What is a Personal Guaranty Agreement?
A personal guaranty agreement is a legally binding contract that obligates an individual to become responsible for a borrower’s debt in the event that the borrower fails to meet the loan’s repayment terms. The borrower—the person or organization borrowing the funds—could be a corporation, partnership, or LLC, and the money can be secured, as in with a mortgage or car loan, or unsecured, such as in a personal loan. When such an agreement is signed by an individual, they are personally vouching for the ability of the borrower to make repayments on the loan and they are asserting that they will take over this responsibility if the borrower cannot .
A personal guaranty agreement gives the lender security, since it provides them with a second source of repayment for a loan if the business or organization is not able to make repayments as required. These agreements can also aid in personal credit history when seeking funds in the future if the borrower happens to have a very low credit score.
Some of the instances in which a personal guaranty agreement may be used include:
Whether an individual decides to sign a personal guaranty agreement comes down to whether he or she trusts the borrower’s ability to repay the loan, and, if they don’t, how strongly they trust that they will be able to follow through with the obligations of the agreement should it fail.
Essential Elements of a Personal Guaranty
A personal guaranty is an agreement in which an individual (the "Guarantor") accepts personal responsibility to fulfill obligations in the event of default by a company or third party. In order for the Guaranty to be enforceable, it must satisfy the formalities set forth in Rhode Island’s Uniform Commercial Code ("UCC"). Personal guaranties not meeting the formalities even under circumstances in which the guaranty would otherwise be enforceable are only enforceable as equitable consults.
While these requirements may appear burdensome, they are designed to protect a Guarantor from adverse consequences should the other party to the contract default. The following are some basic requirements of a personal guaranty:
- Guarantor – A Guarantor may be a legally competent person or a single business entity. If the latter, the personal guaranty should clarify in what capacity the Guarantor is acting. For example, if there are multiple entities involved, the guaranty should indicate whether the Guarantor is signing as an individual or in his/her capacity as representative of an entity.
- Obligee – The Guarantor must be acting for the benefit of a third party (the "Obligee"). As such, the Guaranty must set out the parties to the contract which the Guarantor is guaranteeing. Implied in this is an obligation on the part of the Obligee to notify the Guarantor of matters pertaining to the guaranty.
- Obligations Guaranteed – The Guaranty must set out what obligations are being guaranteed by the Guarantor. There must be a specific default and specific remedy for such default set out in the document forming the Guaranty. If no default or remedy is set out and the Guarantor is having problems, an inquiry as to the status of the Guarantor’s ability to fulfill his/her responsibilities must be made before resorting to remedies under the guaranty.
How Guarantors are Affected by a Personal Guaranty
In situations where a business owner or principal is acting both as the owner of a company and the personal guarantor for a loan issued to the business of which he or she is the sole owner, the guarantor may sign multiple documents governing and affecting the same transaction. In that situation, the guarantor is usually the typical vested individual required to personally guarantee a loan or line of credit. But under circumstances where the guarantor is possibly no longer making the individual decision to open or extend a line of credit, the guarantor’s exposure could potentially be significantly enlarged.
If the manager and/or agent of the guarantor signs the paperwork without the guarantor being present (whether in an E-Sign transaction or otherwise), the guarantor’s signature will still generally constitute a valid and binding contract with the lender. The guarantor may not be aware of the proposed terms of the deal if, for example, the terms of the deal changed from those that the guarantor had originally approved. The lender will have no obligation to ensure that the guarantor has reviewed the terms of the deal or to provide the guarantor with copies of all modifications and changes.
It is also important to understand that whether the guarantor is one of the parties signing the deal or merely the borrowing entity’s manager or agent, the lender may seek recourse directly from the guarantor if any of the guarantees are breached. The lending institution may take action against the guarantor without notifying the guarantor or the guarantor’s legal counsel or anyone else involved in the transaction.
The implications to the guarantor of the foregoing factors potentially could vary depending upon the structure of the lending arrangement and the entity structure of the business. The guaranty that the lender may require the guarantor to execute can be very broad and expose the guarantor to substantial liability. A lender might secure a broad, general guarantee. It might also specify that the guarantor gives the lender a specific power of attorney allowing it to act on behalf of an individual’s interests if needed (e.g., if the guarantor skips town with corporate assets). If the company were to fail, the guarantor (who possibly could be the sole stockholder of the issuing entity under certain scenarios) could potentially be subject to a variety of risks. If the guarantor improperly manages its affairs so that it makes an unpermitted distribution, the guarantor could be primarily liable under various state laws for many of the debts of the borrower.
It will be critical to acquire an accurate projection of the maximum exposure to be incurred by lenders and their loan underwriters. This will help determine how much risk the lender and its investor are willing to undertake in relation to the equity interest being accepted as collateral.
