Business Law Today: May/June 1999 Legal-ease

ABA Section of Business Law
Business Law Today
May/June 1999

Legal-ease

Parents, subsidiaries, guaranties

By Howard Darmstadter

Nobody loves you when you’re down and out — unless, of course, you have your parent’s guaranty. It’s a simple idea: The Worry Wart Whistle Works (On the Web at www.wwww.com! ) won’t supply whistles to thinly capitalized Junior Corp. unless Daddy Corp. guarantees Junior’s obligations. Daddy is to have much the same obligations on the guaranty as Junior has on the whistle-supply agreement.

Sad to say, this simple idea often results in a complicated document with some potentially nasty surprises.

Paraphrasing the 1996 Restatement of the Law (Third) of Suretyship and Guaranty (§1), Daddy will be a guarantor of Junior’s obligations to Worry Wart if, pursuant to contract, Worry Wart has recourse against Daddy for Junior’s obligations to Worry Wart. (Some other things also have to be true for Daddy to be a guarantor, but this is enough for now.)

The first thing to notice about guaranties is that Daddy becomes a guarantor "pursuant to contract." The contract in question is the guaranty or, to put the proper spin on it, a guaranty is a contract! Accordingly, Daddy and Worry Wart can sculpt the guaranty to do whatever they mutually desire. The law of guaranty is thus partly a set of default rules — what you get unless you agree to something else.

But a guaranty is more than a contract, for it involves three separate relationships, one of which is not contractual: First (using the Restatement’s lingo), Junior has an underlying obligation to Worry Wart to pay for the whistles. Second, Daddy has a secondary obligation , embodied in the guaranty, to pay Worry Wart for the whistles if Junior doesn’t. Third, Junior will have reimbursement and other obligations to Daddy if Daddy pays Worry Wart under the guaranty. Junior’s obligations to Daddy (No, they’re not called "tertiary obligations") could be modified by agreement, but seldom are. (For unrelated parties, these obligations are often covered by indemnity agreements. Restatement §18.)

For each of these obligations, there are reciprocal obligations of the other party, and (here the problems begin) a party may have defenses based on the conduct of the other two players. Most important, Daddy could be partially or totally discharged from its guaranty if Worry Wart takes certain actions — such as releasing Junior or Junior’s collateral from the underlying obligation — that increase Daddy’s risk.

The trickiest task in most guaranties is to allow the guarantor the proper defenses. As a guarantor, Daddy will generally have two sorts of defenses against Worry Wart. First, Daddy will have what I shall call the "Junior defenses" — all those defenses that Junior has against Worry Wart under the whistle-supply agreement, except for discharge in bankruptcy and lack of capacity (Restatement §34). If, for example, Junior is not liable to pay because Worry Wart delivered wheezy whistles, Daddy should not be liable on the guaranty.

Little need be said about the bankruptcy exception to the Junior defenses, but "capacity" requires a closer look. When does a corporation lack "capacity"? The Restatement includes in lack of capacity a corporation’s entering into a contract that is beyond its powers (§34, Illustration 7). But suppose Junior has the power to contract for whistles, but did not duly authorize the contract? Because of the relationship between Daddy and Junior, it seems inequitable to allow Daddy to escape liability because Junior has a defense of lack of authorization. After all, Daddy knew enough about the supply agreement to sign the guaranty. Worry Wart may therefore want Daddy to waive all defenses based on Junior’s failure to authorize the agreement.

Besides any Junior defenses, Daddy may also have defenses that arise directly out of Daddy’s status as a guarantor — the suretyship defenses. ("Suretyship" is the legal domain of which the law of guaranty forms one of the larger precincts.)

Suretyship law long predates subsidiary corporations. (The Merchant of Venice, my favorite commercial law play, revolves around a suretyship obligation.) In the noncorporate world, a guarantor might be a relative or other person who can not control the parties to the underlying transaction. The law of guaranty sensibly protects the guarantor against the other parties’ deliberately or inadvertently increasing the guarantor’s risk. Such conduct will often provide a guarantor with a complete or partial defense to a claim under the guaranty. (Guaranties tend to be read in favor of the guarantor; see, e.g., Portia’s reading of Antonio’s bond, In re Shylock , 43 Bard.App.3d 471(ca 1598))

The various suretyship defenses make little sense, however, when a company guarantees its subsidiary’s obligations. Daddy Corp. is likely to have firm control over Junior Corp. Moreover, any benefit that Worry Wart grants to Junior is likely to benefit Daddy as well. (Section 48(2) of the Restatement addresses this situation in part by providing that consent by a subsidiary to an act that would otherwise give its parent a suretyship defense will generally constitute consent to that act by the parent.)

Since a guaranty is a contract, Worry Wart may properly insist that Daddy waive the suretyship defenses. Unfortunately, the law of suretyship is largely judge-made, with no authoritatively complete list of the suretyship defenses. Worry Wart may respond to this uncertainty by having Daddy disclaim a laundry list of specific defenses. This often takes several pages, and at the end Worry Wart may still fear that a defense has been missed. Accordingly, Worry Wart may buttress the specific waivers with a general waiver of "all other defenses."

Call me paranoid, but this last scares me. Mightn’t a waiver of "all other defenses" waive the Junior defenses as well as the suretyship defenses? The context may argue against it, and I don’t believe that "all defenses" has to mean all defenses, but I’d hate to learn the contrary the hard way.

The Restatement favors a refreshingly direct path out of these perplexities: Daddy can waive all (and only) the suretyship defenses with the statement "Daddy Corp. waives all suretyship defenses." That’s all there is to it. (§48(1) and illustration 3).

Will the Restatement’s formula for waiving suretyship defenses be effective in your jurisdiction? A restatement is not the law, only a codification of the law by a respected bunch of legal eagles. It’s persuasive, not precedential. Moreover, the Restatement is too new to have been cited approvingly by many courts.

If you’re worried about your jurisdiction’s acceptance of the Restatement’s one-sentence waiver, you can buttress it with a second sentence, such as, "The parties intend the preceding waiver of suretyship defenses to have the effects described in Section 48 of the Restatement (Third) of the Law of Suretyship and Guaranty." The waiver thus drags in the Restatement, not as a statement of governing law but as a statement of the intent of the parties. Remember [here, trumpets], a guaranty is a contract!

Some guaranties say that "the guarantor’s obligation under this guaranty is primary and not secondary." This is a flat out falsehood — if it’s a primary obligation, then it can’t be a guaranty! Nonetheless, such a statement may work as a waiver of suretyship defenses. The Restatement (§48, comment d) gently allows that

A statement to the effect that the secondary obligor does not have suretyship status, while inaccurate, is ordinarily sufficient [to waive the suretyship defenses], however, because by communicating the absence of that status, it communicates that the incidents of suretyship status . . . are unavailable.

However, if you want to waive the suretyship defenses, there’s no need to dabble in contradiction. Just say "Daddy waives all suretyship defenses."

Saying that Daddy’s obligations are primary isn’t correct, but it’s not entirely wrong-headed. A primary obligor would have the Junior defenses but not the suretyship defenses. When the Worry Warts of this world insist that Daddy waive "all defenses," I often propose that we follow that waiver with a statement that "the parties intend that Daddy shall have only those defenses under this guaranty that Daddy would have if it were a co-obligor with Junior on the supply agreement."