In this very competitive lending environment, it is not uncommon for the principals of a middle market borrower to attempt to push back against a lender’s customary request for unlimited general guaranties of the borrower’s obligations.
If the lender agrees to accept limited (rather than general) guaranties from the borrower’s principals, particular care needs to be taken in negotiating the scope of such limited guaranties especially when drafting and negotiating the term sheet or commitment letter.
With respect to unlimited (or general) guaranties, all guarantors agree to each be responsible for the full amount of the debt or debts being guarantied. For limited guaranties, the scope of such guaranties is trickier and may be limited in any number of ways, for example to a specific dollar amount, or to a specified percentage of the outstanding loan balance which is often tied to a principal’s ownership percentage in the business.
An unlimited guaranty is typically framed as a “joint and several” obligation of each guarantor. By this we mean that each guarantor is fully responsible for repayment of the entire obligation guarantied and the lender may collect the full amount of such obligation from one guarantor or from any combination of guarantors; provided that the lender may only collect the full loan amount once. If one guarantor repays the entire obligation, the other guarantors are off the hook.
With a limited guaranty, the extent of the obligation being undertaken may not be as clear.
Assume a borrower is borrowing $1,000,000 and that its two principals have agreed to execute guaranties of the loan limited to $500,000. It is important that both the lender and the borrower/guarantor parties all have the same understanding as to the extent of the obligation being undertaken by the principal/guarantors. If the limited guaranties provide for “joint and several” liability of $500,000, this means that only the total amount of $500,000 is guarantied by the two guarantors regardless of which one repays it or in what proportions. Once the guarantors have together repaid the lender the amount of $500,000, both guaranties are extinguished and the lender has no further recourse to either of the guarantors.
A lender, however, will often intend to “stack” the limited guaranties such that the full amount of the guarantied obligations, in our example $1,000,000, is recoverable from the guarantors, i.e., $500,000 from each. If the lender intends to stack the guaranties in this manner, the terms of the guaranty must indicate that the guaranty is a “several” and not a “joint and several” obligation of the guarantors. With a “several” guaranty, each guarantor is agreeing to be liable to the lender for up to $500,000 irrespective of what the other guarantor has repaid. In our example, “several” guaranties from the guarantors would provide for full coverage of the $1,000,000 loan.
In negotiating loan terms, it is not unusual for the lender and borrower to gloss over such “technicalities” but clarity on what is intended is critical to avoid confusion in the lender’s internal loan approval process, in the term sheet circulated to the borrower and in the final loan documents. Last minute disputes such as “we never agreed to each be liable for $500,000, but rather to be jointly liable for only $500,000” especially where the loan approval assumed “several” liability of $500,000 each, can be difficult to resolve and can either delay or derail a loan closing.
Further, particular care should be taken when modifying a lender’s standard form of general or unlimited guaranty for use as a limited guaranty to be certain that the customary “joint and several” language of a general guaranty is modified to achieve a “stacking” guaranty. This is an issue which we often see when we review loan documents in connection with undertaking collection activities for lenders and it may materially impact successful collection of the obligation.
Besides limiting the amount of the guaranty obligation undertaken by a guarantor, a borrower and its principals may also request that the guaranty obligation only ripen after the lender has undertaken and/or completed collection efforts against the borrower, i.e., that the guaranty is a guaranty of collection and not a payment guaranty. This type of guaranty is often referred to as a “deficiency” or “marshaling” guaranty. We strongly discourage a lender from agreeing to this type of guaranty where the lender agrees to “look first” to the borrower or to the collateral before seeking repayment from a guarantor. The limitations of a deficiency or marshaling guaranty can materially delay or impair the lender’s ability to legally pursue a guarantor until ALL collection activities against the borrower or collateral have been completed. We recommend that both unlimited/general guaranties and limited guaranties be drafted as primary and unconditional sources of repayment and that they not be contingent on the lender either pursuing the borrower or collateral first or upon a lender’s recovery of its debt from other sources.
As with all loan terms, the earlier the specifics are clearly stated and understood by the lender and the borrower parties (usually in a term sheet or commitment letter), the less the likelihood of disputes and confusion as the loan closing approaches or when enforcement of the loan documents is pursued. It is never helpful for a lender-borrower relationship to start off on the wrong foot because of a lack of clarity as to the loan terms and the scope of a principal’s liability for repayment.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
Up Next...
