Kentucky's Unique Guaranty Statute

Beware the Jabberwock my son,
The jaws that bite, the claws that snatch!
Beware the Jubjub bird, and shun
The frumious Bandersnatch!

- Lewis Carroll, Through the Looking Glass (1872)

And beware the Kentucky guaranty statute, KRS 371.065. Creditors ignore its requirements of stating the maximum amount and termination date at their peril, for it can reach out and bite or scratch the unwary creditor. Noncompliance can result in an unenforceable guaranty.

I. History and Intent

The Kentucky guaranty statute, apparently unique in the United States, was originally proposed in 1986 as an amendment to Article 3 of the Kentucky Uniform Commercial Code, entitled House Bill 286 "AN ACT relating to commercial paper."¹ During the legislative process, the Senate transferred the statute from Article 3 to KRS Chapter 371, the chapter relating to the law of contracts, but the statute "retained its exclusive applicability to guaranties of commercial paper."²

In 1990, the statute was amended to clarify that the "maximum aggregate amount" required to be specified by the statute did not need to include an allowance for interest and fees.³ In addition, the Kentucky Court of Appeals found it significant that the title of the act was changed to "AN ACT relating to guaranties," and discerned a legislative intent to expand the scope of the statute and give it "broader applicability" to guaranties in other contexts.⁴

The statute now reads as follows:

KRS 371.065 Requirements for valid, enforceable guaranty

(1) No guaranty of an indebtedness which either is not written on, or does not expressly refer to, the instrument or instruments being guaranteed shall be valid or enforceable unless it is in writing signed by the guarantor and contains provisions specifying the amount of the maximum aggregate liability of the guarantor thereunder, and the date on which the guaranty terminates. Termination of the guaranty on that date shall not affect the liability of the guarantor with respect to:

(a) Obligations created or incurred prior to the date; or

(b) Extensions or renewals of, interest accruing on, or fees, costs or expenses incurred with respect to, the obligations on or after the date.

(2) Notwithstanding any other provision of this section, a guaranty may, in addition to the maximum aggregate liability of the guarantor specified therein, guarantee payment of interest accruing on the guaranteed indebtedness, and fees, charges and costs of collecting the guaranteed indebtedness, including reasonable attorneys' fees, without specifying the amount of the interest, fees, charges and costs.

The policy of the Kentucky guaranty statute seems directed at protecting guarantors from over-reaching guaranties and unintended obligations. For example, a guarantor intending to guaranty a specific transaction for which he has calculated the risks could be summoned into court years later to answer for a different, larger debt, one for which he had not calculated the risks, and had not intended to stand as surety. The Kentucky General Assembly addressed this perceived problem in the guaranty context by requiring disclosure of the nature of the obligation.

One way to disclose the scope of the guaranty obligation is to expressly disclose the "maximum aggregate amount" and "termination date" on the face of the guaranty document. The statute also specifically authorized a second way for the guarantor to receive adequate disclosure of his or her potential liability under the guaranty: the guaranty may be written "on, or expressly refer to" the obligations guarantied. The Sixth Circuit Court of Appeals described the operation of the statute as follows: "The Kentucky statute on its face reflects the desire to protect against overbroad guaranties of indebtedness made without adequate disclosure."⁵ The Kentucky Supreme Court has stated: "KRS 371.065’s requirement that a guaranty state the guarantor's maximum liability and the guarantor's termination date is a consumer-protection provision designed to protect the guarantor by reducing the risk of a guarantor agreeing to guarantee an unknown obligation."⁶ Thus, some Kentucky lawyers have described it, to askance outlanders, as an "anti-open-end guaranty" statute.

The recent cases discussed below show that there are still a lot of unanswered questions and, hence, risks in using guaranties in Kentucky.

II. Dealership Agreements.

In Duckett v. Kubota Tractor Corporation,⁷ an unreported case, an equipment distributor used a series of contracts bound together in a booklet to establish the distribution arrangement with the dealer. A guaranty agreement, to be signed by the principals and financial backers of the dealer, was on one of the last pages of the booklet. Although the distributor was from out-of-state, the contract contemplated that the law of dealer’s residence would apply, in this case, Kentucky. When the dealer went bankrupt and the distributor sought to enforce the guaranty against the financial backers, the guarantors argued that the guaranty lacked the maximum amount and date required by KRS 371.065. In response, the distributor argued that the guaranty was written "on" the instrument guaranteed.

