THINGS TO CONSIDER BEFORE YOU SIGN THAT GUARANTY
Not every business or individual can obtain credit solely on its own merit. A lender will require collateral to protect it if the loan is not paid. And frequently, lenders will require one or more guarantors to add their credit strength to that of the borrower. Before you agree to be a guarantor (or co-signer) for the debt of another, there are a couple of legal issues you may want to consider.
First, it is a common misconception that the lender must pursue the borrower or the borrower’s collateral before they pursue the guarantor. While at common law the lender was to look to the borrow and the collateral first, today virtually all carefully drafted guaranty documents used by lenders do away with this requirement and the lender may pick and choose who it wishes to pursue if the loan goes in default. If the person or company whose debt you are guaranteeing presents collection difficulty, it is permissible for the lender to simply skip the borrower and even the collateral and go straight to the guarantor for payment. So, the first consideration is to recognize that even though you are simply viewing this as an assistance to the borrower, you could be the one the bank comes to first.
This leads to the second consideration. If you are asked to pay on your guarantee, how will you get the money back from the borrower? Generally speaking, you may not have a right to go after the borrower to recover your payment until the debt is paid in full. So, if you were only required to pay part of the debt, you may have to wait until the lender is paid in full before you can pursue the borrower. Further, even if you can pursue the borrower, how likely is it that you will be able to recover what you are owed from that source? In effect, when you are being asked to guaranty the debt of another, you are making the same credit underwriting decision as the lender. And remember, the lender has apparently made the judgment that the borrower is not sufficiently credit worthy to justify the loan without your additional support. This puts you at greater risk than the lender of recovering in case the borrower does not pay.
So then, if you are going to guarantee the debt of someone else, what will your strategy be to be repaid? Perhaps you are willing to just chalk up your loss to experience. But if you want to recover, you will want to think through what agreement you may wish to make with the borrower before you guarantee the debt. Do you need separate collateral to help protect you in the event you have to pay? Are you better off just paying the debt if there is a default and then stepping into the shoes of the bank as to any collateral it might have? Are you equipped and prepared to do this?
These issues are further complicated if there are additional guarantors of the borrower’s loan. What will be your rights within the guarantor group sharing the loss? Generally speaking, unless the guaranties have been allocated based on some percentage or other limitation, the lender will be just as free to pick and choose among guarantors as they are to choose between the borrower and the guarantor. If they choose you, you now face not only getting your money back from the borrower, but you also may want to force other guarantors to bear some portion of the loss you just incurred.
There are a lot of good reasons to guarantee the debt of another. However, in my experience, very few guarantors fully think through the implications of what might happen if the borrower does not pay. As you may have concluded from reading this article, there are a number of things to think about before you sign that guaranty. And when you do, you may see the advisability to obtain legal advice before you sign that guaranty.