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A Sure Thing

The Restatement (Third) of Suretyship provides much-needed guidance through the complex world of guaranties and sureties. 

By Steven O. Weise 

Steven O. Weise is a member of Heller, Ehrman, White & McAuliffe in its Los Angeles office. His practice concentrates on commercial transactions.

Transactional lawyers must practice exquisite vigilance at every stage of a business deal. One of the hardest tasks is recognizing when a transaction involves a guaranty. A lawyer who fails to spot that a seemingly innocuous part of a transaction constitutes a guaranty may make a fatal error. On the other hand, the lawyer who ferrets out the hidden guaranty can, without too much difficulty, draft adequate provisions to protect the beneficiary of the guaranty. 

The American Law Institute's recent approval of a new Restatement of Suretyship(1) provides an opportunity for transaction lawyers to study a set of rules that illuminate when a guaranty exists. The Restatement masterfully brings together decisions from across the country and formulates analytical rules that organize the underlying principles of these decisions. Its clarity will help practitioners as they determine when a guaranty exists and how to draft provisions to make the guaranty effective. 

"Suretyship law" is an umbrella term that applies to both the law of guaranties and surety bonds, a form of security in real property that appears frequently in construction contracts. "Surety" usually can be used as a substitute for "guarantor," but the reverse is never true. Most commercial lawyers, if not necessarily all, while pleased with the new Restatement, wish that it bore a different name. 

California's law of suretyship resides in Civil Code Sections 2787 through 2856. Though most of California's suretyship provisions were adopted in 1872, they are, for the most part, consistent with the provisions of the new Restatement. California's statutory rules of suretyship are general in nature. The more specific rules and illustrations in the Restatement should provide extensive and instructive guidance for the interpretation and application of the California statutes. 

The Restatement(2) defines a "guarantor" by requiring that two sets of facts exist:
  1. A creditor (the "obligee") has recourse against a person (the "guarantor" or the "secondary obligor") or its property with respect to the obligations of another (the "debtor" or the "principal obligor").    
  2. The debtor has a duty to the guarantor to perform the obligation or bear its cost.
This simple definition can apply to a variety of transactions. When the facts of part of a transaction fit the definition, that part will constitute a guaranty no matter what label the parties place on it. Once the guaranty label applies to part of a transaction, the guarantor may then have the benefits of the protections given to guarantors. Transactions featuring guaranties fall into a variety of basic fact patterns, and the Restatement shines a light on those common functional relationships that all too often can be misconstrued, with significant consequences.

Classic guarantor. 
The traditional guaranty relationship is not hard to spot: 

  • A debtor borrows money from a creditor.    
  • A guarantor promises a creditor that the guarantor will pay the debtor's debt if the debtor does not pay it.    
  • The debtor has a duty to reimburse the guarantor.

    The guarantor is a "secondary obligor" under the definition of the Restatement.(3) 

    Other guarantor transactions flow from frequently surprising and more complicated relationships.

Cosigner of note (single borrower). 
The Restatement wastes no time in confounding the traditional expectations of many lawyers by applying the definition to the following transaction: 

  • A debtor borrows money from a creditor and receives all of the loan proceeds.    
  • A cosigner receives none of the loan proceeds, cosigns the debtor's note, and promises the creditor to pay the debt if the debtor does not pay the note.    
  • The debtor has a duty to reimburse the cosigner if the debtor does not pay the debt and the cosigner does pay the debt.

Many lawyers believe the cosigner is a primary obligor in this transaction. It is not. The cosignor meets the definition of a "guarantor."(4) 

Cosigner of note (coborrowers).
 In a variation on the preceding transaction: 

  • Two debtors each borrow money from a creditor, and each debtor receives a portion of the loan proceeds.    
  • The two debtors each sign the same note.    
  • Each debtor has a duty to reimburse the other debtor to the extent the other debtor pays the creditor the amount received by the one debtor.

Once again, the definition applies. Each debtor is a guarantor with respect to the portion of the loan received by the other debtor. And each debtor is a primary obligor with respect to the amount of the loan that the debtor personally received.(5) 

Purchaser of obligation. 
Many lawyers may not recognize the following sequence as a guaranty transaction: 

  • A debtor borrows money from a creditor.    
  • A third party agrees with the creditor that the third party will purchase the obligation if the debtor defaults.    
  • If the third party purchases the obligation, the third party can enforce the claim against the debtor. The definition applies and the third party is a guarantor.(6)

Third party's grant of a security interest in its own property to secure an obligation of another.  
Lawyers often fail to address guaranty issues when handling the following fact pattern: 

  • A debtor borrows money.    
  • A third party gives a security interest in the third party's property in favor of the creditor to secure the debtor's obligation to the creditor.    
  • If the secured party enforces the claim against the collateral provided by the third party, the third party has a right to reimbursement from the debtor.

