Brother can you spare a dime? A primer on private loans
Shakespeare once wrote, “Neither a borrower nor a lender be, for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.” He also wrote, “The first thing we do, let’s kill all the lawyers.” Reading between the lines, I would guess that at some point Shakespeare made, backed or took out a loan that went south, and he ended up losing more than he bargained for in the process.
Unlike Shakespeare, banks know how to evaluate the financial strength of a borrower, and their regulators (theoretically) require them to avoid imprudent risks. It’s relatively easy to get a bank loan when the borrower is “bankable.” Unfortunately, many worthy causes aren’t bankable, so private “hard money” lenders or friends and relatives often extend loans when a bank won’t. Regardless of the situation, if a guarantor, borrower, or lender you are to be, you should go into the deal with a full understanding of what’s at stake and how to protect your interests. Here are a few pointers:
Let me begin with loan guarantees because I have seen ordinary people unknowingly get into trouble when guaranteeing a loan. A guarantee is basically a promise to a lender that if the borrower doesn’t pay off the loan, the guarantor will make up the shortfall, in whole or in part. In most situations, the borrower and the guarantors will be jointly and severally liable on the loan, meaning that if the borrower defaults, the lender can skip collection efforts against the borrower and proceed against one or more of the guarantors. In this situation, the deepest pocket will oftentimes get caught holding the bag.
A lender will typically want a full, unqualified, unlimited, and joint and several guarantee, but that doesn’t mean that guarantee agreements can’t be negotiated to limit a guarantor’s risk. The guarantee agreement, for example, could limit the amount of the guarantee, or it could be drafted to require that the lender pursue the collateral pledged to secure the loan before going after a guarantor. A guarantor can and should require indemnification from other guarantors and the borrower.
Often times, a guarantor is a sophisticated party that has some kind of financial stake in the underlying venture. Sometimes, a guarantor is a third party who is simply trying to help out a relative or friend. These well-meaning and often unsophisticated guarantors have no less, and probably more, to lose in a loan transaction, so they should be no less diligent about knowing their risks or protecting their interests.
Turning to the arrangements between the borrower and the lender, in every loan transaction, there should be a document, usually a promissory note, that memorializes the essential terms of the loan, such as the amount of the loan, repayment schedule, rate of interest and date of maturity. An unsigned, undocumented promise to pay may end up being worth the paper it’s not written on.
If a borrower defaults on a note, unless collateral is pledged to “secure” the note, the lender’s available remedies may be limited to suing the borrower for the amounts due and owing. Typically, only when the lender gets a judgment in court can it garnish a delinquent borrower’s bank accounts and wages and levy the borrower’s property. If the borrower declares bankruptcy, a lender who has nothing more than a promissory note will find it very difficult to recover its money.
A lender is in a significantly better situation when the borrower pledges collateral to secure the loan. In Colorado, a deed of trust is typically used to pledge real property as collateral. In all states that I know of, a security agreement is used to pledge as collateral personal property, including tangible assets such as cars and equipment and intangible assets such as stocks and bonds.
Under law, there are various means for a lender to seize, sell or otherwise recoup the value of collateral pledged to secure a loan, even if the borrower declares bankruptcy. These remedies, for a number of reasons, are often less costly and more effective than suing the borrower on the note. But simply having a lien by virtue of a deed of trust or a security agreement is not enough. The lender must “perfect” its lien.
Perfection is a method of putting the world on notice that the lender has a lien on the collateral, and it will establish priorities among creditors as to the collateral. A lender with the senior perfected lien will have the first right to recover amounts owed to it. Obviously, a lender should investigate whether other creditors have a prior perfected interest in the collateral before extending the loan. Insurance may be available to insure that a lender has or would have the senior lien.
Different types of collateral require different methods of perfection. These methods are way outside the scope of this column.
Private loans can be tricky business. A promissory note may be relatively simple to put together, but the rights, protections and obligations attending guaranteeing and securing a loan are complex and should be handled by someone who knows what he or she is doing. In a private loan situation, usually that means getting legal counsel to ensure that the risks are known and that interests are protected.
Matthew Trinidad is a transactional attorney at Karp Neu Hanlon PC. He can be reached at (970) 945-2261 or at MLT@MountainLawFirm.Com.
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