by Robert. R. Cross, Partner

I. Introduction

The “Great Recession” of 2008-20?? has taken a severe toll on lenders and borrowers alike. As businesses faced lower profits and real estate values declined, many lenders have turned to guarantors seeking additional sources of repayment. What seemed a remote risk during the “boom years” has turned out to be a very real financial threat as deleveraging proceeds throughout the economy. Indeed, the structure of California’s laws puts a greater burden on guarantors than many borrowers.

Those who signed guaranties need to pay close attention to the legal and practical implications of their positions.

II. Guarantor Rights and Obligations

A guaranty is an agreement to answer for the debt of another, being classified as a form of suretyship (which includes the pledge of collateral by one who is not directly liable on the loan). The lender’s reliance on a guaranty in extending credit to the borrower is sufficient consideration and no separate benefit to the guarantor is needed.

The California Civil Code [beginning at section 2787] defines the rights and obligations of guarantors. The good news for guarantors is that the Code provides various protections; the bad news is that they may be waived. Any savvy lender will ensure that its form guaranty contains blanket waivers of common statutory protections that ordinarily require that the lender:

• First exhaust its remedies against the borrower;
• First resort to collateral pledged by the borrower;
• Use the remedy of judicial foreclosure (rather than a non-judicial trustee’s sale) if the lender wants to be able to pursue a deficiency claim after sale of real property collateral;
• Do nothing to alter the original obligation or to impair its remedies against the borrower without the guarantor’s consent.

Guarantors typically give little thought to the implications of signing guaranties, assuming that the loan will be repaid by the primary borrower or through foreclosure of any collateral pledged by the borrower. But the obligation of a guarantor can create a serious risk exposure, so thorough analysis is necessary both before undertaking the obligation and at the first hint of possible default by the borrower.

III. Key Issues Affecting Guarantors

A guarantor should be aware of a several key issues that will largely determine whether a guaranty can be readily enforced or may be subject to avoidance – which may compel the lender to consider an acceptable compromise settlement.

• Financial Capacity. The guarantor’s best protection is a responsible and financially capable borrower. If the lender is satisfied with the borrower’s efforts and ability to repay the loan, the risk to the guarantor is greatly reduced. If the borrower’s financial capacity has been impaired, the guarantor needs to consider proactive measures rather than simply hoping the lender will forget or ignore the guaranty.
• Collateral Status. A well secured loan should also limit the guarantor’s exposure as the collateral may provide a secondary source of repayment despite the borrower’s credit problems. However, if the loan is undersecured, the guarantor may have fewer protections than the borrower if the lender seeks to collect the deficiency following foreclosure. California courts have held that a guarantor who pledges collateral to support a loan generally does not have the same protections as the borrower.
• Prejudgment Remedies. When a lender sues to collect a defaulted loan, it often makes an immediate motion to attach assets of the borrower (or guarantor) to secure the anticipated future judgment. Guarantors may be subject to having their bank accounts or other assets tied up during the litigation if the lender can satisfy the requirement that the guaranty was provided in the course of the guarantor’s trade or business (since attachment is not available in actions to collect personal, family or household obligations). Where the guaranty supports a loan to a business entity owned or managed by the guarantor, attachment will be permitted, but not if the guarantor is only a non-managing limited liability partner or member of the entity.
• Spouse/Domestic Partner Liability. When the guaranty is signed by only one spouse (or registered domestic partner), special attention must be given to the rights and obligations of the non-signing spouse/partner. In most cases the guaranty cannot be enforced against separate property of the non-signing spouse, and in certain cases it may be possible to argue that even the spouse’s share of the community property is exempt. Note that a property settlement agreement assigning the guaranty obligation to one party will not insulate the other party from the lender’s attempt to enforce the obligation.
• Borrower or Guarantor Bankruptcy. The borrower’s bankruptcy will seldom benefit the guarantor; instead, it may motivate the lender to turn its attention to collection on the guaranty, since its remedies against the borrower will be automatically stayed and the likelihood of eventual recovery impaired. If the liability exposure on the guaranty exceeds the guarantor’s financial capacity, he or she must carefully evaluate the cost and benefit of a bankruptcy filing. Bankruptcy should be the last resort only after all alternatives have been exhausted, but knowing the likely result of a bankruptcy filing can provide strong bargaining leverage in dealing with the lender.

IV. Conclusion

It is important to consult an experienced attorney before signing a substantial obligation, particularly a guaranty of another party’s loan. It is absolutely critical to have legal representation by counsel knowledgeable about creditors’ rights issues at the first indication that a guaranteed loan may be heading for default.

If you have any questions about any of the issues discussed above, please contact Robert R. Cross, Polly A. Dinkel, Elizabeth T. Erhardt, Melvin D. Honowitz, James R. Janz, Ryan J. Meckfessel, Gilda R. Turitz or Constance J. Yu.

This publication is for informational purposes only and is not intended to provide legal or tax advice, or to create an attorney-client relationship.

Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.