Legal Implications of Personal Guaranty Agreements
When it comes to drafting or signing a personal guaranty agreement, there are several legal considerations to keep in mind to ensure that the deal is enforceable against you and to protect yourself from any possible liability under the agreement. First and foremost, the agreement must follow all legal formalities of any contract. It should include the full and legal names of all parties, be signed by all parties, and be dated. While most guaranty agreements are signed when you are agreeing to be liable for the debt of a company, it is important to make sure you also sign the agreement on its own to acknowledge the liability. A well-drafted agreement will often have the requisite signature lines for all parties, so it’s important to make sure the document is drafted properly before signing. It is also important not to use any abbreviations of your name or incorrect addresses, as this could lead to future issues in the enforceability of the agreement. In addition to complying with the above-mentioned formalities, a personal guaranty agreement should be in accordance with the requirements of the Statute of Frauds. As a refresher, the Statute of Frauds governs which types of agreements must be in writing to be enforceable. While several types of contracts fall under the Statute of Frauds, a personal guaranty generally falls under the requirements for "contracts that cannot be performed within one year." Specifically, it states that "[a]n action shall not be brought upon an executor’s promise, or administrator’s promise, to answer for the debt, default or miscarriage of another person . . . unless the promise or agreement upon which such action is brought, or some note or memorandum thereof be in writing, and signed by the party to be charged therewith." State law may also address hand-written alterations or other specific formalities of the agreement. A personal guarantor may also want to seek protection under the doctrine of unconscionability by including a language such as the following in the agreement: "The Lender and the Borrower acknowledge and agree that each has had the opportunity to review the provisions of this Guaranty with legal counsel of its choice and fully understands the rights and obligations of each of them hereunder. The parties further acknowledge that the terms of this Guaranty are fair and reasonable, that there has not been any wrongful conduct on the part of the Lender in connection herewith, that no party has acted under compulsion or duress in executing this Guaranty, and that the provisions contained herein are the product of negotiations which have been fairly and honestly conducted between persons of relatively equal bargaining power." While this language may not void an existing agreement, it will provide for potential legal protection for the guarantor if the agreement is deemed to be unconscionable by the court. Unconscionability provides that courts will not enforce contracts that are unfairly one-sided. State law controls what factors are taken into account when making a determination of whether an agreement is unconscionable. Some factors that a court may consider include: Stay tuned for our next installment in this series: Example of Personal Guaranty Agreements.
Types of Personal Guaranties
A personal guaranty can be either conditional or unconditional. An unconditional personal guaranty obligates the guarantor to pay the full amount of the debt as soon as the debtor defaults and the creditor collects from the debtor. The unconditional type does not excuse the guarantor from his obligation simply because the creditor secondarily pursues the underlying debtor. An unconditional guaranty generally provides that the creditor may proceed against the guarantor prior to proceeding against the debtor.
Conditional guaranties, on the other hand, are much less commonly used in commercial finance transactions. A conditional guaranty makes the guarantor’s obligation to pay the debt contingent on the creditor’s ability to collect the debt from the debtor. Thus , a conditional guaranty generally provides that it will only be enforceable against the guarantor if the creditor has previously exhausted all remedies against the debtor.
There is also a third type of general personal guaranty called an unsecured guaranty. An unsecured guaranty contemplates a promise by the guarantor to pay the debt, but only if the debt is not paid by the debtor itself. As an unsecured guarantor, he or she would be liable only after a court has determined that the debtor was liable for the debt. For example, an unsecured guarantor in a real estate transaction agrees to make the payments only if the tenant fails to do so under the lease.
hedge funds and private equity interests are more commonly unsecured personal guarantors.
Common Pitfalls in Executing Personal Guaranties
There are a number of common mistakes that individuals make when agreeing to bind themselves to a personal guaranty. Some of these are easily avoided, but others are often not apparent until it is too late.
Many people do not understand exactly what they are agreeing to, and sign the document without any explanation. Often times the Lender or Lawyer who is providing the document for signature does not sit down with the Person giving the guaranty, and go through the entire agreement explaining all of the rights and terms.
People frequently do not understand that they are individually binding themselves to an agreement. Often times there is an entity that is involved which a person is a member, shareholder, or officer or director of that entity. Guarantees on behalf of an entity are sometimes signed by that entity and also by the individuals personally.
Another common mistake that is made is not properly reading the entire document. Some individuals skim the document and sign only at the signature page, without reading all of the terms, clauses, and conditions.
Not consulting a Lawyer who is experienced in drafting, negotiating, and litigating personal guaranties is one of the most costly mistakes that a person can make. Even if you are not charged for a full Real Estate closing, the investment in money and time will pay dividends later on. The goal is to minimize risk and to protect your assets.
