The Personal Guaranty
In our current economic conditions, we are still seeing an increased level of defaults and litigation that involve failing businesses, especially small and undercapitalized businesses. Most business customers fully intend to pay when they apply for credit. However, you still need to protect yourself from the adverse economic impact when those customers do not pay. One of the best ways to insure that you get paid when dealing with a business is to obtain a personal guaranty.
If your customer does business as a corporation, a limited liability company or other form of entity with limited liability, then you may only look to the company for payment when things go bad. That is unless you have a signed writing stating somebody else or some other entity will be responsible for paying your customer’s bill if your customer doesn’t. We refer to this signed writing as a personal guarantee or a corporate guarantee. Corporate guarantees work similarly to personal guarantees except that the issuing entity should execute a resolution giving the entity the authority to make the guarantee.
One aspect that is often overlooked in guarantees is whether the guarantor has the ability to pay. Many companies just have the entity’s principal sign the guarantee without ever looking into that person’s credit history or assets. If the person has no ability to pay, what good is the guarantee? A credit report should be obtained so you know what the guarantor’s credit history looks like.
A word of caution is needed here! The FTC is a federal regulatory agency responsible for enforcing certain legislation, including the Fair Credit Reporting Act (FCRA). The National Association of Credit Managers (NACM) requested the FTC to provide an opinion regarding whether a vendor extending commercial credit must obtain consent prior to pulling a consumer credit report to be used for business purposes, or for a personal guaranty of business credit. The FTC states that a vendor must obtain the consumer’s consent prior to pulling a consumer credit report. As a general rule, the FCRA requires a trade credit grantor to obtain written authorization from an individual to run a consumer credit report. Before the FTC opinion, there appeared to be an exception to the FCRA in that consent seemed not to be needed if there was a legitimate “business purpose” in connection with a credit transaction. The FTC opinion does not recognize the business purpose exception.
The FTC notes that the business exception “provides no authority for a vendor to obtain a consumer report in connection with a credit application for any commercial purpose.” The FTC opinion also does not recognize a right to pull a consumer credit report for a personal guaranty without first obtaining consent.
A personal guaranty can help overcome the creditworthiness of a newly formed small business which often times is formed on a shoestring and the guarantor may have better creditworthiness than the business entity. It may also help the customer be more responsive to collection efforts because individuals tend to take their credit standing more seriously and would like to avoid any action that may adversely impact their credit score and history. With a personal guaranty on the line, your business customer will be less likely to simply walk away from your obligation.
It is imperative that the personal guaranty be signed by the guarantor as an individual, not as someone acting in their capacity as an Officer or Director of a company. Their signature should not include titles like President, CEO, Managing Member, etc.
Some companies use a personal guarantee included in the body of their credit application form, while others use it after the application signature line as a separate section with a separate signature line. Personal guarantors will look for ways to avoid individual liability for the debts of the company. To that end, it is best that the personal guarantee be separate and apart from the application and the Guaranty should be notarized to reduce the risk that the guarantor may assert as a defense to payment that the signature was forged.
The Equal Credit Opportunity Act, Regulation B imposes rules concerning extension of credit. Paragraph 7(d)(6)states:
1. Guarantees. A guarantee on an extension of credit is part of a credit transaction and therefore subject to the regulation. A creditor may require the personal guarantee of the partners, directors, or officers of a business, and the shareholders of a closely held corporation, even if the business or corporation is creditworthy. The requirement must be based on the guarantor’s relationship with the business or corporation, however, and not on a prohibited basis. For example, a creditor may not require guarantees only for women-owned or minority-owned businesses. Similarly, a creditor may not require guarantees only of the married officers of a business or the married shareholders of a closely held corporation.
2. Spousal guarantees. The rules in §1002.7(d) bar a creditor from requiring the signature of a guarantor’s spouse just as they bar the creditor from requiring the signature of an applicant’s spouse. For example, although a creditor may require all officers of a closely held corporation to personally guarantee a corporate loan, the creditor may not automatically require that spouses of married officers also sign the guarantee. If an evaluation of the financial circumstances of an officer indicates that an additional signature is necessary, however, the creditor may require the signature of another person in appropriate circumstances in accordance with §1002.7(d)(2).
Caution needs to be taken regarding spousal guarantees. Under Regulation B, § 202.7(d)(1), generally a creditor may not require the signature of an applicant’s spouse or any other person (other than a joint applicant) on any credit instrument if the applicant qualifies for the amount and terms of the credit requested under the creditor’s standards of creditworthiness. This rule applies to all open-end and closed-
end, secured and unsecured extensions of consumer credit and business credit.
If a creditor routinely requires spousal guarantees, for example, without first ascertaining whether an applicant is creditworthy, then conditioning the extension of credit on the spousal guarantee violates § 202.7(d)(1).
There are exceptions to the general rule. A creditor is permitted to take into account state property laws that directly or indirectly affect an applicant’s creditworthiness. For example, if a married applicant requests unsecured credit and resides in a community property state, the creditor may under § 202.7(d)(3)require the signature of the applicant’s spouse on any instrument necessary to make the community property available to satisfy the debt in the event of default.
The bottom line is that a personal guaranty should always be requested when the credibility of the business applying for credit is in question. The spousal guaranty should also be obtained when appropriate.
If you have any questions please do not hesitate to contact our office.
