By: John Murray, Vice President-Special Counsel, First American Title Insurance Company
A mortgage lender is sometimes willing to limit the amount guaranteed by a third party in connection with a mortgage loan. Usually this is because the loan-to-value ratio at the commencement of the loan is sufficiently strong, or there is enough additional credit support or enhancement (e.g., additional collateral, a letter of credit, a master lease, or a defeasance arrangement), to permit only a limited or conditional guaranty of the underlying indebtedness. The lender may also be willing to condition the guarantor’s liability upon the happening of a future event. As noted by the Illinois Appellate Court in Lawndale Steel Company v. Appel, 98 Ill. App. 3d 167, 170 (1981), “[a] conditional guaranty requires the happening of some contingent event before the guarantor will be liable on his guaranty,” while “[a]n absolute guaranty is an unconditional undertaking on the part of the guarantor that the person primarily obligated will pay or otherwise perform.”
There are numerous types of limited and conditional guaranties, including the following: “burn down” or “burn off” guaranties; “top” guaranties (discussed below); “springing,” “exploding” (or “vanishing”), “creeping,” and “shrinking” guaranties; percentage guaranties; construction-completion guaranties; rental-achievement, lease-up, operating-deficit and “break even” guaranties; debt-service-coverage guaranties; dollar-limit or “maximum principal amount” guaranties; limited-time guaranties; “wrongful (or bad) acts” guaranties; “carry,” “interest and carry,” and “excess interest” guaranties (covering obligations other than repayment of the loan principal); loan-in-balance guaranties; and limited-amount liquidated-damages indemnity agreements.
Also, some types of limited guaranties may exempt or exclude certain of the guarantor’s (or guarantors’) assets or a portion of all of the guarantor’s (or guarantors’) assets, from coverage under the guaranty or, conversely, permit recourse only to a specified pool or portfolio of assets owned by the guarantor(s). The nuances of each of these types of guaranties are beyond the scope of this article; however, each of these limited and conditional guaranties must be carefully drafted to avoid giving a court the opportunity to construe the limiting or conditional language against the lender and to further limit or even nullify the liability and obligations of the guarantor(s). Simple “buzz words” and phrases, such as “top X%,” must be avoided. The borrower must also be careful to avoid inclusion of language in the guaranty agreement that would expand its liability beyond that which it intended; the guaranty should be drafted to accurately reflect and state the reasonable expectations of both the lender and the borrower.
A precise definition should accompany any words or phrases of limitation, and the nature and scope of the limitation should be clearly and comprehensively set forth in the guaranty agreement. The 1996 Restatement of the Law (Third) of Suretyship and Guaranty (American Law Institute) (“RESTATEMENT”) provides definitions of terms commonly used in guaranty and surety agreements. It also provides guidelines for interpreting many of the terms and provisions commonly contained in such agreements. The RESTATEMENT does not have any specific definition of an “absolute” or an “unconditional” guaranty. This is probably because such language is deemed unnecessary; under § 8 of the RESTATEMENT, every guaranty is enforceable against the guarantor immediately upon default of the prime obligor unless the guaranty states otherwise, and the guaranty is effective without the obligee having to notify the guarantor of its acceptance.
Many jurisdictions construe an “absolute and unconditional” guaranty as one that is a guaranty of payment and that is effective immediately upon the prime obligor’s default. This is contrasted with a guaranty of collection, which is enforceable against the guarantor only if (1) an execution of judgment against the prime obligor has been returned unsatisfied, or (2) the prime obligor is insolvent, or (3) the prime obligor cannot be served with process, or (4) it is otherwise apparent that payment cannot be obtained from the prime obligor. RESTATEMENT § 15(b).
