We all have favorites: favorite food; favorite song; favorite movie; favorite sports teams; etc.
When it comes to the law, however, we believe that the law does not play favorites: i.e. we all are equal in the eyes of the law. Well, actually there are certain people who receive favoritism from the law, and no, it has nothing to do with political affiliation, money, race, gender, or anything of the sort.
Who are these people and how and why are they given favorable treatment? They are called “guarantors”, or sometimes called “sureties”. A guarantor (or surety) is someone who “guarantees” repayment of a debt of another person or entity. A common example is when an owner of a small business is required by a bank to guarantee repayment of the loan made by the bank to the company. Recall that a shareholder of a company is not personally liable for the debts of the company. However, if that shareholder signs a guaranty of a particular debt, that creates a contract between the guarantor and the bank so that the bank can collect the loan from the guarantor in the event that the company fails to repay the loan.
A guarantor may also pledge property as collateral to repay a loan. In that way the creditor must look to the pledged property for repayment, but the guarantor may not be personally liable, i.e., it may not have to actually pay money to the creditor, but the creditor can sell the property and keep the proceeds to recover on the debt.
The law governing guarantors has developed in such a way as to protect those guarantors as much as possible likely because a guarantor does not receive the money that has been loaned. In fact, the law in Indiana goes so far as to call guarantors “favorites of the law.”
In a recent case, the Indiana Court of Appeals again reaffirmed this principle. In the case, the parents of some borrowers gave a mortgage on the parents’ land to secure repayment of the loan made to their adult son. That loan subsequently was modified in several ways without the knowledge of the guarantor parents. Later the bank sought to foreclose the mortgage to collect on the loan, the parents objected and said that the actions of the bank in modifying the loan had effectively released them from liability and therefore the bank could not foreclose the mortgage. In agreeing with the parents, the Court of Appeals stated:
One who mortgages his or her land to secure the debt of another stands in the position of [guarantor] to the debtor. It is axiomatic that a [guarantor] is a favorite of the law and must be dealt with in the utmost good faith . . . If a [borrower] and creditor make a material alteration in the underlying obligation without the consent of the guarantor, the guarantor is discharged from further liability. A “material” alteration is one that changes the legal identity of the debtor’s contract, substantially increases the risk of loss to the guarantor, or places the guarantor in a different position. It is irrelevant whether an alteration was intended for the [guarantors’] benefit, so long as the alteration entails either a change in the physical document or a change in the terms of the contract between the [borrower] and creditor that creates a different duty of performance on the part of the [borrower].
In that case, the Court of Appeals agreed that the bank’s actions had effectively released the guarantors from any further liability and released the mortgage previously held by the bank.
An interesting aspect of this dynamic is that in many “form” guaranties that banks use and have guarantors sign, there are waivers of many of the defenses that are otherwise available to guarantors. Also, as noted previously on numerous occasions in this blog, Indiana courts will enforce contracts agreed upon by people and companies. In fact, the Indiana Supreme Court just last week again held that “parties are free to choose the terms of their agreements and Indiana court firmly defend this freedom of contract by enforcing agreed-upon terms.”
So if a guarantor has agreed through its contract with the bank to waive defenses otherwise available to him, but the courts treat a guarantor as a “favorite” such that the terms of a loan cannot be changed without the guarantor’s consent, what will a court do? As with many situations in law, “it depends.” The facts surrounding the situation are likely to influence the court’s ultimate decision about the guarantor’s liability. The easy answer is that a creditor should always get the guarantor’s written consent to any change in the credit arrangement. Without that consent, the creditor runs a real risk of releasing that guarantor, or its property, from any further liability for repayment of the loan.