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GUARANTIES – STATE LAW ISSUES

Introduction

Guaranties are often drafted to cover not only a specific obligation but future advances under the original lease or loan and restructurings and other modifications of the terms of the original obligation. A common example of the former is a guaranty that covers all schedules under a master lease. The latter includes agreements between lessor and lessee to extend the term of a lease. Unfortunately, statutory and case law may limit a creditor’s ability to extend the guarantor’s obligations beyond the initial, specific obligation guarantied.

Section 3-605 of the Uniform Commercial Code (“UCC”)

Section 3-605 of the UCC sets forth the rules generally applicable to the discharge (release) of guarantors (referred to in Section 3-605 as “secondary obligors”) in connection with subsequent transactions represented by negotiable instruments. Creditors usually assume that the law expressed by Section 3-605 with respect to negotiable instruments will likely apply by analogy and precedent to amounts owed that arise in other types of transactions that create indebtedness, accounts payable, rent payable, or other financial obligations.

Section 3-605 is based upon contract principles contained in The Restatement (Third) of Suretyship and Guaranty. Among the underlying purposes of Section 3-605 is to “provide flexibility to [lenders] and primary obligors to [structure subsequent transactions], but not to the detriment of secondary obligors.” Draft Official Comment, Uniform Commercial Code Section 3-605. Two concepts form the central theoretical underpinning for the provisions of Section 3-605.

First, a guarantor (or secondary obligor) is generally bound to the terms of extensions, modifications, future advances and transactions, and restructurings subsequently entered into between the creditor and the primary obligor unless the transaction “causes a loss” to the guarantor. If the transaction “causes a loss”, the guarantor is discharged for the amount of the “loss”. For example, if the creditor and the primary obligor agree to an extension of the time for payment of the obligation and the asset supporting the obligation is declining in value, the guarantor may argue that a “loss” occurred to the extent of the asset value that is lost to the creditor during the period for which payment of the obligation is deferred. See generally UCC Section 3-605(c), (d) and (e).

Second, Section 3-605 (i) provides that the guarantor may expressly waive in the guaranty agreement claims for discharge otherwise available under Section 3-605 and other “suretyship defenses”.

Certain state-specific laws may affect the enforceability of the guaranty agreement unless addressed by the creditor at the time of the initial transaction, or when making future advance or subsequent modifications to the initial obligation. A unique Kentucky statute illustrates the pitfalls that may create an unintended result for a creditor unaware of the provisions of such state-specific laws.

Kentucky Revised Statutes §371.065 and Beyond

Section 371.065 of the Kentucky Revised Statutes provides that a guaranty agreement is unenforceable unless (a) the guarantor signs the lease or other document that creates the underlying obligation or the extension or modification itself, or (b) the guaranty agreement (i) describes the document that creates the guarantied obligation, (ii) states the maximum amount of the indebtedness guaranteed, and (iii) sets forth the maturity or termination date for the indebtedness guaranteed. See KY. Rev. Stat. §371.065 (1986). In other words, unless the guarantor signs the lease or loan document itself (meaning the guarantor is aware of the nature of its exposure), the guaranty must limit the guarantor’s obligations in terms of amount and time.

Case law – both published and unpublished – applying the provisions of Section 371.065 demonstrate its scope. The statute applies, for example, not merely to commercial paper, but not to indemnities. 1 As contemplated by the statute, if the guarantor executes the document that describes or anticipates the indebtedness guaranteed, an limitation on the amount of debt or maturity date need not be present. 2 A separate agreement that specifically refers to a Master Note and Schedules (with anticipated amounts and maturity dates) is enforceable; 3  as is specific references in a separate guaranty agreement to the provisions (and page numbers) of a Partnership Agreement that describes the debt guaranteed. 4  A guaranty agreement, however, that describes only a broad range of obligations (promissory notes, security agreements, etc.) is not sufficient. 5  Local commentators have noted that Section 371.065 is easily navigated by the knowledgeable creditor. A guaranty agreement that describes the instrument creating the debt and recites a maximum aggregate amount guarantied that is perhaps ten times the actual anticipated date and a maturity date of even twenty (20) years is acceptable. 6  The point, then, is that if the creditor has consulted relevant state law, insuring enforceability under that law would seem to be relatively simple.

