Is That Personal Guaranty Enforceable?

For creditors, a personal guaranty can provide an important third-party source of payment. For guarantors, its enforceability can mean the difference between solvency and insolvency.

At first glance, a guaranty's language can seem ironclad. Uncompensated guarantors are often said to be "favorites of the law," however, and the courts will strictly construe the guarantor's undertaking. Moreover, various defenses to the enforcement of personal guaranties have evolved. Three of them are discussed below.

Failure to Properly Bind the Marital Community. In order to bind a marital community under Arizona law, both spouses must join in the guaranty transaction. Additionally, there is a strong presumption under Arizona law that all property acquired during the marriage is community property. Accordingly, a creditor's failure to have both spouses sign the guaranty may, as a practical matter, render the guaranty uncollectible.

Modification of the Obligation Without the Guarantor's Consent. Where, without the guarantor's consent, the principal and the creditor modify their contract, the guarantor is discharged unless the modification is of a sort that can only be beneficial to the guarantor. Thus, creditors will want to get the guarantor's written consent to any modification, regardless of to whom it may be viewed as being favorable.

Breach of Duty of Disclosure. A creditor owes a guarantor a duty of good faith and fair dealing. That includes the duty to disclose facts which increase the guarantor's risk. Before this duty arises, the creditor must (i) have reason to believe that there are facts which materially increase the risk beyond that which the guarantor intends to assume and (ii) have reason to believe that those facts are unknown to the guarantor. The duty of disclosure continues throughout the parties' relationship. Thus, a creditor who makes multiple extensions of credit, learns of the debtor's insolvency, and has reason to believe the guarantor is unaware of it, has a duty to disclose the insolvency to the guarantor before making further advances. Its failure to do so can relieve the guarantor of liability on all further extensions of credit.

Conclusion. Creditors and guarantors can tend to overemphasize a guaranty's formidable-sounding language. Thorough examination and review of the surrounding facts and circumstances, however, can lead to the discovery of one or more defenses and to the conclusion that liability is hardly certain.

Each case a business or individual may face is unique and may require legal advice. If you would like additional information regarding the content of this article, please contact the author, Brian Spector, or the Chair of our Bankruptcy, Reorganization & Creditors’ Rights Law Department, Carolyn J. Johnsen

LLC Payment Classifications: Member Distributions vs. Compensation: Beware the Unintended Consequences

Those who do business through a closely-held limited liability company (LLC) often receive their share of business profits in the form of member distributions instead of guaranteed payments (compensation). [1] They may be advised, for example, that there are tax advantages to doing so.[2] What they may not realize, however, is that paying LLC members in the form of distributions instead of compensation may impair the limited liability protection otherwise afforded to LLC members and expose them to creditors’ claims, at least where the LLC engages in activities with a high risk of liability and/or becomes insolvent.

While there may be reasons for choosing to give members distributions instead of compensation, there are potential risks to the LLC’s members from a creditor standpoint. A.R.S. § 29-706 provides that a limited liability company “shall not make a distribution to its members to the extent that at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company would exceed the fair value of the assets of the limited liability company….” Liability is imposed on each member who receives such distributions for the amount of such distributions.[3]

Take, for example, a medical practice that conducts its business as a professional limited liability company[4] and for which there has been a large malpractice claim. If the medical practice thereafter continues to pay its doctor members in the form of distributions instead of compensation, each member potentially can be personally liable for distributions received at any point after the company’s liabilities exceed its assets.

Other legal doctrines[5] can lead to the same result; and similar rules can apply in the context of corporations[6] and limited partnerships.[7] Thus, while there may be good reasons for classifying payments to members as distributions instead of compensation, beware the unintended consequences of doing so: it may adversely affect the limited liability protection otherwise afforded an LLC’s members.

_____________________________________________________________________________

[1] Pursuant to IRS regulations, compensatory payments to LLC members are to be treated as guaranteed payments (similar to payments to an independent contractor) rather than salary.

[2] Whether or not there are actual tax advantages is beyond the scope of this discussion. For example, LLC members may still be liable for self-employment taxes at the personal level, whether they receive distributions or guaranteed payments or neither.

