The Ins and Outs of Personal Guarantees
January 25, 2005
The old saying, “where you sit is where you stand” is especially applicable in the situation of personal guarantees. At different points in time, most business owners will both be a creditor and debtor. And as such, they will grow to have a love/hate relationship with the personal guarantee. They will love them when they are the creditor, and hate them when they are the debtor.
A personal guarantee is a promise by a person (Guarantor), usually a shareholder, to become personally liable for the debt of the corporation. If the corporation cannot pay its debts, and its assets are not worth enough to cover the debt, the Guarantor risks their personal assets being attached and seized by the creditor of the corporation. This exposure can also occur not only when the corporation cannot pay their debt, but also when they refuse to pay their debt. Once the corporation defaults on its obligation to a creditor, the creditor may choose to enforce the guarantee, as opposed to filing a lawsuit against the corporation.
Although shareholders are the owners of the corporation, the corporation itself is recognized as an independent entity under most laws. As such, although a person may be a majority shareholder, or a sole shareholder, the corporate structure does provide a level of liability protection. Typically, the corporation enters into all legally binding contracts and agreements, whether it is for purchasing goods and services or financing arrangements. In the event one of these contracts should be breached, the liability belongs to the corporation. However, if the shareholder executes a personal guarantee, they will be jointly and severally liable for the corporation’s obligation.
As a general rule, creditors cannot seize a shareholder’s personal assets to pay business debts, unless the shareholder specifically gives up that protection. Unfortunately, most small business owners are forced to give up their right to limit their personal liability, especially when entering into credit facilities. Many creditors require personal guarantees from the shareholders of a corporation before they will loan money or extend credit to the corporation. In addition, it is becoming more common place for landlords to require a personal guarantee before they lease commercial property to a corporation.
It wasn’t too long ago that the corporate form was reserved for the General Electrics and Ford Motor Companies of the world. Today, however, businesses that were formerly run as sole proprietorships are taking advantage of the corporate form. The vast majority of the readers of this article are either closely held corporations or, at a minimum, deal with closely held corporations everyday. As such, if you have not had to navigate the world of personal guarantees, it is “guaranteed” you will in the future.
The shareholders of most corporations are required to execute personal guarantees when they seek to obtain financing from a lending institution. While it is always best to attempt to negotiate the credit facility without executing a personal guarantee; being that most lending institutions require them, the small business owner most often must execute a personal guarantee in order to obtain financing. However, each shareholder may still be able to limit their liability via a limited personal guarantee. For example, if a corporation has three shareholders and they all sign personal guarantees, they are each liable for the whole debt. Some lending institution will allow shareholders to execute limited personal guarantees, which only require each shareholder to be liable for their respective interest in the corporation. In the preceding example, each shareholder would only be responsible for one-third of the debt. Most borrowers determine which bank they borrow from based on who has the lowest interest rate. If a bank will extend credit without the execution of a personally guarantee, this may be worth paying a higher interest rate. This decision, however, must be made on a case by case basis.
In addition to personal guarantees becoming common place in the banking industry, there has been an emergence of personal guarantees in business to business relationships. Most businesses purchase goods, supplies and/or materials via credit facilities with other businesses. As a general rule of thumb, if you are allowing another entity to gain possession of your goods on credit, always get a personal guarantee. While it is impossible to run a business without taking some risks, you must always consider the possibility that this debt will go unpaid and you will have to seek legal recourse, and hedge your risks accordingly. With the modern trend of under funding corporations and having the vast majority of the income generated by the corporation being held personally by the corporation’s principles, should you be it successful in a lawsuit against the corporation, your judgment may go unsatisfied. Something to keep in the back of your mind is that a judgment is merely a piece of paper. What is important is to be able to collect on that judgment.
In short, if you are a creditor it is always better to have a personal guarantee. If you are debtor, it is always best not to have executed a personal guarantee. While the reality of the market place will not always make this possible, it should none the less be sought. As stated before, in dealing with personal guarantees, where you sit is where you stand.
Adam J. Basch, Esquire, is an associate with Bacon & Wilson, P.C. He is a member of the Litigation Department with expertise in the areas of construction litigation, personal injury, general litigation and creditor representation. He can be reached at 413-781-0560 or [email protected].
by: Adam J. Basch, Esq.
BusinessWest
December 2004