Personal Guaranty Agreement Enforcement
In the event that a principal debtor fails to meet their financial obligations, the enforcement of a personal guaranty agreement allows the lender or creditor to recover all or part of the loan from the party who provided the guaranty. In cases where the parties have agreed, the lender or creditor will immediately proceed to enforce the guaranty, after giving proper notice to the guarantor and providing sufficient opportunity to satisfy the amount owed under the personal guaranty. However, if the agreement does not clearly provide enforcement procedures, including any necessary notice, the creditor or lender may be required to first obtain judgment against the principal debtor before proceeding to enforce the guaranty against the guarantor.
The enforcement of a personal guaranty agreement typically proceeds in a similar manner as enforcement of a loan agreement. The creditor or lender must adhere to the notice and demand provisions contained in the guaranty agreement. Should the creditor or lender fail to properly establish its right to enforce the personal guaranty through prior notice or demand, the guarantor may have a defense in a breach of contract, fraud, or tortious interference with a contractual relationship action brought to collect the debt owed. When the creditor or lender has satisfied the notice and demand requirements and the guarantor has failed to comply, the creditor or lender is entitled to pursue collection of the secured debt.
For example, suppose a creditor entered into a written agreement with a debtor to lease office space. The debtor is required to make monthly rental payments of $1,500 by the 1st of the month. Additionally, the creditor requires the debtor’s owner to execute a personal guaranty agreement that guarantees the full and timely payment of any sums due under the lease between the creditor and debtor. Should the debtor default by failing to make any rent payments by the due date, the creditor would be entitled to possession of the premises under the written lease agreement without first seeking a money judgment against the debtor.
However, if the creditor has failed to provide the proper notice and demand required under the personal guaranty agreement prior to pursuing enforcement of the guaranty, the creditor would be required to file a lawsuit against the principal debtor, prosecute to judgment, and then seek to enforce the judgment against the guarantor.
In addition, creditors may base their enforcement of personal guaranty agreements upon equitable theories of recovery, including unjust enrichment and estoppel. In such cases, the creditor may seek to recover the debt owed less certain credits or offsets to be allowed under particular circumstances based on the equity of the case. If an express agreement has not been entered into by the parties so as to establish an enforceable personal guaranty, some states still will allow creditors to enforce their claims without the execution of a written guaranty document.
In 2015, a state court dealt with the loss of home to various debts owed by the owners to a home-building company. Under the circumstances presented, the court ruled that insufficient payment of the home’s full value to the building company, supported by evidence of substantial improvements made to the home, and the increased value of the home necessitated monetary payment over and above the specific amounts attributable to the principal balance owed on the home loan. In a breach of contract claim, the court ruled that where a home purchaser had failed to fulfill the obligations owed to the building company, by underpayment for the specific amounts owed, the building company could seek to enforce the remaining unpaid balance based upon an implied contractual agreement to pay the fair and just value of the home based upon the previous fair market value of the home prior to its acquisition by the purchaser. See Bartley v. Shatford, 77 So.3d 583, 586 (Ala. Crim. App. 2015) (This decision dealt with whether the trial court had erred in making a similar decision to that reached in this case.).
Establishment by the creditor or lender of an enforceable personal guaranty agreement, as well as its successful enforcement following a principal debtor’s default, will result in the creditor or lender’s capacity to recover all or part of the loan owed under the personal guaranty agreement from the party who provided the guaranty. While enforcement of a personal guaranty agreement by the creditor or lender may substantially affect a personal guarantor’s assets, the creditor or lender’s failure to comply with strict notice and demand requirements imposed by the parties may bar recovery of some or all of the loan to the extent the creditor or lender cannot establish an implied agreement by the parties precluding, upon the circumstances, the need for notice or demand.
Negotiating and Modifying Personal Guaranties
Many times, personal guaranties are the product of negotiation, but they are not always well thought through. For instance, be cognizant of the fact that the less you negotiate and the more limited the terms, the more likely you are to move the transaction forward. Therefore, it is important to put time into negotiating the personal guaranty long before it is on the table at the closing. Depending on how well your negotiations represent your interests, a poorly negotiated personal guaranty may cost you more that the money you are trying to save by pushing the deal through without any or sufficient negotiation.
A common strategy is to accept a carve-out for acts of intentional misconduct or fraud. While the lender (or landlord or other entity seeking the guaranty) may want you to be responsible for all acts, intentional or unintentional, framing the carve-out as such allows you to limit your liability without significantly increasing your risk . In addition, because the carve-out is not very valuable to the lender, they are more inclined to consider including it in the personal guaranty.
Additionally, keep in mind that the more limited the personal guaranty, the more likely it will be easier to get done. A guaranty that is limited to a specific property and to certain damages that may arise as a result of actions related to such property is often a fair compromise. Where there is not enough of an interest to justify taking a personal guaranty, insurers may be willing to issue a bond for the same amount, or lenders may be readily willing to fund a credit facility of the same amount.
Finally, consider the impact of subsequent closing(s) and how amendments to the personal guaranty can be used to address new developments and issues. If you know that additional raise ready capital will be needed in the future, set your sights on making sure the personal guaranty will cover such additional financing.