by Erich Paetsch, Chair, Financial Services Industry Group
A common requirement of financing and contractual agreements is a guaranty. The reasons to include one are numerous. For example, when multiple entities are involved or a lender would prefer a strong personal commitment to a project or business, a guaranty reduces liability or guarantees performance by generally including other assets or ensuring individual investment in a project’s success. The number and types of guarantees are limited only by the creativity of the parties who structure a transaction and their risk tolerance. This article focuses on the most common guaranty—the personal guaranty—and explores some considerations for a creditor and guarantor including bankruptcy.
What is a personal guaranty?
A personal guaranty is a contract under which the guarantor has an obligation to pay after the default of the primary obligor. Oregon law does not require specific language to form a guaranty, but it is subject to the Statute of Frauds and must be in writing and signed to be valid. Warm Springs Forest Products Industries v. Rimrock Ranch, Inc., 83 Or. App. 175, 178, 730 P.2d 1255, 1257 (1986); ORS 41.580.
Like other contracts, a personal guaranty can only be made by mutual assent and must be supported by valuable consideration to be enforceable. While consideration is required, the guarantor is not required to receive a direct benefit from either the principal contract or the guaranty; a benefit to the principal or a detriment to the creditor is sufficient.
Because a guaranty is a contract, familiar contractual requirements and defenses apply. Typically, a guarantor may raise any defense that the principal obligor may have raised to the underlying obligation. Man-Data, Inc. v. B&A Automotive, Inc., 247 Or. App. 429, 437, 270 P.3d 318, 323 (2011).
In addition to typical contract formation defenses, there are affirmative defenses that may be available to a guarantor to avoid liability under the guaranty. These include material modification of a contract without consent, failure to pursue a primary obligor before pursuing the guarantor, failure to give adequate notice, and fraudulent conveyance law under state law and the bankruptcy code.
Because multiple defenses are available to guarantors, it is common to seek waivers of these defenses. A guarantor may often waive defenses which would otherwise be available, but caution is necessary when using catch-all waivers because some courts have held that waivers must be specific. California Bank & Trust v. DelPonti, 232 Cal. App 4th 162, 181 Cal Rptr. 3d 216 (4th Dist. 2014). Oregon courts have upheld general waivers that are absolute. W.J. Seufsert Land Co. v. Greenfield, 262 Or. 83, 88-89, 496 P.2d 197, 199-200 (1972).
An overlooked risk: ECOA
An overlooked risk for lenders when requiring a personal guaranty is the Equal Credit Opportunity Act (ECOA) and its implementing Regulation B. While commonly considered in the context of consumer transaction, ECOA prohibits discrimination against any applicant based on certain statuses, including marital status, in a consumer and commercial transaction. Regulation B applies whenever the guaranty of a spouse is required as part of a transaction. See 12 CFR §202.
A common violation of Regulation B is requiring the guaranty of a spouse. Generally, Regulation B imposes an obligation to evaluate ownership at the time any personal guaranty is made, including for commercial loans. A change in the form of ownership of assets due to a change of marital status, for example, cannot be considered. In situations where the spouse is an owner or officer of a company, Regulation B recognizes that obtaining a personal guaranty may be appropriate. However, in situations where the spouse is completely independent of the company, obtaining a personal guaranty may run afoul of Regulation B. Alternative arrangements such as obtaining a secondary source of collateral owned by the spouse may provide a better solution than a personal guaranty and scrutiny for compliance with ECOA.
The risks of improperly requiring a personal guaranty under Regulation B can be significant. Including a spousal guaranty, even if ultimately found legal, may delay a speedy recovery through litigation by a creditor if defaults occur. In addition, ECOA includes significant penalties, including a right to recover actual damages, punitive damages, and attorney fees and costs. While commonly overlooked, requiring the guaranty of a spouse or other party protected under ECOA may not resolve performance and payment risks and instead create liability.
Commonly used guaranty terms
Although many types of personal guarantees are available to fulfill the needs of parties and specific transactions, other commonly used guarantees may be considered. These terms are used to define the scope or duration of a guaranty. Examples include unconditional, conditional, limited, and unlimited guarantees.
An unconditional guaranty, or payment guaranty is a contract in which the guarantor promises that if the debtor does not perform, the guarantor will perform. The only condition to the guarantor’s obligation to perform is the principal’s default. A guarantor who makes an unconditional guaranty is not entitled to require pursuit of the primary guarantor first, and becomes primarily liable if the guaranteed obligation matures or is not performed.
In contrast, a conditional guaranty is a contract in which a guarantor promises that they will perform, but only when a contingent event happens or for a specified period. A typical conditional guaranty requires that the creditor pursue collection from the primary obligor before the guarantor is liable.
Another type of commonly used restriction in a guaranty limits the scope that the guarantor is contractually obligated to address. A limited guaranty, or restricted guaranty, concerns a single or limited number of transactions. A limited guarantor only guarantees transactions that are specifically identified. Creditors prefer to use an unlimited guaranty. An unlimited or continuing guaranty is a guaranty that covers a series of transactions, all debt, or all future obligations. An unlimited guaranty is typically used in connection with lines of credit. It includes all current and future transactions that are within the contemplation of the agreement and can include future debt.
