Guarantees and Estate Planning

By: Randall A. Denha, J.D., LL.M.

A guaranty is a legal arrangement that provides assurance to answer for the payment of another’s debt or duty. It is most frequently used to designate a private transaction in which one person, in order to obtain some trust, confidence, or credit from another, engages another party to be answerable to the lender.

This is differentiated from a “personal guaranty” in that a guaranty is a legal concept and obligation that produces an economic effect. A personal guaranty, on the other hand, is often used to refer to a promise made by an individual which is supported by, or assured through, the word of that individual (and most commonly by that person’s other assets).

When utilizing a loan to acquire an investment property, it is common practice for the lender to require some type of guaranty from the borrower. The guaranty can range in scope from full recourse against the borrower (i.e., the lender can sue the borrower for the full outstanding balance if the loan is not repaid) to limited recourse, where the lender’s rights to sue the borrower upon default are restricted to specific situations.

A personal guarantee given by a beneficiary on their business’ behalf, could lead to estate-planning disaster in trying times. If that business is struggling to pay back its debts, the guarantee could be enforced, and the creditor institution could collect on the obligation by taking assets received from the estate. To manage the risk of a potential claim, one might consider having the beneficiary negotiate a provision in the guarantee to exempt assets that the beneficiary may acquire as a gift or inheritance, the rights of the financial institution to collect on their obligation would be limited thereby protecting those assets.  The following is a summary of the types of debts that a borrower could be involved and guarantee.

What is Recourse Debt?

With a traditional mortgage loan, the lender will have a lien on the property in question, and the borrower will be personally liable for the payment and performance of loan obligations. This is the most common situation, whether it is a property the borrower is using personally (e.g., a home or a business location) or a rental property leased to an unrelated tenant. These are called recourse loans or recourse debt, because the lender has recourse against the borrower personally, in addition to rights in the underlying property (collateral) if the borrower stops making timely loan payments or defaults on loan obligations. Recourse loans protect the lender by providing that, in the event of a default, the lender may require the borrower to use unrelated personal funds to cure the default.

What is Non-Recourse Debt?

Some borrowers for rental properties may, however, qualify for a non-recourse loan based on factors that include the underlying value of the real estate, the credit of the tenant(s) and the strength of the rent roll. The non-recourse lender may be able to foreclose and sell the property to satisfy outstanding mortgage indebtedness in the event of a default, but the lender generally cannot look to the borrower’s personal assets for any deficiency or loss.

One of the major advantages of obtaining a non-recourse loan is that the borrower can reap the benefits of leverage without having to personally guarantee payment of the debt in the event of a default. This is particularly important if the cause of the default is something outside the borrower’s control, such as a tenant going out of business, filing for bankruptcy protection or simply failing to pay rent on time. These occurrences may severely impact net operating income and prevent the owner from making timely loan payments.

Having a non-recourse loan does not, however, mean that the borrower does not have to sign any type of guaranty. Lenders often require the borrower and/or its principals to sign a “carveout” or “bad boy” guaranty when they do not have personal recourse against the borrower’s assets.

The Purpose of Carveout Guaranties

A carveout guaranty is a borrower’s promise to abstain from certain “bad acts” with respect to both the loan and the property. These promises generally fall into one of four categories:

• Insolvency
• Fraud or misconduct
• Additional debts or liens
• Transfers

The promises are made by the borrower, as well as its principals, if the borrower is an entity rather than an individual. The liability triggers under the carveout will be actions within the guarantor’s personal control. Carveout guaranties provide that the guarantor will abstain from both misconduct and actions that may impede the lender’s ability to enforce the loan agreement.

A carveout guarantor will be required to make promises to the lender with respect to:

• the insolvency of the borrower and its principals, or otherwise affecting the property;
• abstaining from fraud or other misconduct in connection with the loan and the property;
• additional borrowing in connection with the property; and
• the ownership of the borrower.

Carveout guarantors should review these provisions carefully to ensure that potential liability is limited to actions within the guarantor’s reasonable control.

Other types of borrower misconduct that could trigger liability under a carveout guaranty may include intentionally failing to maintain the property or failing to correct a hazardous condition.

Unsurprisingly, a breach of this type of provision will expose the borrower to claims for damages caused by the fraud or misrepresentation. Additionally, the guarantor’s misconduct may trigger personal liability for the entire outstanding mortgage indebtedness, as well as other amounts due and owing under the loan agreement.

Transfers

A carveout guaranty will preclude the borrower from transferring title to the property to another person or entity without lender approval. If the borrower is an individual, carveout guaranties will typically afford some flexibility for intra-family and estate planning types of transfers. It would not be feasible, for example, to obtain advance approval for a successor if the guarantor dies unexpectedly. Lenders are often amenable to individual guarantors changing the manner in which title is held (e.g., holding title through a living trust), so long as the individual remains liable under the guaranty and retains control of the borrower. These types of transfers are therefore designated as “permitted transfers” or are otherwise excepted from the list of “prohibited transfers”. For these transfers, the lender must be notified promptly afterward, rather than requiring advance approval.

When the guarantor is an entity, such as a partnership or limited liability company, the prohibition of transfers also includes the restructuring or change of control of that entity. The purpose of these provisions is to give the lender some assurance that the party who provides the guaranty at the inception of the loan will remain the responsible party for the carveout obligations throughout the loan term. Any “replacement” guarantor will meet the lender’s then-applicable underwriting standards. Having appropriate carve-out language in your loan documents is very important when transfers are to be made for estate planning purposes!

Other Potential Carveout Guaranty Provisions

Carveout guaranties may contain additional provisions relating to the borrower’s performance under the loan agreement. These may include a personal guaranty:

• of compliance with financial reporting obligations;
• of the lender’s access to the property for inspection or other commercially reasonable purposes;
• to indemnify the lender for certain environmental matters; or
• that the borrower will maintain insurance on the property and pay real estate taxes.

Whether and to what extent a borrower is requested to—and should be willing to—provide these additional carveout guaranties is situation specific. Guarantors should ensure that the language of these provisions is negotiated and tailored to address acts that are within the guarantor’s reasonable control.

For example, if a tenant’s lease at the property restricts the borrower/landlord’s ability to enter the premises unless accompanied by a tenant representative, a guarantor will want to incorporate that limitation in its promise of access to the lender. In the case of financial reporting requirements, a prudent guarantor will insist on an opportunity to cure the default before the lender may exercise remedies under the guaranty.

Breaching a Carveout Guaranty

The consequences of a breach often depend on the nature of the guaranty provision that is violated. For some provisions, such as a bankruptcy filing by the guarantor, a breach will give the lender a right to pursue the guarantor for the entire loan indebtedness. In other cases, such as failures to provide information, the lender will be entitled to damages caused by the breach. The guarantor should always review the provisions of a proposed carveout carefully to ensure that he understands the circumstances that may trigger personal liability. As always, it is best to obtain the advice of a trusted legal or financial advisor before signing a carveout guaranty.