Defenses Asserted by Co-Signers and Guarantors



Guarantors and co-signers in Ohio have certain defenses available to them when faced with enforcement actions by lenders

What is “Suretyship? 

          Over the last several years, defaults in asset-based loans and commercial real estate loans have risen, given the ongoing recession and the sluggish recovery.  After a lender liquidates the primary collateral, if any, for a defaulted loan, the lender usually looks to a “surety” to pay whatever deficiency may remain.  When lenders try to collect against sureties, they sometimes meet resistance, probably in the form of “suretyship defenses” raised by the surety in legal actions against the surety or the surety’s property. 
            Suretyship is “the contractual relation whereby one person, the surety, agrees to answer for the debt, default, or miscarriage of another, the principal, with the surety generally being primarily and jointly liable with the principal debtor.”[1]  A person may serve as a surety whether or not the borrower supplies “consideration” (a benefit or promise) to the surety.  A bonding company that issues a payment or performance bond, at the request of a general contractor, for the benefit of the property owner/borrower and the construction lender, is an example of a surety that serves for consideration.  The borrower or the general contractor pays a fee, the consideration, to the bonding company to issue the payment or performance bond.  
            The most common sureties in loan transactions are (1) “guarantors,” who generally execute a guaranty agreement separate from the promissory note that evidences the debt, and (2) “accommodation parties,” who execute the promissory note as a co-signer but do not receive loan proceeds.[2]  An accommodation party is sometimes referred to as an “accommodation maker.”  An accommodation party, not having received any proceeds of the loan, has a right of recourse against the borrower to the extent of any payment on the loan made by the accommodation party.[3]  
            In most commercial loans today, the surety, usually an affiliate, a member, or a majority shareholder of the borrower, signs a guaranty rather than the promissory note.  A lender can choose from among several different types of guaranties.  A “guaranty of payment” obligates the guarantor to repay the loan to the lender if the borrower defaults, whether or not the borrower has the ability to repay the loan.  A “guaranty of collection,” however, is similar to an indemnity and obligates the guarantor to repay the loan only after the lender has obtained a judgment against the borrower and executed on the judgment without full satisfaction.  In addition, a party may sign a promissory note for “collection” only, in which case that party is liable to the lender only if the lender cannot obtain full payment from the borrower.[4]  
            If the underlying obligation is a mortgage loan, the lender may require a “guaranty of payment and performance,” in which the guarantor agrees to pay and perform all obligations of the borrower under the loan documents, including payment of the note and all other obligations contained in the mortgage or loan agreement.  Alternatively, using a limited guaranty of performance, the lender could provide that the guarantor must perform only certain specified obligations under the loan agreement.  For example, the lender could require the guarantor to finish the infrastructure of a residential development using remaining loan funds and the guarantor’s own funds, but not require the guarantor to repay the loan. 
            In some commercial loans, the surety may sign a mortgage or a security agreement, but not the promissory note or a guaranty.  In that case, the surety pledges or assigns collateral as security for the loan, but does not agree to b personally liable for any loan obligation.  Upon a default of the loan, the lender may exercise its rights with respect to the collaterals, but cannot seek a personal judgment against the surety.  

Who May Assert a Suretyship Defense? 

            Under certain circumstances, whether or not the borrower has paid a fee to the surety, the surety may assert one or more defenses to avoid or reduce the surety’s liability to the lender.    These defenses are commonly referred to as “suretyship defenses.”   Accommodation parties, guarantors, and pledgors of collateral may assert suretyship defenses.  In addition, the endorser of a promissory note, who is liable to the lender on the note after notice of dishonor and protest, may assert suretyship defenses against the lender.[5]    
            A waiver of suretyship defenses, set forth in a guaranty, is enforceable in Ohio.[6]  That waiver is commonly found in guaranties of commercial loans, and commercial real estate loans, from institutional lenders. The waiver prevents the guarantor from asserting a suretyship defense against the lender in a legal proceeding to enforce the guaranty.   

What Suretyship Defenses are Asserted Most Frequently?         

Modification Without Consent.   

            A surety’s liability to the lender is limited to the surety’s obligations as stated in the document signed by the surety.[7]  If the borrower and the lender modify or amend any loan document without the surety’s consent, the surety’s liability to the lender is reduced by any loss the surety suffered because of the amendment or modification, unless the guaranty or the promissory note provides otherwise.  For example, if the borrower and the lender extend the maturity date of a promissory note without the consent of a surety that has a right of recourse against the borrower, and the financial condition of the borrower deteriorates after the extension agreement has been executed, the surety’s liability to the lender is reduced by the amount of the decline in the borrower’s net worth.[8]  
            From the lender’s perspective, the document that the surety executes, whether a promissory note, a guaranty, a mortgage, or a security agreement, should provide that any extension of the maturity date of the loan, or any other amendment or modification of the loan documents, will not affect the surety’s obligations.  On the other hand, written waivers of the defenses of extension, compromise and delay in enforcement set forth in a guaranty, are enforceable in Ohio.[9]  In a case heard by the Ohio Supreme Court, those waivers were sufficient to defeat a guarantor’s claim that he was discharged because the lender delayed in asserting its rights under the promissory notes that he guarantied.[10]  Whenever possible, a lender should condition the extension of the maturity date of a loan, or any other amendment or modification of the loan documents, on the prior written consent and acknowledgement of the surety.  

