The following is the text of an e-bulletin that I prepared that was published by the Corporations Committee of the Business Law Section of the State Bar of California. This was republished (under the title of “Excluding Assets from a Personal Guaranty”) by the following committees: Insolvency Law Committee, Commercial Transactions Committee, Financial Institutions Committee, and Partnerships & LLCs Committee.
Guaranty Carve-Outs
As almost all lawyers who represent closely-held entities know, lenders to a limited liability entity (such as a corporation or LLC) will typically require the entity’s principals to sign a personal guaranty of the entity’s obligation to the lender. Occasionally, a lender will agree to carve out one or more assets from the reach of the guaranty. For example, a lender might agree that the lender would have no recourse to a principal’s residence in the event the lender has to enforce the guaranty.
But what happens if the guarantor sells the residence? That was the situation in Series AGI West Linn of Appian Group Investors De LLC v. Eves (June 14, 2013) 13 C.D.O.S. 6177, which presented a single issue:
If a personal guaranty specifically excludes a particular asset as a source of recovery for the lender, are the proceeds from the sale of that asset still excluded when the lender seeks to enforce the guaranty?
According to the court, this issue appeared to be one of first impression, not only in California but also in the entire country.
In April 2007, the plaintiff lent $3.1 million to a limited partnership for a real estate development in West Linn, Oregon. The plaintiff’s loan was junior to a loan secured by a first deed of trust. At the same time, Robert Eves executed a personal guaranty of the loan. An addendum to the guaranty had a provision styled “Limitation of Recovery” to the following effect:
Notwithstanding the foregoing, the personal guaranty may only be collected from assets not expressly excluded, as provided in the Asset Exclusion Schedule for Eves attached to the guaranty as Schedule 1.
The asset exclusion schedule for Eves listed his personal residence in Como, Italy, and its contents.
Eves sold the Como residence in the summer of 2011. The proceeds of the sale were all cash and were deposited in accounts segregated from other assets. No part of the proceeds of the sale was comingled with any other funds.
When the senior lender foreclosed, the plaintiff’s security was wiped out. The borrower made no payments on the loan, and Eves refused to honor his guaranty. In March 2012, the lender filed suit to recover the loan balance and attorney’s fees. Shortly after filing its complaint, the lender applied for a prejudgment order of attachment.
Eves opposed the attachment to the extent it sought “proceeds from the sale” of the Como house, which he argued were excluded from attachment by the terms of the personal guaranty. Eves appealed the issuance of the writ of attachment.
The court of appeal held that writ was properly issued because the guaranty’s plain language limiting the exemption from attachment to assets “expressly excluded… in the Asset Exclusion Schedule” did not extend to the proceeds of the sale of such assets, for the proceeds were not expressly excluded by the terms of the asset exclusion schedule.
The court noted that the deed of trust and security agreement that Eves signed on behalf of the borrower on the same day as he signed the guaranty had numerous references to “proceeds” in different contexts, which the court said demonstrated that the concept of proceeds was not overlooked by the borrower or Eves.
The court also said that the language of the excluded assets showed that some care was given to their description. If Eves meant to anticipate the liquidation or sale of an excluded asset, all he had to do was insert language to cover that contingency.
Eves argued that the exempted asset consisted not of his former residence in Como, as such, but of the market value of that residence (and the contents) at the time the guaranty was executed. That was not, however, what the plain language of the guaranty said. At the time of the lawsuit, Eves no longer owned the Como residence or its contents. According to the court, the sale of those assets vitiated the exclusion.
California Uniform Commercial Code § 9315(a)(2) provides that a perfected security interest “attaches to any identifiable proceeds of collateral” covered by the security agreement, and the security agreement is created by the contract between the parties. Eves argued the personal guaranty was “the mirror image of the concept expressed” in the UCC. But the court said that there is no equivalent statute for sureties, which makes it a matter for the parties’ contractual negotiation.
Finally, Eves argued that “proceeds” should be treated as an implied term on the theory that “after examining the contract as a whole it is so obvious that the parties had no reason to state the [omitted term], the implication arises from the language of the agreement, and there is a legal necessity.” The court said that implied terms “are justified only when they are not inconsistent with some express term of the contract and, in the absence of such implied terms, the contract could not be effectively performed.”
The court found that the supposedly implied term was contrary to the unequivocal language of the personal guaranty that, to be exempt from the guaranty, assets must be “expressly excluded.” The guaranty was fully capable of being effectively performed without the insertion of the term “proceeds.”
Eves could have inserted language extending the residence’s exclusion from the guaranty to the sale proceeds of the residence. He failed to do so. Judicially correcting that omission would amount to an improper rewriting of the parties’ contract. For this reason the court of appeal agreed that the proceeds of the sale of the house were not exempt from being attached to satisfy Eves’s obligation under the personal guaranty.
Comment
In drafting an agreement, it can be convenient to employ a term that is in common use, but the careful drafter should consider whether there are different possible meanings of the term. If there are different possible meanings, the drafter should clarify the meaning in the document. For example, if a guaranty says that a specified asset “and the proceeds thereof” are excluded, how should the exclusion of “proceeds” be expressed in the guaranty? Is it safe to assume that “everyone knows what proceeds are” and therefore no need to clarify the term? The short answer is no.
In the case of a sale, if the cash proceeds are commingled with other funds, do the proceeds lose their character as “proceeds”? (In the case discussed above, that was not an issue, for the guarantor had kept the funds segregated.)
If the cash proceeds from the sale of the specified asset are used to purchase other property, is that other property “proceeds”?
If the specified asset is exchanged for other property (like kind or not), is that the property received in exchange “proceeds”?
And what about proceeds of a new loan secured by the specified asset? Would loan proceeds be “proceeds” for the purpose of the exclusion?
Thinking about whether there are different possible meanings of the term “proceeds” and hypothesizing situations in which the term might be used can lead the drafter to clarify the term and reduce the prospect of disputes.
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This e-bulletin was prepared by Richard G. Burt, Vice–Chair, Judicial Developments, Corporations Committee of the State Bar of California. Mr. Burt practices in San Jose.
