Adopting a commercial credit facility is a process of weighing various risk mitigation factors until the lender is satisfied that the potential for loss is within their tolerance. By evaluating collateral value, loan history, financial statements, real estate reports, asset economics, project feasibility, market conditions and myriad other variables, the lender can accurately weigh the risks and rewards of a business. One of the key elements in this balancing act is the payment guarantee.
Basically, a payment guarantee allows the lender to look up past the single-purpose limited liability structure used by the vast majority of borrowers; past the collateral and its reliance on favorable market conditions; past operational problems of the borrower or liquidity problems; to the people or institutions that make up the real value of a company.
Under optimal circumstances for the lender, any principal and any affiliate of a borrower can (I use the term “sponsor” to refer to the decision maker behind the borrower) should provide an unlimited, unrestricted payment guarantee, often referred to as a “full recourse guarantee”. Properly worded, this guarantee allows the lender to compel one or more of the guarantors to make any payment that would have been due by the borrower. In other words, regardless of the obligations of the borrower to the lender (at least in relation to the payment), the surety has the same obligations. The advantages of this instrument are obvious, but suffice it to say that with a full recourse guarantee it doesn’t matter where the company’s value goes – the lender has a backstop in the guarantor. Regardless of whether it is fraud, mismanagement or bad luck, for whatever reason, the lender can claim each and every guarantor for the full debt.
Sponsors often make no noise when negotiating promissory notes, loan agreements, mortgages and the like, but become loud as soon as the topic of guarantees comes up. It makes sense to the sponsor: if the project fails, leave the collateral to the lender and move on, but be personally responsible? Forget it. Many lenders will ask you to follow step by step so that they can get all the information that they want.
If business economics requires it, it is easy to tell a sponsor that the lender will accept nothing less than a guarantee of full rights of recourse. “Take it or leave it” is the simplest negotiating position. But if a project has a low loan-to-value ratio, a strong balance sheet and / or cash flow forecast, a sponsor with a long and flawless payment history, or even a particularly savvy sponsor, the guarantee quickly becomes a target for the sponsor’s own risk management goals. Then how can a lender maximize their own risk mitigation and still close the deal – and do so with enough goodwill to ensure future business with the sponsor? Here are some options:
The limited warranty. A limited surety can remedy this, and there are several ways to limit the surety’s liability. The first and easiest is to simply set a dollar value cap. “Without prejudice to other provisions to the contrary herein, the guarantor’s liability is limited to $ _____.” Straightforward, simple, effective, and probably too insecure to appeal to most lenders. The next step from that first, bare option would be a debt percentage. It’s the same basic idea (keep it simple), but this option allows both the lender to take on a larger portion of an early payment default and the guarantor to be relieved of some liability if the loan is over a significant portion of the term is working.
The multiple guarantee. When there is more than one guarantor, sometimes the main objection to the surety is to be held responsible for the entire debt. According to a legal term known as “joint and several liability”, there are full recourse guarantees individually responsible for all Fault. With regard to joint and several liability, the lender takes the view that the cause of the default is irrelevant; the guarantors may quarrel among themselves after the lender has repaid. In essence, when two people do business together, they – not the lender – take the risk of that affiliation. This risk provides another way of limiting each guarantor’s liability by setting limits for each guarantor individually (or, individually) and not jointly and severally.
The specific performance guarantee. Each of these options can also be customized to choose between the Types of commitments guaranteed. For example, the lender may require the guarantors to guarantee only part of the principal but still guarantee all interest, default interest and enforcement costs. Or the surety can be required to guarantee the fulfillment of a certain obligation, for example the completion of a construction project.
The burn-off guarantee. Another possibility to limit the guarantor’s liability is a “burn-down” or “burn-off” clause. This provides an incentive approach for a limited warranty, where the guarantor’s liability is reduced or waived if one or more conditions are met. According to the terms of most burn-down / burn-off guarantees, the guarantee is covered to a maximum on the first day of the loan period. From there, the insurance coverage is reduced, depending on the conditions, if the conditions are met, and may expire completely. The reduction and / or termination of cover can be linked to any number of performance incentives, such as the fulfillment of a sales or leasing target, the acquisition and pledging of additional collateral or simply the elapse of a certain time without a target being met.
The recourse carve-out guarantee. If a burn-up guarantee represents a “carrot” for the guarantors, the corresponding “stick” is the recourse carve-out guarantee (or, depending on who you ask, the Not– Regress carve-out guarantee). This guarantee is comparable to guarantees for certain obligations and is colloquially often referred to as a “bad boy” guarantee because its function is to ensure that sponsors do not commit any wrongdoing, but rather to release them from liability for failures outside the company their control. This is a particularly attractive option for sponsors as they put control of their liability into their own hands. As long as you don’t embezzle (think) the borrower, you won’t have any personal liability. That seems like a low bar.
In reality, a properly worded “market” regress carve-out guarantee covers more than just fraud. The easiest way to categorize the protection a lender enjoys under a recourse carve-out guarantee is between “recourse events” and “loss events”. A “recourse event” triggers full recourse to the guarantor for the entire debt. A “damaging event” triggers liability towards the guarantor only for the specific damage suffered by the lender as a result of the initiating event.
Recourse events are characterized by the fact that they can affect the lender’s ability to enforce the loan documents and usually include: a voluntary bankruptcy petition, an involuntary bankruptcy petition that is not dismissed within a certain period of time (usually 60 to 90 days), the unauthorized Transfer or encumbrance of collateral or interests in the borrower / guarantor, bankruptcy of the borrower and any attempt by the borrower to challenge the lender’s enforcement or exclude liability. Each of these points will make it difficult (and also costly and time consuming) to repay the lender in full, and therefore require full recourse from the guarantors. The lender’s ability to act quickly against a surety protects them from the loss of time and assets that typically result from bankruptcy or apportionment suits.
Damages, on the other hand, can make it practically difficult for the borrower to repay the loan, but ultimately leave the matter to the original parties. Deliberate fraud, embezzlement, waste, environmental damage and the commission of criminal activities usually fall into this category. Any of these items can hurt the borrower’s business value and affect the borrower’s ability to repay the loan, but in the end the lender can still pull out the borrower’s residual value without having to fend off competing claims so the hammer has to be brought down on the surety is not so urgent. Even so, many lenders believe in bringing down the hammer anyway, so negotiating a recourse carve-out guarantee is often a dispute over whether each trigger goes into the “loss events” or “recourse events” basket Lenders are pushing for full recourse and guarantors are pushing for mere compensation.
It is important to remember that including a limitation in a guarantee can open the door to an objection by the guarantor that the requirements for enforcement are not met. Accordingly, it is critically important that in creating a guarantee, however limited, the lender’s enforcement barriers are minimal. Since the lender may need to demonstrate to a court that the prerequisites are met prior to enforcement, a well-worded guarantee is both easy to achieve and easy to prove.
Of course, a full recourse guarantee is always the best convenience, but a limited guarantee, when well worded and accepted with a clear understanding of the guarantors’ resources, can go a long way in getting a deal across the line. It will come as no surprise that the above warranty types and features can be broken down and recomposed into infinite variations to suit the specifics of a particular business. Lenders and lenders should take care that borrowers and guarantors do not tip over from guarantor liability without appropriate counterweights.