In Duckett, the Federal District Court for the Western District of Kentucky sided with the guarantor, finding that the guaranties failed to comply with the statute. The court observed that the distributorship agreement did not create any independent obligation to be guarantied. Rather, all the payment obligations arose outside (though as a result of) the distributorship agreement. Further, the distributorship agreement itself contained no financial terms indicating the maximum amount or duration. The court speculated that the "instruments" might be the invoices relating to particular pieces of equipment sent to the dealer for sale — but none of these had guaranties "written on" them. Despite the inequitable result to the distributor, this court felt compelled to enforce the mandate of the statute.⁸

III. Credit Applications.

The Kentucky Supreme Court addressed the Kentucky guaranty statute for the first and only time in Wheeler & Clevenger Oil Co. v. Washburn.⁹ There, an oil supply company extended a line of credit to a trucking company to enable it to purchase fuel and other merchandise. The supplier required the trucker to fill out an "Application for Credit" form that included a guaranty of all "extensions of credit," to be signed by the president of the trucking company. When the trucking company became delinquent in its account, the supplier sought to enforce the guaranty against the president. The president argued that the guaranty did not specify a maximum amount or a termination date, and thus failed to comply with KRS 371.065. The supplier argued that the guaranty was written "on" the credit application and therefore met the second prong of the statute.

Confronted with these arguments, the Kentucky Supreme Court sought to "steadfastly adhere" to the plain-meaning rule. The Court observed that "the guaranty agreement is written on the credit application in two places" and concluded that the risk of the guarantor guaranteeing an unknown obligation was negligible.¹⁰ Accordingly, the Court held that the guaranties were written "on the instruments" as required by KRS 371.065, and so were not required to state the maximum amount or termination date. Consequently, the guaranties were enforceable.

If notice of the nature of the obligation guaranteed is the crucial issue, then it is very difficult to reconcile Duckett with Wheeler. The distributorship agreement in Duckett would have given more notice to the guarantor of the nature of the obligations to be guaranteed than a mere credit application.¹¹ In addition, a guaranty written on a page of a bound booklet seems to be written "on" the instrument.

IV. Indemnity Agreements.

When is a guaranty not a guaranty? Perhaps when it is an indemnity. So held one court, which found that an indemnity agreement need not comply with the Kentucky guaranty statute.

In Intercargo Insurance Co. v. B. W. Farrell, Inc.,¹² a construction bonding company was required to pay under its performance bond and sought to enforce an indemnity against the principal of the defaulting construction company. The trial court held that the indemnity was, in effect, a guaranty, and since it did not comply with KRS 371.065 by stating the "maximum aggregate amount" and the "termination date," it should not be enforced. The Kentucky Court of Appeals carefully distinguished between indemnities, where the undertaking of the indemnitor is to "protect its promisee against loss or damage through a liability on the part of the latter to a third person," and guaranties, where the undertaking of the guarantor is to "protect the promisee against loss or damage through the failure of a third person to carry out his obligations to the promisee."¹³ The court found that this contract insuring performance was clearly one of indemnity, and not subject to KRS 371.065. Thus, the court of appeals directed the lower court to enforce the indemnity agreement.

A different panel of the Court of Appeals addressed the indemnity/guaranty issue in a different way in Huntington Bank v. Porter.¹⁴ There, a national bank based in Ohio entered an automobile floor planning agreement with a rental car dealer in Louisville, Kentucky. In connection with an $8.6 million loan facility, the bank required the stockholders of the dealership corporation to execute an "Indemnity Agreement." The dealership fell into the common, fraudulent habit of selling its cars without forwarding the proceeds to the bank and, finding itself undersecured, the bank called the note and when the dealership lacked sufficient assets, sought to enforce the indemnity against the stockholders. As in Intercargo Insurance, the stockholders argued that the "Indemnity Agreement," promising, as it did, to protect the bank from liability for a debt resulting from the failure of a third party to honor an obligation to that promisee, was in substance a guaranty agreement. If a guaranty, it plainly did not comply with KRS 371.065, and would be unenforceable. The bank argued that the "Indemnity Agreement" was not subject to the requirements of KRS 371.065.

The court agreed with the stockholders, concluding that this Indemnity Agreement was in substance a "straightforward guaranty contract regardless of the label and wording used."¹⁵ As a result of its failure to comply with KRS 371.065, the bank took a loss of $3.8 million.

