The Danger of Giving your Personal Guarantee

In order to support a borrowing request, the directors of a limited company may offer to provide personal guarantees. What issues should you be aware of when taking these guarantees and how would you address any concerns?

The support for guarantees provided by directors has changed a lot since the early days of banking. Whilst it used to be acceptable for a level of trust and a personal relationship to be enough for security for a bank, these days the directors need to provide a host of supporting evidence to show the worth and validity of their personal guarantee. Formal procedures are in place that mean that subjective information about a client is less important than their financial records and evidence to support their personal guarantee (Newton, 2000, pp. 177-181).

The primary goal for the director to put forward personal guarantees is to reduce credit risk for the bank and therefore gain better credit. Therefore, when taking the guarantee the financier will look for signs that if the debtor’s assets are insufficient to meet all of the creditor’s claims that they can recover some or all of the payment from the item secured through the personal guarantee. There is risk on both sides of the personal guarantee – the director is putting themselves at risk by putting forward something they personally own, and therefore if the business fails they stand to lose their security. For the banker, they must establish that the guarantee is sufficient to cover the risk being put forward by the bank, and of enough value that they will be able to claim a significant portion of their outlay back should the debtor be unable to make payment (Goode, 2003, pp. 1-3).

When taking a personal guarantee, the director of the company needs to be aware of a number of issues. Firstly, they need to understand that whilst the business may have limited liability, if a personal guarantee is offered as security then this can be claimed by the creditor and taken for payment of debt. Therefore, the liability is not as limited anymore for the director who issues a personal guarantee. With personal guarantees usually coming in the form of personal capital assets such as property, it can be extremely damaging to put forward such a guarantee if things are likely to go wrong.

Financiers should be aware that it is generally businesses with a higher risk factor that put forward personal guarantees in order to offset the risks. This means that whilst security is being offered, the overall risk of the business failing is still potentially high. Whilst banks need to look out for their interests, it should also be clear that they should not enter into agreements with directors whose personal guarantees are not sufficient to offset the risk of potential business failure (Lloyds TSB, 2008).

A financier should first look at the business of the director and the potential risk of financing such a venture. Once this has been looked at, it is also important to make sure the director has in place protection from liability and has taken steps to avoid personal liability. This might include liability insurance and full health and safety precautions. This will reduce the risk of liability for the director and therefore make them less risky as a debtor. Although the business may be free of liability, as a financier it is prudent to have a personal guarantee from the director so that they have more of an incentive to repay the loan and make the business succeed.

Most of us, if put in our lender’s shoes, would want the same thing. Our lender wants to make sure we have every incentive to repay the loan, including (and maybe most importantly) the risk of personal liability. A lender’s hook into the personal assets of the business borrower is an important part of the deal for the lender and, even in good times, it can be difficult to avoid signing a personal guaranty. Once the guaranty is signed, life is never quite the same again. Being personally liable for a business debt brings cold hearted reality to every business dream (Hassett, 2008).

The financier should also be concerned with what exactly the debtor is offering as a personal guarantee. There needs to be documentation to ensure the security behind the guarantee is of sufficient value and that it is owned by the debtor. Items of security that are joint-owned may be more difficult to claim against for the creditor, so it is generally preferred that securities are solely owned by the director.

It is important that the debtor and creditor agree on the limits of the personal guarantee. Whilst a financier may want no limits to the guarantee, the director should look for a limit equal to their share within the company. This means that if there is more than one director in the company, the debtor offering a personal guarantee will only be liable for debts on their portion of the company. The length of the personal guarantee should also be looked at in terms of how long it will act as security. As debts reduce the debtor and creditor should have an agreement whereby security is removed once the debtor is established as a reliable borrower (Hassett, 2008).

What are the key areas of concern for the bank in the control, monitoring and perhaps ultimate realisation of such security?

There is a balance to be had in personal guarantees between the security or collateral being offered and the monitoring of the individual offering the guarantee. Whilst the collateral may be sufficient to cover debts, banks should not put their faith in just the security. Careful monitoring of the individual offering the personal guarantee and their company is important to make sure that they are able to repay their creditors and that the likelihood of foreclosure is small. Relying too much on the security offered will result in a loss of money for the bank and potential lending to debtors who are unable to pay. The risk-reduction offered by security from the personal guarantee is not a substitute for monitoring of credit and business of the debtor (Ono and Uesugi, 2005, pp. 1-2).

Monitoring is also important because of the need to make sure directors are acting appropriately and legally within the company. If monitoring of their practices does not occur then their conduct could lead to debts that cannot be covered by the personal security offered. Although liability insurance should cover directors against negligence and breach of security, such actions may lead to a loss for the bank when other creditors look to claim against security (Finch, 1994, p. 880).

If the monitoring is accurate then the banks can help the debtor to improve the situation and rescue the business before it fails so that the debtor can continue to make repayments. Most banks will only claim against security as a last resort because they are likely to lose money this way. Instead, a rescue package may be put in place to aid the debtor and help the bank recover debts in the long-term (Franks and Sussman, 2000, pp. 1-6).

Banks will generally remain risk-averse though, particularly to small businesses and this is why personal guarantees need to be offered in order to secure funding (Keasey and Watson, 1994, p. 349). However, the risk involved usually means that banks are keen to make sure they can secure the claim against the debtor in the future if necessary. This is why it is important for the creditor and debtor to agree on a time limit for the security. As the economy worsens, banks are now trying to claim against directors who gave personal guarantees but have since left companies.

