Preserving the Commercial Real Estate Guaranty -- A Primer on Principles and Pitfalls
 
December 17, 2002
 
James H. "Jim" Watson- Atlanta

Many ordinary actions by the beneficiary of a guaranty will release the guarantor.  Sometimes such actions are taken without a full assessment of their consequences because of extraordinary business pressures.  At other times, the beneficiary may not focus on a guaranty analysis because the transaction in which the beneficiary is engaged is not characterized expressly as a guaranty.  It is also possible that guaranty beneficiaries may not know when and how to protect a guaranty against inadvertent release.  Whatever the circumstances, a refresher on some basic principles of guaranty law will help the vigilant beneficiary avoid release of the guarantor.

Increasing the Guarantor’s Risk

Suppose you are the landlord of a major, single-tenant, commercial property.  The tenant asks to be released from the lease so that the tenant can relocate its headquarters.  You negotiate a lease termination agreement, which includes a replacement lease of the property to a new tenant and the old tenant’s guaranty that the rents will be paid.  As part of this agreement, you promise to loan the new tenant a substantial amount to pay for refitting the premises.  You also agree that if the new tenant defaults, you will diligently and in good faith use all reasonable efforts to re-lease the premises.

During the renovations, a dispute develops between you and the new tenant about the construction work expense, and after negotiations you eventually pay significantly less than the maximum allowable advance.  No guarantor’s consent to this compromise is obtained.

Business worsens for the new tenant, who defaults under the new lease.  You have various communications with the guarantor and new tenant while making demands for the rent from both of them.  The guarantor pushes for a business resolution without litigation.  You are anxious for a resolution because the commercial lease market has worsened, the new tenant’s net worth has plummeted to the depths of potential bankruptcy, and your mortgage lender is extremely unhappy with your newly negative cash flow.  You are forced to cut your losses and know you will not be able to collect more than a fraction of the mounting delinquent rent from the new tenant.  You reach a tentative agreement with the new tenant on a compromise amount, which the guarantor approves, but the new tenant drags its feet in finalizing the settlement and payment.  Frustrated, you file a lawsuit for eviction against the new tenant, without getting the guarantor’s consent to litigation and without joining the guarantor.

After the new tenant is evicted, you attempt to re-lease the property at the same rent (which is now above market), you brush off real estate brokers to avoid paying a commission, and you offer no loan or improvement allowance this time.  You take all of these actions without consent of the guarantor.

Your subsequent demands for payment from the guarantor are met by refusal to pay and the contention that your actions have released the guarantor from the guaranty.

On what basis can the guarantor claim to be released by such actions?  The answer is better remembered through a simple diagram that depicts the relationships in a guaranty.

When a guarantor undertakes a guaranty in favor of the beneficiary to support the principal obligation, the law characterizes the guarantor’s obligation as secondary, and implies automatically that the principal owes the guarantor a duty not to increase the risk to the guarantor in connection with the guaranty.  The guarantor is deemed to have made an assessment of the risks arising through the guaranty, and actions that increase that risk will release the guarantor.

The long-standing and well-entrenched policy underlying such a release is that the law should protect guarantors because their willingness to undertake such risks is essential to promotion of commerce.  Various legal doctrines have been applied to implement this policy.  Courts have found a duty to the guarantor by the principal to perform in favor of the obligee, as well as rights of the guarantor to receive reimbursement from the principal for the guarantor’s performance, to be subrogated to the beneficiary’s rights against the principal (and others) in order to recoup the guarantor’s expenditures, and to have restitution from the principal.  Detailed discussion of these concepts is beyond the scope of this article, but a recognition that guaranty law involves legal mechanisms for protection of guarantors aids understanding the critical general principles that may lead to a guarantor’s release.

In Georgia, the basic principle stated above is statutory.  Section 10-7-22 of the Official Code of Georgia Annotated (O.C.G.A.) provides:

10-7-22.  Discharge of surety by increase of risk.

  Any act of the creditor, either before or after judgment against the principal, which injures the surety or increases his risk or exposes him to greater liability shall discharge him;  a mere failure by the creditor to sue as soon as the law allows or neglect to prosecute with vigor his legal remedies, unless for a consideration, shall not release the surety.

In the hypothetical example above, the guarantor will claim increased risk because (1) decreased renovation payments to the new tenant made it more difficult for the new tenant’s business to succeed, and (2) re-leasing efforts were stymied by unrealistic re-leasing terms, decreased exposure to prospective replacement tenants, and litigation that tarnished the property reputation. 

Changing the Deal

Consider a second hypothetical.  Suppose you are the seller under a contract for sale of a commercial store property.  The contract permits the buyer to assign the contract only with your consent.  The contract also provides that even if there is a buyer’s assignment with consent, the buyer is not released but remains liable if the assignee does not fully perform.  Pending closing of the purchase, the buyer finds a more desirable property, and obtains your consent to assign the contract to a new buyer.  The assignee, who assumes the contract, is a franchisee.  After the assignment and before closing, the franchisor exercises franchise rights, which require the assignee to reconstruct part of the store improvements before operation.  This requirement delays the intended occupancy date by six months, and the assignee agrees to pay you the amount of your debt service and other expenses on the property for six months in exchange for a six-month extension of the closing date. You bind yourself to this extension without obtaining the consent of the original buyer.

Before closing, the assignee discloses that recent market interest rate spikes have made it impossible for the assignee to finance the acquisition.  The assignee refuses to close.  You sue the assignee and the original buyer for damages.  The original buyer raises the defense that it had merely a secondary obligation as a guarantor, and that your extension of the closing date has released the original buyer.