‘BURN DOWN’ GUARANTIES: BANK OF AMERICA V. SCHULSON
As noted above, the borrower and lender (and their respective counsel) should pay special attention to the negotiation and documentation of limited and conditional guaranties, including “burn down” guaranties. For example, in Bank of America National Trust and Savings. Association v. Schulson, 305 Ill. App. 3d 941 (1999), modified and reh’g denied (Jun. 30, 1999), reh’g denied (Sept. 9, 1999), appeal denied, 186 Ill. 2d 565 (1999), the issue involved the interpretation and enforceability of a “burn down” clause that appeared in separate but identical personal guaranties executed by the two individual owners of Lunan Family Restaurants Limited Partnership, an Illinois limited partnership (“Lunan”). The burn-down provision automatically reduced the amount due under each of the guaranties by a fixed percentage as principal payments were made on a $13.5 million loan (“Loan”) to Lunan by Bank of America (“Bank”). The Loan was secured by a mortgage recorded on October 2, 1991, as modified a First Amendment to Mortgage dated April 22, 1994 (“Mortgage”), as well as the owners’ guaranties. The Mortgage covered, inter alia, Lunan’s leasehold interests in four family-style chain restaurants operated under a Shoney’s Inc. franchise. The appellate court reversed the holding of the trial court, which had ruled that the “burn down” clause in each of the guaranties was ambiguous and would apply to the Bank’s receipt of principal payments made after Lunan’s default, including proceeds from the sale of the Loan collateral in Lunan’s subsequent bankruptcy proceeding.
Each of the guaranty agreements repeatedly described the guaranty as “absolute” and “unconditional,” and guaranteed “full and prompt payment, when due, whether by acceleration or otherwise, of all obligations.” The right of recovery under each of the guaranties, however, was expressly limited to the payment of $3 million; as such sum might be reduced by the burn-down provision contained in each guaranty. The “burn down” clause stated that the amount of the guaranty “shall be reduced by an amount equal to 36% of any principal payments made with respect to the Liabilities.” The separate guaranty agreements did not provide for joint and several liability of the guarantors.
Lunan defaulted on the Loan at the end of 1993, and Lunan and the Bank subsequently entered into an Amended and Restated Loan and Security Agreement in March 1994. As part of this Loan restructuring, the Bank was paid $18,300 from the sale of equipment that constituted a portion of the Loan collateral. In accordance with the burn-down clause, the Bank credited this amount against the unpaid principal balance due on the Loan, reducing the guaranties by 36% of this amount. In October 1994 Lunan filed a Chapter 11 bankruptcy proceeding, which both the Bank and the guarantors agreed constituted a default that triggered the guarantors’ obligations under the guaranty agreements. In September 1996, the restaurants that constituted the Bank’s security for the Loan were sold free and clear of all liens pursuant to § 363 of the Bankruptcy Code, with liens to attach to the sale proceeds. The bankruptcy judge ordered that approximately $8 million of the bankruptcy sale proceeds be applied to reduction of the unpaid principal of the Loan.
On November 10, 1994, the Bank sent each of the guarantors a notice of Lunan’s default under the Loan and demanded payment under the guaranties. On December 15, 1994, the Bank filed separate actions against each of the guarantors, seeking payment under the guaranties. The trial court later consolidated the two cases. The guarantors filed counterclaims seeking a declaration that they were each entitled to a reduction in the amount owed under the guaranties, in the amount of 36% of the amount of the proceeds received by the Bank from the bankruptcy sale of Lunan’s restaurants. The counterclaims also alleged breach of contract by the Bank and a breach of the implied covenant of good faith and fair dealing (these claims were later voluntarily dismissed, without prejudice, by the guarantors). The Bank immediately moved for summary judgment, arguing that the burn-down clause applied only to principal payments made before the guarantors’ obligations became due on November 10, 1994. The trial court found that the burn-down clause in each of the guaranties was “ambiguous.” After reviewing the drafting history of the clause and the evidence regarding negotiation of the clause by the parties, the trial court held that the parties intended the burn down provision to apply to payments made at “any” time by Lunan, including post-default payments received by the Bank as the result of the bankruptcy sale of Lunan’s assets.
The bank argued strenuously on appeal that the trial court had erroneously construed the guaranties as guaranties of collection instead of payment. The Bank asserted that this interpretation was unjustified, because the language of the guaranties clearly provided that the Bank was entitled to collection under the guaranties immediately upon Lunan’s default, notwithstanding the existence of the burn-down provisions.
The appellate court agreed with the Bank’s interpretation of the guaranty agreements. After reviewing the rules of construction applicable to contracts as developed by case law, the court held that it was bound to give effect to each of the guaranty agreements as a whole, i.e., each of the provisions of the agreements must be given effect and read in light of the other provisions. The court noted the distinction between guaranties of payment (requiring immediate payment of the debt if the debtor fails to pay) and guaranties of collection (requiring payment only if all efforts to collect against the debtor have first been exhausted). The court noted that the guarantors had abandoned their initial argument that the Bank was first required to attempt collection against Lunan before seeking recovery under the guaranties (although they still insisted that they were entitled to a reduction in their obligations under the burn down provision as the result of payments made at any time, including collection of the bankruptcy sale proceeds).
