On August 6, 2015, in the case of Smith v. M&M Pump and Supply (pdf), the Indiana Court of Appeals upheld the trial court’s summary judgment order in favor of a creditor against a guarantor. M&M was a supply company that provided materials to Lily Group. Smith was an employee of Lily Group who signed a personal guarantee in favor of M&M guaranteeing the performance of Lily Group under the contract. As one might guess from the fact that this matter made it to the Court of Appeals, Lily Group defaulted on the agreement and M&M sued Smith for the debts owed by Lily Group.
A personal guarantee is often used by creditors of small businesses to hedge their bets when they might be uncertain as to whether the small business will continue to be viable over the duration of the contract. The guarantee signed by Smith read as follows:
(Preferably owner of Business Organization with largest ownership
The individual who signs below personally guarantees to M & M Pump & Supply Company, Inc. that if the Business Organization identified above fails to pay any of the amounts owed either under an invoice or under this Agreement, the individual will pay to M & M Pump & Supply Company, Inc. that amount owed within 30 days after written demand is received from M & M Pump & Supply Company, Inc. The individual who signs below understands that credit would not be extended without this guarantee and waives any right to notice of default or presentment.
Smith advanced a shotgun array of defenses, and the Court of Appeals knocked them down in order.
1. Consideration as guarantor
Any contract has three elements – offer, acceptance, and consideration. Consideration is something of value received from each side. Courts will not typically spend time evaluating whether the consideration represents a good deal for any of the contracting parties, but there does have to be something of value that can be said to induce the contract. Smith argues that he did not get anything out of the deal and so his status as personal guarantor should fail for lack of consideration. The Court noted that Lily Group undoubtedly got value out of the contract and, under Indiana law, no further consideration is necessary to sustain the personal guarantee. “If a guarantee is made contemporaneously with the principal contract, then consideration sufficient to create the contract is also sufficient to support the guarantee. . . . It is not necessary for a guarantor to derive any benefit from the principal contract or the guarantee for consideration to exist.” I would argue, additionally, that the guarantor can be said to sign the guarantee to induce one party to enter into a contract with the other. The very fact that M & M entered into the contract with Lily Group can be seen as consideration with respect to the personal guarantee.
2. Smith’s lack of knowledge that he was signing a guarantee
Smith argued that it was a question of fact (and therefore not appropriate for summary judgment) as to whether he knew he was signing a guarantee. The Court of Appeals said that this cannot create a question of fact because, “under Indiana law, a person is presumed to understand the documents which he signs and cannot be released from the terms of a contract due to his failure to read it.” In other words, even if the judge or jury found that, in reality, Smith did not know what he was signing, it would still not be a legal defense and would not affect the outcome holding him responsible for the terms of the agreement.
3. Pending bankruptcy of Lily Group
Smith argued that, because Lily Group’s bankruptcy was pending, and it had not yet been determined that Lily Group would not pay the debt, it was improper to enter judgment against Smith holding him responsible. The Court of Appeals rejected this argument, holding that the guarantee was triggered when Lily Group defaulted and failed to pay the balance when due — it was not necessary to wait until a bankruptcy completely foreclosed M&M’s ability to collect.
4. Impairment of Collateral
A secured creditor who has a personal guarantee can compromise that guarantee when it fails to perfect its security interest in the collateral. Essentially, a guarantor can expect a creditor to act in a reasonable way to mitigate potential losses and, by extension, limit the guarantor’s risk. Smith alleged that M&M failed to properly perfect its security interest. However, the Court rejected this argument because M&M’s agreement with Lily Group did not provide for any security interest in the first place.
5. Attorney’s fees
Finally, Smith argued that, because the personal guarantee did not specifically mention attorney’s fees, his exposure under the personal guarantee should not be extended to cover those fees. The Court of Appeals rejected this argument. Where the agreement itself specifically references attorney’s fees, that is sufficient even if the guarantee clause does not specifically reference those fees.
The end result is that the judgment in favor of M&M and against Smith in the amount of $63,913.26 was affirmed. As a creditor, it is a good idea to get personal guarantees when extending credit to corporate entities that may go out of business. As an individual, it is a good idea to avoid signing such guarantees if your business has other ways of getting access to the credit or materials it needs or, alternatively, to revoke the guarantee before the business gets too deep in the hole.