Guaranty Contracts Explained: The Ultimate Guide

What is a Guaranty Contract?

Much like a suretyship, a guaranty contract creates liability where none would otherwise exist. However, a guaranty is a separate contract. It is a promise to answer for the contractual obligation of another. The guarantor agrees to fulfill the terms of the original contract if the original promisor breaches, and, more specifically, the guaranty contract allocates risk of the breach to the guarantor. A suretyship encompasses a broader allocation of risk and, oftentimes, is not a separate contract. The known risk in a suretyship often includes the promisor’s breach and the sole purpose is to guarantee the debt. Therefore, the line between a guaranty and a suretyship often requires a fact-intensive analysis. Most courts will find a suretyship where it is clear that the promisor’s breach was anticipated.
A common example of a guaranty contract is a guarantor on an apartment lease. If the tenant breaches her lease and damages the apartment beyond normal wear and tear, the landlord may require the guarantor to pay for the additional costs. This is true even though the guarantor never entered into a contract with the apartment complex.
Continually, practitioners view guaranty contracts as an important way to ensure that, in the event of a breach, one party is able to fulfill its obligations under the original contract. If drafted properly, the guaranty should be enforceable irrespective of whether the original contract is enforceable . The guaranty contract essentially deprives the promisor of a valid defense to its liability to perform. If the original promisor is not liable for any reason, the guarantor must fulfill the original obligation. The guarantor can then file a breach of contract action against the promisor for the same amount.
The facts in Ritchie Capital Management v. Liberty Media Corporation are illustrative. 2008 WL 3076336 (Del. Ch. Aug. 4, 2008). In Ritchie Capital Management, Liberty Media Corporation and Liberty Dialysis, Inc. entered into an agreement whereby the defendant promised to fund Liberty Dialysis’ payment obligations. In the event the payment obligation is not met, the defendant must pay over the amount of the default and any related costs. When the plaintiff defaulted on its obligations, the defendant refused to pay under the guaranty contract claiming that the underlying obligation at issue was illegal. However, the Court found that the validity of the underlying contract is not at issue when enforcing the guaranty contract. The Court reasoned that the guaranty contract was terminable only by its own terms and the parties clearly provided for what would happen if the underlying contract was invalid. Because the underlying contract provided for enforceability irrespective of its validity, the guarantor was required to fulfill its obligations under the guaranty contract.

Characteristics of a Guaranty Contract

In order for a guaranty to be valid, he or she must be a party to the contract containing a pledge to pay an obligation in the event of default. Without the guaranty having been "promised" to the obligee, there can be no further action against the guarantor. A guaranty contract typically responds to a situation where a third party is borrowing money from a borrower like a bank or finding services or goods on credit from a supplier. A guarantor would typically guarantee the principal’s debt to a third party. In this situation, the lender is the obligee, the borrower is the principal, and the person who guarantees repayment of the loan is the guarantor.
One of the primary elements to a guaranty contract is the principal. The principal is the third-party entity that is the subject of the guarantee. Without the principal, there is no underlying obligation or promise to be guaranteed. This may, however, be a bit tricky because you may have a contract that binds multiple parties for one principal and it also encompasses a number of promises to different entities. In other words, the principal may be a general contractor and the promisee may be a supplier and subcontractor of the general contractor, but that is not the end of the story because the promisee can also be a designer, architect and engineer.
A few examples of general contract principals include simple loan guarantees to lenders for new loans as well as general contractors of private projects that you may assume formalize the obligations of a party to perform work, rendering those duties moot. In my experience, the obligations are not unique to the project, requiring the project to ensure the obligations were met, but are unusual project-specific obligations such as agreement to a waiver of lien, providing design services, or a warranty. The waiver of lien is a promise to a claimant, but there is an underlying contract of some type to the owner. To put it simply, the obligation needs to be clear.
Another prime element is the promise to a promisee. The promise to the promisee is essentially the guarantor’s acknowledgement that it will take over the principal’s obligations in the event of a default. This may be somewhat vague and may be easiest to see as a guarantee of payment of money owed to a third-party. It should also be noted that the promise may be to the promisee or to a third party that the promisee is contractually obligated to pay for its services. From a practical standpoint, the promise is to pay the promisee for those entities listed in the contract who are owed payment, if the principal does not make payment. For obvious reasons, most guaranties are limited to specific parties, such as subcontractors, rather than general contractors.
The principal’s debts are the final component of a guaranty contract. The principal’s debt is any obligation incurred by the principal to a promisee that the guarantor has agreed to pay if the principal defaults. While we have already discussed the composition of the principal, along with the obligation of the promissor to pay all sub-principals out of party yields clarity. Of course, just because all of the parties are bind to the obligation does not mean that they are all synonymous and the guarantor may choose to pay one party over another, but guarantors can justifiably expect principal of a practical same project to be treated the same.

