By R. David Weber, Esq.
(The Goering Center recently published this article in its March 2018 eNewsletter.)
Your business is growing, and you are hiring to meet increased demand. To accommodate your new employees, you must purchase more office furniture, new computers, and upgrade the telephone system and computer server. To finance these necessary capital improvements, you approach your trusted lender to seek a business loan. Your lender is happy to extend the loan, however, there is one “small” condition: the lender wants you, as the business owner, to personally guarantee the loan. What does this mean, and what should you do?
A personal guaranty is a written promise to pay the debt of another. Personal guaranties work to effectively sidestep the limited liability protections of incorporating your business or registering it as limited liability company. If you personally guarantee a business loan or line of credit, you are promising repayment out of your personal assets if your business cannot meet its obligations.
Guaranteeing a business loan with personal assets, including your home, vehicles, and bank accounts has risk. However, many times, a lender will not lend to a business without a personal guaranty. Given this reality, what can business owners do to protect themselves?
Seek to Limit the Scope and Duration of Personal Guaranty
While saying “no” to the personal guaranty typically ends the negotiations, other counterproposals may not. If possible, try to limit the dollar amount, duration and scope of the assets covered by the personal guaranty. In addition, always be wary of guaranty terms which make you personally liable for the lender’s attorney’s fees and expenses if the lender initiates collection efforts against your business. While a lender may not be willing to negotiate on all of these key points, winning just one or two concessions can make a significant difference if the lender ever attempts to enforce a personal guaranty.
Understand your State’s Relevant Laws
In all states, including Ohio, personal guaranties must take the form of a clear and unambiguous writing. Any personal guaranty that is not in writing will generally be unenforceable.
Kentucky, however, places additional restrictions on personal guaranties. In Kentucky, a personal guaranty will only be enforceable if it: (1) is written on the document it guarantees; or (2) expressly refers to the document it guarantees; or (3) is signed by the guarantor and specifies the guarantor’s maximum liability and the personal guaranty’s termination date. Any personal guaranty that does not comply with these requirements is generally unenforceable in Kentucky.
Because of Kentucky’s strict statutory requirements regarding personal guaranties, lenders will often try to ensure that another state’s laws will apply by inserting a “choice of law” clause into the personal guaranty. While many courts will enforce these clauses, there are exceptions, especially when all parties are located in Kentucky and the personal guaranty was signed in Kentucky. Ensuring that Kentucky law applies when possible will typically add some measure of protection versus other states’ laws.
Finally, Kentucky permits married couples to title real property in such a way that protects the real property from creditors of an individual spouse. Thus, if one spouse signs a personal guaranty, real property titled “by the entirety” is typically protected as long as the couple remains married.
Look to Other Owners of the Business
If a lender asks you to sign a personal guaranty, but your business has more than one owner, consider asking the other owner(s) to also sign the guaranty. Alternatively, you could execute an indemnification or contribution agreement in which you agree to sign the personal guaranty in exchange for the other owners’ agreement to reimburse you should your personal assets be tapped to pay a business debt. Either arrangement ensures that each owner of the company shares in the risk of the transaction. Be careful, however, if your spouse is one of the other owners of the business. In that case, it is generally not advisable to have both spouses sign a personal guaranty, even if real property is titled by the entirety.
Beware of Cognovit Provisions
A cognovit provision, which lenders may add to a promissory note or a personal guaranty, operates to cut off a debtor’s available defenses in the event of default. Once exercised, the cognovit provision allows the creditor to take a judgment against the debtor without notice and begin collection immediately. Consequently, cognovit provisions are a very powerful tool for debt collectors.
Creditors who use cognovit provisions are required to place a warning in bold-type letters at the end of the instrument. Thus, if you are presented with an instrument containing a cognovit provision, you will likely know it. Properly presented and executed cognovit provisions are legal and enforceable in commercial settings in Ohio, but they are generally not legal or enforceable in any setting in Kentucky. Businesses operating in Ohio should exercise extreme caution when entering into a transaction or signing a personal guaranty containing a cognovit provision.
For businesses, personal guaranties are often a fact of life when seeking access to credit. Yet, understanding personal guaranties and related cognovit provisions can help reduce personal exposure while also providing your business with necessary capital. Thoroughly reading and understanding any personal guaranty (and other loan/credit documents) prior to signing is vital to ensuring that personal assets are not needlessly risked when taking on business debt.
This article is for general informational purposes only, is not for the purpose of providing legal advice, and does not establish an attorney-client relationship. You should consult with an attorney to obtain advice as to your particular issue or circumstances.