Sad Tale of the Uninformed Co-Borrowers

Have you ever been asked by a family member, friend or promoter to personally guarantee or co-sign a loan?

Guaranteeing a loan and co-signing have very different consequences.  These days, private and institutional lenders seem to prefer setting up guaranteed loans as “co-borrower” arrangements rather than using “personal guarantors.” Knowing the differences is crucial and may save you from a big hit to your personal wealth.

Co-Borrower Status

Co-borrowers all sign the loan as primary borrowers and are typically equally liable. This means the lender can directly go after you, some of the co-borrowers or all of them for the entire loan amount under the legal doctrine of joint and several liability. Many co-borrowers think they are only responsible for their share of the loan.  WRONG.

Personal Guarantor Status

Personally guaranteeing another party’s loan is much different than being a co-borrower.  Certain protections for personal guarantors became part of the law as it evolved.  For example, it may be necessary for the lender to first pursue the primary borrower before pursuing any personal guarantors. If the lender can’t get its money back from the primary borrower, only then may the lender go after any personal guarantors for any remaining balance owed.

Sad Tale

Wheeler dealer Sam envisions developing a commercial building with separate office spaces for himself and others, and shared amenities like a conference room. He can’t afford this project by himself, so Sam recruits investors. He chooses business owners who would like to be tenants and have ownership in the building, and other investors who would not be tenants. Sam hires attorney Joe to set up a limited liability company that will own and operate the building. They call their company We R. Rich, LLC. All the investors are members of We R. Rich.

Sam arranges for construction and permanent financing for the building from Flash-in-the Pan Bank. Sam tells his investors that attorney Joe has reviewed the loan paperwork, and it all looks fine. The completed building will be pledged as security for the loan. Sam also tells his investors they have to guarantee the loan or the bank won’t give them the money. Sam advises them they don’t have to worry about We R. Rich failing because the value of the building will cover the loan in the unlikely event the limited liability company defaults on its loan. The investors decide it isn’t necessary to have another attorney duplicate the work of attorney Joe, and they all sign the loan paperwork as unknowing co-borrowers.

Flash-in-the Pan Bank is shut down by its government regulator for having too many real estate loans in default. No bank will take on the bank’s loan portfolio, so the regulator ends up selling We R. Rich’s loan to a loan recovery group.

The commercial building does poorly during the economy’s downturn and the limited liability company gets behind in its loan payments. The loan recovery group declares the loan in default and takes steps to foreclose on the property pledged as security for the loan.

During negotiations with the loan recovery group, Sam’s co-borrower investors learn the property securing the loan has lost so much value that the foreclosure sale may not generate enough to cover the loan balance.  The co-borrowers are stunned to learn the loan recovery group expects them to personally make up the difference between the loan balance and the proceeds from the foreclosure sale.  Then, the co-borrowers receive a truly unexpected smack in the face.  Sam tells them he will not be contributing any of his own money towards paying off the loan recovery group.  Sam has transferred all of his assets offshore, and neither the loan recovery group nor the co-borrowers can collect anything from him. We R. Rich’s sole asset is the building, and the investor co-borrowers now face being on the hook for the whole amount sought by the loan recovery group.

The investor co-borrowers believed they only owed their respective share of the loan. They are angry Sam has left them holding the bag. Some of the other co-borrowers are broke. The solvent co-borrowers are even more dumbfounded when they learn the loan recovery group can sue just one, some or all of them for the entire amount owed.

Had the investors hired an attorney with experience in business law and financing commercial real estate projects to review the papers before they signed on the dotted line, they would have better understood what they were getting into and the risks involved.   They might a have been able to modify the arrangement to reduce their risk, or simply walked away.

None of the investor borrowers are as rich as they were before investing in Sam’s big dream.

This article is particular to Washington State. Laws on this subject may vary from state to state. The foregoing example raises numerous other legal issues which are not covered in this article.

By Robert Hawkinson