We have previously reviewed the important distinctions between limited and general guaranties of which a lender should be aware in structuring a loan.
Review prior post here. We also looked at the issues surrounding the consideration needed for guaranties to be enforceable and the potential invalidity of certain types of guaranties in particular settings. Review prior post here. In this third installment on guaranties, we will address some key provisions usually included in the boilerplate language of guaranties and why they are significant in protecting a lender’s rights to pursue a guarantor.
A key characteristic of a guaranty is that, legally, the contract of guaranty is deemed to be separate and independent from the contract made by the borrower in signing a promissory note. While the guaranty and the promissory note are clearly part of the same business transaction, from a legal perspective they are technically two different, albeit related, obligations. As observed by Massachusetts appellate courts, the obligations of the guarantor are not predicated on the note, “but upon the contract expressed in the guaranty.” The potential ancillary liability undertaken by a guarantor “flows from the … independent written guaranty agreement …” Because guaranties are deemed to be separate contracts from the promissory notes, a lawsuit by a lender for collection under a guaranty need not be brought in the same action as those on the underlying promissory notes. Moreover, because they are separate contracts, the extent and scope of liability under a guaranty may be quite different from that of the borrower under a promissory note.
Because of the independence of a guaranty from the underlying promissory note, it is important that the guaranty be an “absolute and unconditional” one and that it contain a waiver of defenses arising from the lender’s interactions with the borrower. Such provisions will ensure that a guarantor’s liability is not somehow limited by any defenses which a borrower may attempt to assert with respect to payment on a note. As mentioned above, a party’s liability as a guarantor is determined exclusively by the terms of the executed written guaranty. When a guaranty is absolute and unconditional this means that the guarantor undertakes to repay the borrower’s debts upon default, regardless of any claims or defenses belonging to the borrower. This type of provision, especially when coupled with a waiver of defenses provision, ensures that even if a borrower has defenses or offsets to repayment of the underlying loan, the guarantor’s liability remains outstanding for the entire debt guarantied.
It is worth noting that typically a lender will bring suit against both borrowers and guarantors in the same action for the sake of simplicity. While there is often good reason to proceed in this fashion, the distinction with respect to the waiver of defenses by a guarantor may often then be inadvertently ignored. Therefore, the decision to bring suit against both the borrowers and the guarantors in the same lawsuit should always be made only after a full analysis of the pros and cons of doing so. As a strategic matter, where a borrower is no longer in business or has no assets, it may be prudent to simply sue the guarantor and not include the defunct borrower as a nominal party in a lawsuit in order to avoid muddying the issues of the guarantor’s independent and absolute liability for repayment of the debt.
A final extremely important provision in most guaranties related to the waiver of defenses is the so-called “waiver of suretyship defenses” provision. The legal effect of giving a guaranty is that guarantors become a type of surety. At common law (i.e., in the history of cases involving guarantors) where one party guarantied another’s obligation to repay a debt, it was incumbent upon the lender not to modify or alter the guarantied obligation or any security granted in connection therewith in any respect without the guarantor’s prior written consent. If an obligation was modified without such consent, it would automatically extinguish the guaranty. The guarantor/surety was entitled to argue that it only guaranteed a very specific obligation and not one that differed from the original undertaking in any respect. In the context of a workout or desired modification of a lending relationship, so-called “suretyship defenses” placed a lender (and borrower) at the mercy of a guarantor’s decision making and ability to withhold consent or demand concessions.
Consequently, the waiver of suretyship defenses provision in a guaranty provides that a lender is authorized to modify the underlying loan obligation or to release any obligor or to release any collateral securing the loan without thereby automatically voiding the guaranty. In essence, as a result of the waiver of suretyship defenses, the guarantor gives advance permission to the lender to deal with the borrower, other obligors on the debt or any collateral securing the loan as may be agreed upon between a borrower and the lender without needing to first seek the guarantor’s permission and without impairing the enforceability of that guaranty in any respect.
Guaranties are complex agreements which contain many terms which address very important protections for a lender behind what might appear to be just boilerplate verbiage of no particular significance. Because of this, lenders should critically analyze and resist efforts by guarantors to modify or eliminate such terms from guaranties if they in any way significantly diminish the lender’s rights, in order to protect the ability of the lender to rely on the guaranty to ensure repayment of a debt.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.