When a family business borrows money, the lender often requires some or all of the business owners to guarantee the loan. If one of the business owner guarantors pays on the guaranty, that guarantor is entitled to contribution payments from the other guarantors. However, the default state law about the proportion of the loan that each business owner guarantor is obligated to pay is often different from what the business owner guarantors would have agreed upon if they had considered the issue in an informed way at the time they gave the guaranties. To avoid uncertainty and litigation, family business owner guarantors should always enter into a contribution agreement setting out their relative contribution obligations in the event the guaranties are called upon.
Consider the simple example of three members of a family business established as a limited liability company, which borrows three million dollars from a bank to finance the purchase of commercial property. The loan is secured by a mortgage on the property and the three LLC members jointly and severally personally guarantee the entire loan. One LLC member guarantor owns a 60% interest in the LLC, another owns 30% and the third LLC member owns 10%. The loan goes into default and the lender demands payment from the LLC member guarantors. The LLC member guarantor owning a 10% interest pays the entire loan balance and then asks the other guarantors to pay their fair shares of the defaulted loan. How much does each remaining LLC member guarantor have to pay?
Even in the absence of a contribution agreement, the paying LLC member guarantor is entitled under common law contribution principles to repayment of a part of the amount paid to the lender. It comes as a surprise to many that, in the absence of an agreement to the contrary, the general rule (subject to many exceptions and qualifications) is that guarantors are obligated to settle up with one another so that each pays an equal percentage of the total amount paid by the guarantors even though they may have wildly differing ownership percentages in the borrower. In the example above, without a contribution agreement specifying guarantor payment obligations consistent with LLC member ownership, each non-paying LLC member guarantor would be obligated to pay the paying LLC member guarantor one-third of the amount he or she paid to the bank, so that each of the three LLC member guarantors would ultimately bear one-third of the loss. All LLC member guarantors would be entitled to full reimbursement by the LLC, but since the loan went into default, the LLC is likely unable to pay what it owes.
Questions family business owner guarantors should consider in deciding how to structure a contribution agreement include:
- Should each business owner guarantor’s share of the debt be equal or should or should it be based on percentage ownership in the borrower?
- Are spouses of business owners guaranteeing the debt treated as one guarantor or two for purposes of calculating the contribution obligation?
- Is the paying business owner guarantor entitled to be paid interest on the amount paid to the lender? If so, at what rate?
- What if one or more of the business owner guarantors is insolvent, dead or otherwise unavailable to contribute?
- What if one or more of the guaranties was limited to a maximum amount less than the total loan amount?
- What if the guaranties cover only “bad acts carve-outs” and one business owner guarantor is responsible for the action that triggers liability on the guaranties?
- What if the paying business owner guarantor paid the loan off despite a belief by the others that there were defenses to payment, which should have been pursued before paying the lender?
- What if one business owner guarantor’s guaranty is legally defective and that guarantor has defenses to paying the lender that are not available to the other guarantors?
- Are there other business owners who did not guaranty the loan, but who could reasonably be expected to share part of the loss if a business owner guarantor pays on a guaranty?
- Should one or more business owner guarantors be required to bear the full burden of the failed transaction and fully indemnify others for the loss? For example, a person who has no interest in the borrowing business, but guarantees a loan to the business as a favor to a relative who owns the business and also guarantees the loan, might expect the business owner to reimburse the non-owner guarantor in full if his or her guaranty is called.
- If the transaction involves more than one state, what state’s law should govern the contribution obligations?
All of the applicable issues should be addressed in a well-drafted contribution agreement. In the absence of such an agreement, the answers can be unclear and can vary from state to state. The business owner guarantors should also be mindful of the federal income tax implications of their contribution obligations, especially for the ability to allocate losses of a borrowing business that is a partnership or a limited liability company taxed as a partnership.
These issues can come up in many contexts beyond guaranties. They exist in any situation where multiple parties are liable, or provide collateral, for the same debt.
Here is a link to an article exploring the issues in much greater detail: After the Guarantor Pays.