Ask the Lawyer: Enforcing Personal Guaranties
By Charles (CJ) Schoenwetter and Michael A. Montgomery

Enforcing personal guaranties is not always a slam dunk. Although lenders draft these documents to be air-tight, there are many valid defenses that may allow an individual to escape personal liability under a contract of guaranty.

Lenders Seeking To Enforce Personal Guaranties at an Alarming Rate

With the residential construction industry in distress, many lenders are content to foreclose on property serving as collateral for loans, but some are not. In the last 12 months, an ever increasing number of lenders have filed suit against personal guarantors of non-performing loans. A paramount issue these individuals face is whether personal liability exists for the debts of their companies based on personal guaranties they signed years ago.

Are Personal Guaranties Different Than Other Contracts?

Personal guaranties are a special type of contract with unique defenses and rules of interpretation.

For example, courts generally construe the terms of a contract against the drafter — typically the lender in cases involving a personal guaranty. Case law specifically addressing the interpretation and applicability of guaranties goes further. Contracts for guaranty must be strictly construed in favor of the guarantor.

Courts addressing whether personal guaranties are enforceable extend this principle to explain that guarantors have the right to prescribe the exact terms upon which they will enter into the guaranty obligation and to insist on a termination of the guaranty if those terms are not strictly observed.

This case law precedent may allow a guarantor to avoid personal liability for even minor variations between the operative facts and the terms of the guaranty. In other words, guarantors possess the right to insist that they be bound only to the extent, in the manner and under the circumstances specified in their guaranties, and no further.

Typical Defenses in an Action to Enforce a Guaranty

Typical defenses that can be raised in an action seeking to enforce a personal guaranty include:

Failure of the lender to accept the personal guaranty — by providing notice of acceptance, for example

Failure of consideration

A material increase in the risk to the guarantor without the guarantor’s consent

The lender’s impairment of collateral securing the underlying loan

The lender’s material alteration of the underlying loan agreement without consent of the guarantor

These defenses – two of which are discussed in greater depth below — are based on specific facts and may not be applicable to all, or even most, cases.

The Offer of a Personal Guaranty Must Be Accepted

A guaranty itself is typically just an offer — that must be accepted by the lender.

The terms of a personal guaranty may often require the offer of guaranty to be accepted in a particular manner, such as by extending the time period for paying off an existing loan. In such cases, failure to comply strictly with the manner of acceptance stated in the guaranty will result in no contract being formed. Thus, the personal guaranty cannot effectively be enforced against the would-be guarantor.

As one leading commentator has explained: “Until the requested acceptance has been made, the promise of the guarantor is nothing but an offer and creates no binding obligation on the guarantor even though the promise was in writing and signed by the promisor; nor does the mere signing of what is in fact an offer for a contract of guaranty create a contractual obligation, and in this respect the name which the parties attach to the instrument is immaterial.’

Additionally, when the manner of acceptance does not otherwise require the lender to act, failure to give notice of acceptance may also be a valid defense to an enforcement action.

Something of Value Must Support the Guarantee

A personal guaranty also must be supported by consideration or something of value to be enforceable. A guaranty given for no consideration is merely an unenforceable gratuitous promise.

Personal guaranties are often form documents. Many times they contain a pro forma recitation that consideration (i.e., something of value) has been provided in exchange for the guaranty. However, such language is not determinative and individuals have successfully challenged the consideration recited in loan guaranties.

Consideration flowing to the borrower, however, does not need to result in a personal benefit to the guarantor in order to render the guaranty enforceable. Generally, consideration supporting the underlying obligation is sufficient to support the guaranty, if the promise of the guarantor is part of the transaction that created the original debt.

However, where the guaranty agreement is entered into independently or after the underlying debt obligation has been entered into, new consideration becomes necessary to support it.

Failure of consideration and/or lack of adequate consideration can provide grounds to

avoid liability under a personal guaranty, especially when the guaranty was obtained as part of a work-out with a lender. Under such circumstances, courts have repeatedly dismissed claims against third-party guarantors when no additional funds have been extended.

A pre-existing debt is not sufficient consideration for a third-party guaranty. As expressed by one court, “consideration is not found in a mere naked promise to pay the existing debt of another.” However, something as simple and small as “an extension of credit is ample consideration for execution of a guaranty.”

Guarantors are often willing to sign personal guaranties in exchange for promises by the lender that there will be forbearance. There is no requirement to specify a definite period in an extension of the time for payment of an obligation. However, a lender’s promise not to sue for the underlying overdue debt is not sufficient consideration unless the forbearance lasts for a reasonable period of time If a lender does not forbear for a reasonable time, there is a failure of consideration and the guarantor is discharged from liability.

In one case involving a debt of $200,000, a bank’s forbearance of less than 80 days was held unreasonable, and the personal guarantor was released from his personal liability under the guaranty.

Whether a reasonable length of time for forbearance has been provided to adequately support the consideration required for a personal guaranty is always a question of fact.

Accordingly, this issue may be used to avoid summary judgment against the guarantor and force a trial, and may add three to six months (or longer) to the length of a case.

This additional time can often be used effectively by a guarantor and the underlying debtor to restructure or refinance the loan in order to avoid liability altogether.

Additional Factors on Enforceability

Documents drafted by lenders can be onerous and one-sided, with a lender at times providing representations and assurances as an inducement. At other times, lenders may enter into oral modifications of the underlying written loan agreement, or engage in unfair practices or bad faith relating to aspects of the lending relationship. It is possible for these circumstances to provide additional grounds for a defense.

For example, if a guaranty agreement does not state that it is the exclusive agreement between the parties regarding the issues addressed in the guaranty, then evidence of oral agreements made prior to, or contemporaneously with, the written guaranty may be used in determining the scope and terms of the guaranty contract.

Additionally, although many guaranties contain language stating that they may only be modified in writing signed by both parties, most courts recognize that contracts nonetheless may be modified orally or in the course of dealing between the parties. Those changes, though, typically must be demonstrated by clear and convincing evidence rather than a mere preponderance of the evidence — making them difficult to prove at trial.

If a lender has induced a material breach of the underlying loan agreement, then that may serve as a defense as well as the basis for an affirmative claim against the lender.

Lenders are required by law to exercise good faith and fair dealing in their contractual dealings with borrowers and guarantors. If a lender engages in unjustified actions hindering another party’s performance, then that is, in itself, a breach that may excuse performance.

Similarly, if the principal purpose of entering into a guaranty is frustrated, through no fault of the guarantor, by the occurrence (or non-occurrence) of an event that was a basic assumption on which the guaranty was made, then a guarantor’s performance (i.e., payment of the underlying debt) may be excused.

Under this scenario, if a guaranty was procured with everyone’s understanding that the lender would “work with” the borrower through a tough housing market — but then the lender immediately declares the borrower in default and sues on the personal guaranty — there may be a very strong “frustration of purpose” argument to assert against such a claim.

Determining When Guarantees Are Enforceable

Whether a personal guaranty is enforceable must be determined on a case-by-case basis.

In an overwhelming number of circumstances, a personal guaranty is typically enforceable. However, when the stakes are large and the transaction supporting the personal guaranty involves circumstances that are not standard, then the odds of a personal guaranty being vulnerable to a legal challenge substantially increase.

Personal liability under a guaranty can impose significant economic hardship for individuals while providing a quick and easy recovery for lenders. But recovery is not always certain. To determine whether a personal guaranty is enforceable, you should speak with an experienced attorney.

© 2008 by Bowman and Brooke LLP and Charles (CJ) Schoenwetter

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