
This is an article that previously appeared in the Utah Banker's Newsletter.
This post was written by attorney Rick L. Knuth