The third party is a guarantor.(7) 

Sale of accounts with recourse. 
This transaction occurs frequently. If the buyer of the accounts fails to recognize the guaranty nature of the transaction, the buyer could run into significant enforcement problems: 

  • An account debtor buys something from a seller.    
  • The seller then sells the obligation to a third party and the creditor agrees to repurchase the obligation from the third party if the account debtor defaults.    
  • If the creditor repurchases the obligation from the third party, the creditor can then enforce the claims against the account debtor.

The seller is a guarantor.(8) 

Sale of accounts with collection warranty. 
In a variation on the preceding transaction, though with little difference as a matter of substance: 

  • An account debtor makes a purchase from a seller.    
  • The seller then sells the account debtor's obligation to a buyer and warrants to the buyer that the account debtor will perform the obligation.    
  • If the creditor has to honor the warranty, the creditor has a right to reimbursement from the account debtor arising out of their relationship.

The creditor is a guarantor. 

Sale of collateral by debtor. 
Lawyers should be careful about this somewhat hidden guaranty: 

  • A debtor borrows money from a creditor and grants the creditor a security interest in the assets of the debtor.    
  • The debtor sells the collateral to a buyer who assumes the secured debt.    
  • If the original debtor has to pay the debt to the creditor, the debtor has a right to reimbursement from the buyer of the collateral.

The original debtor is a guarantor.(9) 

Sales of assets of a business. 
Lawyers frequently are involved in the sale of the assets of a business. This transaction also can create a guaranty without using that word: 

  • A debtor incurs debts to creditors.    
  • The debtor then sells the assets of the business, and the buyer of the assets assumes the debts of the business as a part of the purchase price.    
  • If the debtor has to pay one of its creditors that the buyer had agreed to pay, the debtor has a right to reimbursement from the buyer.

The debtor is a guarantor.(10) 

The Restatement excludes from its definition of "secondary obligor" several transactions that might otherwise fit the definition and thus qualify as a guaranty: 

  • A customary financing transaction involving the sale of accounts(11) (even though it is subject to Article 9 of the Uniform Commercial Code(12)). The seller usually warrants that the account debtors would perform their obligations under the accounts. The Restatement also excludes a sale of accounts where the only warranties made by a seller do not relate to whether the accounts are collectible.(13)    
  • Loan transactions with a party other than the borrower providing a "keep well" agreement to the lender. These agreements take many forms and generally include a statement of intent by the person giving it to keep the borrower well.(14)

A creditor's identification that a guaranty exists is only the first step for the creditor seeking to protect its rights against a guarantor. In addition to the extensive definition of "guarantor," the Restatement provides a comprehensive set of rules for the creation and enforcement of guaranties. 

The Restatement provides that a guaranty does not require ordinary contract consideration when: 1) The promise by the guarantor induces reliance by the creditor; 2) the guaranty obligation was created after the underlying obligation as part of the exchange for which the obligee/creditor bargained; or 3) the guaranty is in writing.(15) 

A holder of a guaranty may transfer it under ordinary rules of contract law. A transfer of an underlying obligation automatically transfers the guaranty obligation.(16) 

Loan transactions often involve a "continuing guaranty,"(17) which extends the guaranty to future obligations of the borrower to the creditor. The guarantor can terminate the continuing nature of a continuing guaranty with notice to the creditor, subject to a waiver of this right. Even when the guarantor has terminated the continuing guaranty, the guarantor remains secondarily liable for debts and commitments made before giving the termination notice. 

A creditor that correctly identifies the existence of a guaranty cannot rest on that achievement. A guarantor has important rights that arise out of its suretyship status even in the absence of any agreement providing for those rights.(18) 

The debtor owes a duty directly to the guarantor to perform the debtor's obligations to the creditor.(19) The guarantor can require the debtor to perform the obligation. The debtor has this obligation only when the debtor has notice of the guaranty obligation. The guarantor does not itself have to perform any guaranty obligation before enforcing the debtor's duty to perform. 

The debtor also owes the guarantor a duty to reimburse the guarantor to the extent the guarantor performs the debtor's obligation.(20) As with the duty of performance, it applies only when the debtor has notice of the guaranty obligation. It is not a requirement that the guarantor already would have paid the creditor in full. If the guarantor pays the creditor before the debtor was obligated to pay the creditor, the debtor does not have to reimburse the guarantor until it would be required to pay the principal obligation. 

