As most small business owners know, creditors will often require owners to give personal guaranties for the repayment of the company’s debt. Landlords, suppliers and bankers require these guaranties to secure an additional source of repayment and perhaps to get the owners to demonstrate their commitment to the business. While guaranties are a fact of life for the small business owner, the ongoing nature of some of these commitments can have harsh and unintended results for the borrower.
In general, guaranties are either for a single transaction or for a series of transactions. A guarantor might be required to sign a guaranty for a term real estate loan or lease, which will expire if and when the loan or lease is fully performed.
If a series of transactions is contemplated, the creditor may require a continuing guaranty, which obligates the guarantor to repay any future extensions of credit to the borrower. This type of guaranty is common with suppliers and banks that offer revolving credit lines.
Problems can arise when the guarantor departs the business, debt increases and/or the guarantor forgets about the guaranty.
A recent Idaho Supreme Court case is instructive on the potential for guaranties to haunt guarantors. In Washington Federal Savings v. Van Engelen, a husband and wife owned two development companies, an LLC and a corporation. In 2002, the corporation borrowed $126,000 from the bank, and the owners were required to sign a continuing guaranty, which imposed liability on the owners for any funds loaned to the corporation at the time or in the future. The loan was paid off in one year.
In 2005, the LLC borrowed funds, and the bank asked for a similar guaranty from the owners. The owners refused, stating it was their policy to no longer guaranty the debt of the entities they owned. The bank agreed to loan funds to the LLC without a guaranty from the owners.
In 2006 and 2007, the corporation entered into six additional loans with the bank. While no new guaranty was entered into for these loans, the owners’ continuing guaranty from 2002 remained in effect. The loans went into default, and the bank sued the husband and wife for $4.5 million.
The husband and wife defended by asserting they believed that their conversations with the bank in 2005 made it clear they no longer intended to guaranty the debt of either of their companies. The court disagreed, and held that the failure of the husband and wife to revoke their 2002 guaranty in writing made them liable for the $4.5 million. This result, while appearing harsh, is not surprising. Most guaranties are drafted in favor of the lender and require the guarantor to waive most defenses upon collection.
Another pitfall associated with guaranties may occur upon the sale of a business, or the departure of one of the owners of a company. Oftentimes no thought is given to the number and nature of guaranties that are outstanding. It is not uncommon for a seller to discover years later that the buyer has not paid suppliers, landlords or the bank. The amounts outstanding may be far in excess of the debt existing at the time the guarantor sold out of the company. In many cases, the guarantor remains on the hook for full payment.
Guarantors should keep track of all guaranties to which they are subject. Guaranties of accounts that are inactive should be terminated in writing, as should continuing guaranties associated with term loans, when the loan is paid off. Upon the sale of a business, the seller should make sure all guarantied accounts are closed and the guaranties terminated in writing. In some instances, it is not possible to eliminate liability under a guaranty, but liability for future extensions of credit can be avoided.
Mike Baldner is a partner with the law firm Meuleman Mollerup LLP, practicing in the areas of real estate law and business law with a focus on complex high value real estate transactions and commercial litigation. He represents corporate tenants, developers, landlords, sellers, lenders, title companies, construction companies and a variety of retail and restaurant businesses. Mr. Baldner can be contacted at 208.342.6066 or by email at email@example.com. More information at lawidaho.com.