Categories of Guaranty Contracts

When entering into a credit transaction, the creditor may sometimes seek the protection of an additional contractual guarantee for the repayment of the debt. This is often obtained by requiring the signature of the borrower(s) on one or more guaranty contracts.
There are four main types of guaranty contracts: A conditional guaranty contract is a type of guaranty where the guarantor’s liability is triggered only upon the occurrence of a certain event, usually the borrower’s inability to repay the debt. For example, a lender and borrower may agree that the lender will not request payment under the guaranty unless the lender first attempts collection directly form the borrower but is unable to recover the full amount due under the contract.
An unconditional guaranty contract, in contrast, does not require the guarantor to perform a certain act as a condition precedent to the lender’s demand for payment. In other words, a guarantor under an unconditional guaranty cannot delay payment by asserting the lender’s failure to satisfy a condition precedent, such as the lender’s failure to collect on the debt from the borrower.
A limited guaranty contract is a guaranty where the guarantor’s liability is limited to a specific maximum dollar amount, or for a specified period of time. If one or more of the guaranteed transactions generates losses not covered by the limited guaranty, the guarantor is under no obligation to indemnify the lender for those losses.
An unlimited guaranty contract imposes no cap on the guarantor’s liability, meaning that the guarantor will be responsible for all losses resulting from the debtor’s default. The guarantor under an unlimited guaranty has no limit or deadline on his or her liability.
A guaranty contract is a useful tool for a creditor that is taking deposits from a multitude of different borrowers who may each have a different credit quality. By requiring borrowers with poor credit to sign guaranties, the creditor can lower its risk of loss if one or more borrowers default on their debts.

Legal Landscape and Laws

Guaranty contracts are subject to both common law and statutory requirements that vary across jurisdictions. Generally, the Statute of Frauds requires that contracts in certain categories be in writing. The categories that are relevant for guaranty contracts include: (i) a promise to answer for the debt or default of another; and (ii) a contract made upon consideration of marriage (as opposed to a contract to marry). Some jurisdictions have codified the Statute of Frauds, and other jurisdictions have eschewed it altogether. The Statute of Frauds is governed by the Uniform Commercial Code (UCC) for secured transactions (Article 9). Finally, some jurisdictions have specific laws that govern guaranty contracts for very high dollar amounts.

Advantages and Disadvantages

Guaranty contracts can provide significant advantages to both parties entering into them. For a lender, they facilitate the expansion of a loan portfolio without the bank having to use its own capital. For a guarantor, they also allow for the expansion of loan portfolios by guaranteeing additional loans under the same terms as past loans, thereby reaping economic benefit without exposing the guarantor to additional risk.
The downside of such contracts for the lender is that they are exposed unless the guarantor has personal wealth, either in the form of cash reserves or liquid debt instruments, of at least as much as the loan for which they are guaranteeing repayment. If the guarantor does not possess wealth to meet the entirety of the outstanding debt of the note they are guaranteeing, and the note goes into default , the bank must proceed to collect from the business. While the guarantor may be liable for the entirety of the note, the guarantor and the business may have jointly owned assets that the bank will not be able to sell to satisfy the note. Failing to ascertain all security interests that the guarantor may have can prevent a bank from fully satisfying the debt involved with the loan.
For a business, a guaranty will free up capital. Many businesses operate along profit margins that can be extremely small, and many business owners would not have been able to expand without a guaranty from a family member or other individual of personal wealth. However, the major concern for a business is that a guaranty contract places its business assets at risk, because a judgment against the guarantor will satisfy any debts of the business, leaving the business with a smaller capital base than it had prior to the guarantee being activated.

