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Guaranties in
California Transactions
INTRODUCTION:
If one person or entity agrees to pay the existing or potential debts or
obligation of another person or for an entity such as a corporation or
limited liability company, then one is said to be “guarantying”
the debt and one becomes as liable for payment as if one had incurred
the obligation directly. The “guarantor” is the person
guarantying the debt while the party who originally incurred the debt is
the “principle” and the creditor is the “guaranteed party.”
Under California law, if properly drafted, a guaranty is a fully
enforceable obligation which allows the guaranteed party to proceed
directly against the guarantor, often without having to even exhaust
first any remedies against the principle.
The reader should first read the article on
contracts and on
promissory notes before reading further.
The guaranty is a
powerful and common tool both in business and real estate transactions
and forms the basis for thousands if not tens of thousands of
transactions in California annually. Most creditors and landlords,
confronting a
limited liability entity without substantial assets, will
demand a guaranty from the owners of the business so that if the company
becomes insolvent, personal liability may be imposed on the owners or
whoever else guaranteed the debts. Landlords renting to such entities,
banks granting credit lines, manufacturers providing products to
distributors…all such transactions often require guaranties being
provided by the owners of the entities.
If you are a
creditor, such a tool is probably the single most powerful weapon in
your arsenal of collection and, assuming the owners of the entity have
assets, can provide payment even if the entity becomes defunct or files
bankruptcy. If you are the owner of the entity seeking credit, or a
person seeking to have credit provided to another person, the guaranty
is an obligation to be taken seriously. It is not unusual for a father’s
guaranty of a son’s obligation or a departing shareholder’s continuing
guaranty of a company she has left to result in significant liability
being imposed, often years later after the guarantor may have even
forgotten that the guaranty was granted.
It must be recalled
that typically the guaranty applies to the debt regardless of the cause
of the debt or if the principle acted wisely or foolishly. It applies
whether or not the guaranteed party failed to notify the guarantor of
its actions or whether or not the creditor was foolish in continuing to
lend the money.
It is, in short,
almost a blank check written to the creditor on behalf of the principle.
Before undertaking such an obligation or, if you are a creditor relying
on a guaranty, the basics described in this article should be understood
and, of course, good legal advice obtained before creating such a
document.
CALIFORNIA REQUIREMENTS FOR A GUARANTY
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IN WRITING
Oral guaranties are almost never enforceable in California though many
creditors have attempted to enforce them claiming that they only
extended credit predicated on various oral assurances from the owners of
the debtor. While the law provides that a guaranty must be written,
inventive creditors have sought to impose liability on the verbal
“guarantors” by claiming constructive fraud, negligent misrepresentation
and
piercing the corporate veil
theories. These efforts are seldom successful and both the statute and
common sense indicate that something as serious as a guaranty MUST be in
writing which carefully lays out the principle, guarantor, and
guaranteed party and whether the guaranty relates to all debts and is in
effect for a specific period of time.
The writing must be
executed by the Party to be charged to perform under the guaranty (the
guarantor)
and is usually but need not be executed by the principle and the
guaranteed party. The key is to have the guarantor sign.
The writing should
clearly state all elements of the guaranty and describe in some detail
the process for revoking the guaranty.
The writing should
indicate whether the principle must first have its funds exhausted
before the creditor can seek recovery from the guarantor. (Minus clauses
to that effect in the document, many courts require exhaustion of
remedies against the principle first.)
The usual standard
terms of any contract, ranging from clauses as to how to alter the
contract to a provision providing for arbitration and attorneys fees
being awarded to the prevailing party should be included and the reader
is advised to review the article on
Contracts as well as on
Arbitration on this website for a full discussion of such
terms.
2. CONSIDERATION
The writing should
specify some form of “consideration” being given to the guarantor for
the guaranty. As noted in the article on
Contracts, to be binding either
some form of consideration must be paid to a party, or reasonable
reliance and detriment must be shown for the relying party. One can not
be bound to a contract unless one either gets something for such
obligation or leads the other party to presume that you will perform.
Mutuality of consideration, in which parties to a contract either get
something for agreeing to be bound, or require the other party to give
something up, is an element of most contracts, including guaranties.
Commonly, the
guarantor has an ownership interest in the entity or a family interest
with the principle and that fact should be recited in the guaranty.