Discharge of Borrower  

            Traditionally, if a lender voluntarily released the borrower from his or her loan obligations, without a reservation of rights against the surety, the surety was also released from its obligations to the lender, because there was no obligation left to be paid by the surety.[11]]  Effective on September 6, 2008, however, under Ohio Revised Code (“R.C.”) section 2307.30, if a “joint debtor” makes a separate composition or compromise with a creditor, the composition or compromise operates as a full and final discharge to that joint debtor, but does not discharge other joint debtors or impair the creditor’s right to proceed against joint debtors that have not entered into a composition or compromise with the creditor.  R.C. 2307.30 does not define “joint debtor,” but a creditor could argue that R.C. 2307.30 includes sureties within its scope, so that a creditor’s compromise or composition with one surety does not discharge the borrower or other sureties. 
            The Ohio Revised Code does provide that if an accommodation party has a right of recovery against the borrower for the accommodation party’s payments to the lender, and the lender releases the borrower from its obligations on the promissory note, the accommodation party is not thereby released from its obligations to the lender.[12]  Likewise, a discharge afforded to a debtor in bankruptcy does not relieve a surety of its liability to the lender on a guaranty, or other suretyship document, related to the discharged debts.[13]      

Impairment of Collateral   

            Unless the surety waived the right of subrogation, the surety is subrogated to the rights of the lender upon the surety’s payment of the underlying debt.  Subrogation places the surety in the shoes of the lender; thus, the surety may recover from the borrower any amount that the surety paid to the lender.  The surety may also foreclose or liquidate any collateral for the loan to obtain reimbursement.  If the lender has “impaired” (lessened) the value of the collateral, however, the surety’s ability to collect against the collateral has been compromised.[14]  The surety’s obligation is discharged to the extent that the lender has impaired the collateral.[15]  For example, if a lender takes possession of collateral as the result of repossession or foreclosure, and the collateral decreases in value because of the lender’s negligence in caring for the collateral, the surety’s liability on the promissory note or a guaranty is reduced by the loss in value of the collateral.[16]   
            A lender may also impair collateral by failing to perfect its security interest in the collateral, for example, by neglecting to file a Uniform Commercial Code Financing Statement (UCC-1) in the appropriate recording office.  A failure of perfection on the part of one creditor may allow another creditor to obtain a higher priority with respect to the collateral.[17]  In that situation, the surety’s liability would be reduced by the amount recovered by the competing secured creditor from the sale of the collateral.[18]    
            Moreover, the failure to dispose of collateral properly, for example, due to lack of proper notice of a sale of personal property after repossession, or the failure to sell that property in a commercially reasonable manner, is also an impairment of collateral.[19]    
            A specific waiver of the defense of impairment of collateral, set forth in a promissory note executed by a maker and a co-signer, is enforceable in Ohio.[20]    Moreover, after the occurrence of a loan default, a person that pledged collateral for the loan, or a surety for the loan, may waive the right, otherwise available under the Uniform Commercial Code, to receive notification of the disposition of the collateral.[21]  Also, after the occurrence of a default (except in a consumer goods transaction), the pledgor of collateral, or a surety for the loan, may waive the right, also otherwise available under the Uniform Commercial Code, to redeem the collateral.[22]   

Is Lack of Consideration a Suretyship Defense? 

            Ohio courts have generally held or recognized that the benefit derived by a borrower from a loan is sufficient consideration to support the guarantor’s obligation to the lender.[23]  Similarly, the fact that an accommodation party did not receive any consideration from the loan transaction, either directly or indirectly, is not a defense to the enforcement of the promissory note against the accommodation party.[24]  On the other hand, a guaranty obtained by the lender after the initial closing of the loan should be supported by additional consideration, for example, by the lender’s agreement to extend the loan’s maturity date or to forbear from collecting on a defaulted loan.   

If More than One Individual or Entity Will Be Liable for Repayment of a Loan, How Should the Lender Document the Loan? 

