Guaranty Agreements – A Sure Thing or a Paper Tiger?

Third Quarter, 2010

A guaranty agreement is generally enforceable and, in practice, a guaranty agreement is enforced the overwhelming majority of the time. However, lenders tend to discuss a guaranty agreement with the same certainty that the sun will rise the next day. This article is designed to outline some of the recurring issues with respect to enforcement of guaranty agreements.

As a threshold matter, guaranty agreements are not treated like typical contracts. The law with respect to guaranty agreements developed from the arcane law of suretyship. Accordingly, the applicable law tends to have more than its share of legal quirks.

There are two general categories of defenses to guaranty agreements that appear in recurring factual scenarios. First, there is a class of defenses challenging the facts at the time the guaranty was executed. If there is no “consideration” for a guaranty agreement, the guaranty agreement is unenforceable. Generally, the extension of credit to a borrower is sufficient consideration to support the guaranty agreement. However, where a guaranty agreement is subsequent to the initial loan or can be classified by the guarantor as otherwise independent of the loan, the guaranty agreement may be unenforceable. Also, if the lender misrepresented the nature of the guaranty agreement to the guarantor, the guaranty agreement may not be enforced. The lender will, of course, rely on the obligation of the guarantor to read and understand the guaranty agreement.

Second, and more commonly, guarantors take the position that subsequent actions by the borrower and lender release, expressly or impliedly, the guaranty agreement. This is so because the guarantor assumed the risk based on the facts existing at the time the guaranty agreement was executed. where the lender and borrower changed the “deal” (e.g., release of collateral, modification of the loan terms, release of co-guarantor, extension of maturity, etc.), the guarantor can claim the risk that the guaranty agreement was modified without his/her consent and defend on that basis. Modification of the borrower/lender relationship is particularly problematic where undertaken by a handshake or inaction (e.g., the lender fails to act on a default based on a relationship, etc.). The lender will rely on the terms of the guaranty agreement which many times specify that the guarantor has consented to the subsequent modification between the lender and guarantor. The Courts have been inconsistent in balancing their sympathies for the guarantor and the lender’s right to enforce a written guaranty agreement.

Contrary to the expectations of lenders, the enforcement of a guaranty agreement is often specific to the facts and circumstances of a particular case.