Some 30 years or so ago, I was in a trial in Houston when a very well-respected local person, one of the icons of the Houston community, was called as a witness. The witness was asked if he had signed his name to a particular document, and the witness agreed that he had. The witness was then asked whether he intended to fulfill the promises made in the document. The response made quite an impression by saying, “You can take my word to the bank.” Indeed, the witness was proven to have fulfilled each and every promise that he had made in the document, as if in his case there was ever any real doubt. Thereafter, his testimony dominated the case.
The impact of this statement was clear in that if he gave his word about something, he would be bound by it. This also illustrates the concept of the old saying that, “A man’s word is his bond.” This brings us to today’s topic of personal guarantees.
A borrower seeking a loan may have various problems. The borrower may not have sufficient collateral to back the loan, or the borrower may have a poor or non-existent credit rating. In such a case, the borrower will find a third-party to promise to make the lender whole in the event that the borrower doesn’t fully repay the loan according to its terms. This third-party is known as a guarantor. If the guarantor is an individual, then the promise to make the lender whole is known as a personal guarantee.
A very common form of a personal guarantee is where a teenager wants to buy a car, but the teenager doesn’t any credit much less a good one. Thus, to facilitate the teenager’s purchase, one of his parents will step in and guarantee the lender that if the teenager doesn’t repay the loan, they will. That is probably the lowest level of a personal guarantee, but of course they take on more substantial forms.
The type of personal guarantee that I see almost every day in my practice is this: A real estate developer forms ABC LLC to do some real estate project. However, ABC LLC doesn’t have any credit history and no lender in their right mind would loan to it at normal rates of interest. Nor does ABC LLC have sufficient collateral to assure the lender that the loan will be repaid, since it’s only assets consists of the raw dirt that has been purchased and the hope that someday the project will pay off bigtime. The lender, however, knows that the real estate market could crash and the value of ABC LLC’s assets could plummet dramatically ― thus leaving the lender holding an empty bag when it forecloses on ABC LLC’s assets. Thus, in pretty much every real estate loan of this type, the lender will require that the real estate developer personally guarantee that the lender will be repaid in full on the loan, no matter what happens to ABC LLC and its assets. The lender will also require that the real estate developer provide a financial statement which shows that the real estate developer personally has the financial strength to make good the loan even if ABC LLC’s project flops for whatever reason.
Here is where we come to the first major misconception of personal guarantors, which is that the lender is restricted to collecting against only the assets that the guarantor has listed on the financial statement. This is false. To the contrary, the truth is that a personal guarantor pledges the entirety of their non-exempt assets to guarantee the loan. So, let’s say that the guarantor gives a financial statement to the bank, but then later starts other completely new projects which become valuable. Or, the guarantor receives an inheritance. Or, the guarantor wins the lottery. These are all assets of the guarantor and as such are available to the lender to execute against to satisfy the loan, even though the guarantor did not list them in the financial statement given to the lender.
When the borrower (ABC LLC in our example) defaults on a loan, the bank will foreclose on the borrower’s collateral. Whatever shortfall then exists is reduced to something known as a deficiency judgment. Both the borrower and the guarantor are jointly liable for the deficiency judgment. It is upon this deficiency judgment that the creditor can elect to pursue any other available assets of the borrower or proceed against the assets of the guarantor. To obtain a deficiency judgment though, the creditor must first obtain a judgment and that requires either a court case which ends in a judgment, or an arbitration that ends with the civil court confirming the arbitrator’s award as the judgment. In both cases, the guarantor will be able to assert defenses. The question thus becomes: What defenses are available to the guarantor?
We can parse the guarantor’s defenses against a creditor into two general groups, being those that can work and those that usually flop.
Potentially Viable Defenses Of The Guarantor
Here we will list and explain in a very cursory fashion many of those defenses that a personal guarantor can assert which have a decent chance of working, if the facts support them.
Defenses Of The Borrower. The guarantor is allowed to assert whatever defenses the borrower (ABC LLC in our example) could assert. Thus, if the borrower was defrauded into entering into the loan agreement, then the guarantor could assert that as a defense to the personal guarantee as well. But note that some loan documents require the personal guarantor to waive the defenses of the borrower. Also note that if the borrower asserted these defense and lost on the merits, the guarantor will be precluded by either claim preclusion (res judicata) or issue preclusion (collateral estoppel) from relitigating those defenses.
Loans Terms Were Materially Modified Without The Guarantor’s Consent. This is among the most successful of the defenses to a personal guarantee if the facts support it. What happens is that after personal guarantee is made, the lender and borrower agree to a material modification of the loan terms but without first obtaining the waiver and consent of the guarantor. This relieves the guarantor from liability, since a guarantor cannot be held to guarantee a different deal that the guarantor did not agree to. In this context, material means something that causes a significant detriment to the rights of guarantor. Even a change in terms that benefits the borrower might be a material change in some circumstances that relieves the guarantor from liability.
Loans Terms Were Not Followed By The Lender And Borrower. Similar to the previous defense, if the lender and borrower do not adhere to the loan terms, but instead adopt a practice that is contrary to the loan terms, this might support a defense by the guarantor because it acts as a de facto modification of the loan.
Usury. In some states, the statutory usury rate might only apply to natural persons ― meaning that it would not apply to business entities like corporations or LLCs. Thus, a lender might charge a higher rate of interest to ABC LLC than it could legally charge to an individual. If ABC LLC defaults, however, and the lender attempts to enforce a personal guarantee, the guarantor might be able to assert usury as a defense to the guarantee. This is a frequent trap for so-called hard money lenders who are private lenders who charge sky-high interest rates to borrowers who can’t get loans elsewhere.