The debtor does not have to reimburse the guarantor if the guarantor has waived a defense available to the debtor, unless the guarantor had notice of a defense of the debtor that was available to the guarantor but paid anyway in the exercise of reasonable business judgment. 

If the debtor has given the guarantor collateral to secure this reimbursement obligation, the collateral also secures the debtor's duty of performance.(21) 

Another route available to the guarantor to make itself whole is restitution.(22) A payment to the creditor by the guarantor of the debtor's obligation enriches the debtor and the enrichment creates the restitution obligation. This duty applies even if the debtor does not have notice of the existence of the guarantor. 

Subrogation is the right of the guarantor that is generally considered, along with reimbursement, to be the means for the guarantor to get its money back from the debtor.(23) It may be somewhat less advantageous than some of the other guarantor rights. Subrogation gives the guarantor "all rights" the creditor has against the debtor. It gives the guarantor all of the rights of the creditor as if the obligation had not been satisfied. The guarantor may pursue any collateral that the creditor held for the debtor's obligation, with the same priority the creditor had enjoyed. The debtor can raise against the guarantor any defenses it would have had against the creditor. 

The guarantor's right of subrogation arises upon the guarantor's "total satisfaction" of the underlying obligation by the guarantor paying the creditor what the debtor owes. If the guarantor pays the creditor before the debtor is in default, the guarantor cannot use its subrogation rights until performance by the debtor comes due. 

The guarantor may not recover more than its "cost of performance." Thus, if the guarantor can buy its peace with the creditor for less than the amount owed to the creditor by the debtor, the guarantor can pursue the debtor only for the amount it cost the guarantor to accomplish that result. 

A primary debtor can become a guarantor in certain circumstances. This might strike a creditor as unfair because guarantors have special rights that debtors do not have. To protect creditors, the apparent debtor does not enjoy guarantor attributes until the creditor has notice of the debtor's new status.(24) 

Even with notice, a former debtor who provided collateral to a creditor and sold collateral subject to a debt retains its status as a primary debtor for purposes of the guarantor discharge rules unless the creditor "assents" to the debtor's new status. Assent does not arise when the creditor accepts debt payments from the transferee of the collateral, but it may if the creditor deals with the transferee as the "principal debtor." A creditor that becomes aware of these circumstances must proceed with caution. 

Absent an effective waiver, a guarantor generally may assert any defenses available to the debtor against the creditor. The guarantor may sometimes use the set-off claims available to the debtor.(25) The guarantor also may use its own set-off claims against the creditor to the extent permitted under other laws. The guarantor may not assert the debtor's bankruptcy or lack of capacity. 

In addition to the debtor's defenses, a guarantor may also raise defenses special to guarantors. These are the defenses that make the need to identify the existence of a guaranty so critical. Many of these defenses arise out of the activities of the creditor. 

If a creditor takes action that "fundamentally alters the risks" of the guarantor, the guarantor is fully discharged from further performance. If the creditor takes any other action that prejudices the guarantor, the guarantor is discharged to the extent the creditor's action damages the guarantor.(26) For example, if a guarantor guarantees a loan to a start-up computer-hardware company and then the lender and borrower decide instead that the borrower will create only software products, the change would be considered so fundamental that the guarantor would be fully discharged. 

If the creditor releases the debtor from its obligations to the creditor, the guarantor is released in the same manner,(27) because the debtor itself is released from duties of performance and reimbursement in favor of the guarantor to the extent the creditor releases the debtor. If the creditor intends to retain its claim against a guarantor when it releases the debtor, the creditor may pursue that claim but it will be subject to reduction for any amount paid by the debtor and any loss sustained by the creditor's release of the debtorÑassuming the debtor could otherwise have paid the guarantor. 

When the creditor gives the debtor an extension of time to perform its obligations to the creditor, the debtor's performance and reimbursement obligations to the guarantor are extended as well.(28) In addition, the guarantor is discharged to the degree the extension "cause[s] the secondary obligor [the guarantor] a loss." However, the creditor's delay in enforcing a claim against the debtor does not trigger this rule. 

When the creditor agrees to modify the debtor's obligation to the creditor, the debtor's performance and reimbursement obligations to the guarantor are also modified. The secondary obligor is fully discharged if the modification is "fundamental." Less than fundamental modifications discharge the guarantor if the modification "causes the secondary obligor [the guarantor] a loss."(29) For example, if a guarantor guarantees a loan that provides for 9 percent interest and the creditor and borrower later change the interest to 9.5 percent, the impairment discharges the guarantor to the extent of the increased burden of the higher rate. 

