Reed Law Monthly - March 2010


Debt Guarantees: 5 Critical Steps

With commercial property markets continuing to struggle, debt burdens are overwhelming many borrowers. For commercial real estate that cannot service its debt and/or the market value of the property is less than the unpaid principal balance of its secured debt (i.e., “negative equity”), there are generally three approaches a borrower may take: 1) hang on for dear life in hopes of an income/value recovery; 2) hand the keys back to the lender; or 3) initiate a workout/restructuring with the lender.

Non-recourse borrowers typically will be attracted to approach 2, but if debt recourse and guarantees are involved, approach 3 should be the focus. Below I discuss one of the more important aspects of successful workouts/restructurings: Guarantees.

Issues surrounding debt guarantees, and the creditor’s recoverability thereof, are numerous and complex. Follow these steps for a proactive approach to achieve a better outcome.

  1. Value Assets. To understand the guarantee, you must first understand the guarantor’s asset values. In today’s economic environment, a pragmatic approach, that includes both standard asset valuation methodologies and variations thereof, is essential. Be realistic and don’t assume previous or peak “values” will return any time soon.

  2. Apply Discounts. If a creditor is looking to go after a guarantor’s assets to satisfy the pledged guarantee, then certain discounts should be applied to such assets. In certain situations these discounts are applied because of fire-sale pricing and/or the asset’s illiquidity due to limited buyers, lack of buyer financing, or legal issues.

  3. Identify Parties. All the parties need to be identified (creditors, borrowers, and guarantors) and analyzed. The original debt may have been structured among multiple parties, resulting in various loan participation interests on the creditor side. The borrower may be a single purpose entity, holding company, corporation, or an individual (hopefully not the latter!). Finally, a guarantee can be in the form of personal (“PG”) or corporate (“CG”). To complicate matters more, the guarantor’s main assets may be held by the borrowing entity, causing serious concerns surrounding potential “recoverability” on any PG or CG by the creditor.

  4. Calculate Costs. The creditor’s cost to enforce a guarantee is not insignificant. Direct litigation and/or bankruptcy legal expenses, together with the time allocated by creditor staff, will reduce any potential net monetary recovery. The debtor side will incur costs as well. If there’s low financial recoverability on the guarantee, then it will likely be in all parties’ best interest to consensually workout a settlement.

  5. Engage Attorney. Legal issues surrounding a guarantee are numerous and complex. A passive approach to guarantee issues will not likely yield an optimal outcome for either the debtor or creditor. Early analysis of both legal and business issues will lay the groundwork for more productive negotiations. Engage legal counsel early in this process, before some resolution options are no longer available.