Bill Gross’ statement on Friday that the decline in Treasury yields to 60-year lows “reflect a high probability of recession in the United States” is the latest edition to the increasing sentiment that the U.S. is heading back into a recession.  The reasons are many – from persistently high unemployment, the dismal housing market, the debt crisis (in both the U.S. and Europe), to concerns over a variety of bubbles in China – and pressure is now on the credit professional to prepare for the worst.

This post is the first installment in our series on credit enhancements that aims to educate and inform the reader on what alternatives can be used to protect credit sales.  The series includes enhancements such as guaranties, credit insurance, consignments, letters of credit, bankruptcy swaps, certificates of deposit, credit cards, factoring arrangements, secured transactions, and alternative forms of credit arrangements.

A guaranty can be defined as a promise by a guarantor (often a principal of the customer or customer’s affiliate) to carry out the primary obligor’s (customer) commitment to the promissee (seller).  There are also two types of guaranties.  The first is a guaranty of payment or collection, in which the principal amount is due at a specified date.  The second is a continuing guaranty, which covers future dealings over an unspecified length of time.

A personal guaranty must be in writing and should include a statement that the signing party is personally guarantying the debt of the customer.  The full legal name and fictitious business name of the customer should be stated, and the guaranty should also include, under the signature block line, the individual guarantor’s social security number and home address.  The creditor should also consider requiring the guarantor to notarize the guaranty.

Ordinary rules of offer and acceptance under the law of contracts apply to guaranties.  Unless notice of acceptance is expressly required, an offer to become a guarantor may be accepted by performance or by acceptance of other consideration.  Note that a creditor’s right to enforce a contract of guaranty must be based on knowledge of the existence of the guaranty and the credit must be extended in reliance thereon.

The benefit of having another party responsible for payment is the primary purpose of a guaranty and usually come into play when our customer defaults.  But what happens if we are paid by our customer, and the customer files bankruptcy within 90 days of making the payment?  Can the creditor recover the preferential transfer from the guarantor?  The short answer is yes.

If we encounter another surge in corporate bankruptcies, the principal of revival could provide the creditor with a way to keep its money received from the sale.  This occurs when the customer files bankruptcy and the party pursuing the preferences makes a claim to avoid and recover a transfer that was guaranteed, and the creditor is forced to return the preference.  Fortunately for the creditor, bankruptcy courts recognize that the obligation under the guaranty is revived and preference returned, including attorneys’ fees and interest, must be repaid to the creditor by the guarantor.

Research Credit: Adam Pollock