Although Huntington Bank seems on its face inconsistent with Intercargo Insurance, they can be reconciled by the recognition that both courts sought to put aside the labels and forms of the agreements in order to look at the underlying substance of the intended transactions. Despite the label of "Indemnity Agreement," Huntington Bank involved a straightforward guaranty. In Intercargo Insurance, the obligation in the nature of a performance bond relates to the undertaking of the indemnitor to protect the indemnitee from loss through a liability of the latter to a third person, similar to an insurance contract. Under this analysis, the "Environmental Indemnity Agreements" frequently encountered in real estate financings should usually be considered true indemnity agreements, and not required to comply with KRS 371.065.

V. Conflict of Laws.

Can a creditor avoid the Kentucky guaranty statute by the simple expedient of choosing another state's law to govern the guaranty? The Sixth Circuit Court of Appeals confronted this issue in Wallace Hardware Co. v. Abrams¹⁶ involving a wholesale hardware distributor based in Tennessee that extended a line of credit to a retail hardware store located in Kentucky. In connection with the line of credit, the shareholders were asked to execute a "Guaranty Agreement," accepting individual liability for the store's debts. The agreement lacked the "maximum aggregate amount" or "termination date" as required by KRS 371.065. The agreement contained a choice of law agreement providing that it was to be "governed by and construed in accordance with the laws of the State of Tennessee." Upon failure of the retail store, Wallace Hardware sought to enforce the guaranty against shareholders of the retail store, the Abrams. The Abrams sought to renege on their promise to stand as surety for the failed business. They argued that the Kentucky guaranty statute embodied a "fundamental policy" of the General Assembly of such importance that the court should ignore the parties' choice to have Tennessee law govern their dealings.

The federal district court reviewed the prevailing Kentucky precedent on choice of law, and concluded that Kentucky courts apply their "own law unless there are overwhelming interests to the contrary."¹⁷ The lower court stated "Kentucky courts are egocentric concerning choice of law questions," and predicted that a Kentucky court would find the guaranty at issue unenforceable under KRS 371.065.¹⁸

The Sixth Circuit Court of Appeals reversed, holding that the Abrams must be held accountable to the terms of their guaranties. The Court observed: "The Kentucky statute on its face reflects the desire to protect against overbroad guaranties of indebtedness made without adequate disclosure."¹⁹ However, in the case before it, the Court found an arm's length transaction among experienced businesspersons who could not have been unaware of the implications of the guaranties they were asked to sign as a condition of the dealership. The Court of Appeals also noted that, given "the short term of the relationship," there was no claim that the obligee had unfairly "expanded the scope of the Abrams' obligations beyond that contemplated when they executed the guaranty."²⁰

The Sixth Circuit felt that the district court had overstated the provincial tendency of Kentucky courts to apply their own law. Instead, it predicted that the Kentucky Supreme Court would follow the more conventional choice of law rules set forth in §187 of the Restatement (Second) of the Conflict of Laws. Under §187, a court will respect the parties' contractual choice of law unless (1) the chosen state has no substantial relation to the parties or the transaction or (2) application of the chosen law would violate a fundamental public policy of the forum state.²¹ The Court of Appeals analyzed the policies underlying the guaranty statute and found that the statute was intended to "protect against the misuse of superior bargaining power in the context of credit transactions."²² Because the evidence in this case indicated an arms length transaction between commercial parties represented by counsel, the court concluded that enforcement of the Tennessee choice of law would not violate a fundamental Kentucky public policy. As a result, the Sixth Circuit reversed the district court, and enforced the Tennessee choice of law provision. The guaranty was clearly enforceable under Tennessee law, and the court so found.

While the Wallace Hardware case is not, strictly speaking, binding on the Kentucky courts, the reasoning does seem persuasive and correct, at least as applicable to commercial transactions. The case might not be dispositive authority as to guaranties in consumer transactions, since a court might deduce from the statute and dicta in Wheeler a compelling and fundamental public policy to protect consumers from "superior bargaining power" of the counterparties to their transactions.

