Worth Magazine, April - May 2013
Before you agree to pay someone else’s debts, know what you’re in for.
A former partner of mine used to define a guarantor as “a schmuck with a pen.” That characterization was a bit dramatic, but he had a point: No one should ever guarantee, cosign for or indemnify someone else’s obligation without considering the risks. These include the possibility that the primary borrower won’t pay the debt, as well as the amount of the repayment obligation or liability exposure.
You’re probably familiar with guarantying a family member’s obligation, such as a mortgage, credit card, car loan or apartment lease. These financial exposures are usually easily quantifiable and containable: You know the amount of the monthly car or mortgage payment, credit cards can be given limits and cosigners can be notified either when predetermined balances are exceeded or on a transaction-by-transaction basis. The guaranties that I’m talking about are often harder to quantify and far more expensive.
In its purest sense, a guaranty means the requirement that the guarantor pay the debt of another if the primary obligator fails to pay. These so-called guaranties of payment are a common subject on law school exams but seldom occur in real life. Instead, in the vast majority of situations where people agree to “guaranty” debt, they are actually becoming what’s known as a co-borrower.
The distinction between guarantying and co-borrowing is important. With a guaranty, if the primary borrower can’t pay his debt, the lender must first sue the borrower. Only upon a failure to be repaid can he then pursue the guarantor.
But that’s not the case with co-borrowing. In that situation, the lender doesn’t need to exhaust his remedies against the primary borrower before making demands upon and possibly suing the co-borrower. If the primary borrower fails to make a payment or is otherwise in default, the lender can pursue the co-borrower even if the co-borrower has no knowledge of that default. To make things worse, sometimes when a default occurs, a much larger balance may become immediately due because of a so-called “acceleration clause.” This contractual provision requires that the entire balance of a loan or total future payments under a lease be paid upon a default—even if that default is, for example, a late payment of only a single installment, or a simple breach of a covenant, like a failure to provide a document (a tax return or financial statement, perhaps) to the lender on time. Once acceleration occurs, the lender has the contractual right to payment in full.
Sometimes a guaranty occurs in the context of an investment. For example, a subscriber to a privately placed investment might be asked to make one or more capital contributions to acquire his stake in the venture. Buried in the offering or subscription documents may also be a commitment to contribute more capital should certain contingencies occur.
Another analogous situation is the case of contractual indemnities. Indemnities are like guaranties; they may require you to pay the debt of the indemnified party. Indemnities may be of two types: direct and third party or indirect. A direct indemnity protects the indemnified party from losses and expenses associated with the direct relationship between the contracting parties. For example, the indemnifying party agrees to pay the expenses of the indemnified party if the indemnifying party breaches the agreement between them. A third-party indemnification means that the indemnifying party agrees to pay the losses or expenses of the indemnified party if the indemnified party is sued by a third party and is required to pay the third party’s claim. A common example might be if you buy a piece of real estate and the seller agrees to indemnify you for claims brought by, say, the EPA.
Being a borrower when you didn’t intend to be one is risky business. If you really feel the need to become a guarantor, co-borrower or indemnitor, you’d better know exactly what you’re signing up for.