The creditor will discharge the guarantor if the creditor does something that impairs the value of any collateral for the debtor's obligation. The discharge equals the difference between the amount the guarantor can recover from the debtor and what it would have recovered, including the value of the collateral. The creditor impairs collateral by failing to obtain or maintain perfection of a security interest in collateral, releasing collateral without receiving new collateral or the paydown of the debt, or by not complying with the law in the disposition of collateral.(30) 

The creditor also discharges the guarantor when the creditor lets the statute of limitations run against the debtor.(31) 

Just in case one of these methods of discharge does not operate to discharge a guarantor, the Restatement contains a residual discharge rule. The creditor discharges the guarantor by any other act that impairs the guarantor's performance, reimbursement, or subrogation claims. The guarantor is discharged to the extent the impairment "causes a loss."(32) For example, a creditor's nonjudicial foreclosure of real property, which gives the debtor antideficiency protection in California, would discharge the guarantor.(33) 

The creditor's refusal of a tender of performance by the debtor discharges the guarantor to the extent the refusal causes a loss to the guarantor.(34) The refusal of a tender could have that effect as interest may continue to accrue or the debtor's ability to pay may decline. 

This catalogue of guarantor-protection rules could make a creditor wonder whether it should even bother to get a guaranty. Creditors should not wonder for long. The Restatement provides that the guarantor can waive most defenses and that most acts of the creditor are subject to consent by the guarantor.(35) As a practical matter, creditors usually have sufficient bargaining power to obtain the upper hand. 

Waivers may be specific or general. A provision in the guaranty that the guarantor's duties are "absolute" or "unconditional" is not sufficient. However, the guarantor generally may waive suretyship defenses. The guarantor does not have to waive each defense separately, and the guaranty does not have to explain the legal effect of the waivers.(36) 

The Restatement does not require the creditor to proceed first against any collateral provided by the debtor before proceeding against the guarantor,(37) unless the guarantor has made a guaranty of "collection" instead of a guaranty of "payment." 

The statute of limitations on the guarantor's reimbursement claim against the debtor accrues at the later of the date for the debtor's performance of the underlying obligation and the date of the guarantor's performance of its obligation. The guarantor's subrogation claim, which puts the guarantor into the creditor's shoes, accrues whenever the creditor's claim against the debtor would accrue.(38) 

Sometimes the debtor actually pays its obligations and the guarantor breathes a sigh of relief, figuring the guaranty has gone away. It then turns out that the debtor goes into bankruptcy and its payment to the creditor was a voidable transaction, such as a preference. Thus the creditor has to return the payment. The guarantor's obligation, which had been discharged by the debtor's performance, is automatically revived in this circumstance. The creditor then can lay claim to its evocatively named "claw back" rights.(39) 

  1. Restatement (Third) of Suretyship (1995) [hereinafter Restatement].    
  2. Restatement Section1.    
  3. Restatement, illus. 4b.    
  4. Restatement, illus. 4a.    
  5. Restatement, illus. 20.    
  6. Restatement, illus. 4d.    
  7. Restatement, illus. 4c.    
  8. Restatement, illus. 4e-4i.    
  9. Restatement, illus. 19.    
  10. Restatement, illus. 18.    
  11. Restatement Section39A.    
  12. UCC Section 9-102(1)(b).    
  13. Restatement cmt. h.    
  14. Restatement Section 1, illus. 6.    
  15. Restatement Section 6.    
  16. Restatement Section 10.    
  17. Restatement Section 12A.    
  18. Restatement Section 14.    
  19. Restatement Section 17.    
  20. Restatement Section 18.    
  21. Restatement Section 21.    
  22. Restatement Section 22.    
  23. Restatement Section 23.    
  24. Restatement Section 28.    
  25. Restatement Section 31.    
  26. Restatement Section 33.    
  27. Restatement Section 35.    
  28. Restatement Section 36.    
  29. Restatement Section 37.    
  30. Restatement Section 38.    
  31. Restatement Section 38A.    
  32. Restatement Section 39.    
  33. See Code Civ. Proc. Section 580d (1989).    
  34. Restatement Section 40.    
  35. Restatement Section 42.    
  36. This rule rejects the result in Cathay Bank v. Lee, 14 Cal. App. 4th 1533 (1968).    
  37. Restatement Section 45. California has the opposite rule. See Civ. Code Section2845.    
  38. Restatement Section 56.    
  39. Restatement Section 65.

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