Both the Bank and the guarantors focused on the word “any” in the clause in each of the guaranty agreements that referred to “any principal payments made with respect to the liabilities.” The Bank argued that the word “made” in this clause referred only to principal payments made by Lunan prior to Lunan’s default and the Bank’s demand for payment served on the guarantors. The guarantors, on the other hand, asserted that the word “any” meant that the burn-down provision would apply to payments made at any time, whether before or after default by Lunan and notice to the guarantors. The guarantors also argued that the definition of “liabilities” in each of the guaranties included accelerated obligations, and thus the discount provided by the burn down provision should also apply to payments made on such accelerated obligations.
The appellate court agreed with the Bank’s contention that the guarantors’ interpretation of the burn down clause would contradict several other clauses in the guaranties, rendering them meaningless and ineffective. In particular, the court noted, the guaranties each contained numerous references to the “absolute” and “unconditional” nature of the promises and obligations of the guarantors. The court agreed with the Bank’s argument that the “absolute” and “unconditional” language would be nullified under the guarantors’ interpretation of the burn down clause. According to the court, “[w]hen a guaranty is ‘absolute and unconditional,’ the guaranteed party is not required to complete a foreclosure on the debtor’s security before seeking payment under the guaranty” (citations omitted). Schulson, 714 P.2d at 26. The court also noted that in addition to the words “absolute” and “unconditional,” each of the guaranties contained a provision that allowed the Bank to “resort to the undersigned . . . for payment of any of the Liabilities, whether or not the Bank . . . shall have resorted to any property securing any of the liabilities or any obligation thereunder.” Id.
The appellate court also noted that each of the guaranties stated that the Bank was entitled to “full and prompt payment” upon default by Lunan and/or notice of default to the guarantors. According to the court, this language would also become meaningless under the guarantors’ interpretation. The court found that this triggering provision would be nullified if the due date could be extended, as occurred in this case, for a period of almost two years (i.e., until the date of distribution of the bankruptcy sale proceeds to the Bank). In support of this conclusion, the appellate court referred to its previous holding in Telegraph Savings & Loan Association v. Guaranty Bank & Trust Company, 67 Ill. App. 3d 790 (1978), a case in which, the court stated, “the facts are very close to those before us.” The appellate court ruled in Telegraph that under the express terms of the guaranty the guarantors’ obligations became due and owing immediately upon the borrower’s default, and that only “voluntary” payments of principal – not payments received as the result of the subsequent foreclosure sale of the loan collateral - would release the guarantors from their obligations.
The appellate court in Schulson further ruled that payments received as the result of a sale of the loan collateral, whether through a foreclosure sale or a bankruptcy sale, did not qualify as “principal payments” under the terms of the burn-down clause. The court noted that each of the guaranties required “full and prompt payment” when Lunan’s obligations became due without the Bank having to resort to the loan collateral. Therefore, according to the court, a ruling favoring the guarantors’ interpretation of the clause would make the guaranties illusory because the amount actually owed by the guarantors could never be finally determined until the loan collateral had been sold.
The appellate court also rejected the guarantors’ argument that “added language” prevails over printed forms. The court noted that each of the guaranties was a typed form with no added language, and found that in any event the contested language of the burn down provision could be “harmonized” with the other guaranty provisions. Similarly, the court also rejected the guarantors’ argument that the burn-down provision contained “specific” terms that should control over the “general” terms of the guaranties. The court found no evidence that the burn down provision was specific and that the other provisions referred to by the Bank were general, and held that the provisions could – and would - be construed as consistent so as to give effect to the entire agreement.
The appellate court next addressed the guarantors’ assertion that the parol evidence rule should be “provisionally” considered to determine whether the burn-down clause was ambiguous. The court acknowledged that in some circumstances, parol evidence might be provisionally introduced to determine whether a contract that appears clear on its face contains an ambiguity. The court further acknowledged that the parties had exchanged five drafts of the guaranties and that the burn-down provision had been heavily negotiated. However, the court held that the provisional consideration of parol evidence would only be applicable where required to clarify the definition of specific terms of a contract, in order to determine an ambiguity. The court found that the language in the guaranties requiring prompt and punctual payment, and allowing the Bank to seek collection from the guarantors without first resorting to the collateral, was clear and unambiguous. The court therefore refused to permit the introduction or consideration of parol evidence by the guarantors.
