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Risky business for owners your personal liability for debt
You choose a business entity at least in part to take advantage of the limited liability protections it offers. But no matter the operating form, you will inevitably be exposed to personal liability risks. Some of them are apparent, but others are latent, objectionable, and most important, avoidable.
The personal guaranty is often an afterthought in today’s credit facility. Anybody who has sought commercial financing in the last few years knows the owner’s guaranty is essentially a boilerplate on every bank’s term sheet, often buried in a bullet-point well below the terms that seem most material at the time, like interest rate, credit limit and term. However, lenders can have a very broad viewpoint of what that “Personal Guaranty of Principals” means. Further, you need to clarify what it means before executing the likely one-sided guaranty form the bank puts in front of you.
Consider the following issues:
Are there any limits? Guaranties can either be limited or unlimited. Limited guaranties can take a number of forms, most often limiting liability to either a specific dollar amount or a percentage of the outstanding indebtedness. However, even limited personal guaranties often provide that the limitation only applies to the principal indebtedness and that the guarantor’s liability for interest, costs and other fees (including the bank’s attorney fees) is unlimited.
Guarantying payment or collection? If there is ever an issue with the credit, you want the bank to be required to first look to the collateral supporting the debt for repayment before pursuing you for any deficiency. This is referred to as a guaranty of collection. However, the bank wants the option to pursue the guarantor for repayment without having to look to the collateral. That’s called a guaranty of payment. Here we have a frequent source of serious disconnect between bank and business owner. Also, pursuing the guarantor without first liquidating the collateral is a tactic lenders have been using to pressure principals of borrowers in negotiations, especially in commercial real estate credit matters. Negotiate for a guaranty of collection up front. You’ll give yourself additional leverage and reduce your exposure if things deteriorate.
Is this thing ever going to go away? It’s also important to understand what you are guarantying. You might think of yourself as guarantying a specific debt, but most bank guaranty forms actually provide that you’re guarantying any and all indebtedness of the borrower to the bank, whether they exist at the time of the guaranty or arise after the fact, and whether the debt relates to the guarantor or to the contemplated credit. This can cause you to unintentionally guaranty an obligation without even being aware of its existence or even if it arises years later, after you no longer own the company. To protect against this risk up front, if possible make sure your guaranty is specifically limited at execution to only the then-contemplated indebtedness. In addition, although this will not relieve you of any outstanding liability, you can generally give the bank written notice that you are terminating a guaranty in order to eliminate any additional exposure.
Have I waived my rights to my firstborn, too? Standard bank guaranty forms contain very broad waivers. Many even state that the guarantor waives every right and defense possible, the sole exception being payment in full of the guarantied obligations. These waivers can substantially impair your ability to negotiate a resolution to your guaranty at a later time and can be especially problematic if you’re not active in the day-to-day operations of the business. If possible, avoid waivers of rights to notice or to raise defenses.
Can you put that in writing? Before taking action to enforce its rights under a guaranty, a bank usually transfers internal responsibility for a credit to its special assets group. This group is tasked with managing credits the bank has determined to be high risk. As a result, if there is ever an issue with an understanding on a guaranty, you will likely no longer be dealing with your loan officer, but with a special assets officer instead. This means that if you and the lender agree to any modifications to the guaranty up front, you must make sure they’re well-documented. You don’t want any misunderstandings down the road, when someone else is handling the matter for the bank.
Can you guaranty bad boys? The bad-boy guaranty is a tool lenders are using more and more often. With very few exceptions, such guaranties have been enforced by courts. A bad-boy provision triggers a springing guaranty liability if the debtor violates certain covenants in the loan documents. These are usually covenants structured to compel debtors to act in the best interest of the lender and the collateral. They typically prohibit activities that may pose special risks to creditors — for example, placing additional liens on the collateral or filing a petition for bankruptcy. The concern with bad-boy guaranties is that they have generally been specifically enforced by courts, even when the alleged breach has been unintentional, has been undone, or has had no material negative impact on the lender. Make sure you review your loan documents prior to execution to identify and address any possible springing liability.
Is it too late? Many guarantors do not focus on the issues noted here until their lending relationship is stressed. Even then, although it’s certainly more difficult, it’s not too late to minimize or reduce guarantor exposure. Many forbearance agreements and loan renewals (whether distressed or not) include modifications to guaranty terms.
Robert D. Wolford is part of Miller Johnson's Bankruptcy-Creditor/Debtor Rights practice group and is vice-chair of the firm’s business section. He can be reached at firstname.lastname@example.org