            Each party to a loan transaction receiving loan proceeds should execute the promissory note as a joint and several borrower or maker.  Under joint and several liability, each borrower is liable for the repayment of all loan proceeds.  Despite the foregoing, in a multi-borrower transaction, one or more of the borrowers may have the negotiating power to limit his or her liability to the amount of loan proceeds that the borrower has actually received.  In either case, the promissory note should state specifically that each borrower is receiving proceeds of the loan and is primarily liable to the lender on the loan, either jointly and severally for the full amount of the loan or severally for the loan proceeds actually received by the respective borrower, whatever the case may be.  In addition, when all signers of the note are receiving loan proceeds, the promissory note should state that no borrower is an accommodation party, and that no borrower will seek “contribution” from any other person until the loan has been repaid in full.  A contract among the borrowers may give one or more borrowers the right of contribution (reimbursement) against one or more other borrowers for payments made to the lender.   
            If only one party receives loan proceeds, but the lender has determined that one or more sureties are required as a condition to making the loan, the lender can structure the loan in two different ways: 

Accommodation Party on the Note   

            If the promissory note is negotiable, the lender could require the surety to sign the note as an accommodation party.  The note should then provide that the accommodation party is jointly and severally liable with the borrower for the full repayment of the loan.  The note should also state that the accommodation party waives all suretyship defenses, including the impairment of collateral, and that no accommodation party will seek indemnity from the borrower or any other surety until all obligations on the loan have been paid and performed in full.  
            If the lender wants to hold an accommodation party liable for the borrower’s obligations under any other loan document, for example, the payment of insurance and taxes, and the upkeep and maintenance of the property, under a mortgage, the lender should require the accommodation party to execute the mortgage as a co-mortgagor.  The accommodation party would then, be jointly and severally liable with the mortgagor for the obligations set forth in the mortgage.   
            The advantages of the accommodation party structure over the guaranty structure are: 
(i)         If the lender voluntarily discharges the borrower and the accommodation party has a right of recourse against the borrower, the accommodation
party, unlike a guarantor, will not be discharged from his or her obligations on the note, and 
(ii)       If the loan is unsecured, the loan will be evidenced by one document, the note, as opposed to a note and a guaranty. 
           R.C. 2329.54 affords some protection to a surety.  That Section provides that, if a creditor obtains a judgment against a principal debtor and a surety on a single instrument signed by both, the surety can force the creditor to execute against the real and personal property of the principal debtor before executing against the surety’s property.  One example might be a promissory note, signed by the borrower and an accommodation party, for which the borrower and the surety are jointly and severally liable to the lender.  To obtain the protection, the surety must first present evidence to the court rendering the judgment that the surety signed the promissory note merely as surety for the principal debtor.  If the surety is successful in proving his status to the Court, the Clerk will then indicate on the judgment entry which judgment debtor is the principal debtor and which is the surety.  Any writ of execution issued by the Clerk on that judgment entry will order the Sheriff to execute against all real and personal property of the principal debtor before executing against any property of the surety.  Arguably, a guarantor who signs a separate guaranty of payment of a promissory note, rather than signing the promissory note, does not enjoy the protection of R.C. 2329.54.         

Guaranty Structure   

            The surety could sign a full guaranty of payment and performance, obligating the surety to pay and perform all of the borrower’s obligations under the loan documents, including the promissory note and any mortgage or loan agreement, or a guaranty of payment if the loan is unsecured.  In either case, the guaranty should state that the guarantor waives all suretyship defenses, including the impairment of collateral, and that the guarantor will not seek indemnity from the borrower or any other surety until all obligations on the loan have been paid and performed in full. 
            The advantages of a loan enhanced by a guaranty over a loan with an accommodation party are: 
(i)         The lender can sue the guarantor on the guaranty without bringing an action on the underlying promissory note, if so provided in the guaranty.[25]  
(ii)        If the loan is secured, the guaranty can provide that the guarantor is liable for all of the borrower’s obligations under the loan documents, eliminating the need for the guarantor to sign the mortgage or other security instrument; 
(iii)         The surety will generally prefer signing a guaranty rather than the promissory note, believing that the guaranty is a contingent or indirect liability, as opposed to the direct liability of a co-signer of the promissory note.  In reality, a well-drafted guaranty will state that the guarantor’s liability to the lender is direct and absolute.   
            In either the accommodation party or guarantor context, courts will first look to the language in the promissory note or the guaranty, as applicable, to determine the obligations of the surety to the lender and vice versa.  Thus, in either case, surety defenses can best be avoided by the inclusion of an explicit waiver of those defenses in the document signed by the surety, whether the note, a guaranty, a mortgage, or a security agreement. 
Donald E. Miehls, Esq.
Walter & Haverfield LLP

This overview is intended as general information only.  Please note that this information is not legal advice.  The reader should consult an attorney with knowledge in this area of the law to determine how the information applies to any specific situation.