Personal Guaranties: Are They What You Think They Are?
It is quite common for family business owners to have to personally guarantee certain indebtedness of the business owed to its lenders, most often indebtedness owed to conventional financial institutions (i.e., banks, credit unions, etc.). Many business owners, who are also guarantors of the debt of the business, do not realize that, if the lender exercises its rights and remedies with respect to the indebtedness, such lender is typically not obligated to first proceed against the business (i.e., the borrower) to collect the debt or against the collateral securing such indebtedness prior to proceeding against the guarantor for payment. Furthermore, if the lender exercises its right to enforce the guaranty against the guarantor, the guarantor may be obligated to pay more than the guarantor’s proportionate share of the indebtedness. While a guarantor who pays the indebtedness pursuant to the guaranty is entitled to contribution payments from the other guarantors, the law about the relative proportion of the loan that each guarantor is obligated to pay may be different from what the guarantors may believe or would have agreed to had they understood the issues and the risks related to the guaranty. As a result, it is often in a guarantor’s best interest to set forth the guarantor’s right to contribution in a written agreement among the guarantor and any other parties against whom the guarantor would like to seek recovery.
For example, let’s assume there are three (3) members of a limited liability company, which borrows $1,000,000 from a bank to finance a purchase of a piece of equipment, and each member signs a guaranty, whereby they agree to jointly and severally be reliable for the entire loan, and that the loan goes into default, and the lender then demands payment of the loan from the guarantors. Then, assume that one of the guarantors, who owns only a 40% ownership interest in the company, pays the entire loan balance, and then asks the other guarantors to pay the paying guarantor their fair share of the amount that the guarantor paid to the lender. Under common law principals, that paying guarantor may be entitled to repayment of part of the amount paid to the lender. However, the amount that the paying guarantor is entitled to recover from the other guarantors depends on a number of factors. Absent a written Contribution Agreement among the guarantors, the guarantors may believe that they are each only liable up to the portion of their percentage ownership interest in the company. However, unless agreed to otherwise in a Contribution Agreement, common law will typically provide that each of the three (3) guarantors are liable for one-third (1/3) of the debt, despite the fact that their ownership interest in the company may be greater or lesser than one-third (1/3). While courts have held that the paying guarantor would have a claim against the non-paying guarantors for the amount that the paying guarantor paid in excess of his fair share, the courts have also held that each member’s fair share is to be measured against the amount of the indebtedness, not the amount of any settlement reached between the company, the guarantors and the lender. Therefore, if a paying guarantor is responsible for 40% of the indebtedness, but the amount of the settlement was less than 40% of that indebtedness and the paying guarantor paid what equated to the entire settlement amount, that paying guarantor did not pay more than his 40% of the indebtedness, and, therefore, the paying guarantor would not have a claim of contribution against the other guarantors.
Taking into account the uncertainties as referenced above, guarantors may want to strongly consider entering into a written Contribution Agreement with the other guarantors. The typical Contribution Agreement should include as parties, not only the guarantors, but any other party against whom any or all of the guarantors wish to recover, including possibly any owners of the business who may not be guarantors. Essentially, the Contribution Agreement would provide (a) for a determination or definition of what constitutes a guarantor’s fair share of the indebtedness, (b) that the guarantors would agree to reimburse each other for any payments made by a guarantor on the borrower’s indebtedness in excess of the paying guarantor’s fair share, and (c) that the guarantors would (i) pay for the defense of the paying guarantor, (ii) pay costs of enforcement of the Contribution Agreement by the paying guarantor, and (iii) pay interest on any and all amounts owing under the Contribution Agreement. A guarantor’s fair share can be based on a number of factors but often is determined based on (a) the total amount of the indebtedness at issue or (b) the total amount of guaranty payments, then either (x) divided by the number of guarantors or (y) multiplied by the guarantor’s percentage ownership interest in the business. In the event that any of the guarantors become insolvent or die, the Contribution Agreement should expressly provide for a recalculation of the fair shares because such guarantors would be unavailable to contribute.
In conclusion, personal guaranties are often not what the guarantor may think they are and when multiple parties guarantee a loan or other obligation, executing a Contribution Agreement may be a wise decision, particularly since many guarantors are under the misguided understanding that they will only be responsible for their share of the indebtedness based on their proportionate ownership interest in the business.
Contact David P. Dewick at 920-430-1900 for more information.