Personal Guaranty Loopholes
Obtaining financing is one of the biggest challenges facing business owners. Virtually every bank will require a personal guaranty before it agrees to approve a loan to your business. In the event that you default on the loan, lenders will always attempt to collect on a personal guaranty. Let’s look at what a personal guaranty is and some loopholes that might help a guarantor avoid personal liability.
What is a personal guaranty?
A guaranty is personal a promise to pay a business debt. The guarantor is the person making the promise. The guarantor is often the person who needs the loan, but the guarantor can also be someone other than borrower (often called a “third party”) that promises to make payment on behalf of another.
What liabilities are you assuming when you sign a personal guaranty?
When you sign a personal guaranty on behalf of a business, you agree to be personally responsible for repaying that debt from your personal assets if the business later fails to pay the loan. In the event of default, the lender will file suit against the business and the guarantor to collect the debt. If the bank cannot recover the balance of its loan from the assets of the business, it will sue the guarantor personally for the remaining balance. In other words, when you sign a personal guaranty in order for your business to receive a loan, you pledge your personal assets as collateral, including your home, the cash in your personal checking account, your savings and investments, and your future wages, which the bank can try to garnish.
Must the lender sue the business before the guarantor?
No. Most commercial guaranties do not require that the lender sue the borrower first. Most commercial guaranties provide that the guaranty is a guaranty of payment and not a guaranty of collection. As such, the lender has no obligation to attempt to collect from the borrower first. Often, the lender will file suit against the business and guarantor simultaneously.
Limited Recourse
Limited recourse loans are similar to full recourse loans but limit the amount the lender can recover from the guarantor to a specific dollar amount or percentage of the loan amount.
Non-Recourse
Under non-recourse loans, the guarantor is not generally responsible for losses the lender incurs, unless they commit certain bad acts; such as fraud, waste, damage or destruction, misapplication, misrepresentation, bankruptcy, or environmental contamination. These bad acts are generally known as non-recourse carveouts. If a borrower under a non-recourse loan is unable to make its monthly payments or pay off the loan at maturity, they can give the property back to the lender without the guarantor having to repay the loan and the lender’s losses so long as they have not violated one of the non-recourse carveouts.
How do you limit your liability as a guarantor?
Personal guarantees are a critical aspect of most business loans, so entrepreneurs and business owners should familiarize themselves with ways to limit their personal liability. This is especially true for guarantors who have a minority ownership interest in the business that is the borrower. Minority owners have little control over how the business spends its money and whether it pays the business loan.
Get an agreement with the business concerning payment of the loan.
For minority owners signing a guaranty, this important issue cannot be overlooked. Minority owners typically lack control over business decisions, including how revenues are spent and which debts are paid first. If you guaranty a business loan, its important to have a written agreement in place that requires the business to prioritize paying the loan that you guaranty ahead of all other expenses, including payments to owners. You will also want the business to sign an indemnity agreement entitling you to be paid back from the business for any amounts you are required to pay to a lender on a guaranty.
Get a contribution agreement from co-guarantors.
If there are multiple guarantors, its important to understand that you could be required to pay the entire debt off, not simply your ”share” of the debt. The guaranty means that the lender call collect the entire debt from any single guarantor without seeking contribution from other guarantors or the business. If you end up paying all or a substantial portion of the debt, you’ll want to seek contribution from your fellow owners. The law may entitle you to repayment, but contribution rules can be unclear and vary from state to state. Guarantors should also be mindful of the federal income tax implications of their contribution obligations, especially for the ability to allocate losses of a
borrower that is a partnership or a limited liability company taxed as a partnership.
Consider a limited guaranty
It is not uncommon for some or all guarantors of a loan to guarantee only a part of the loan amount. Such guarantors are referred to as “partial guarantors” to distinguish them from “full guarantors,” whose guaranty liability is for the full amount of the loan. Here are three types of limited guaranty obligations.
Limited Recourse Loans
Limited recourse loans are similar to full recourse loans but limit the amount the lender can recover from the guarantor to a specific dollar amount or percentage of the loan amount.
Non-Recourse Loans
Under non-recourse loans, the guarantor is not generally responsible for losses the lender incurs, unless they commit certain bad acts; such as fraud, waste, damage or destruction, misapplication, misrepresentation, bankruptcy, or environmental contamination. These bad acts are generally known as non-recourse carveouts. If a borrower under a non-recourse loan is unable to make its monthly payments or pay off the loan at maturity, they can give the property back to the lender without the guarantor having to repay the loan and the lender’s losses so long as they have not violated one of the non-recourse carveouts.
Guaranty of collection
The Guarantor guarantees to the lender full collection of all monies payable by the borrowing business to the lender. However, this guaranty is limited and conditional in that it is a guaranty of collection only and the guarantor is obligated to make payments only after the lender has reduced its claims to judgment and execution on the judgment has been returned unsatisfied (by the business). An additional limitation would be that to the extent the loan is secured by any property of the Company, the Guarantor is not obligated to make payments unless there remains a balance outstanding under the loan after all such collateral has been liquidated and the net proceeds applied to the loan.
Can a personal guaranty be revoked later?
An otherwise valid and enforceable personal guarantee can be revoked later in several different ways. A guaranty, much like any other contract, can be revoked later if both the guarantor and the lender agree in writing. The guaranty can sunset after passage of a certain period of time or not be valid above a certain amount. Some debts owed by personal guarantors can also be discharged in bankruptcy.
Many factors can affect the enforceability of personal guarantees. If you have any questions about the enforceability of a personal guaranty that you have signed, or if you are considering signing one to get financing approved, please consult with one of our experienced Pennsylvania business law attorneys who will assess your case and offer thoughtful legal guidance to support your decision.