Personal Guarantees in Subcontract Agreements
The subcontract may be the most employed agreement in the construction industry. The upstream contractor uses the subcontract to “push down” part of its scope of work to a specialized trade. Construction subcontract agreements are vanilla and predictable. The drafting or reviewing construction attorney can anticipate the same provisions using stock language: scope of work, payment terms and timing, insurance and indemnity, warranty, independent contractor, retainage, lien releases, safety and compliance with laws, dispute resolution, termination rights, blah blah blah. Wrinkles are rare. One wrinkle recently confronted on a few occasions is a purported “personal guarantee” provision seeking to obligate the principal of an entity subcontractor. (This article does not apply to the naked sole proprietor construction contractor. Which should never happen.)
The subcontract personal guarantee generally consists of a couple paragraphs and states that the principal signing on behalf of the subcontractor entity shares the entity’s obligations and personal financial responsibility for obligations, losses, and damages owed to the upstream contractor. The supposed effect is the upstream contractor may go outside the entity shield and seek to recover financial loss from the principal’s personal real property, bank accounts, income, and other assets. The provision is one way with no reciprocal Construction Law Newsletter personal guarantee by the principal of the upstream contractor.
The question addressed by this article is whether the subcontractor principal’s personal guarantee is worth the ink (referred to herein as the “Downstream Guarantee”).
Personal guarantees are part of everyday dealings in the financial and commercial world. Lenders, landlords, vendors supplying on credit, and others facing at risk transactions are motivated and wise to obtain personal guarantees to incentivize compliance with payment obligations and provide an alternative source of recovery in the event of entity failure. Personal guarantees are important and standard where a party is extending credit or other capital to a new business or other obligor with inadequate collateral to cover amounts extended.
The Downstream Guarantee seems inapposite to the usual personal guarantee scenario. In the flow down of payments standard for construction, the subcontractor is typically the creditor fronting labor and materials to the upstream contractor with an expectation of later payment.
The upstream contractor’s financial risk under a subcontract, on the other hand, is hypothetical and undefined. Financial loss under a subcontract only springs in the event the subcontractor fails to perform or some other unanticipated event. An upstream contractor has several tools to protect itself, such as the rights provided by the standard subcontract, retainage, bonds, warranties, and insurance. When choosing which tool to choose, pursuing enforcement of a personal guarantee is clearly the worst and last tool to protect an upstream contractor from financial loss.
That “moreover” for putting a personal guarantee next to the Yankee Driver in the tool box is provided by Oregon decisional and statutory law concerning the enforceability of personal guarantees. Enforcement of a personal guarantee may entail a facts and circumstances inquiry into entry of the guarantee and the subsequent performance of the subcontract. Such an inquiry should be read as code for “money and risk.” The saying goes that “the only thing personal guarantees guarantee is extended litigation.” An addition to the adage in the Downstream Guarantee should be “and troubling attorney fee exposure under the subcontract’s prevailing party attorney fee clause.”
Guarantees are simple to draft, often involving not more than a paragraph. The interpretation and enforceability of a guarantee, however, are not necessarily restricted to the four corners of the guarantee. Extracontractual factors may be at issue, and assuredly are in construction subcontracts. Some concerns arising out of the Downstream Guarantee are summarized below.
Ambiguous Scope: A provision requiring a principal to guarantee “all financial loss” to an upstream contractor is inherently and unavoidably ambiguous. The guarantor’s potential liability at the time of subcontract entry is non-specific and entirely contingent. The normal scenario is potential liability would remain nothing more than a contingency as the subcontract is performed without unexpected financial loss to the upstream contractor. The exception may arise when some unexpected delay, improper construction, or accident occurs during subcontract performance.
At that unanticipated point, the general guarantee language does not specify the risk, nor does it specify the amount guaranteed. Consider efforts to pin personal liability on the principal of a siding subcontractor with a $47,000 scope of work for $250,000 delay claim. It would involve a huge challenge proving the general vague language reflected the intent of the parties. See ORS 42.220 (circumstances including ”situation of the subject and of the parties” may be considered in interpretation); ORS 42.230 (guarantee construed as what is “contained therein, not to insert what has been omitted, or to omit what has been inserted”).
Consideration and Materiality: Oregon decisional authority remains distinguishing a gratuitous guarantor from a compensated guarantor. Marshall-Wells Co. V. Tenney, et al, 188 Or 373 (1926). There is some question whether that distinction remains viable today. See Marc Nelson Oil Product v. Grim Logging, 199 Or App 73 fn 6 (2003) (1996 adoption of Restatement (Third) Suretyship and Guarantee eliminated distinction between compensated and gratuitous guarantors).
Regardless, as mentioned above, subcontracts consist of the same predictable provisions, except scope of work and price. Those issues are specifically negotiated as part of every construction subcontract. It is hard to imagine that a personal guarantee would be included in negotiations. While a personal guarantee’s stock language may purport that the subcontract was awarded in consideration of the guarantee, that is very unlikely to pass the straight face test. While not a complete defense, the secondary nature of an atypical term would be a glaring issue in efforts to enforce.
Modifications: Well drafted subcontracts contemplate construction as a process as opposed to static and unyielding. The scope of work, obligations, timing of work, and other conditions may and typically do change during the construction process.
A material change in risk may result in a guarantor being discharged entirely. In Lloyd Corp. v. O’Connor, 258 Or 33 (1971), the court consulted the Restatement of Security for the rule that:
Where, without the surety’s consent, the principal and the creditor modify their contract otherwise than by extension of time of payment
(a) The surety, other than a Compensated surety, is discharged unless the modification is of a sort that can only be beneficial to the surety, and
(b) The compensated surety is
(i) discharged if the modification material increases his risk, and
(ii) not discharged if the risk is not material increased but his obligation is reduced to the extent of loss due to the modification.
Answering the question of “consent” and “material increase of risk” are factual questions requiring analysis of much more than the language of the guarantee. See Fassett v. Deschutes Enterprises, Inc., 69 Or App 426 (1984); Samuelson v. Promontory Inv. Corp., 85 Or App 315 (1987); Marc Nelson Oil Products v. Grim Logging, 199 Or App 73 (2005).
ORS 30.140: Finally, the dreaded anti-indemnity statute on its face applies to guarantors.
(1) Except to the extent provided under (2), any provision in a construction agreement that requires a person or that person’s surety or insurer to indemnify another against liability for damage arising out of death or bodily injury to person or damage to property caused in whole or in part by the negligence of the indemnitee is void.
(2) This section does not affect any provision in a construction agreement that requires a person or that person’s surety or insurer to indemnify another against liability for damage arising out of death or bodily injury to persons or damage to property to the extent that the death or bodily injury to persons or damage arises out of the fault of the indemnitor, or the fault of the indemnitor’s agents, representatives, or subcontractors. Oregon law treats personal guarantors as sureties. Lloyd Corp., supra.
Conclusion: Personal guarantees may seem simple in concept and a provision with little downside from the perspective of the upstream contractor. Enforcement of a personal guarantee can involve a true fist fight and vastly superior tools are available to protect an upstream contractor from financial loss. One attorney’s opinion only, but even in an increasingly paperless world it is challenging to value the Downstream Guarantee as worth the ink.
Please contact Steve Norman with any questions.
