The type of entity a business is established as determines whether a principal or business owner is responsible for fulfilling the obligations of the business. The liability of an owner or principal that is not personally liable for the debts of a business can be obtained if they agree to personally guarantee the business’ obligations. This guarantee would be provided through a separate personal guarantee agreement. Personal liability of the principals of a borrower for the borrower’s debts relies on the following factors:
- Principals are personally liable when a borrower entity is a sole proprietorship or when the principal is acting as a general partner in a partnership.
- Principals are not personally liable when a borrower is a corporation (S or C Corporation), LLC, LLP, not-for profit co-op, trust, or an association unless the principal signs a separate agreement to personally guarantee the terms and conditions of the loan.
In small business, investor real estate, and privately held entity lending, it is standard practice for principals of a business entity to assume the majority of the risk by personally guaranteeing a loan. This is appropriate, because business owners or principals benefit the most from the success of the business operation, and should shoulder the bulk of the risk.
Personal guarantees provide an additional form of credit enhancement for a commercial loan by solidifying a principal’s long-term commitment to the success of the business operation (the borrower). Without this personal commitment, reinforced by a guarantee, a principal’s economic incentive and willingness to work through adversity can be diminished. A firm commitment by the principal is vital to preserving the value of a borrower’s business, either by improving operations or, in the worst case, by preserving asset values in liquidation. The guarantor’s economic incentive is to manage the business prudently and retain value, which will ultimately reduce any deficiency they would be obligated to pay. Guarantors, either individually or in aggregate, should have sufficient financial resources at risk to solidify their commitment to ensure the maximum repayment of a loan by the business operation.
The most effective guarantee is an unlimited, joint, and several personal guarantee from principals that have a controlling interest of a borrower’s operation.1 Such principals have the authority to manage operations, as well as an economic incentive to maximize borrower value and retain assets in the borrowing entity.
- Unlimited means the entire amount of a borrower’s indebtedness (past, present and future), to a lender.
- A joint and several provision allows a lender to pursue one or all guarantors for the full amount of indebtedness, at the lender’s discretion, until the debts are satisfied.
- The guarantor is to provide a payment guarantee, which requires the guarantor(s) to fulfill the payment obligations of a debtor, either through scheduled payments or under terms of default when the repayment of the debt is accelerated.
Regulatory Requirement
In May 2016, the NCUA’s requirement for personal guarantees changed from an explicit requirement to an implicit expectation. NCUA regulation § 723.5(b) of the regulation dealing with collateral and security states that "...A federally insured credit union that does not require the full and unconditional personal guarantee from the principal(s) of the borrower who has a controlling interest in the borrower must determine and document in the loan file that mitigating factors sufficiently offset the relevant risk."
A personal guarantee from those with a controlling interest in the borrower is an appropriate risk mitigant for loans to privately held entities. A credit union should only waive a requirement for a personal guarantee when the credit union has a rigorous credit risk management program in place and the ability to properly mitigate the additional risk. The reliance on a personal guarantee should not be relinquished solely to meet competitive pressure.
Credit Union Policies
Generally, credit unions should have those with a controlling interest in a borrower provide their full, joint and several personal guarantee for debt owed by the borrower to a credit union. However, credit unions have the flexibility to forego a personal guarantee in order to meet the needs of a financially strong borrower.
Financially strong borrowers demonstrate a preponderance of the following criteria:
- Superior debt service coverage
- Positive income and profit trends
- A strong balance sheet with a conservative debt-to-worth ratio
- Historical track record of meeting obligations with vendors and other lenders satisfactorily
- Readily salable collateral supporting the loan
- A low LTV ratio for the loan
- Documentation evidencing sufficient due diligence to verify the borrower’s creditworthiness
When a personal guarantee is not required, or when a credit union accepts a partial, limited guarantee or a guarantee from an individual who does not have a controlling interest in the borrower, the credit union must determine and document in the loan file that mitigating factors sufficiently offset the risk. The credit union should establish appropriate criteria in its policy and adopt processes to mitigate the additional risk.
Credit unions must also set concentration limits in their policies on the maximum amount of assets allowed in unguaranteed commercial loans.
Underwriting and Documentation
When conducting an exam or a supervision contact of a credit union that grants commercial loans without requiring the personal guarantee of the principals, exam staff will evaluate the strength of the credit union’s credit risk assessment and management process at inception and throughout the life of the loan.
A credit union should support the decision to forgo the personal guarantee with a comprehensive risk assessment. The quality of the financial information used in the financial analysis should be commensurate with the level of risk and complexity of the borrower and principals’ operations. Credit unions should be diligent in detecting any changes of risk associated with the borrower operation.
For an explanation of financial statement quality, see section d(1) of Supervisory Letter 14-04, Taxi medallion lending, and the preamble to Part 723.
Credit unions should monitor a borrower's financial condition by requiring frequent financial reporting and compliance with specific well-defined financial covenants. The borrower’s operation should be monitored by frequent contacts by the credit union with the borrower to evaluate if there have been material changes to the operations, specifically in management, markets, industry or physical deterioration the plant or equipment. If a credit union identifies a change in risk, it should timely take appropriate action.
Portfolio Controls and Management
When conducting an exam or a supervision contact of a credit union that grants commercial loans without requiring the personal guarantee of the principals, exam staff will evaluate the credit union’s portfolio management process to determine if it is sufficient.
A credit union that grants commercial loans without requiring a personal guarantee should limit its exposure to risk associated with these loans by establishing a concentration level appropriate for the credit union’s capital position and management ability. Examiners should determine whether a credit union adheres to its policy in granting unguaranteed commercial loans. Examiners should give particular attention to the credit union’s ability to monitor the performance of these loans. Loans without the benefit of a personal guarantee should be reported to the board in the aggregate and clearly monitored for adverse changes in their repayment performance or overall risk.
Last updated November 25, 2016
