Potential Pitfalls of Upstream Guaranties
December 21, 2011
Subsidiary guaranties, also commonly known as upstream guaranties, are instruments used for the benefit of lenders and borrowers alike. Upstream guaranties benefit borrowers and lenders because they enable borrowers to obtain more favorable terms and enable lenders to lend based upon a larger asset pool to secure debt. Despite these benefits, there are potential pitfalls that lenders must be aware of when documenting any upstream guaranty, particularly when an upstream guarantor will not be receiving any of the proceeds being loaned. Potential risks include avoidance of an upstream guaranty due to lack of consideration or a determination that the guaranty was fraudulently conveyed in the event the guarantor files for bankruptcy.
If consideration does not move directly between a lender and an upstream guarantor, an upstream guarantor may argue that the loan to their parent corporation does not provide it a direct benefit and, as a result, the guaranty is unenforceable for lack of consideration. One answer to this argument is to document in the upstream guaranty the benefits that will be received by the upstream guarantor, such as their ability to use any equipment being financed. The question of consideration is particularly problematic when the upstream guaranty is provided after closing and is not part of the initial loan transaction. Lenders should make sure to document that the loan was made in anticipation of the upstream guaranty and that it would not have been made absent this assurance.
Fraudulent conveyance arguments arise when at the time an upstream guaranty is provided the guarantor insolvent or without adequate capital, and the upstream guarantor did not receive equivalent value for the guaranty provided. If the guarantor was insolvent at the time it granted the upstream guaranty, the upstream guaranty may be avoided in a bankruptcy proceeding. Further, under bankruptcy law, upstream guaranties may be found to be constructively fraudulent if provided (1) within two years from the date bankruptcy was filed, (2) in exchange for less than reasonably equivalent value and (3) when the upstream guarantor was in poor financial condition. Therefore, even if an upstream guarantor is solvent when it grants an upstream guaranty, the upstream guaranty may be determined to be constructively fraudulent based on these three requirements.
Reasonably equivalent value is the value received by an upstream guarantor and is determined from the viewpoint of its creditors. While courts have began to acknowledge indirect economic benefits from a guaranty, such as goodwill from the parent’s financial strength and enhanced ability to borrow due to the upstream guaranty, the issue of reasonably equivalent value is currently on appeal to the United States Court of Appeals for the Eleventh Circuit. In 2009, the U.S. Bankruptcy Court for the Southern District of Florida held in a case involving a borrower and several of its subsidiaries that had granted upstream guaranties that fraudulent conveyance had occurred because the subsidiaries had not received reasonably equivalent value in exchange for the liens they had granted and the obligations they had incurred. Further, that Bankruptcy Court refused to enforce the savings clauses in the upstream guaranties, which limited the amount that would be avoided in the event that a fraudulent conveyance had occurred. On February 11, 2011, the United States District Court for the Southern District of Florida quashed the Bankruptcy Court’s decision and held that a fraudulent conveyance had not occurred. See In re TOUSA, Inc. v. Official Committee of Unsecured Creditors of Tousa, Inc., 444 B.R. 613 (S.D. Fla. 2011). The District Court did not address the issue of the validity of the savings clauses in the upstream guaranties; however, this issue may be addressed on appeal. Therefore, the enforceability of savings clauses remains an issue that lenders should be aware of when receiving upstream guaranties. In order to increase the likelihood that a savings clause will be enforceable, lenders should structure upstream guaranties so that an upstream guarantor only guarantees as much debt as it reasonably can afford.
In light of the foregoing issues, there are a few options to be implemented by lenders when receiving an upstream guaranty. An initial option is for the upstream guarantors to become borrowers under the loan agreement, but this is only advisable when each borrower is actually receiving value from the loan because courts will likely look at the substance of the transaction rather than its form. When evaluating the issuance of a loan supported by an upstream guaranty, the lender should conduct its own due diligence, assess the solvency of each upstream guarantor and determine whether each upstream guarantor will be insolvent or undercapitalized at the time when the loan and any upstream guaranty are provided. If possible, the upstream guarantor should provide the upstream guaranty at the time the loan is closed, and if the guaranty is not executed with the loan document, the lender should document that the loan is made in anticipation of receipt of the upstream guaranty. Further, at closing the lender should receive representations and warranties from the upstream guarantor that it is solvent and adequately capitalized and an opinion letter from counsel that the upstream guaranty is valid and enforceable.