Seeking Personal Guarantees
QUESTION: I was thinking of having a customer on a large project sign a guarantee agreement. I’m wondering how common that is and whether a court would even enforce it. Assuming my customer will agree to sign one, what’s the best way to go about it?
Answer: Guarantee — legalistically, guaranty — agreements come in many forms and can bind not only individuals, but also companies, as guarantors. Guarantees can be tremendously helpful in cases where customers have recently been incorporated or organized, undercapitalized, cash-poor or just chronically late in making payment, but using them properly starts with understanding what they are and how they can help.
What is a guarantee? For our purposes it is a written promise to answer for the lawful unsatisfied debt or obligation of another. There are other definitions, such as those used in marketing, but this is the one most suited to the equipment and event rental industry for purposes of collecting rent.
There are many different types of guarantees, including:
- Payment: A payment guarantee obligates the guarantor to pay a debt upon maturity or default.
- Performance: A performance guarantee obligates the guarantor to perform some obligation on behalf of the debtor for the benefit of the beneficiary of the guarantee.
- Collection: A guarantee of collection is the guarantor’s promise that if the creditor cannot collect the claim after the exercise of due diligence — usually after exhaustion of legal remedies against the debtor — the guarantor will pay the beneficiary or creditor.
- Restricted or Limited: A restricted or limited guarantee typically is restricted to a given transaction or series of transactions, limits its duration, and/or caps the total potential liability of the guarantor, regardless of the term(s), number and/or amount(s) of the debt(s) guaranteed.
- Conditional: A conditional guarantee requires the occurrence of some contingency other than the debtor’s default before the guarantor becomes liable — an “if this, then that” analysis
- Absolute: An absolute guarantee requires a guarantor to pay or perform the obligations of the debtor upon default without qualification or limitation. If a guarantee does not contain words of limitation or conditions, it typically is construed as an absolute guarantee.
- Continuing: A continuing guarantee is not limited to a single transaction but instead, applies to a future course of dealing, which may involve multiple transactions, continue for an indefinite period and/or secure payment or performance of multiple debts and/or other obligations.
- Downstream: A downstream guarantee is a guarantee given by a parent company to secure prompt payment and/or performance of the obligations of its subsidiary. Such guarantees often are required because of the parent company’s superior credit history, asset base and/or financial strength.
- Upstream: An upstream guarantee is the reverse — a guarantee by a subsidiary of the obligations of its parent company. A creditor may require an upstream guarantee when the parent’s assets consist entirely or largely of the stock of the guarantor-subsidiary, thereby enabling the assets of the subsidiary to effectively serve as security for the parent’s obligations.
- Cross-Stream: A cross-stream guarantee is a guarantee given by one affiliated company for the benefit of another, where the equity of both is owned by the same parent.
When are guarantees necessary? Equipment lessors are not legally required to obtain any guarantees from their customers, and many don’t, but one issue should motivate most lessors to at least consider doing so. As anyone who rents equipment knows, many rental customers are small companies with limited assets — usually contractors. Those contractors typically set up small S corporations or limited liability companies (LLCs). Limited liability corporation is a misnomer — there is no such legal entity, though both corporations and LLCs offer limited liability to their owners. That corporate shield of limited liability enables those contractors to sign agreements that make their companies, but not themselves, liable for significant debts. Thus, even though you may believe you’re renting to “Joe Customer,” if Joe sets up “Joe Customer LLC,” you actually may be renting only to an LLC owned by Joe. Why does that matter? Because most business operators only have a vague idea how well or thinly capitalized their small business customers are. That means Joe Customer LLC’s $1,000 worth of assets may be the only security you have for his rental of a $50,000 skid steer — unless you require him to sign a personal guarantee.
How can guarantees be useful? The vast majority of equipment lessors use guarantees for a single primary purpose: collecting the amounts owing under a rental contract or a series of rental contracts, which may include among other things, rent, taxes, interest, attorneys’ fees and/or repair costs. In the above example, if Joe Customer destroys your skid steer after providing you with an expired insurance certificate, no matter how much your verdict may appear to be worth after you sue his LLC, in most cases its real value will be $1,000 or less — unless you required him to sign a personal guarantee. Why? Because the poor unsuspecting lessor cannot obtain more than the assets owned by Joe’s LLC in most cases, unless the rental operator can prove Joe commingled his personal assets with those of his LLC and/or committed fraud, and by doing so, pierce the corporate veil of limited liability maintained by his LLC. If, however, Joe personally guaranteed his LLC’s debt under the rental contract, the lessor also would have the option to pursue Joe’s personal assets. This, of course, not only makes more assets available to pay the rental operator’s judgment, it also places the rental operator in a far superior position relative to others who may have extended credit to Joe Customer LLC without obtaining a personal guarantee.
Who gets paid and when? Who is Joe likely to pay first in this scenario? If Joe’s car, boat, real estate and more are at risk of being seized in order to satisfy a judgment, Joe is likely to be far more accommodating in negotiations, meaning the rental operator may never have to file suit in the first place. Even if Joe decides to bankrupt his LLC, that bankruptcy won’t stop the lessor’s collection efforts against Joe’s personal assets, at least not for long if its guarantee is properly written.
Who should you require to sign a guarantee? It depends on the customer/lessee and its ownership structure, but the most common guarantors tend to be the majority owners, officers and/or directors of business-entity customers — who themselves may be individuals or in many cases, other business entities. As a general proposition, the more guarantors there are on a given contract, the more security for payment and performance will be available to the lessor/creditor. Rental operators should, however, consider carefully whether a judge or jury would be willing to enforce a guarantee against a given guarantor or group of guarantors. In most cases, guarantees cannot be enforced against minors or intoxicated or mentally incapacitated individuals. Guarantees signed by delivery drivers, office administrative personnel, on-site representatives, installers and other non-owners of business-entity guarantors are rarely, if ever, enforced. That said, in the above example, Joe Customer still is likely to be held liable, provided the rental operator properly and fairly documented and dealt with the transaction.
Guarantees can be immensely valuable for rental operators who know how and when to use them. As helpful as they can be, particularly when a customer goes bankrupt or destroys a piece of equipment, they are overlooked or foregone in a surprising number of cases, even when obtaining them would have been relatively easy. The painful lessons learned in the aftermath of the 2009 economic downturn should be well remembered and put to good use.