[caption id="attachment_35960" align="alignleft" width="176" caption="Kenneth Neale"][/caption]
In the current lending environment, small businesses are often required to provide personal guaranties from their owners in order to obtain loans, even those secured by real property or other assets. Two of the most common forms of guaranty found in commercial loan transactions are the full guaranty of payment and performance and the non-recourse carve-out guaranty.
Full guaranty
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 does not require the lender to first exhaust its remedies against the borrower or any collateral before seeking performance from the guarantor. If such a guaranty cannot be avoided, you should consider negotiating the following points:
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. Consider negotiating for the guaranty to be several, with each guarantor responsible only for a specified percentage of the loan (usually corresponding to that guarantor’s ownership interest in the business).
Seek to negotiate a monetary cap on liability under 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.
You may be able to negotiate that the guaranty terminates if the borrower meets certain well-defined milestones, such as better financial performance or an increase in collateral value. The lender may require that the guaranty spring back into existence if those milestones are not maintained, however.
Non-recourse carve-out guaranty
Many real estate and other secured term loans are, with certain exceptions, non-recourse to the 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 come under one of the following two categories:
Partial recourse carve-Outs
These carve-outs protect the lender to the extent it suffers harm due to certain “bad acts” of the borrower. The list of “bad acts” has grown in number and scope over the years. While it is fair to say there is no standard list of exceptions, the typical carve-outs are for fraud, misappropriation of funds (including rents, condemnation proceeds, insurance proceeds and security deposits), waste, and failure to maintain insurance or pay taxes.
What to negotiate?
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 into a full recourse loan. The events which typically lead to this result are (i) bankruptcy; (ii) violations of the due on sale or encumbrance provision 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 was not harmed.
What to negotiate?
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 convert the loan to a full recourse loan.
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 full recourse liability, particularly if the sales proceeds are used in the borrower’s business.
Separateness covenants are often broadly worded and easy to violate. Violations could include, for example, incurring additional indebtedness, failing to keep a separate address and phone number for your business or amending governing documents without lender’s consent. You should 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. A lender will tend to be more flexible if it knows it is competing for your business so it is also useful to have other lending alternatives.
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Kenneth A. Neale is a Director with the law firm Howard Rice in San Francisco. He has extensive experience in real property transactions, including commercial leasing, acquisitions and dispositions, construction contracts, financings and restructurings, and environmental and bankruptcy issues affecting real estate. Mr. Neale can be contacted at 415-677-6322 or kneale@howardrice.com.
