One of the trickiest issues we deal with in business control disputes relates to the impact and management of personal guaranties on the part of the individual shareholders/members. A personal guaranty can be an impediment to a transaction among the shareholders consolidating ownership, an impediment to the withdrawal of a shareholder/member, or even a trigger of default under the terms of financing agreements in place between a business and its bank. Managing the impact and expectations of business owners as to a personal guaranty should be considered in the early stages of any potential transaction.
In nearly every small business banking relationship, the bank requires personal guaranties on the part of business owners. Personal guaranties, often even the more overbearing “spousal” personal guaranties, are the norm. Of course, the purpose from the bank’s perspective is to increase the level of security against repayment. The individual terms of the personal guaranty are governed by the language of the agreements.
The net effect of a personal guaranty is to, in effect, pierce the corporate veil and render the guarantor liable for the debt to the bank (or other creditor party to the guaranty agreement). In this way, not only does the bank obtain another source from which it can recover, but also dramatically impacts its practical bargaining power. Often we see shareholder agreements including and incorporating indemnification provisions which reference those situations in which a shareholder/member has guarantied an obligation to a lender. The value of such indemnification provisions is suspect given that the bank is always going to look to the path of least resistance to recover the extent of its obligation. In a guaranty the company is the primary obligor to the creditor. It is the primary obligor’s default which leads to exposure under a personal guaranty. In that instance, the company is not likely in a position to indemnify as its assets are likely devoted to the repayment of the primary guarantied obligation.
The best and most frequent approach to a personal guaranty in a business control dispute is to secure the release of the guaranty by the bank or other creditor as part of the transaction. Certainly, if the debt is retired in a third party sale, accounts are closed and the issue is moot. Not necessarily so in an ownership consolidation transaction involving a transfer among existing owners or members, or where one or more shareholders/members leaves the business. In that case, the business may continue and banking relationships may remain unmodified. The bank is not required to release the guaranty. Even further, under certain circumstances and agreements, a transaction may constitute an event of default of the credit arrangement. Management of the personal guaranty becomes an important part of the deal.
It is obviously always better to secure a release of a guaranty contemporaneous with a transaction. If that course of action is unavailable, indemnity is the only other option. In such cases, indemnification should flow from both the company and individuals as, if the guaranty is ever an issue, it is likely the Company’s ability to pay in the first place, which gives rise to creditor’s pursuit of the guarantor.