For all of the foregoing reasons, the appellate court ruled that the guarantors’ obligations were triggered upon Lunan’s default and that the burn down clause in each of the guaranties applied only with respect to principal payments made at that time. The court specifically directed the trial court “to consider only principal payments made before Lunan filed bankruptcy in calculating the offset to which defendant was entitled.” Schulson, 714 P.2d at 28.
Finally, the appellate court addressed the guarantors’ contention that because the guaranties did not provide for joint and several liability, each guarantor should only be required to pay the expenses incurred with collection of his own guaranty. The court noted that although there was no joint and several liability, each guaranty provided that the guarantor would pay “all expenses” of enforcement. Therefore, the court held that each guarantor was liable for payment of the full amount of the Bank’s collection expenses, but the Bank could only collect this amount once. The court further held that the guarantors could present evidence to the trial court to show that some expenses had been incurred with respect to collection of one of the guaranties but not the other.
IMPORTANCE OF CLEAR AND PRECISE DRAFTING
As is evident from the court’s holding in the Schulson case, supra, careful and precise drafting is essential with respect to limited and conditional guarantees. See, e.g., Tenet Healthsystem TGH, Inc. v. Silver, 203 Ariz. 217, 221-22 (Ariz. App. 2002) (following appellate court’s holding in Schulson and Telegraph, supra, based on similar facts and citing other cases holding similarly to these cases, and stating that “Other courts have reached the same conclusion on [guaranty] agreements similar to the ones at issue in Schulson, Telegraph Savings & Loan, and here”).
In other cases where the guaranty agreement limits the guarantor’s liability to a specific dollar amount or a stated percentage of the debt, courts have held that foreclosure proceeds obtained by the lender upon its foreclosure sale of the mortgaged property should be applied first to reduce the guaranteed portion of the debt, even where the lender has the option under the guaranty agreement to pursue the guarantor separately in lieu of foreclosure or “resort to any security.” See, e.g., BankEast v. Michalenoick, 138 N.H. 367, 370-71 (N.H., 1994) (guarantor guaranteed up to $100,000 of loan indebtedness of $800,000 and guaranty stated it would be reduced by amount of any principal paydown on debt; parties agreed that guaranty was unconditional and lender was not required to first resort to mortgage security and that guaranty applied to first $100,000 paid down on the loan; court held that once bank chose to foreclose and obtained total of $635,000, reducing debt to $129,000, guaranty was extinguished by its own terms, which stated that guarantor’s liability extended only to the “first $100,000” of indebtedness).
With respect to the liability of partners in a partnership for limited or conditional guaranties, see TMG Life Ins. Co. v. Ashner, 21 Kan. App. 2d 234, 244-46 (1995). In this case, the Kansas appellate court held that the guaranty executed by the borrower partnership’s general partners that limited the guarantors’ liability, in their individual capacity, “to an amount equal to one-third of the amount of the loan from time-to-time outstanding,” did not require that value of mortgaged property transferred to the lender as a result of the borrower partnership’s Chapter 11 bankruptcy proceeding be credited to the obligation created by the guaranty. But the court remanded the matter to the trial court because it also held that the valuation of the property at the time of the transfer had not been determined by the trial court and such valuation was necessary to compute the amount of liability based on the “from time to time” language in the guaranty and which amount, once finally determined, would then be deducted from the gross amount outstanding under the loan because the lender repossessed the property before the amount of the guarantors’ liability was determined and therefore fixed.
Historically, lenders have had a difficult time drafting and enforcing guaranty language that obligated a guarantor to pay, e.g., the “top x%” of the loan amount. Such language, without more, is generally understood to mean that the guarantor is only liable for the difference between the loan balance and an amount set as a percentage of the original loan amount. This type of provision is often used by lenders to provide a “cushion” if the property decreases in value down to the base level as established by the percentage amount of the original loan for which the guarantor is liable. The guarantor generally understands that its liability at any time will be limited to no more than the percentage amount it has agreed to, and that its liability will disappear when the loan balance has been paid down to a certain amount.
