We are often asked about the consideration needed for a guaranty to be enforceable. Often when loans go into default, guarantors will claim they received nothing of value themselves in exchange for their guaranty and therefore it should not be enforced.
Fortunately for a lender, in most circumstances such arguments by a guarantor fail and consideration is found to exist for guaranties supporting a loan. In this article we will briefly analyze the law in regard to consideration for guaranties.
Legal consideration can be defined as something bargained for or received in exchange for a promise, such as an agreement to make a loan. Alternatively, it can signify something provided as part a deal which is relied upon by a lender in making a loan. In the case of an individual guarantor, there is ordinarily no issue of consideration in regard to a guaranty provided as part of a new loan transaction, a further discretionary advance, a forbearance or a loan modification agreement. The lender, in agreeing to such new or modified loan terms, is providing the required consideration to make the guaranty binding. The lender has relied on the guaranty in making the loan or modification or in forbearing and a guarantor will have a difficult time trying to invalidate the guaranty after the fact.
Typically, consideration problems might arise where a further guaranty is requested by a lender “out of the blue” (i.e., unconnected to either the initial loan grant or any forbearance or modification or where the loan is not in default). In such circumstances neither benefit, nor reliance would support consideration for this serendipitously given guaranty. Because of this, it is important that any required guaranty be signed more or less contemporaneously with the grant of the new loan or modification and not significantly after the other loan documents have been signed and funds have been advanced. If for any reason the loan must close without immediate execution of a guaranty, the subsequent execution and provision of the guaranty should be included as one of the loan covenants in the documents that are executed, with the failure to provide the later guaranty being an event of default. With such a default provision, consideration (i.e., not declaring a default) exists for the post-loan guaranty.
At this point a reminder is in order, however. While a lender can condition a loan on the provision of a guaranty, a lender may not require the guaranty of a spouse of a principal who is uninvolved in the borrower simply because of his or her existence or because the lender believes such a guaranty will be given if asked for. To make such a blanket request for a guaranty from a spouse of a principal who is neither an owner nor an officer of a borrower would run afoul of the Equal Credit Opportunity Act and Regulation B potentially rendering not just the guaranty void, but exposing the lender to significant legal liability[1].
Issues of enforceability of guaranties are far more complicated in regard to related business entities, especially in the event of a bankruptcy. Fraudulent transfer law may render ineffective both guaranties of parent and affiliate entity obligations given by subsidiaries and other affiliates (respectively, “upstream” and “cross-stream” guaranties) as well as security interests and mortgages given to secure those guaranties. This is more likely to occur where the guarantor entities do not receive any of the loan proceeds or any other significant benefit from the transaction. While a detailed analysis of fraudulent transfer law as applied to entity guaranties is far too complicated for purposes of this brief note, the following concepts generally apply and should guide the lender in assessing how a loan is structured.
Fraudulent transfer claims may be asserted against a lender when guaranties and the liens securing them are given at a time when the guarantor is insolvent, or they render the guarantor insolvent, or leave the guarantor with insufficient capital or assets for the guarantor’s continuing business. In such cases, if a court determines that the guarantor did not receive “reasonably equivalent value” for such guaranties and liens, the guaranties and liens may be avoided as “constructively fraudulent transfers.” Guaranties and liens securing them may also be challenged as “intentional” or “actual” fraudulent transfers, however, such challenges are rarely successful in the context of challenges to the guaranties and liens of institutional lenders. “Downstream” guaranties and liens granted by parent entities with respect to their subsidiaries are not ordinarily regarded as fraudulent transfers since the guarantor parent entity benefits from the transaction by reason of its ownership of the subsidiary.
Given the complexity of many loan transactions and the structure and relationships of many corporate entity groups, special rules apply in determining whether the guarantying entity has received anything of value in exchange for its guaranty. Given these concerns, special care must be given to how a loan is structured where guaranties of affiliates or subsidiaries are involved. Determining which entities will be borrowers and guarantors and the form of the loan will be key to ensuring a lender obtains the guaranty and collateral support for the loan it intended. In addition, a lender should make sure that a guaranty is signed “under seal” whenever possible since consideration is thereby presumed and in addition the guaranty may be thereby subject to a 20-year statute of limitations.
The topic of enforceability of guaranties can be a complicated one. This article provides only a brief over-view of the issues in play. Hopefully, however, this review will at least inform loan officers of when caution should be exercised and counsel consulted.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
[1] If the purpose of requesting a spousal guaranty is for ease of attaching jointly held assets in the event of a default, the better and legally correct approach is to request a mortgage or other security document signed by both spouses as security for the guaranty of the spouse involved in the business. This avoids requiring a guaranty from the uninvolved spouse and does not violate Reg. B.
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