You signed a guaranty. That guaranty enabled the partnership you had sponsored to obtain a loan. That loan enabled the partnership to buy and develop some much needed housing for your community, which in turn would earn a nice return for your investors and your family.
Now, the loan is due but can't be refinanced, the project can't be sold for enough to pay what's owed, and as a result you aren't sleeping well at night. To add insult to injury, your advisors are telling you that you could well owe the tax man as well as the lender, and that, despite what your family thinks, you would have been in better shape if you had been reckless and signed even more guaranties.
These are difficult times for individuals who have signed personal guaranties in California. Billions of dollars of guarantied construction, residential and commercial mortgage debt are coming due (or in default), but lending standards have tightened, asset values have dropped, and there are few buyers except bottom fishers. There are some practical options, however, but guarantors need to understand the process, the goals of the institutions holding their guaranties, and what's negotiable. In this article we will discuss these considerations, using as an example a guaranty of a real estate loan; the general principles, however, apply to most guaranty situations.
The Whys and Whats of Guaranties
Lenders usually have two goals in demanding a guaranty: underwriting an additional source of recovery to support the loan and, often more important, incenting the borrower's sponsors to act in the lender's interests and not to walk away from a troubled project. Lender's often refer to this as "holding the sponsor's feet to the fire". These goals are reflected throughout the forms of guaranties themselves and in the lender's behavior in negotiations.
Guaranties come in many flavors, the most common ones in the real estate industry being: (1) the general guaranty ("I guaranty any obligation of the borrower to you, whenever incurred"); (2) the completion guaranty ("I guaranty completion of the project on time and on budget, including payment of all cost overruns and damages resulting from delay"); and (3) the "bad boy" guaranty ("I will pay any losses you suffer if the borrower skims rents or otherwise acts badly or if there is an environmental problem, and I will guarantee the whole loan if the borrower files for bankruptcy").
Variations sometimes encountered include: (1) the limited liability guaranty, sometimes referred to as a "first dollar" or "last dollar" guaranty, where the exposure is capped at an agreed upon number plus the costs of enforcement (the lender does not want you fighting against it on its dime) or recourse is limited to specific assets, (2) the guaranty of collection or deficiency guaranty ("I will pay you any deficiency remaining after you have exhausted your remedies against the borrower"), or (3) the indemnity guaranty ("I will cover any losses if X happens").
It is all too easy to view the many pages of a bank form of guaranty as just so much "boilerplate" and they often are not heavily negotiated as a result. The "boilerplate", however, has consequences. The most important is that a guaranty is usually structured as an "independent obligation". This means that the lender can seek to enforce the guaranty before, at the same time as, or after, seeking to enforce the obligation against the principal borrower. It can act immediately upon a default in the underlying loan and does not have to wait until it has foreclosed on its collateral and realized a deficiency. It can be enforced against a guarantor not withstanding that the actual borrower might have effective defenses: For example, the guarantor will not have the protection of anti deficiency, one action or other borrower protections found in many states.
The usual way that a guaranty is enforced is through a written demand (although this is not usually required in most forms) followed by the filing of a law suit. If the guarantor has pledged collateral to secure the guaranty obligation, foreclosure proceedings against that will often be commenced. The lender may pursue these remedies independently of any action the lender is taking against the borrower and its collateral or the lack thereof. Tactically, however, a lender will often file a suit to collect on a guaranty at the same time that it starts foreclosure proceedings against its borrower's collateral, with the goal of ensuring that it has the guarantor's attention and engagement early in the process.
Lawsuits, as we all know, are time consuming and expensive, which restores some leverage to the guarantor. To counteract that, to force the attention of a non-responsive guarantor, and to prevent dissipation of a guarantor's assets, lenders often seek pre-judgment attachment, an order placing assets under court supervision (and outside the discretion of the guarantor) while a lawsuit is pending. Because of the paucity of guarantor defenses, these writs of attachment are frequently granted, which can be highly disruptive, to say the least.
If there was no collateral given by the guarantor, then the creditor needs to wait until it obtains a judgment, and then the creditor can attempt to levy (have the sheriff seize and sell) assets that are not otherwise encumbered to other creditors or exempt by law (homesteads, for example), a process that can take some time, depending on how difficult the assets are to identify and locate and the sheriff's workload. However, a collecting lender will be able to foreclose on any personal property collateral posted by a guarantor in as little as two weeks, and on any real property collateral in anywhere between three to four months.
Multiple guarantors are a special case. These guaranties are usually "joint and several", which means they can be enforced against all guarantors concurrently or against any one for the entire amount. This reflects the lender's concern that it not be caught in the middle of squabbling guarantors; the lender's attitude that "you decided to go into business together, so pay me and then you can work out who owes what among yourselves."
Defenses: "I Waive, I Waive, I Waive"
The potential harshness of the independent obligation principle has historically led courts to be hostile to guaranty enforcement. This, in turn, gave guarantors a potent arsenal of technical defenses. As a result, a well drafted guaranty (and most institutional lender form guaranties are well drafted in this respect, if not particularly readable) is largely made up of waivers of those defenses.