VI. Open Issues.

By finding that the guaranty on a credit application pulls in all subsequent dealings, the Wheeler case gives comfort to lawyers involved in transactions with many documents, and with continuing transactions occurring after the guaranty is signed. However, is a credit application really an "instrument" as contemplated in the statute? Promissory notes and loan agreements are more typically thought of as "instruments." Also, it is possible to imagine fact patterns that would seem to compel a different result. For example, assume that the guarantor in Wheeler retires and leaves the business, and the company expands rapidly into other areas. Would the court really enforce a guaranty signed on a credit application after such a change in circumstances? It is not clear whether the Wheeler decision is elastic enough to stretch so far.

The Wheeler reasoning seems more at home with Duckett, where the guaranty was clearly a part of the distribution arrangement. Yet Duckett went the other way. Fortunately, Wheeler carries more weight than Duckett, and as an unpublished decision, Duckett is unlikely to be followed.

Wallace Hardware raised a couple of questions. The first is whether a Kentucky state court will follow the reasoning of the Sixth Circuit in applying §187 of the Restatement to the analysis of a choice of law provision in a guaranty. Hopefully, the state courts will do so. Many courts and commentators have commented on a perceived bias in Kentucky courts to apply its law, even when other states have a stronger interest.²³ Such a bias undermines the predictability of the law. It would be preferable for the Kentucky courts to confirm the interpretation of the Sixth Circuit.

The second question raised by Wallace Hardware is whether its reasoning will apply to consumer transactions. The court in Wallace noted that the guarantors were experienced businessmen dealing at arms-length. Their sophistication was a significant point in the court's conclusion that no fundamental public policy of Kentucky would be violated by enforcing the choice of law provisions. However, a consumer is arguably less able to protect himself — more subject to the kind of over-reaching, coercive commercial conduct than the Kentucky guaranty statute seems designed to address. It is possible that a Kentucky court would refuse to apply a choice of law provision in a form contract that would deprive a consumer of the protection of the Kentucky guaranty statute.

VII. Conclusion

The recent rash of cases involving the Kentucky guaranty statute was predicted for many years, and, having arrived tardily, has been helpful in counseling lenders. In most transactions, the Kentucky guaranty statute is easily navigated with the proper forms and careful planning. However, failure to appreciate the applicability of the statute risks great loss in the event a court finds a guaranty unenforceable.

____________________
¹1986 Kentucky Acts Ch. 485, § 1. APL, Inc. v. Ohio Valley Aluminum, Inc., 839 S.W.2d 571 (Ky. App. 1992).
²APL, Inc. at 575.
³1990 Kentucky Acts Ch. 38 § 1.
⁴APL, Inc. at 575.
⁵Wallace Hardware Co. v. Abrams, 223 F.3d 382 (6th Cir. 2000).
⁶Wheeler & Clevenger Oil Co. v. Washburn, 127 S.W.2d 609 (Ky. 2004).
⁷No. 5:01-CV-228-R (W.D.Ky. February 4, 2002).
⁸As an unpublished decision of a federal district court interpreting state law, this decision seems to be of little precedential value.
⁹127 S.W.3d 609 (Ky. 2004).
¹⁰Id.
¹¹Interestingly, the Sixth Circuit in an earlier case suggested that a guaranty written on a credit application would not comply with KRS 371.065. Austin Power Co. v. Flaugher, 1991 U.S. LEXIS 19409 (6th Cir. 1991). In Austin Powder, the guaranty had been executed prior to the enactment of KRS 371.065, and so did not apply to the transaction.
¹²89 S.W.3d 422 (Ky.App. 2002).
¹³Id. See also 38 Am.Jur.2d "Guaranty," §14.
¹⁴2001-CA-505 (August 27, 2004).
¹⁵Id.
¹⁶223 F.3d 382 (6th Cir. 2000).
¹⁷Id. at 381 (relying on Paine v. LaQuinta Motor Inns, Inc., 736 S.W.2d 355, 357 (Ky. App. 1987), and Harris v. Comair, Inc., 712 F.2d 1069, 1071 (6th Cir. 1983).
¹⁸Id.
¹⁹Id. at 399.
²⁰Id. at 400.
²¹Id. at 398.
²²Id. at 399.
²³See Uniform Commercial Code § 3-104 (2004 uniform text).
²⁴See e.g., Paine, 736 S.W.2d 355, 357; Harris, 712 F.2d 1069, 1071; and Leathers, Choice of Law in Kentucky, 87 Ky.L.J. 583 (1998-99).

_________________________
This article is reprinted in its entirety with permission from Consumer Finance Law, Quarterly Report, ^©2005.