Best in Law: Loan Guarantees
Todd Gee Gives the Good and Bad News on Loan Guarantees in California
By Todd Gee
The bank asks for a personal guarantee on your business loan. The good news is California is a borrower-friendly state. The bad news is California law is not so guarantor-friendly. If you are asked to guarantee a loan for your business, you should understand and consider your options carefully.
Guarantees are a way for lenders to minimize risk, and they provide another way to collect on a loan if the borrower doesn’t pay. Even when the loan is secured by commercial property, lenders often ask for, or require, guarantees when the business owners have substantial personal assets and the borrower only owns a single asset (like a building or a business).
A lender may also require a guarantee if the lender is concerned about the borrower’s ability to repay the loan. (The rules and legal protections are different when a personal residence is involved.)
The guarantor’s obligation under the loan is completely separate from the borrower’s obligation. The same party should never be both a borrower and a guarantor. Why? Because the borrower is already obligated to pay back the loan. A guarantee thus adds nothing to the strength or credit of the transaction. The most common type of guarantee is a payment guarantee where the guarantor promises the lender the loan will be repaid. There are also performance guarantees, where the guarantor promises to complete the borrower’s non-payment obligations.
Every business needs access to capital to succeed. While a guarantee can sometimes make the difference in getting approved for a loan, the strongest borrower protections in California — the anti-deficiency rules and the “one-action rule” — only apply to guarantors in certain circumstances. Further, most lenders ask guarantors to waive most, if not all, legal protections given to guarantors.
California’s anti-deficiency rules were created to protect borrowers from being sued by their lender for the shortfall in unpaid loan balance after foreclosure. Most foreclosures in California are done by a trustee sale because they are faster and less expensive than foreclosing on property in court (called a judicial foreclosure).
The risk for the lender in a trustee sale is the foreclosure proceeds might not pay the entire amount the borrower owes the lender, and the anti-deficiency rules prevent the lender from suing the borrower for the difference.
So what might the lender do? Sue the guarantor.
Except in certain circumstances, guarantors are not protected by the anti-deficiency rules because the guarantee is a separate obligation. So, while the borrower is off the hook, the guarantor is left holding the bag for the remaining balance of the loan after foreclosure.
The “one-action rule” requires a lender to use foreclosure to collect on a debt secured by the borrower’s real estate before suing the borrower to collect the unpaid balance. But the rule doesn’t protect guarantors, except in certain circumstances. If there is a guarantee, the lender can sue the guarantor first and still foreclose on the loan security property later on.
Many businesses need loans to fund new projects or expansions. If a lender asks for a personal guarantee, remember that California is borrower-friendly, not necessarily guarantor-friendly, and someone guaranteeing an obligation for their business could be left with significant liability if the lender isn’t paid in full.
Before agreeing to guarantee an obligation, you should work with an attorney to preserve as many protections as possible, and understand the implications and risks.
This article first appeared in the Los Angeles Daily News and other Southern California Newspaper Group publications online on Sept. 15, 2019. Republished with permission.