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Personal Guaranties;
What Small Business Owners Should Know

by Joe F. Kolb

 

            As a small business owner, it’s likely you’ve been asked to sign a personal guaranty agreement.  If not yet, you will be. Personal guaranties are staples of small business financing.  Consequently, it’s to your benefit to know a few things about them.

            Here are four questions to ask.  First, exactly what is a personal guaranty?  Second, what is the extent of your liability under a personal guaranty? Third, what happens if the principal debtor on a loan you guaranteed defaults? And fourth, is there any way to limit your liability under a personal guaranty?  The answers to these questions are important. Why? Because it’s your personal assets on the line – your home, your car, your checking account – not just your business assets. 

            Okay then, what is a personal guaranty?  Simply put, it’s a contract between you and a creditor which obligates you to pay the debt of another if that other person (or entity) defaults. The example most familiar to small business owners is: your company needs money to grow; a lender agrees to give your company a loan if you’ll sign a personal guaranty.  The guaranty pledges your personal assets for the repayment of your company’s loan in the event your company defaults.

             What is the extent of your liability under a personal guaranty?  It can vary. But in the end, your liability is whatever the agreement says it is.  It’s important, therefore, to read and understand what you’re signing. Most agreements drafted by lenders are very broad and are written in terms very favorable to the lender and not so favorable to the guarantor.  A typical guaranty reads something like this:

 

 “you unconditionally guarantee the full and prompt payment of any and all indebtedness of the debtor to the lender of every kind and nature whether now existing or hereafter created, including any modification, extension or renewal thereof...”

 

Read that again giving emphasis on the words in italics.  Scary, right?  Under this provision, if your company defaults on a loan you guaranteed, the bank may look to you to pay from your personal assets the full debt your company owes the lender.  The “full debt” generally includes accrued interest, costs of collection, attorney fees and a myriad of other charges – often thousands of dollars more than just the principal that’s owed.  And, under this provision, your guaranty would apply not just to the debt owed to the lender at the time you executed the guaranty, but also to any debt or loans which may arise in the future as a result of some transaction not contemplated by you at the time you signed the guaranty.

            So what happens if the principal debtor defaults on the underlying loan? Again, it will depend on the terms of your guaranty agreement. But, absent a specific provision to the contrary, a lender may choose to pursue collection first from the assets of the principal debtor, or from your personal assets, or from both, either sequentially or simultaneously.  In other words, a lender generally is not required to first exhaust its remedies against a principal debtor before it seeks collection from you.  That means you could end up losing your house while the principal debtor gets off scot-free.

            Is there anything you can do to limit your liability under a personal guaranty?  Yes.  Arkansas courts recognize that a guarantor may limit his liability under a guaranty agreement by whatever conditions he and a lender may agree upon.  If the lender later fails to comply with those conditions, it will be barred from seeking recourse against the guarantor.  Where a guarantor attaches a certain condition or conditions to his agreement, the failure of the creditor to strictly comply with any condition invalidates the guaranty.

             Of course, you may not always have the bargaining power to demand more favorable terms from a lender. But it is completely within your rights to ask for certain limitations or conditions.  Examples would be terms that would:

 

  • Limit the guaranty to a set dollar amount
  • Limit the guaranty to a specific loan or transaction
  • Require notice to you of, and approval from you for, any modifications, renewals or extensions of the debt guaranteed
  • Require notice to you of any default by the principal debtor
  • Require the lender to exhaust all its remedies against the principal debtor before it has a right to recover from your personal assets
  • Require the lender to disclose to you pertinent facts it knows affecting the risk you are undertaking including, but not limited to the financial condition of the principal, any confidential or secret agreements between the parties, and all relations of the creditor and third parties to the principal

           In addition, you should think twice about signing any guaranty with a “waiver of defenses” clause – a provision by which you waive “any and all defenses of any kind or nature” which you may have against the creditor.  The effect of such a clause is to strip you of any right you may have now – or you may have in the future – to argue that the lender should not be allowed to enforce the guaranty against your assets. Arkansas courts have held that such a clause is enforceable even in a case where it appears that the lender may have done something that would otherwise render a guaranty agreement unenforceable.

             So what are the take-ways?  (1) As with any contract, read a guaranty agreement and know what you’re agreeing to before you sign it. (2) Don’t be shy about asking the lender for terms that will limit the amount, extent, or duration of your liability under the agreement. And, (3) avoid signing a guaranty with a “waiver of defenses” clause.  

             Taking these three simple steps before you sign on the dotted line could save your personal assets from the auction block.