There exist other examples of state-specific laws that can affect the enforceability of a guaranty agreement. Chapter 43 of the Texas Civil Practices and Remedies Code sets forth a suretyship defense that is unique to that state. The provisions of that statute state that if a guarantor receives notice of a default by the primary obligor on indebtedness guaranteed, the guarantor may, by notice to the creditor, require that the creditor file suit on the guaranty agreement. If the creditor fails to do so by the “next term” of the court having jurisdiction for the suit (or the next succeeding term if creditors failure to initiate the action by the “next term” is justifiably excused), the guarantor is released from liability under the guaranty agreement. See Chapter 43, Tex. Civ. Prac.& Rem. Code (Vernon, 2005). The provisions of Chapter 43 may be waived, and a creditor should so provide for such a waiver in the guaranty agreement.

1. See Intercargo Ins. Co. v. Farrell, 89 S.W.d 422 (Ky. App. 2002).
2. See MAXX Parts v. MSD Mining Co., No. 2003-CA-002189-MR (Ky. App. 2005).
3. See Smith v. Bethlehem Sand & Gravel Co., No. 2009-CA-000913-MR (Ky. App. 2011).
4. See Aliant Tax Credit Fund v. Nicholasville Community Housing.  633 F. Supp. 2d 575 (E.D. Ky. 2009).
5. See Brunswick Bowling v. NG-Cadlaon, No.2010-CA-001844-MR (Ky. App. 2011).
6. See Greene, “The Decline of the Bulletproof Guaranty”, The Arrow, greencooper.com (2008).

New York law presents another example of the way in which state-specific law affects a creditor/guarantor relationship. In most states, Section 3-605 of the UCC displaced what is now often known as “old 3-606” or “Former 3-606”. Under this pre-1990 provision of the UCC, any future advance, rearrangement, modification, or extension of the underlying indebtedness guaranteed, if done by a creditor without consent from the guarantor or an express “reservation of rights” jeopardized the effectiveness of the guaranty agreement. In some jurisdictions, a “pre-consent” or “advance consent” contained in the guaranty agreement was generally recognized; in other jurisdictions, the question remained unclear. Unlike 3-605 in effect today, former 3-606 was not particularly creditor friendly. Accordingly, most creditors – when 3-606 was the prevailing law – obtained a consent from the guarantor for most subsequent transactions that modified or amended the underlying transaction in any material respect.

In jurisdiction that is often referred to for “cutting edge” guidance in matters involving commercial law, New York has interestingly retained “old Section 3-606” as the law applicable to the discharge of guarantors. Many commercial transactions (for reasons unrelated to the right of guarantors) are made intentionally subject to New York law. Whenever “old 3-606” is prevailing, it is suggested that a creditor obtain the consent of guarantors for subsequent transactions, or provide for special and specific, or “carve out” provisions to address a guarantor’s “advance consent” to future transactions that modify the underlying indebtedness.

The examples of state-specific laws contained in this Article are not intended to be exhaustive. Instead, these examples are provided as useful “prompts” for consideration by creditors contemplating transactions governed by the laws of a state for which the creditor may not be familiar.

Choice of Law

As an important part of its analysis of transactions involving one or more guarantors, a creditor should give due attention to the choice of law provisions selected in the controlling documentation. In Wallace Hardware Co. v. Abrams,  7  the Court of Appeals for the Sixth Circuit rendered a decision involving Kentucky Revised Statute 371.065 discussed above. In an action brought in the courts of Kentucky involving documents having a Tennessee choice of law provision, a lower court – on policy grounds that deferred to the debtor protection aim of the Kentucky Statute – applied Section 371.065 to invalidate a generally worded guaranty agreement. The 6th Circuit disagreed, stating its belief that Kentucky courts, applying traditional choice of law principals, would recognize the Tennessee choice of law provision. Noting that Tennessee law contained nothing of the restrictive nature of the Kentucky Statute, the guaranty agreement was enforceable.

