You might wonder whether lenders can enforce a guaranty of a loan from an individual or entity that has no formal connection with the borrower, i.e. someone who is not an owner or affiliated company. Generally, the answer is yes with some qualifications for potentially insolvent guarantors discussed below. However, lenders are well-advised to take the steps outlined at the end of this post to minimize the risk of a subsequent challenge by the guarantor.
With respect to guaranties, Connecticut courts have generally followed the Restatement (Second) of Contracts § 88 (1981) (“Restatement”). According to the Restatement, a party may enforce a guaranty under one of three theories:
A promise to be surety for the performance of a contractual obligation, made to the obligee, is binding if:
- The promise is in writing and signed by the promisor and recites a purported consideration; or
- The promise is made binding by statute; or
- The promisor should reasonably expect the promise to induce action or forbearance of a substantial character on the part of the promisee or a third person, and the promise does induce such action or forbearance.
Under Connecticut law, an enforceable guaranty must either induce reliance or be supported by consideration as required by § 88 quoted above. All guaranty agreements should recite consideration in the text, and the consideration itself can be nominal.
Generally, form prevails over substance; therefore, it is important to include an exchange of nominal consideration in the language of the guaranty. In Connecticut, the recital of consideration acknowledged as received is prima facie evidence of the fact recited. See A.T. Clayton & Co. v. Hachenberger, 920 F. Supp. 2d 258, 265 (D. Conn. Jan. 29, 2013).
To avoid issues of whether the guarantor is an “accommodation” party under the UCC, the guaranty should be a separate document. Furthermore, Connecticut General Statute 42a-3-419 permits parties to incur liability without receiving a direct benefit of the value given for the instrument. Guarantors and “accommodation parties” are each types of sureties. The accommodation party is jointly and severally liable with the primary obligor, unless its signature is accompanied by unambiguous language that it is guaranteeing collection rather than payment.
The lender’s file should contain evidence that the guarantor is not insolvent. If the guarantor is insolvent at the time of executing the guaranty or the guaranty is likely to render the guarantor insolvent, a creditor outside of bankruptcy or the trustee in bankruptcy could avoid the obligation under the guaranty. A recent case provided lenders with a painful reminder that they must inquire as to the impact of a guaranty on a guarantor. Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re Tousa, Inc.), 680 F.3d 1298 (11th Cir. 2012). In Tousa, a lender loaned $500 million to a large homebuilder that was guaranteed by the borrower’s subsidiaries and liens on their assets. The borrower used the proceeds to pay a debt for which the subsidiaries were not liable, and the guaranties rendered the subsidiaries insolvent. The bankruptcy court found that the subsidiaries did not receive reasonably equivalent value for their guaranties and therefore the execution of the guaranties constituted a fraudulent transfer. The court then voided the lender’s liens and ordered the lenders to return $421 million (the amount of the parents’ debt) to the bankruptcy estate. Although the district court reversed the bankruptcy court, the 11th Circuit reinstated the bankruptcy court’s decision.
The guaranty should be a separate document and recite the consideration. Every personal guaranty should be absolute and unconditional, waiving all legal and equitable defenses such as misrepresentation or lack of notice. Guaranty defense waivers prevent collateral attacks on the guaranty and increase the probability that courts will enforce the guaranty. To avoid violating applicable fraudulent conveyance law, it is also advisable to receive and analyze the financial statements of any guarantor.
Because of the individual exposure and liability, a guarantor may have the personal guaranty reviewed by an attorney. Guarantors also have the opportunity to protect personal assets by purchasing personal guaranty insurance, a new type of insurance geared toward managing risk.
Every lender should take five steps to avoid risk and ensure maximum protection:
- a clear recitation of consideration, which can be for $1.00;
- the guaranty should be contained in a separate document;
- incorporating a waiver-of-defenses provision;
- having an owner or principal or other sophisticated party signing the guaranty in addition to the unaffiliated guarantor; and
- retaining a financial statement showing the guaranty will not render the guarantor insolvent.