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
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
1. 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.”
3. 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.