Failure To Give The Guarantor Notice Of Default. In some situations, the failure of the lender to timely advise the guarantor that the borrower has defaulted will result in the guarantor being discharged from the guarantee. This is because the guarantor might be able to take steps at the time to cure the default (such as lending the borrower money for this purpose), but by delaying the notification of the default the lender cuts off these options.
Release. If the lender releases the borrower from liability on the loan, such as through a settlement, this can often have the effect of releasing the liability on the personal guarantee as well.
This are some of the most common defenses to personal guarantees. All defenses are determined by state law (with the exception of a loan made by a bank that is later taken over by the FDIC), and of course the various states have their own peculiar defenses to personal guarantees. But now let’s look at some attempted defenses that typically fall flat.
Bad Defenses Of The Guarantor
There are some very common defenses that are raised by guarantors which rarely succeed. This include the following.
Fraudulent Inducement. Here, the guarantor argues that she was fraudulently induced by the borrower or lender to enter into the personal guarantee, usually because (she claims) she didn’t understand what she was entering into. A variation of this defense is that the lender orally told the guarantor that the guarantee would never be called, which usually fails simply because the loan agreements say otherwise and they control. An additional problem here is that most personal guarantees have language stating that the guarantee is “absolute and unconditional” and this language has been interpret to block this and many other defenses.
Lack Of Consideration. Personal guarantors will frequently try to argue that their guarantee is invalid because they did not receive any consideration (i.e., they received no personal benefit) for making the guarantee. While lack of consideration would be a good defense raised by a borrower, it is not a defense of the guarantor. Essentially, the law sets out a position that is something like, “if you’re not getting anything out of the guarantee, then don’t enter into it.”
Duress/Undue Influence. Another common but failed defense is that of duress where the guarantor argued that they were unconscionably forced into signing the guarantee. The problem here is that the alleged “duress” is that the lender would not have made the loan to the borrower had not the personal guarantee.
The Personal Guarantee Was Unnecessary. Here, the guarantor complains that the lender did not need to require a personal guarantee because the borrower was credit-worthy and then had plenty of assets. This defense pretty much always fails, not the least of which reasons being that the fact that the borrower did eventually default and the guarantee was called illustrates why the lender needed the guarantee in the first place.
The Guarantor Did Not Anticipate The Guarantee Being Called. Believe it or not, this is a defense to a guarantee that I’ve personally seen asserted by guarantors on a number of occasions. The guarantor’s argument here is that the guarantor thought that the personal guarantee was a mere formality and not a legally-binding thing. Except that formalities exist for the very purpose of documenting legal relationships and it is therefore a binding thing.
The Lender Did Not Pursue The Borrower’s Assets First. The guarantor argues here that the lender should collect against the assets of the borrower before it calls the personal guarantee and goes after the assets of the guarantor. While this sounds good to guarantors, it is not a defense since one of the purposes of the guarantee was that the lender would not have to go after the assets of the borrower but instead could simply demand that the guarantor pay up.
Impairment Of Collateral. If the lender does something that decreases the value of the borrower’s collateral (known as impairment of collateral), this can operate to release a guarantee at least to the extent of the decrease in value. Impairment of collateral can and does often happen through the neglect of the lender in failing to take necessary steps to protect the collateral, such as by failing to perfect its security rights thus allowing another creditor to obtain priority. Screwing up a foreclosure sale of real estate is another example.
Lender Allows Statute Of Limitations To Run Against Borrower. Depending on the state, it might be a defense to a personal guarantee if the lender allowed the Statute of Limitations to run against the borrower, thus relieving the borrower of liability on the loan. This seems to happen with some frequency after crashes, where lenders are dealing with lots of defaulted loans and particular cases fall through the cracks, or where loans are packaged and resold as a security but somebody down the line doesn’t get notice of the default.
There are numerous other attempted defenses to personal guarantees that likewise flop, but this gives a good flavor of the most common ones.
Reimbursement Of The Guarantor
If a personal guarantee is called and the guarantor must cut a check to the lender, then the guarantor may seek reimbursement from the borrower. This is, of course, usually cold comfort since the borrower just defaulted and is probably in deep financial distress.
Concluding Thought
Since a personal guarantee is a pledge of all one’s worldly non-exempt assets to back the underlying loan, a personal guarantee is basically a financial noose that one puts their head into and then waits to see if the trapdoor opens. The best way to avoid liability on a personal guarantee is simply to not enter into them in the first place. While this is not always possible for one’s business, every attempt should be exhausted to try to avoid giving a personal guarantee before finally agreeing to it. Personal guarantees should not be treated lightly and should not be given for mere convenience or a slightly lower rate of interest.
Unfortunately, a lot of folks treat personal guarantees as a big nothingburger. They don’t expect their projects to fail and thus never anticipate ever having to satisfy the guarantee. But projects do fail and personal guarantees are called, and then it is often a financial wipeout of the guarantor. I see this all the time in my practice and hardly a week goes by that somebody doesn’t show up with a personal guarantee that sooner or later will be called. By that time, there is often nothing that anybody can do for them (it is too late for asset protection planning if that’s what you’re thinking), other than to explore the circumstances to determine if there is a viable defense against the guarantee. But it’s a bad position to be in. And it really isn’t a nothingburger.
Don’t be one of those folks.