Guaranty vs Warranty

Contracts often include, often by the given name or my personal favorite "terms of incorporation" a distinction between a guaranty and warranty. While these words both exist in most Standard form contracts and are indeed frequently used to refer to promise relating to Goods or Services in one form or another, they have differing legal meaning depending on their use. A warranty is simply a statement of fact, or promise or assurance made to the other party. The warranty being part of the parties’ contractual agreement, the warranty becomes a term or term of the contract and gives rise to a right to a remedy if the term is breached. In contrast, a guaranty is a secondary promise. It arises where a person or party enters into a contract agreeing to assume the responsibilities of one party, in the event the primary negotiator-party fails to perform its obligations become the responsible party under the circumstances described in the guaranty. The guarantor is essentially a third party beneficiary to the contract. Many standard forms, such as ANSI Standard A199-2000, Arctic Corps Standard 0652, and JPL Standard 4562, which are all incorporated by reference into many standard contracts would ordinarily govern any type of contract. All things being equal, most would presume in the construction industry especially AIA A201-2007: General Conditions of the Construction Contract, may be the most recognized form of contract so far as the construction industry is concerned. However, while the term "warranty" appears only 6 times within the A201, when read in context, this relatively low number I believe is deliberate and reflective of the fact that the word is only used where it is intended, as it is defined in Black’s Law Dictionary Table and Additional Terms. The same goes for the more common use of the word "guaranty" in the context of construction contracts.

Creating and Enforcing Guaranty Contracts

Guaranty contracts should clearly set forth the obligations owed to the creditor. A guaranty contract is an independent obligation from the primary obligation, so it must be clear what the guarantor is promising. A typical guaranty contract will set forth the amount of the guarantee, and it should clearly set forth whether the obligation is limited or unlimited. There are typically carve-outs from enforcement, such as bankruptcy. The guarantor should also be held jointly and severally liable with the debtor. A waiver of defenses by the guarantor in the guaranty agreement will allow the guarantor to waive the protections afforded by statutes of limitations and defenses to liens and privileges. A guarantee of payment should clearly set forth that the creditor may proceed directly against the guarantor without first proceeding against the debtor.
In the event that the creditor seeks to enforce the guaranty agreement, it is recommended that the creditor not request a judgment be entered at the outset of the action. The creditor can proceed directly against the guarantor once an obligation is past due without having to prove any default. The creditor can seek a collection judgment directly against the personal guarantor unless the guarantor has a defense. However, once a judgment is obtained, the creditor can only proceed against the guarantor after obtaining a judgment against the debtor.
In the event that the creditor obtains a judgment against the debtor, the creditor will have to wait until the claims in the bankruptcy are resolved against the debtor. At that time, the creditor can then proceed against the guarantor for the balance owed on the guaranty. If the creditor has a judgment against the debtor, the creditor can offset any amount recovered against the debtor from the guarantor.

Examples of Guaranty Contracts

Guaranty contracts are commonly used in a variety of real-world business dealings. In the business realm, for example, a commercial lender will often require a personal guarantee of the principal of a borrower as a condition of making a loan to that borrower. The personal guaranty is there to provide the lender with an additional source of repayment should the borrower default on the loan. Similarly, a landlord may require a fourth party, such as the parent of the college student, to guaranty a lease to guarantee payment in the event the college student defaults on the lease . Now a less common but growing trend is for a bank to request that an insurance agent guaranty the debts of an insurance brokerage firm. In some cases, acting as a guarantor can be a means of securing credit or negotiating better credit terms.
Aside from business transactions, personal guaranty contracts can be found in many other real-life situations. For instance, the maker of a promissory note may be an older parent and when the Maker passes away, the Guaranteeor or co-signer agrees to assume the debt.