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COMMERCIAL FINANCE 701 — Loan guaranties: Skin in the game

EDITOR’S NOTE: Commercial Finance 701 is a continuing series on commercial loans written exclusively for the Mississippi Business Journal. This series is geared to lenders, developers, investors and transactional attorneys.
MOLLY MOODY & BEN WILLIAMS

MOLLY MOODY & BEN WILLIAMS

M any a furl-browed borrower has questioned a bank’s need for guaranties.  The borrower – excited about his can’t-miss venture – may be slightly offended that the bank even thinks a guaranty is necessary and, contradictorily, hesitant to put his net worth on the line.  Today’s bank – making loans at historically low rates but all too cognizant of several economic bumps over the last 30 years – is merely looking to be repaid.  This article is about guaranties, what we’ll refer to as “skin in the game.”

A guaranty is the secular tie that binds.  The rhetorical “what could go wrong” is, unfortunately, from time to time answered.   And when faced with losses, the borrower’s principals may simply want to close the doors, lick their wounds, and move on.  Isn’t it enough they lost their investment?  Wasn’t the bank their partner?  Well, no.  The bank isn’t a partner.  If the venture is a phenomenal success and the investors enjoy a quick 300% return, the bank still receives only the originally contracted low interest rate.  Partners, not banks, participate in profits.  The bank would simply like to be paid back – even if the business fails.  Hence, the bank wants some personal assurance of repayment.

The Basic Guaranty

The basic loan guaranty usually takes one of two forms – the personal guaranty of a specific debt, which extinguishes upon the repayment of a specific debt; and the “continuing guaranty” that covers existing and future debt and “continues” past repayment, refinance and other changes. Both are generally “absolute” in nature – that is, there are no conditions to the obligation.

Pro-Rata Guaranties

Past the basic types, things tend to get more complicated, frequently driven by the number and types of principals. Four physicians guaranteeing a loan might not be inclined to provide “full” guaranties, but rather, may prefer “pro-rata” guaranties.  Their argument is that if all four physicians guarantee the loan, then the bank would have 400% in guaranties, notwithstanding the bank’s obvious ability to collect only 100% of the debt.   Assuming the physicians each owned 25% of the borrowing entity, the principals might ask the bank to accept limited guaranties from each partner for 25% of the debt (4 x 25% = 100%).  Generally, a bank will decline the request as, at the outset, it can’t predict the future net worth or status of each physician.

In those few instances where a bank will consider a pro-rata guaranty (perhaps because of other collateral that mitigates risk), the bank will likely require that the limited guaranties, in the aggregate, total more than 100% of the debt (e.g., 4 x 50% = 200%).

Other Types of Guaranties

In many cases, the guaranty simply secures the repayment of debt.  In construction loans, however, there may also be a “guaranty of completion” by which the principals assure the project will be finished.  (A completed building tends to have more value than an unfinished structure.)

In some construction loans, the guaranty amount may decline or “bleed off” once construction is complete and/or some level of occupancy is obtained, reflecting the improvement in the bank’s collateral position. A “full” guaranty might convert to a reduced “pro rata” guaranty.

As discussed in our article Permanent Loans & Other Oxymora (April 30, 2015), non-recourse permanent loans (Fannie Mae, Freddie Mac, CMBS, etc.) include “bad boy” carve-out guaranties that somewhat limit guarantors’ liability.  This limited guaranty (sometimes referred to as a springing guaranty) has expanded of late to include non-egregious liability triggers that were historically seen in only conventional recourse loans.

Confusingly, a “springing guaranty” might also refer to the guaranty of a conventional loan that, though executed at closing, purports to hibernate until the occurrence of a predefined event such as a failure to achieve financial covenants for two consecutive testing periods at which time the guaranty “springs” to life.   Another contrivance is a “cash flow maintenance agreement” by which the “guarantor” might simply promise to inject cash or capital into a borrower or project on the happening, or non-happening, of certain events.

All creativity aside, a bank’s preference is, naturally, a nice, clean, uncomplicated, unqualified, tried and proven guaranty.

Tiered Structures

More and more frequently, the borrower entity with multiple investors will have a tortuous organizational chart with a smorgasbord of entities of all shape, size and purposes (including trusts) formed in various jurisdictions under various state laws.  The seasoned credit officer – who has seen this structure before – typically requests guaranties from all entities in the chain and the individual principals.  The structure, while admittedly serving noble legal purposes, complicates the required due diligence and loan documents.

Default 

In the event of a default, it is important to note that, in Mississippi, a bank need not exhaust its remedies before pursuing its guarantors, unless otherwise agreed to in the documents.  Subject to the terms of a guaranty, a bank could elect to not foreclose on collateral or sue the borrower.  It could first proceed against one or more of the guarantors with deep pockets, or it could pursue remedies on multiple, concurrent, parallel paths.

Risk

A guaranty is part of the overall loan package and designed to reduce risk, but, of course, risk is a function of myriad fluid variables.  Construction risk may be mitigated by a payment and performance bond.  Working capital lines may be mitigated by audited financials, lock boxes, and field inspections.  Loan-to-value ratios, liquidity requirements, financial covenants, past history, maturity, market saturation – the list of factors is long if not endless – all affect risk. The risk analysis determines, firstly, whether the bank will even make the loan, and then, what the loan terms will be. But the starting point for a bank always includes the assumption of a full guaranty by the principals.  Attempting to limit the guaranty moves the risk needle.

Abundans cautela non nocet.

» Ben Williams and Molly Jeffcoat Moody  are attorneys in a commercial law practice at Watkins & Eager PLLC (watkinseager.com).   Ben is recognized by Chambers USA and Best Lawyers in America and was selected as Best Lawyer’s 2014 Commercial Finance Lawyer of the Year in Jackson.   Molly is recognized by Chambers USA in the area of Real Estate Law. 

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