Both courts and legislatures have become increasingly concerned that the highly technical nature of these defenses have the potential to allow sophisticated business guarantors who knowingly assumed guaranty risks to unfairly avoid their obligations, and therefore the trend in both the statutes and court cases is to give effect to these waivers. A guarantor is well advised to assume the legal enforceability of his or her guaranty when planning any negotiations. Notwithstanding the legal enforceability of most guaranties, however, courts are sympathetic to the argument that a guarantor acted unreasonably by failing to mitigate its losses or increasing the guarantor's exposure (for example, by allowing collateral to deteriorate, or by poorly thought out foreclosure sales procedures, or by ignoring a liquid source of recovery), so the lender's behavior is by no means off the table as a topic of discussion and negotiation.
The Tax Man Cometh
All in all, a guarantor's legal position is not a pleasant one, and, unfortunately, it gets worse. The tax authorities are the silent partners in most transactions, and that includes guaranty collection actions and workout negotiations. Most troubled real estate projects are held by tax transparent entities in which the guarantying sponsor holds an interest. As a result, a foreclosure of the borrower's principal asset that recovers less that the outstanding debt may trigger capital gains recognition on the difference. Forgiveness of all or any portion of the underlying debt obligation or the guaranty may trigger ordinary income recognition. Guarantors should be aware that many exemptions that can be used to shelter assets from the demands of lenders and other creditors are ineffective against the IRS, increasing the practical exposure.
Tax planning for a guarantor of a troubled project is complicated, requiring consideration of federal and often multiple state taxing jurisdictions, whether obligations are recourse or non recourse, and the impact on the rest of the guarantor's business. There are techniques that can reduce a guarantor's current tax exposure, particularly if the guarantor can demonstrate his or her insolvency. Taking advantage of these techniques may have consequences (such as triggering defaults) under many seemingly unrelated loan agreements or other contracts, so planning needs to be done with care and knowledge of a guarantor's entire situation.
Beating the Odds: The Successful Workout
Does this mean that a guarantor's position is hopeless? Hardly. Our experience is that many guarantors are able to negotiate a decent resolution and live to fight another day. They are able to do so, notwithstanding the lender's formal leverage, because they recognize that most lenders are highly practical and are fighting a lot of fires with not a lot of resources.
Successful guarantors understand that negotiating guaranty work outs is the art of the possible. The first step is to get in front of the right people. Often these are not your friendly relationship team, but instead the ‘special asset" or work out group you may have been trying to avoid. These teams often have much more experience dealing with troubled situations, take the matter less personally, and are much more realistic about what cannot be done than the team that originated the loan. Second, you should thoroughly understand the documents and history of the deal. This means fly specking these highly technical documents to ensure that there are in fact no viable defenses and no prejudicial acts on the part of the lender. In addition, because form guaranties are so dense and technical, they frequently do not reflect the deal that a sponsor thinks he has reached or assurances given by the lender's relationship team. While it is much better to understand the consequences of the guaranty as written before you sign it, even at this late stage it may give you something to discuss.
Assuming you are talking to the right people and have determined that asserting legal defenses is not likely to be fruitful, it is time to get practical. Remember that one of the reasons lenders ask for guaranties is to underwrite additional sources of recovery if things go bad. Lenders frequently approach guarantor negotiations with an eye toward a guarantor bankruptcy. Lenders are not afraid of bankruptcy, however, what a lender can recover in such a bankruptcy, after taking into account the costs and delays inherent in the process, is implicitly the floor in the negotiations. Whatever is likely to yield more is potentially attractive to the lender.
As a result, the most effective guarantor defense is often the simplest: empty pockets. If you can convince a skeptical special assets team that you are essentially judgment proof and that liquidating your assets in bankruptcy is unlikely to yield them more than pennies on the dollar, they have little incentive to tie up time and resources pursuing you. It is for this reason, ironically, that signers of multiple guaranties are often in the best place to effect a settlement: Lenders can add, and a stack of obligations in excess of any conceivable net worth you may have is a powerful argument for the futility of pursuit. Also, unless you are living lavishly or are perceived to have behaved badly (attempting to hide or transfer assets, for example) lenders are often not all that interested in ordinary personal or household assets.
Conversely, lenders understand that a guarantor that has a track record of successful cash flow generation over the years and who has the opportunity to start over in a new venture free of the specter of creditor suits or bankruptcy may well be able to generate future cash for the lender above and beyond what would be available in a bankruptcy liquidation. These lenders are often willing to limit a guarantor's current exposure and uncertainty in return for a share in that upside. Finally, lenders, as we have mentioned, insist on guaranties to prod sponsors to cooperate. Where maximizing the liquidation value of a borrower's or guarantor's assets requires the sponsoring guarantor's continuing participation and cooperation, there is an opportunity for the guarantor to negotiate for concessions in return.
The ultimate structure of any workout depends on the mix of recoverable assets in liquidation, realistically anticipated future cash flows and value of continued cooperation. Absolute or conditional releases, caps on recoveries, limitations to specified assets, extended payment terms and cash flow payment arrangements are all realistic results in the right cases. A lender holding a guaranty often may insist that any work out be part of a global resolution with all of the guarantor's creditors in order to give the guarantor a realistic chance of future success. Because the lending relationship may reflect the strain of recent events and sponsors are often seen as overly optimistic, use of skilled advisors to provide a reality check and strategic guidance, avoid tax traps, address complex inter-creditor issues and help make a credible presentation to the lender is usually time and money very well spent and often the key to getting a deal done.
The specter of facing a guaranty call is undeniably worrisome, but it is not the end of the world. A realistic assessment of the situation from both your and your lender's point of view, good advice, advanced negotiation skills and a creative, business-like approach can produce a livable resolution that sets the stage for future prosperity.