In Georgia statutes and cases reflecting basic principles of guaranty law, the buyer-assignor in this case will find support for its refusal to pay.  The buyer-assignor will likely be given an opportunity to try to prove that keeping him obligated under the assigned purchase contract “if the assignee does not fully perform” was intended to mean that the buyer-assignor has only secondary liability and therefore is essentially a guarantor.  No express statement identifying the assignor as a guarantor is necessary for such guarantor characterization to apply, under O.C.G.A. Section 10-7-4:

10-7-4.  Form of contract immaterial.

The form of the contract is immaterial, provided the fact of suretyship exists.

Once guarantor status is established, the guarantor may invoke O.C.G.A. Section 10-7-21, which states:

“10-7-21.  “Novation” defined; effect on surety’s liability.

  Any change in the nature or terms of a contract is called a “novation”; such novation, without the consent of the surety, discharges him.

The result in the second hypothetical case could be not only delay and significant expenses in dealing with the guarantor’s defense contentions, but also real risk that the guaranty beneficiary will ultimately bear the loss.

Recognizing and Remembering the Guarantor

In the first hypothetical example above, the guarantor made an express, written guaranty.  In the second hypothetical involving a buyer-assignor, guarantor status could be established by implication.  There are many other circumstances in which guarantors are found by implication.  Parties whose mortgage loan is assumed, who have assigned their leases, who co-sign a promissory note or other obligation, or who mortgage property as an accommodation to support another’s obligation, have all been characterized as guarantors without any express statement of guaranty.  A clue to potential implied guarantor status is any transaction in which one party (the eventual guarantor) has undertaken an obligation that comes to be the performance obligation of another party without an express and complete release of the first party.  The observant beneficiary will think “potential guarantor” whenever such circumstances are present, and will seek advice before taking actions that could release the guarantor.

A very common guaranty context involves a guarantor who is affiliated with the principal, such as a corporate parent or individual shareholder who is a guarantor for a thinly capitalized subsidiary.  Because such principals and guarantors are affiliated, and the beneficiary may deal with the same persons who represent both the principal and the guarantor, special attention may be necessary for a beneficiary to remember that the parent or owner is legally a separate, arm’s-length guarantor who can be released by the beneficiary’s actions.

Recognizing Release Scenarios

The astute beneficiary will also keep in mind a non-exclusive list of general actions that could generate a guarantor’s release argument.  Some of the more common actions of this kind include:

• changing any material part of the transaction or parties’ obligations from their original content or form
• releasing the principal from some part (or all) of the principal obligation
• releasing or impairing the value of collateral for the principal obligation
• delaying enforcement of the principal obligation, or
• impairing the principal’s ability to perform or to make the guarantor whole if the guarantor performs

To illustrate the last circumstance above, consider the following.  Company B sells a portion of its assets to Company P, and takes back a promissory note for part of the payment.  Shareholder G of Company P guarantees the note.  Companies P and B compete in the same type of business.  Before the promissory note is due, Company B engages in competitive actions that Company P alleges are illegal as unfair trade competition, and Company P loses half of the market share it previously had.  When the note is due to be paid, if Company P cannot pay, guarantor G will be able to contend that the alleged illegal competition impaired Company P’s ability to pay and therefore released the guarantor G.

Understanding these general scenarios will help the beneficiary be alert to various fact patterns that signal a risk of releasing the guarantor.

Getting the Guarantor’s Agreement or Consent

Well-written guaranties should contain advance agreements by the guarantor that the guarantor will not be released by actions of the beneficiary that would otherwise cause a release.  Many guaranty documents have such terms, that may specify actions that the beneficiary may take without releasing the guarantor, and may even purport to be a complete waiver of the guarantor’s rights to release by any manner other than full performance.  Georgia law recognizes that a guarantor may make binding, anti-release agreements in advance, and in many cases, such a comprehensive guaranty document will prevent release. 

While necessary and advisable, however, such document provisions are not foolproof insurance against release in all cases when subsequent actions involving the beneficiary and the principal become necessary.  In the process of drafting a guaranty, it is not possible to foresee every circumstance that could be a release scenario.  In addition, many commercial guarantors have sufficient bargaining clout to negotiate away terms that would prevent release of the guarantor.  Additionally, the policy of protecting guarantors because of their value to commerce means that document uncertainties could well be resolved in favor of the guarantor.  Further, a determination whether a guarantor’s risk has been increased often will be judged through hindsight, making it more likely that increased risk will be found.  Moreover, a guaranty may be subject to the same contract defenses as any other contract. 

Consequently, whenever there could be an issue regarding a guarantor’s release, the beneficiary should evaluate specifically whether to seek the guarantor’s additional, separate, express consent to the beneficiary’s planned action.  Even if the beneficiary’s conclusion is that no consent is required, giving notice of the planned action to the guarantor is normally a good practice.

Summary

Guaranty beneficiaries should learn and understand the principles and policies that may release guarantors from commercial real estate guaranties, and particularly the effect of actions that increase the guarantor’s risk, change the deal in which the guaranty was given, or fall within other typical release scenarios.  Learning to identify such scenarios as well as transactions in which guarantor characterization could be implied will aid in preventing release.  Taking a well-written guaranty with terms that attempt to give maximum protection against guarantor release is an essential, good practice and should be done whenever possible, but beneficiaries should also remember to seek a special consent from the guarantor whenever there is any question whether the guarantor could be released. 

For more information, contact James H. Watson, toll free, at 888-688-8500.