Depending on the scope and other requirements of the guaranty, different guarantor defenses apply unless waived. For example, an unconditional guaranty eliminates a guarantor’s requirement of enforcement against the primary obligor before enforcing the guaranty. The type of guaranty used may also affect options in the event of insolvency on the part of the primary obligor. A creditor, unless prohibited by the bankruptcy court, may pursue an unconditional guarantor, whereas a conditional guaranty might limit any rights against the guarantor until after any bankruptcy proceeding has concluded.
Bankruptcy injunction protection for personal guarantors
Some personal guarantors assume that bankruptcy on the part of the primarily responsible party will protect the guarantor from liability after a payment or performance default. This belief is understandable, considering general knowledge of the so called “automatic stay” and bankruptcy law. The automatic stay is commonly understood to prohibit a creditor from enforcing their claims once a bankruptcy case is filed. However, this understanding does not recognize that the automatic stay is limited to protecting the debtor in bankruptcy, and not third parties. There is an exception for Chapter 12 and Chapter 13 bankruptcy cases when the so-called co-debtor stay applies under the Bankruptcy Code. The co-debtor stay is not typically available in nonagricultural commercial bankruptcy cases, which are filed under Chapter 11 of the Bankruptcy Code. In addition, the co-debtor stay does not resolve liability; it only prevents activity by a creditor for a period. Because a guarantor is a third party and not the debtor in a bankruptcy case, a personal guarantor cannot assume that the automatic stay will protect them from legal action to enforce the terms of their personal guaranty after a bankruptcy case if filed.
An evolving topic under bankruptcy law is the extent to which a bankruptcy filing can be used to protect a guarantor while the bankruptcy case is pending. When the automatic stay does not apply, a principal obligor may try to use an injunction to delay or prevent action against a personal guarantor. These efforts involve the entire bankruptcy process, from the start of the bankruptcy case until the end of any confirmed plan of reorganization. The use of injunctions to protect guarantors as part ofa bankruptcy case remains controversial and is the subject of ongoing litigation.
In the Ninth Circuit, an injunction in favor of a non-debtor party such as a guarantor after a bankruptcy is filed is permitted when the requirements for obtaining an injunction are generally satisfied. In Re American Hardwood, Inc., 885 F.2d 621 (9th Cir. 1989). However, even if an injunction is granted, the duration of such an injunction is not unlimited. In a typical Chapter 11 bankruptcy case, the goal of the debtor after filing is to receive a discharge of liability as part of a confirmed plan of reorganization. To confirm a plan and to receive a discharge of liability, the Bankruptcy Code requires that the discharge “…not affect the liability of any other entity on, or the property of any other entity for, such debt.” 11 USC §524(e). The Ninth Circuit has made it very clear that a confirmed bankruptcy plan cannot discharge the liability of personal guarantors. See In re Lownschuss, 67 F.3d, 1394, 1401 (9th Cir. 1995) (“This court has repeatedly held, without exception that §524(e) precluded bankruptcy courts from discharging the liabilities of non-debtors.”) As a result, a debtor in the Ninth Circuit cannot use a confirmed Chapter 11 bankruptcy plan to protect or eliminate a guarantor’s liability under a personal guaranty.
Efforts to include an injunction to protect guarantors as part of a confirmed Chapter 11 plan have been repeatedly rejected by the Ninth Circuit. In re Excel Innovations, Inc., 502 F.3d 1086, 1095 (9th Cir. 2007). However, it is possible to include a post-plan confirmation injunction that might ultimately result in a third-party release of the personal guarantor. To do so, the courts require a consensual third-party injunction involving the parties to be affected. In re Astria Health, 623 B.R. 793 (Bankr. E.D. Wash. 2021). In the absence of such consent, the rule in the Ninth Circuit remains that an injunction protecting third parties cannot be included as part of a confirmed Chapter 11 plan that also results in a discharge of liability. The challenge and opportunity for guarantors, therefore, is to obtain consent of the affected creditors as part of any proposed plan of reorganization under Chapter 11 of the Bankruptcy Code.
Conclusion
The use of personal guarantees will remain a common way to allocate risk among parties in commercial transactions. The parties should remain mindful of common contractual requirements and defenses and how to waive them when permitted. Bankruptcy by the principal obligor may provide a short-term reprieve from liability under a personal guaranty through the co-debtor stay or a pre-confirmation injunction. However, a guarantor cannot assume a bankruptcy filing by the primary obligor will eliminate their liability as a guarantor. Obtaining an injunction as part of any confirmed plan and discharge of the primary obligor and the guarantor will require the consent of the affected creditor under existing Ninth Circuit precedent.
Erich Paetsch is a partner in the Creditor’s Rights and Bankruptcy Practice Group and chair of the Financial Services Industry Group. The information in this article is not intended to provide legal advice. For professional consultation, please contact Erich at Saalfeld Griggs PC. 503.399.1070. © 2022 Saalfeld Griggs PC
