Suppose you are one of multiple individual owners of a company, and you all agreed to guarantee the company’s loan from a bank. The business does not go quite the way you had hoped, and the company defaults on the loan. The bank sends demand letters to the guarantors and threatens legal action. To avoid litigation, you negotiate a partial payment to the bank to buy more time. You wire the money to the bank, and then ask your coguarantors to chip in their pro rata share. They refuse.

     Under these circumstances, you might think you have a legal right to reimbursement from the other guarantors. Not so, at least according to a recent case from the Indiana Court of Appeals - Small v. Rogers, No. 29A02-1001-PL-30 (Ind. Ct. App. Nov. 17, 2010).

     In that case, three members formed a limited liability company (the “LLC”). The LLC took out a loan, and one individual related to each member – including Rogers and Small – executed a personal guarantee. The LLC subsequently defaulted on the loan, and the bank demanded payment from the guarantors for all amounts owed, including more than $1.6 million in principal, plus interest, fees and costs. Rogers convinced the bank to hold off on any litigation in exchange for payment of the outstanding interest. Rogers made the full interest payment and sought contribution from his co-guarantors. Small refused. Rogers then sued for contribution. Rogers also sued Small on a similar claim under an unrelated guarantee and loan.

     Rogers won in the trial court, which granted summary judgment in Rogers’ favor. The court held that “Small is liable to Rogers for his pro rata share of the amounts paid. It is not necessary that Rogers have paid the liability in full. . . . The law finds the right of contribution when one party pays more than his share of the common obligation.” The trial court awarded more than $40,000 in damages.

     Small appealed, and the Indiana Court of Appeals reversed the trial court’s decision. According to the appeals court, Rogers was not entitled to contribution because he did not pay off the entire debt and because he had not paid more than his proportionate share of the entire debt. In other words, the court refused to treat the partial payment as a discrete amount subject to allocation among the three guarantors:

 [I]n this case, the debt still exists. Rogers did not discharge the debt, either by paying the debt or a judgment on the debt. . . . Furthermore, the amounts paid by Rogers do not constitute more than his proportionate share of the more than $5,000,000.00 of debt incurred. He therefore is not entitled to contribution from his co-guarantors at this time.

     Under the court’s rationale, Rogers would not be entitled to contribution from Small unless and until he paid his proportionate share of the overall liability on joint transactions –or the underlying debt was fully discharged (for example, by payment of a lesser amount in exchange for a release of all guarantors).

     This decision is consistent with cases from other jurisdictions, and it appears to reward guarantors who, when faced with threats of legal action, choose to sit back, while more risk averse guarantors negotiate forbearance agreements in exchange for partial payments.

     If you are faced with a similar situation, do not assume that the other guarantors will reimburse you for any money you pay out to stall a collection action. And before agreeing to execute a co-guarantee, consider whether to define the parties’ respective obligations with respect to intermediate, partial payments of the underlying debt. By contract, the parties could require contribution in situations like Small, even if the common law would not provide a remedy.