Negotiating Small Business Loan Guaranties

By Kenneth A. Neale
415 677 6322

In the current lending environment, it is often necessary for a small business to provide personal guaranties from owners of the business in order to obtain a loan, even one secured by real property or other assets.

What's a Guaranty?
In its basic form, a guaranty is an agreement to pay the debt or perform an obligation of another in the event of a default by the borrowing party. Guaranties can take many forms, however. Two of the most common types used in commercial loan transactions are the full guaranty of payment and performance and the non-recourse carve-out guaranty.

Guaranty of Payment and Performance
A full guaranty of payment and performance would allow a lender to require payment or performance of a loan obligation by the guarantor upon default by the borrower. It typically would not require the lender to first exhaust its remedies against borrower or any collateral before seeking performance from the guarantor. You should do your best to avoid having to provide such a guaranty, but if it cannot be avoided, you should consider negotiating the following points:

• Negotiating Loan Covenants. You should carefully review the loan documents themselves to minimize the chance that the borrower will be in default for non-monetary obligations. A breach of a non-monetary obligation could result in the entire loan becoming due and payable in full. Make sure that the loan covenants are reasonable and achievable given the circumstances of the business. As long as the borrower is not in default, there is no liability under the guaranty.
  
• Joint and Several Liability. If there is more than one guarantor, which is often the case when there are several owners of a business, a lender will want the guaranty to be joint and several, meaning that each guarantor is liable for 100% of the loan and the lender could choose to collect from some or all of the guarantors up to the full amount of the liability. Consider negotiating for the guaranty to be several, meaning that each guarantor is only responsible for a specified percentage of the loan (usually corresponding to that guarantor's ownership interest in borrower). If this cannot be negotiated, the guarantors should enter into a contribution agreement amongst themselves whereby each guarantor agrees to be responsible for its percentage share of the loan obligations and requiring indemnity and reimbursement if one guarantor pays more than its share. Be aware though that many guaranties limit the rights of the guarantor to pursue the borrower or other guarantors, at least while the loan remains outstanding.
  
• Financial Caps. Seek to negotiate a cap or burn down of the guaranty. A full guaranty does not just involve a guaranty of the loan amount, but also of interest, including default interest, late payment fees and attorney's fees. Sometimes a lender will accept a flat monetary cap on the liability of the guarantor. The lender may also permit the cap to reduce over time provided the loan remains in good standing.
  
• Disappearing Guaranty. You may be able to negotiate that the guaranty disappears if the borrower meets certain well-defined milestones relating to financial performance or an increase in collateral value (and therefore the loan-to-value ratio). The lender may require that the loan spring back into existence if those milestones are not maintained, however.

Non-Recourse Carveout Guaranty
Many real estate and other secured term loans are, with certain exceptions, non-recourse to borrower, meaning that in the event of a default the lender's remedies are limited to foreclosing on the real estate or other collateral securing the loan. These loans invariably have carve-outs to their non-recourse nature, however, which typically must be guaranteed by the principals. The carve-outs generally have two components, partial recourse carve-outs and full recourse carve-outs.

• Partial Recourse Carve-Outs. These carve-outs protect the lender to the extent it suffers harm due to certain "bad acts" of the borrower. These "bad acts" are not all the same and have grown in number and scope over the years. It is fair to say there is no standard list of carve-outs. Instead, they vary significantly from one lender to the next. The typical carve-outs are for fraud, misappropriation of funds (including rents, condemnation proceeds, insurance proceeds and security deposits), waste, and the failure to maintain insurance or pay taxes.
  

  What to Watch For?
  

  • You should carefully review the list of carve-outs to make sure they cover truly bad acts.
    
  • You should avoid carve-outs for negligent acts or for the failure to pay taxes or other expenses where funds are not available to do so (if this cannot be avoided, you should pay taxes, insurance and other operating expenses before paying the loan).
    
  • You should make sure that the language clearly limits the guaranty obligation to the harm suffered by the lender due to the particular bad act.
    
    
• Full-Recourse Carve-Outs. Full recourse carve-out provisions are particularly risky because they act as a switch converting a non-recourse loan to a fully recourse loan, thus turning the guaranty into a full guaranty. The events that typically lead to this result are (i) bankruptcy; (ii) violations of the due on sale or encumbrance provisions of the deed of trust or security agreement; and (iii) particularly for real estate secured loans, failing to comply with separateness (or single-purpose entity) covenants contained in the loan documents. Recent court decisions in this area have generally upheld these provisions, even in situations where the lender arguably was not harmed.

What to Negotiate?

• No Liability for Involuntary Actions. The carve-outs for bankruptcy and breach of the due on sale or encumbrance provisions should be limited to voluntary actions. An involuntary bankruptcy or an involuntary lien (such as a mechanic's or judgment lien) should not transform the loan to a recourse loan.
  
• Incidental Transfers. Incidental transfers of collateral should be exempted. Due on sale provisions often cover all collateral, including personal property. The sale of small amounts of personal property should not be cause for recourse liability, particularly if the sales proceeds are used in the borrower's business.
  
• Separateness Covenants. These are often very broadly worded and easy to violate. Violations could include, for example, incurring additional indebtedness, failing to keep a separate address and phone number for the business or amending governing documents without lender's consent. You should first try to narrow these covenants as much as possible so that they are not so easily breached. You should also attempt to negotiate materiality and cure periods for any violations.

* * *Guaranties should be taken seriously as they could lead to substantial personal liability. The best way to negotiate a guaranty is to raise issues early on in the loan application process. It is also useful to have other lending alternatives. A lender will tend to be more flexible if it knows that it has competition for your business.