[3] Subsection D provides: "If a member receives a distribution with respect to his interest in a limited liability company in violation of this chapter or an operating agreement, he is liable to the limited liability company for a period of six years thereafter for the amount of the wrongful distribution."

[4] A.R.S. § 29-706 is made applicable to professional limited liability companies through A.R.S. § 29-843

[5] In Hullet v. Cousin, 32 P.3d 44 (Div. 1 2001), for example, the Arizona Court of Appeals applied fraudulent transfer law. There, after a limited partnership sold its only asset (an apartment complex), it distributed the net proceeds to its partners. A creditor later sued the limited partnership for claims related to the apartment complex. The creditor obtained a default judgment against the partnership, but the judgment was uncollectible because there were no assets remaining in the partnership. The creditor then sued the limited partners, arguing that the limited partnership's transfer of assets to them was voidable as fraudulent pursuant to Arizona Revised Statutes "A.R.S." sections 44-1004 and 44-1005. The Arizona Court of Appeals directed that judgment be entered in favor of the creditor on his fraudulent transfer claim against the limited partners. In so holding, the Court (citing to the functional equivalent of A.R.S. §29-706 as respects limited partnerships) recognized that a “limited partner is not entitled to distribution from a limited partnership to the extent that it would cause the liabilities of the limited partnership, other than those to partners on account of their partnership interests, to exceed the fair value of the limited partnership's assets. A.R.S. § 29-337 (1998).”

[6] A.R.S. §10-640(C).

[7] A.R.S. § 29-337.

Renowned Sports Law Attorney Travis Leach Joins the Phoenix Office of Jennings, Strouss & Salmon

PHOENIX, Ariz. (January 18, 2012) – Jennings, Strouss & Salmon, PLC, a leading Phoenix-based law firm, is pleased to announce that Travis J. Leach has joined the firm as a Member in the Phoenix office.

“Travis is a talented attorney with extensive experience in the areas of securities, mergers and acquisitions, and corporate governance,” states Richard Lieberman, Chair of the firm’s corporate, securities and finance department. “As a certified contract advisor by the NFL, he also brings a substantial professional sports practice, which will enhance the firm’s growing sports and entertainment group.”

Leach will focus his practice in the area of securities, including public offerings, private placements, corporate governance matters (including Sarbanes-Oxley compliance), SEC reporting obligations, and mergers and acquisitions. He will also help lead the firm's Sports and Entertainment practice. As such, he will counsel professional athletes, coaches and ownership groups in contract and licensing negotiations and a variety of other individual and collaborative business ventures. His experience supplements the firm’s ability to advise professional athletes and entertainers in all their personal and business legal matters.

“It is an honor to join such a dynamic team of attorneys and I look forward to helping the firm grow its footprint in the sports industry,” said Leach. “Jennings Strouss is a firm with creative and talented attorneys who have solid reputations for delivering great client service; characteristics that provide positive synergies with clients in the sports and entertainment industry.”

Leach is certified as a Contract Advisor by the National Football League Players’ Association and the Canadian Football Players’ Association. He earned a J.D. from University of Miami Law School and a B.S. from Arizona State University.

Jennings, Strouss & Salmon Elects Bradley V. Martorana as a New Member

PHOENIX, Ariz. (January 12, 2012) – Jennings, Strouss & Salmon, P.L.C., a leading Phoenix-based law firm, is pleased to announce that Bradley V. Martorana has been elected a Member (Partner) of the firm, effective January 1, 2012.

“Brad’s success with clients in a wide-range of industries has been impressive and we are proud to have him join us as a Member of the firm,” said Richard Lieberman, Chair of Jennings, Strouss & Salmon’s Corporate, Securities and Finance department.

Mr. Martorana focuses his practice on advising businesses and their owners in structuring, negotiating and documenting a wide range of business transactions and relationships. Mr. Martorana has previously practiced at a large firm in Baltimore, Maryland, and is a certified public accountant (CPA) with experience at a “big four” accounting firm. He has earned a B.S. in Accounting and Finance from Georgetown University’s McDonough School of Business, a J.D. from The University of Maryland School of Law, and an M.B.A. from Arizona State University. Mr. Martorana is licensed in Arizona, California, Maryland and Washington, D.C.