A GUARANTY FOR EVERY NEED: AN OVERVIEW OF THE VARIETY OF LOAN GUARANTIES-AND HOW TO SELECT THE RIGHT ONE
Underwriting a commercial credit facility is a process of weighing various risk mitigators until the lender is satisfied that the potential for loss is within its tolerance. By evaluating collateral value, credit history, financial statements, property reports, facility economics, project feasibility, market conditions, and countless other variables, the lender can precisely balance a deal’s risks and returns. One of the most substantial weights in this balancing act is the payment guaranty.
At its most basic, a payment guaranty allows the lender to look past the single-purpose, limited-liability structure that the vast majority of borrowers use; past the collateral security and its dependence on favorable market conditions; past the borrower’s operational issues or cash-flow problems; and straight through to the persons or entities who hold the actual value behind an enterprise.
Under optimal circumstances for the lender, each principal and affiliate of a borrower (I’ll use the term “sponsor” to mean the decision-maker behind the borrower) should grant an unlimited, unrestricted guaranty of payment, often referred to as a “full-recourse” guaranty. Properly drafted, this guaranty permits the lender to force one or more of the guarantors to make every payment that would have been due from the borrower. In other words, whatever the borrower’s obligations to the lender may be (at least in terms of payment), the guarantor has the same obligations. The advantages of this instrument are obvious, but suffice it to say that with a full-recourse guaranty, it doesn’t matter where the enterprise value goes–the lender has a backstop in the guarantors. It doesn’t matter whether it happens by fraud, mismanagement, or just bad luck, whatever the cause of the default, the lender can pursue each and every guarantor for the full indebtedness.
Sponsors often don’t make a peep when negotiating the note, loan agreement, mortgage and the rest but become quite vocal as soon as the subject of the guaranty comes up. It makes sense for the sponsor: if the project fails, let the lender have the collateral and move on, but being personally responsible? Forget it.
When the deal economics require it, it’s easy to tell a sponsor that the lender will accept nothing less than a full-recourse guaranty. “Take it or leave it” is the easiest negotiating position to assume. But when a project boasts a low loan-to-value ratio, a strong balance sheet and/or cash flow projections, a sponsor with a lengthy and flawless payment history, or even just a particularly savvy sponsor, the guaranty quickly becomes a target for the sponsor’s own risk management goals. How then can a lender maximize its own risk mitigation and still bring the deal to closing—and do so with enough good will to ensure future deals with the sponsor? Here are a few options:
The Limited Guaranty. A limited guaranty can provide the solution, and there are several ways to limit the guarantors’ liability. The first, and simplest, is to simply place a dollar value cap on it. “Notwithstanding any other provision herein to the contrary, Guarantor’s liability hereunder shall be limited to $_____.” Straightforward, simple, effective, and probably too uncertain to be attractive to most lenders. The next step from this first, bare-bones option would be a percentage of the indebtedness. It’s the same basic idea (keep it simple), but this option allows both the lender to take a bigger piece of an early default and the guarantor to be relieved of some liability if the loan performs for a significant part of the term.
The Several Guaranty. When there is more than one guarantor, sometimes their primary objection to making the guaranty is being liable for the entire debt. Under a legal concept known as “joint and several liability,” full-recourse guarantors are each individually responsible for the entire debt. The lender’s position with respect to joint and several liability is that the cause of the default is irrelevant; the guarantors can fight among themselves after the lender is repaid. Essentially, if two people go into business together, they–not the lender–assume the risk of that affiliation. This risk presents another opportunity to limit each guarantor’s liability by placing limits on each guarantor individually (or, severally) rather than jointly and severally.
The Specific Performance Guaranty. Any of these options also can be tailored to differentiate between the types of obligations being guaranteed. For example, the lender might require the guarantors to guarantee only a portion of the principal but still guarantee all of the interest, default interest, and costs of enforcement. Or the guarantor can be required to guarantee the performance of a specific obligation, such as the completion of a construction project.
