The Anatomy of a Loan Transaction: Preventive Care for Guarantors
Businesses of all types and sizes and across all industries utilize capital provided by lenders to support their operations. The basic premise of a loan transaction is always the same: the lender makes a loan to the borrower and the borrower agrees to repay the loan with interest. From the lender’s perspective, the primary goal is to reduce the risk that the loan is not repaid. To accomplish this goal, the lender usually secures the borrower’s promise to repay with property of sufficient value (i.e., collateral). The lender may also seek a personal guaranty of payment from the owners of the borrower (i.e., a personal promise to pay the debt of the business).
Especially for closely held businesses, the lender will often require collateral from the business and a personal guaranty from the owner (or owners). The premise is that often times, in a closely held business, the owner of the company is the business. That is, without the day-to-day efforts of the owner, the business could not operate and, therefore, the risk to the lender is greater. For those businesses where the owner’s direct efforts are required for the business to continue as a going concern, the lender will want assurances that the owner is committed to maintaining those efforts, at least until the loan is repaid, and that the owner will not just "walk away" if the business is failing.
Unfortunately, the requirement for a personal guaranty is contrary to many asset protection measures taken by the owners of closely held businesses. For example, a common asset protection strategy used is the formation of a limited liability entity to own and operate the business. A properly formed and maintained limited liability entity protects the owners of the business from individual/personal liability for the debts and obligations of the business. In other words, if the business fails, the owners will lose their respective investments in the business, but not their homes, cars, or other personal assets. An owner’s personal guaranty, however, effectively eliminates the protection of a limited liability entity (at least with respect to the lender to which the guaranty is given), and allows the lender to pursue the owner and, ultimately, the owner’s assets if there is a default on the guaranteed debt.
Although our advice is to always engage competent legal counsel in matters of significance to the business, our experience is that many, if not most, small business loans are implemented without legal representation of either the lender or the borrower. In such cases, lenders use standard loan documents that invariably contain very broad provisions intended to protect the lender, but which may not be appropriate or necessary for the specific transaction.
We typically see three primary concerns with the guaranties used in standard loan documents, particularly those that are not negotiated. First, many guaranties provide that in the event of the death of a guarantor, the loan automatically becomes due. Such a provision may be overly broad when multiple guarantors are present or when replacement guarantors are available. Second, guaranties typically provide that the guaranty is unlimited in amount and duration. That is, the guaranty will continue indefinitely until all of the indebtedness of the borrower (including future debts) is paid in full. Third, if the loan transaction involves more than one guarantor, the liability of the guarantors will typically be characterized as joint and several (i.e., each guarantor is liable for the total amount of the indebtedness regardless of the number of guarantors).
These standard guaranties can be problematic for an owner of a closely held business. For example, if a guaranty is unlimited and continuing, an owner may not be able to exit from the business when desired without remaining liable for debts of an entity he or she no longer controls. In addition, some guaranties, by default, place limitations on the guarantors’ ability to sell personal assets or incur debts or grant liens. In many instances, these provisions are overly broad and, if enforced literally, could prevent a guarantor from obtaining personal credit (i.e., home loan or auto loan) or selling personal assets, or might give rise to inadvertent events of default as to the underlying loan. A lender is justified in contractually prohibiting a guarantor from impoverishing himself or herself, but if a guaranty is necessary, a well-crafted guaranty can make a distinction between such conduct and normal course activities, and can further be drafted to address the primary concerns noted above without negating the security sought by the lender.
In conclusion, lenders and borrowers should both understand that credit arrangements involving a closely held business give rise to a number of issues not found in loan transactions with larger companies. For many valid reasons, lenders do, and sometimes must, require personal guaranties. However, where the circumstances warrant, lenders and borrowers should consider whether a guaranty can be limited or, in the right circumstances, eliminated entirely. A multitude of factors impact this decision, such as the size of the loan, the borrower’s expectation for pricing, the number of owners/guarantors and whether they are critical to the continued operation of the borrower’s business, the value of collateral, the credit risk tolerable by the lender, the strength of the underlying business enterprise, etc. Careful drafting of loan documents and willingness to avoid the "one size fits all" form is imperative for both lenders and borrowers. Engaging competent legal counsel, experienced in structuring such loan transactions, can add significant value whether you are the lender, the borrower, or the guarantor.
By Richard D. Vroman and Matthew J. Speiker