Beware Retained Policies

Despite the generally applicability of the more creditor friendly provisions of Section 3-605 of the UCC, some creditors have retained – as a matter of “best practice” – policies and procedures that require the consent of a guarantor whenever the creditor amends, modifies, increases, or extends the underlying indebtedness (or requires at least notice to guarantors). Creditors that wish “going forward” to avoid to often inconvenient process of obtaining a guarantor’s consent should consider the appropriate documentary process for a transition to a more liberal guarantor policy. If a creditor simply abandons a policy of guarantor consent or notice – a policy that has been perhaps not required – risks an argument by a guarantor that the creditor has established a “course of dealing” on which the guarantor may justifiably rely for an expectation that the creditor will obtain its consent or provide notice in connection with transactions subsequent to the guaranty agreement, and that the creditor’s failure to obtain consent or provide notice discharges the guarantor’s obligations under its guaranty agreement. The creditor should, when making the transition, obtain the written agreement of the guarantor with respect to future policies and requirements for subsequent transactions.

7. 223 F.3d 382 (6th Cir. 2000).

Conclusion

While the law relevant to the rights and protections of guarantors is relatively uniform across jurisdictions, a creditor makes a wise investment by determining, before engaging a transaction for present and future debt, if any state-specific law exists that would affect the enforceability of a guaranty agreement. The creditor may discover – as described in this Article – that careful and knowledgeable drafting may be required to adequately address the applicability of these state-specific laws.

Note: It should be noted that many jurisdictions are quite flexible and “creditor friendly” in connection with the modification, extension, etc. of guaranteed debt. See e.g., Vision Bank v. 145, LLC, No. 10-00521-KD-B, 2011, WL 5289070 (S.D. Ala. 2011).

When a Continuing Guaranty Does Not Continue?

(Table of Research)

Kentucky Statute

Kentucky Revised Statutes §371.065 (1986)

Kentucky Cases

  • Wallace Hardware Co. v. Abrams, 223 F.3rd 382 (6th Cir. 2000)
  • Austin Power Co. v. Flaugher, 1991 U.S. Lexus 19409 (6th Cir. 1991)
  • Aliant Tax Credit Fund v. Nicholasville Comm. Housing, 633 F.Supp. 575 (E.D. Ky. 2009)
  • Wheeler v. Clevenger, 127 S.W.2d 609 (Ky. 2009)
  • Brunswick Bowling v. Ng-Cadlaon, No. 2010-CA-001844-MR (Ky. App. 2011)
  • Smith v. Bethlehem Sand & Gravel, No. 2009-CA-000913-MR (Ky. App. 2011)
  • MAXX Parts v. MSD Mining Co., No. 2003-CA-002189-MR (Ky. App. 2005)
  • Intercargo Ins. Co. v. Farrell, 89 S.W. 2d 422 (Ky. App. 2002)

Texas Statute

Chapter 43, Texas Civil Practice & Remedies Code (Vernon, 2005)

New York Statute

NY Code, Uniform Commercial Code, Article 3, Section 3-606 (2010)

Alabama Case

Vision Bank v. 145, LLC, No. 10-00521-KD-B, WL 5289070 (S.D. Ala. 2011)

Articles

Greene, “The Decline of the Bulletproof Guaranty,” The Arrow, greenecooper.com (2008) Cohen, “The Calamitous Law of Notes,” 68 Ohio State Law Journal 161 (2007)

Other

Restatement (Third) of Suretyship & Guaranty (1996)

ABA Commercial Law Newsletter (Winter 2011):

apps.americanbar.org/bus/law/committees/cl190000pub/newsletter/20112_commercial_law_newsletter.doc

freddiemac.com/multifamily/docs/guaranty_cme_