Attention Investors, Individuals, and Small Business Lenders: Protecting and Enforcing Personal Loan Agreements

A loan agreement, or “note”, is a simple and common contract that typical identifies the lender or creditor, a borrower or debtor, the principal amount being lent, an interest rate, the repayment terms, and in some cases, a trustee, which is often dependent on if the loan agreement has a certain type of collateralization.  A loan agreement does not have to involve a bank or other financial institution, such as a mortgage loan.  In fact, many loan agreements are between two individuals, two businesses, or combination of the two.  It is routine for banks and other financial institutions to perform both background and credit checks as well as to take collateral on any note or loan agreement they issue.  However, this is not always common practice between individuals and/or businesses.  Unfortunately, failure to follow these common practices can result in a business or individual lender having difficulty recovering funds on a note or loan agreement in an event of an incurable default of payment.

The question then becomes how can an individual or business lender protect itself in a loan agreement?  

In an individual or small business setting, it is more common to see notes or loan agreements between family members, neighbors, or close friends.  There is nothing inherently wrong with such a transaction, but it is important for the parties to treat it as a standard business transaction and to take the appropriate precautions.  A credit and/or background check, although recommended, may not be practical in this type of social dynamic.  Consequently, it is more important in such setting to be sure that as a lender you understand fully what the money is being used for and how the borrower is planning to generate the funds to pay you back.  If this is for a business venture or investment, you should evaluate the business plan to ensure that it makes sense to you before you agree to anything.  If you believe the borrower has the means to pay you back and you wish to create a loan agreement, be sure that all of the terms agreed to by the parties are laid out in a clear and easy to understand contract or agreement which is executed by both parties, preferably in front of a notary public.

Some of the key terms that a loan agreement should identify in detail include how interest is calculated, repayments dates, and what occurs in the event of a default.  It may also be worth putting in collection or prevailing party attorney fee language into the loan agreement to deter the borrower from defaulting on payment.  Another consideration is to have other family members or individuals sign the loan agreement as well to guaranty payment in the event of a default by the borrower. This addition can be in the form of a surety or guarantee agreement, as we have discussed in more detail in a previous post.

One of the most important considerations in any loan agreement is collateral.  It is amazing the number of times individual and small business lenders get into trouble for failing to collateralize a loan, which can be a tremendous financial burden on a lender who did not get repaid.  In some extreme cases, it can even force the lender to seek relief through bankruptcy.  Typically, collateral is some form of property that will be transferred to the lender in the event of an incurable default by the borrower.   Common examples of collateral include a house or a car.  Ideally, you would want the collateral to be valuable enough to cover the entirety of the amount owed or outstanding on the note.   Further compounding the importance is that without collateral, you are likely to be deemed an unsecured creditor and as such, any amount owed to you could be at risk of being discharged in the event that the borrower or debtor went into bankruptcy.  As a result of the dangers and considerations involved, it is extremely important to work with someone experienced in contracts and loan agreements. You do not want to find yourself struggling financially, especially to the point of filing for bankruptcy protection, because you did not take the time to ensure that your loan had adequate repayment assurances.

Personally Guarantying Payment on Behalf of Your Company or Another Third Party

Sometimes the only way to persuade another party to enter into a contract is too guaranty that the amount owed will be paid by a third party in the event that you cannot completely pay the amount owed. This provides an extra layer of protection to the non-guarantying party as the guarantying party becomes responsible for any amount owed that is not satisfied. The Personal Guaranty / Guarantee Agreement and its language in the agreement will determine the terms of this deal and when the guaranty to pay by the third party will activate.

A Guarantor, is the party guarantying that the consideration or amount owed will be satisfied; a Guarantee is the party to whom such guaranty is made. For example, with respect to student loans, parents may act as a Guarantor and guaranty that the student loans their child is borrowing will be repaid to the Guarantee organization, such as Sallie Mae, whom loaned the money to their child.

In many business, financial, and commercial contracts, you many times run into guaranty language, either embedded within a contract or as a wholly separate contract attached as an exhibit or addendum that guaranties part or all of a larger agreement.  In a typical business contract, two businesses will contract in a way that Business A agrees to pay Business B an agreed upon amount for the agreed upon good(s) or service(s).  However, in some transactions, such as a commercial lease, commercial loan agreement, or other payment overtime agreement, one of the businesses may want the other business’ owner(s) to sign a guaranty.  Ultimately, this guaranty requires payment by the individual(s) who made the guaranty in the event of a default of payment by the business.

Guaranty clauses or agreements can be drafted very conservatively or extremely aggressively.  For example, many business guaranty agreements have language that in the event of default of payment do not require the Guarantee to exhaust all remedies against a business Guarantor, including even filing a lawsuit against the business Guarantor, before enforcing the guaranty and demanding payment from the individual(s) who executed the guaranty.   As a result, in a breach of contract case, it is common practice for attorneys representing a business Guarantee to sue both the other business and the individual Guarantor(s) who signed the guaranty at the same time as opposed to separate or subsequent lawsuits.  This is why it is extremely important that the drafter or the reviewer or negotiator of a guaranty provision or agreement understand when the obligations of a Guarantor are triggered. A poorly negotiated guaranty provision or agreement could put individual third parties at unnecessary or excessive risk.

As noted above, guaranty language can either be embedded within an overall contract as one or more provisions or clauses, or rather such language can be drafted into its own, wholly separate contract attached as an exhibit or addendum to a larger agreement. In Virginia, as in many jurisdictions, a guaranty is often considered a separate agreement between two or more parties.  A very simple and well-articulated opinion outlining this concept, written  by Judge James Chamblin, can be found in the 1989 Loudon County case Snyder v. Keller, 12132., 1989 WL 646376 (Va. Cir. Ct. Sept. 13, 1989).  As this opinion explains, Virginia guaranty agreements must be in writing and signed by the guarantor.  This opinion is also the likely result of why many organizations use a separate document, or contract, for the guaranty as opposed to simply including guaranty language in a single overall document.

As a result of the common practice of using separate documents, it is that much more important for drafters and reviewers / negotiators to ensure that the language in both documents is consistent.  There have been interesting Virginia Supreme Court cases that highlight the pitfalls of document inconsistency and its unintended consequences. Such unintended consequences give way to exploitation by clever litigators, which only heightens the need for quality contract drafting. Use of separate documents also gives way to the importance of proper use of specific terminology and contract language, such as “attached hereto, incorporated herein, and made a part hereof” language, but that is the topic of another day and another article.