Personal Guarantees: Pitfalls for the unwary!

Steve ElliottPosted 30 July 2015 By Steve Elliott, Business Recovery and Insolvency Partner In Business Recovery & Insolvency

Since the financial crisis, it has become increasingly common for Banks and Asset Based Lenders (ABLs) providing commercial finance to smaller companies to ask for personal guarantees from directors.

At the time those guarantees are sought and given, the directors’ attitude generally tends to be an optimistic one, in that the prospect of formal insolvency is remote, or they believe sufficient worth will remain in the company to repay the borrowing. Sadly, the unforeseen often plays a part and we see the “hard cases” where that optimism has proven ill-founded.

This article looks at some of the issues that should be considered when giving a personal guarantee.

No supporting debenture

Where personal guarantees are given without a debenture being taken by the lender over the company assets, any shortfall arising under the finance agreement will be unsecured in any insolvency process and almost inevitably lead to a call on the guarantee.

To be blunt, the bank will be happy to take a charge on a directors’ homes with plenty of equity and may care little for a debenture but even at a small additional cost a guarantor should insist that a debenture be given to protect their position and maybe ultimately save their home.

Multiple guarantors but no reduction in risk

All directors may be asked to give personal guarantees limited to a fixed sum. Those directors involved often misunderstand that they are all liable individually for the whole amount of the sum guaranteed, regardless of whether a fellow director makes a payment under his. In addition, there is a further misconception that guarantees will be reduced by funds realised through the insolvency process; sadly, this is not the case and the shortfall to the lender after completion of the insolvency process remains to be sought under the guarantee.

Unfortunately, often in an insolvency scenario the asset realisations are considerably less than the directors anticipated when they gave their personal guarantees. In particular, realisations from work in progress and book debts tend to be particularly difficult to collect, and significant write-offs occur. Any significant problems in the realisation of the assets will increase the likelihood of the directors’ personal guarantees being called upon.

Standard debentures – the order of priority

What we now commonly call a standard debenture, includes fixed and floating charges over all company assets. What is fixed and what is a floating asset is much clearer now and understanding those differences is important in the context of where the statutory priority of payment lies. For example, we now know that a bank will only (usually) hold a floating charge over the book debts of the company, whilst an ABL factoring agreement creates a fixed charge over the book debts; this can make a huge impact in the order of payment and the ultimate guarantee call.

The fixed charge will extend to freehold and leasehold property, intellectual property and goodwill. Other assets, such as vehicles and plant and machinery, will fall under the floating charge unless subject to lease or hire purchase.

Assets subject to fixed charge will attract deductions for the selling costs only before any balance is paid to the charge-holder; the position before payment to a floating charge holder is more complex. The most significant deduction from the proceeds of floating charge asset sales is the cost of the entire insolvency process followed by any preferential creditors (usually now limited to employee claims for arrears of wages up to £800 and all accrued holiday pay).

If sufficient assets remain to cover the costs of the insolvency process and the preferential creditors and more than £10,000 remains for distribution to the floating charge holder, yet further deductions will occur. This provision is known as the “Prescribed Part” and applies to floating charges created after 15 September 2003, so will now apply to the vast majority of debentures.

The Prescribed Part carves out a fund to be set aside for the benefit of unsecured creditors only. This was the historic “quid pro quo” for the Crown giving up preferential status for PAYE & VAT. The fund comprises of £5,000 from the first £10,000 of floating charge asset sale proceeds and 20% of any remainder (subject to a fund limit of £600,000).

The effect on the guarantor

To illustrate the impact of the lack of any debenture we have based this example on a small chain of retail shops that we dealt with where the director had given a personal guarantee; the bank debt was £35,000 of total debts of circa £160,000:

 

No Debenture Held

Debenture Held

 

£

£

£

£

Assets:

 

 

 

 

 Goodwill

 

25,000

 

25,000

 Stock

 

18,000

 

18,000

 Vehicles

 

7,000

 

7,000

 

 

50,000

 

50,000

 

 

 

 

 

 Less:

 

 

 

 

 Preferential claims

4,000

 

4,000

 

 Insolvency costs

8,000

 

8,000

 

 Prescribed part

 

8,000 

 

   

12,000

 

20,000

Balance after costs & prescribed part

 

38,000

 

30,000

 

 

 

 

 

Available to debenture holder:

 

 

 

 

Goodwill (falls under fixed charge)

 

 -

25,000

 

Balance after prescribed part applied

 

 -

5,000

30,000

Dividend of 23.8 pence on the £

 

8,330

 

 -

 

 

 

 

 

Total payable to debenture holder

 

8,330

 

30,000

The difference in outcomes is stark; where no debenture is held, the bank only receives an unsecured dividend of £8,330, leaving the director to find another £26,000 plus rather than £5,000.  By contrast, the bank all but clears their debt where the debenture is in place.

Conclusion

Professional advisers need to be aware of the complexities of the order of priority in insolvency situations; I suspect that it is only a matter of time before a client asks why he wasn’t made aware of the possibility to minimise damage under a personal guarantee.

To discuss this or anything else contact Steve Elliott on 01793 818300 or send him an email.


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