The Burn-Off Guaranty. Another way to limit guarantor liability is with a “burn-down” or “burn-off” provision. This represents an incentive approach to a limited guaranty, in which the guarantor liability is reduced or eliminated upon the satisfaction of one or more conditions. Under the terms of most burn-down/burn-off guaranties, on day 1 of the loan term, the guaranty is at its maximum coverage. From there, depending on its terms, coverage will diminish as the conditions are satisfied and, if applicable, eventually terminate altogether. The diminution and/or termination of coverage can be tied to any number of performance incentives, such as the satisfaction of a sales or leasing target, the acquisition and pledge of additional collateral, or simply the passage of a certain amount of time without the occurrence of a default.
The Recourse Carve-Out Guaranty. If a burn-off guaranty represents a “carrot” to the guarantors, the corresponding “stick” is the recourse carve-out guaranty (or, depending upon whom you ask, the non-recourse carve-out guaranty). This guaranty is similar to guaranties of specific obligations and is often referred to colloquially as a “bad-boy” guaranty because its function is to guarantee that the sponsors won’t commit any bad acts but absolves them of liability for defaults that occur outside their control. This is an especially attractive option for sponsors because it places control over their liability into their own hands. So long as they don’t embezzle from the borrower (they think), they won’t incur any personal liability. This seems to be a low bar.
In reality, a properly drafted, “market” recourse carve-out guaranty will cover more than just fraud. The easiest way to categorize the protections a lender enjoys under a recourse carve-out guaranty is between “recourse events” and “loss events.” A “recourse event” triggers full recourse against the guarantors for the entire indebtedness. A “loss event” triggers liability against the guarantors only for the specific losses suffered by the lender as a result of the triggering event.
Recourse events are characterized by the potential to disrupt the lender’s ability to enforce the loan documents and usually include: a voluntary bankruptcy filing, an involuntary bankruptcy filing that isn’t dismissed within a certain time period (usually 60 to 90 days), the unauthorized transfer or encumbrance of collateral or shares in the borrower/guarantor, borrower insolvency, and any attempt by the borrower to challenge the lender’s enforcement or disclaim its liability. Each of these items is going to make it more difficult (not to mention more costly and time-consuming) for the lender to be repaid in full, which is why full recourse is demanded from the guarantors. The lender’s ability to move quickly against a guarantor will protect it against the drain of time and assets that usually results from a bankruptcy proceeding or partition action.
Loss events, on the other hand, may make it more difficult for the borrower to repay the loan in a practical sense, but they ultimately leave the matter between the original parties. Intentional fraud, misappropriation, waste, environmental damage, and the commission of criminal acts usually fall into this category. Any of these items might harm the borrower’s enterprise value and impair the borrower’s ability to repay the loan, but in the end the lender can still extract whatever value remains from the borrower without having to fight off competing claims, so the need to bring the hammer down on the guarantors isn’t as urgent. Notwithstanding, many lenders and lenders’ counsel believe in bringing down the hammer anyway, so negotiating a recourse carve-out guaranty is often a fight over whether each trigger will go into the “loss events” basket or the “recourse events” basket, with lenders pushing for full recourse and guarantors pushing for bare indemnity.
It is important to remember that building any limitation into a guaranty can open the door to a guarantor defense that the pre-conditions for enforcement haven’t been satisfied. Accordingly, it is critical that when drafting any guaranty, however it might be limited, the lender’s barrier to enforcement is minimal. Because the lender might need to demonstrate to a court that prerequisites have been satisfied before enforcing, a well-drafted guaranty will make those prerequisites both easy to achieve and easy to prove.
Obviously, a full-recourse guaranty is always the best comfort, but a limited guaranty, when well-drafted and accepted with a clear understanding of the guarantors’ resources, can help enormously to get a deal over the finish line. It will come as no surprise that the foregoing guaranty types and characteristics can be broken up and re-assembled into infinite variations to suit the particulars of a given deal. Lenders and lenders’ counsel should take care not to allow borrowers and guarantors to tip the balance away from guarantor liability without corresponding counterbalances.