However, this type of limitation on a guarantor’s liability, if not carefully and clearly negotiated and drafted, may be open to a claim of ambiguity with all of the potentially negative consequences that could result from a court’s recharacterization of the clause. For example, the lender may contend (which contention is usually unsuccessful and will be vehemently contested by the guarantor) that the language should be construed so that the guarantor is always liable for an amount equal to the stated percentage of the original loan amount, regardless of the actual amount of the outstanding loan balance. Alternatively, the lender may seek an interpretation of the language (which can also be expected to be hotly contested by the guarantor) that would provide for the guarantor’s liability to decrease (but never end until full payment) on a sliding scale, i.e., the guarantor would remain liable throughout the term of the loan but such liability would decrease pro rata to the extent the principal balance has been paid down by the borrower.
It is crucial when utilizing this type of guaranty to clearly define and clarify exactly what type of payments will qualify to reduce the guarantor’s liability. For example, the proceeds from a foreclosure proceeding are generally applied first to the nonrecourse portion of the debt. If this were not the case, the “top” guaranty would be virtually worthless because the amount of foreclosure proceeds available would frequently be more than what would be required to satisfy the top portion of the debt. The lender generally expects a “last dollar” and not a “first dollar” guaranty, i.e., it anticipates that payments it receives from a foreclosure sale will first be applied against the unguaranteed (or nonrecourse) portion of the loan and that the guaranty will remain in effect until the loan has been paid in full. The language in the guaranty regarding the guarantor’s “top” obligation should therefore provide that foreclosure (or bankruptcy) sale proceeds will first be applied to the nonrecourse portion of the debt and that, to the extent the proceeds are insufficient to fully pay the loan, the guarantor remains personally liable for the difference. See, e.g., University Savings Ass’n v. Miller, 786 S.W.2d 461, 463 (Tex. App. 1990) (guaranty language, which guaranteed top 10% of all amounts owing on debt, explicitly provided that lender was not required to apply foreclosure proceeds to unguaranteed portion of debt before applying it to indebtedness owed by guarantor)
The cases discussed in this article clearly highlight the risks and dangers to lenders in taking limited and conditional guaranties from third parties as additional security for mortgage loans. Unless carefully and comprehensively drafted, a percentage or “burn down” guaranty, which provides for guarantor liability for a stated percentage of the debt, presents an especially attractive target for a challenge based on its “ambiguous” meaning. To what amount does the percentage apply – to the net amount after collateral recovery or to all amounts due and owing at the time of the borrower’s default, or from “time to time”? Do regular principal payments received by the lender reduce pro-rata the percentage amount owed by the guarantor(s)? At what time is the amount determined – upon the borrower’s default, upon notice to the guarantor(s) of the acceleration of the debt, or upon collection of all proceeds available from the loan collateral, whether by foreclosure, bankruptcy or other collateral sale? What about interest on the guarantor’s unpaid share of the principal balance of the loan? What about the lender’s attorneys’ fees and other expenses of collection? What about the order, proportions and priority of the application of amounts received by the lender? What about the application of proceeds received from personal property and other ancillary forms of collateral? If there is more than one guarantor, is the total liability joint and several or are all guarantors equally liable? Should the guaranty contain a “springback” or “clawback” provision that provides for reinstatement of the guarantor’s (or guarantors’) obligations if changing facts subsequently eliminate the condition or occurrence upon which the guaranty was initially released? All of these questions, and more, should be addressed and answered to the satisfaction of both the lender and borrower, and covered in the provision(s) of the guaranty limiting or conditioning the liability of the guarantor(s).
* Nothing in this Article is to be considered as the rendering of legal advice for specific cases, or creating an attorney-client relationship, and readers are responsible for obtaining such advice from their own legal counsel. This article is intended for educational and informational purposes only, and no warranty or representation is made as to the accuracy or completeness of the information contained herein. The views and opinions expressed in this Article are solely those of the Author, and do not necessarily reflect the views, opinions, or policies of the Author’s employer, First American Title Insurance Company.
** Mr. Murray is an attorney licensed to practice in Illinois and is and is vice president-special counsel for First American Title Insurance Company. He received his bachelor of business administration and law degrees from the University of Michigan.