This can be the fault of the debtor for not securing a time limit, or the fault of the creditor for not monitoring the debtor. Once they have left a company it could be harder to secure the claim against the personal guarantee. A bank will look to recover the debt in any way possible if the debts are not being repaid. As personal guarantees are separate from their actual mortgage or business agreements, unless a debtor is released from the personal guarantee they can even sell the business and still be liable for future debts as they are still the guarantor (Cranage, 2008).

In this case it is the bank that should advise debtors more accurately and monitor the business so that if they need to claim against a personal guarantee there are no problems with regards to a debtor having left the company. A bank should also make sure that they follow procedures when signing the guarantee so that it can be claimed against if needed. Any alterations to the agreement, misrepresentation on the part of the bank, coercion by the bank or non-disclosure of information will void the agreement and the bank will not be able to claim against it. It is important to make sure these steps are followed so that a debtor cannot remove themselves from their obligation because of such procedural failures (Goodman Derrick, 2002).

Banks generally have a great deal of control over restructuring or liquidation of a company should the debtor fall behind with repayments. This means that recovery against the personal guarantee is not generally a problem for the bank. However, it can be made easier or not required if monitoring is improved and there is less of a reliance on recovery against the guarantee in the eventuality of business failure (Franks and Sussman, 2005, pp. 85-92).

The most important factors for the bank to consider are the monitoring of the director before an agreement is signed, and the way in which the agreement is eventually agreed. If these procedures are followed then the bank will only be taking on clients whose risk of default is lower, and the accurate monitoring will make sure that the debtor remains on course to pay debts and claiming against the guarantee will not be necessary.

Most banks have different policies and contracts with regards to how the personal guarantee is set up, so it is important for the bank to accurately and openly describe the process and the meaning of the contract to the director. If this is not done properly then it will be much harder for the bank to claim against the guarantee, because a claim cannot easily be made if the debtor was not accurately informed of the nature of the agreement they were entering (Tuller, 2007, pp. 144-146).

Once a document is signed and the debtor and creditor are fully agreed on its terms, then monitoring of the business situation and personal assets of the debtor is still crucial. The bank needs to make sure that the business is performing sufficiently for the debtor to continue payments, and also that the security offered in the personal guarantee is still intact and of sufficient value to be used as security. This monitoring will allow the bank to see any problems before they become too serious and hopefully correct them so that the debtor can continue to make payment (Steingold, 2008, pp. 13-19).

However, should this not be possible, as long as the agreement is carried out correctly then claiming against the personal guarantee will not be a problem for the bank. They have control because of this personal guarantee, and therefore even if the business fails the bank should be able to recover a significant portion of the outstanding debt by claiming against the personal guarantee and the assets of the director mentioned in this agreement (Keay, 2005, pp. 431-437).

Monitoring is also important because even if the guarantee cannot be claimed against because of procedural issues, if the debtor’s business enters insolvent liquidation due to wrongful trading then the creditor can make a claim against the director to contribute to the outstanding debts from their personal assets. Although this is an extreme measure, it shows that monitoring is the most important factor for a bank in making sure they secure a personal guarantee correctly and that foreclosure is avoided. However, if foreclosure is required then accurate monitoring will allow the bank to recover as much of the outstanding debt as possible.

Bibliography

Cranage, J., 2008. The Danger of Giving Your Personal Guarantee. Birmingham Post, August 7th 2008.

Finch, V., 1994. Personal Accountability and Corporate Control: The Role of Directors’ and Officers’ Liability Insurance. Modern Law Review, 57, p. 880.

Franks, J., and Sussman, O., 2000. The Cycle of Corporate Distress, Rescue and Dissolution: A Study of Small and Medium Size UK Companies. World Bank Study. Available at: https://www.worldbank.org/wdr/2001/wkshppapers/berlin/frankssuss2.pdf

Franks, J., and Sussman, O., 2005. Financial Distress and Bank Restructuring of Small to Medium Size UK Companies. Review of Finance, 9(1), pp. 65-96.

Goode, R.M., 2003. Legal Problems of Credit and Security. London: Sweet and Maxwell.

Goodman Derrick., 2002. Personal Guarantees. (Online). Available at: https://www.goodmanderrick.co.uk/news/documents/Personal_Guarantees.pdf (Accessed 26th October 2008).

Hassett, T., 2008. The Personal Side of Personal Guarantees. (Online). Available at: https://www.felhaber.com/ARTICLES/personal_guarantees.html (Accessed 25th October 2008).

Keasey, K., and Watson, R., 1994. The bank financing of small firms in UK: Issues and evidence. Small Business Economics, 6(5), pp. 349-362.

Keay, A., 2005. Wrongful Trading and the Liability of Company Directors: A Theoretical Perspective. Legal Studies, 25(3), pp. 431-461.

Lloyds TSB., 2008. Becoming a company director and your responsibilities. (Online). Available at: https://www.lloydstsbbusiness.com/support/businessguides/becoming_a_company_director.asp (Accessed 24th October 2008).

Newton, L., 2000. Trust and virtue in English banking: the assessment of borrowers by bank managements at the turn of the nineteenth century. Financial History Review, 7, pp. 177-199.

Ono, A., and Uesugi, I., 2005. The Role of Collateral and Personal Guarantees in Relationship Lending: Evidence from Japan’s Small Business Loan Market. RIETI Discussion Paper Series 05-E-027. Available at: https://www2.warwick.ac.uk/fac/soc/wbs/conf/int-sme-finance/programme/6_-_ono.pdf

Steingold, F., 2008. Legal Forms for Starting & Running a Small Business. Nolo.

Tuller, L.W., 2007. Finance for Non-Financial Managers: And Small Business Owners. Adams Media.

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