Typically, a clause will read, “X agrees to pay all debts of Y, a
company in which X has an ownership interest,” or “X wishes Bank
to loan monies to Y and understands that Y has refused to do so unless X
guaranties all obligations of Y to Bank. Bank relies on this
unconditional guaranty of X to pay obligations of Y to Bank in making
any loans to Y hereunder.”
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CONDITIONS OF
GUARANTY
An unconditional guaranty does not place upon the guaranteed party any
obligation to perform certain functions before relying on the guaranty.
For example, a guaranty may be conditioned on first exhausting all
efforts to collect against the principle; it may be conditioned on the
debt being only for a particular type of transaction; it may be
conditioned on the guaranteed party giving adequate and written notice
to the guarantor of the obligations being incurred.
Most modern
guaranties, however, are unconditional, placing the full burden on the
guarantor without requiring the guaranteed party to do more than make
demand for payment upon the guarantor whenever a debt is not paid.
Typical language in such a guaranty is:
“Guarantor
unconditionally and irrevocably guarantees all obligations of X owed to
Y, and waives forever any right whatsoever to require Y to first proceed
against X before making demand upon Y for payment in full. The guaranty
shall continue in full force and effect and may only be terminated in a
writing delivered to Y thirty days before termination of the guaranty
and such termination shall not eliminate the guaranty as to sums already
advanced. Y shall not be required to advise Guarantor as to any sums
advanced to X hereunder and it shall be incumbent upon Guarantor to keep
itself fully advised as to the state of the transactions between X and
Y. Guarantor shall promptly and fully pay all obligations of X to Y upon
receipt of written demand for payment from Y.”
4. DEFENSES TO A GUARANTY
Normally, a guarantor obtains all the benefits of the clauses protecting
the principle. Thus, if the principle has a clause in its contract with
the guaranteed party that limits the obligation or which delays when
payment is due, the guarantor may rely on those protections as well: the
guarantor, in effect, steps into the shoes of the debtor, no better, nor
worse. It is thus a very good idea for the guarantor to carefully review
all the documents binding the principle before the guaranty is made.
But the danger
remains that the obligation of the principle to the guaranteed party may
be altered between them without notice or warning to the guarantor and
many guaranties give the guaranteed party the right to do precisely
that. The careless guarantor may therefore find itself guarantying an
obligation far broader and more onerous than first encountered. The
prudent guarantor shall insist in the guaranty that the obligation may
not be altered in its terms without prior advice and consent of the
guarantor.
5. CREDIT APPLICATIONS AND GUARANTIES
Amidst the small print and recitals at the end of many bank loan
applications as well as line of credit applications one finds guaranties
which, if not carefully considered, can have devastating effect on the
debtor. Our office makes it a standard practice when drafting credit
applications for our clients to submit to new customers which have a
guaranty provision just before the signature line for the credit
application so that the potential customer is confronted with the
question of whether to guaranty the debts of the corporation or limited
liability company from the moment the account is opened. It is a fact of
business that once the account is opened it is much more difficult to
approach the principles of the business and then ask them to execute the
guaranty.
To our surprise,
when we take action to enforce such guaranties in the credit
applications we find that many of the debtors did not even realize they
were executing a guaranty when signing the credit application!
Apparently after filling in the various blanks with the information the
credit manager wanted, they glossed over the wording above the signature
which usually provided words to the following effect: “The Applicant
for the Credit hereby unconditionally and irrevocably agrees to guaranty
any and all obligations of the Company to XYZ Supplier and understands
that such guaranty is a condition to supplying any credit from XYZ to
Company.”
Many of our clients
will not sell to owners that will not personally guaranty the purchases
of their limited liability entity. As one client put it, “If he does not
trust his company to pay, why should I?”
CONCLUSION:
In troubled economic
times, guaranties are vital for the protection of creditors so we may
expect to see them proliferate as one more tool that creditors will seek
to utilize. They are fully enforceable if created in the correct manner
and the new business can expect them to be demanded by any bank,
landlord, or vendor dealing with the start up.
Before issuing a guaranty, the new business owner should carefully
determine if the personal risk is worth it and understand that the
limited liability entity will do little good if guaranties are too
freely given. As with any legal commitment, careful thought and good
legal advice should be obtained before signing on the dotted line.
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