Last September the Wall Street Journal reported that the Cababie family’s Grupo Gicsa, one of Mexico’s largest real estate development companies, was in danger because the family had made personal guarantees in the hundreds of millions of dollars on loans they used to finance two major U.S. projects. In August, the Cababies filed for Chapter 11 bankruptcy protection on their Everglades on the Bay condominium tower in Miami.
Another real estate family, the Soffers of South Florida, lost control of their unfinished Fontainebleau Las Vegas casino-hotel in February after the project went bankrupt. The family had grappled with a litany of financial problems, including $220 million in personal loan guarantees signed by the founder’s son, Jeffrey Soffer. Debt problems also threaten another Soffer property, the original Fontainebleau hotel in Miami Beach, which the family bought in 2005.
If these megamillion-dollar family enterprises can teeter on the brink when their lenders threaten to call in their personal loan guarantees, is there any hope for a smaller family business?
A personal loan guarantee is a promise by a company principal to use personal assets to repay the loan if the business cannot do so. The promise is backed by all assets of the guarantor. Collateral, by contrast, is the pledge of a specific asset, like equipment, inventory or receivables. Especially during periods of tight credit, most banks require business owners to sign personal guarantees on commercial loans, often in addition to requiring collateral.
Risking the loss of personal assets is sobering. But bankers and financial advisers say a personal guarantee need not cause sleepless nights (not too many, at least)—as long as borrowers keep a sharp eye on their businesses and carefully manage their relationships with lenders.
Borrowers’ obligations
In 2007, Jim Sagalyn, 64, president of Holyoke Machine Company in Holyoke, Mass., wanted to purchase an office building for a side venture. Initially, the local bank—where he does most of his personal and other business banking and knows the president and loan officer—wanted a personal guarantee for the full amount he was borrowing. He managed to negotiate to have the guarantee diminish over time. “As I pay down the principal, the amount of the personal guarantee is reduced,” explains Sagalyn, whose company was founded in 1863. He says he’s not particularly nervous about the guarantee because even with a few vacancies, the office building produces enough rental income to more than cover his monthly payments.
At Sunwest Bank in Orange County, Calif., virtually 100% of the loans made are backed by personal guarantees, according to Glenn Gray, the bank’s president and CEO. Gray says that when a family business owner approaches his bank for a loan, he pays close attention to the company’s net worth. “Family businesses tend not to leave much profit in the company because they want to minimize the tax situation,” Gray says. “It’s a two-edged sword. They take distributions, pay themselves well and find other ways to run personal expenses through the company. The result is they’re not building up much of a net worth, so you see requests for personal loan guarantees.”
Gray says that in the four years he has worked at Sunwest, there have been only two cases in which the bank has had to act on a personal loan guarantee. In one case, Gray says, he had to make the borrower aware that “if he didn’t live up to the obligations in the loan agreement, I would strongly consider going after his personal guarantee. He did have a fair amount of real estate and liquid investments, and he worked hard to get my loan paid off.” This borrower ultimately defaulted on a loan from another bank that did not require a personal guarantee, Gray says.
In the other case, Gray recalls, Sunwest Bank had to take legal action to get a writ of attachment (a court order to seize an asset). The court action “didn’t even give us a senior position on [the borrower’s] home, but it brought the business owner to the table,” Gray says. “That’s all we ever wanted in the first place.”
Two schools of thought
There are two schools of thought about personal loan guarantees. In one camp are bankers who argue that borrowers who are confident in their ability to repay the loan should not hesitate to sign a personal guarantee. “It’s more of a psychological edge that keeps people focused on taking care of problems should they arise,” says Gray. “At the end of the day, [a guarantee] only gives a lender the right to sue the borrower.” Gray says that if a borrower hits hard times, his bank will go after personal assets only if the borrower is capable of paying down the loan but does not cooperate with the bank to do so.
If hard times cause a borrower to struggle, Gray says, his bank is willing to work with the business owner to restructure the loan. “Bad things happen to good people,” Gray acknowledges. “If they’re working through the issues and doing everything they possibly can, going after the personal guarantee doesn’t make things any better.” On the other hand, Gray warns, “If I know someone has the ability to pay the loan, but he’s still pulling excessive money out of the business and has a lot of liquidity on the side, then I’d go after [that borrower].”
Those who oppose personal guarantees believe that a banker who lacks confidence in a business owner’s ability to repay a loan should simply not lend that company any money.
Patrick K. Hines, principal of the Rainier Group, a Bellevue, Wash., financial consulting and wealth management firm, says that in the mid-1980s, many banks began hiring sales-driven loan officers who lack relationship banking skills. “As long as the economy is healthy and profits are expanding, everyone is happy,” says Hines, who formerly was a senior commercial banker with Wells Fargo Bank. “But when things turn, they lack the ability to help solve clients’ problems and don’t know how to apply liquidity with a reasonable rate of return that can be paid on time.” Loan guarantees are a way of protecting banks from bad loans they shouldn’t have made in the first place, Hines argues.
Before the days of mega-mergers, banks weighed a potential borrower’s character heavily when making lending decisions, and assessed the business owner’s collateral and capacity (essentially, cash flow). Today, with so few independent local banks remaining, loan officers are less likely to know business owners personally and have all but removed character from the equation, says Hines.
“Most business owners that have homes feel as if their bank is asking for the shirt off their back for what they consider to be a fairly straightforward financing, with cash flow of the business plus fixed assets sufficient to repay the loan,” Hines says.
In reality, few borrowers’ homes are at risk. Bankers would likely prefer to target other assets, such as investment portfolios. With the real estate market currently in a slump and many home values dropping, banks would have a hard time extracting much value even if they could sell a borrower’s residence. Moreover, the process of foreclosing on a residence using a personal guarantee is not simple, says Hines. The guarantee only allows a banker to petition the court to allow the bank to put a lien on the borrower’s assets. It doesn’t necessarily mean the bank will ultimately liquidate those assets. In addition, other creditors, such as the first mortgage lender for the guarantor’s home, generally have priority ahead of the commercial lender.
Even so, Jim Barrett, managing director of Cresheim Management Consultants in Philadelphia, says personal loan guarantees, which also require the signature of a business owner’s spouse, can put stress on a marriage. “The spouse now becomes a guarantor for the business,” Barrett says. According to Barrett, many loans don’t go forward because the business owner’s spouse refuses to sign the personal guarantee.
Negotiating tactics
How can you protect yourself if your lender insists on a personal guarantee and you can’t afford to walk away?
• Get your accountant in on the act. Your accountant can help you through the often-arduous application process and assist in negotiating the terms of the loan. But be sure your accountant’s reputation will be an asset, not a liability, Barrett warns.
• Provide collateral. The more collateral your business can offer and the more liquid those assets are, the less important personal guarantees may be. Typically, lenders look for company assets that can easily be liquidated if necessary. Receivables are generally pretty good collateral, but inventory can be hard to value and hard to sell. While hard assets such as vehicles, buildings and equipment are strong sources of collateral, if their value falls below the outstanding loan balance, that could put the borrower in technical default and trigger a loan recall—even if the borrower has not missed a single payment. Gray points out that some banks that need liquidity will call in loans based on technical defaults. That is why the next point is so important:
• Do your own due diligence. Ask your advisers, colleagues in your community, vendors or customers if they can offer insights on the reputations of the banks you’re planning to approach. Also make sure the bank is financially stable. You can look up a bank’s financial statements through the Federal Deposit Insurance Corp.’s website (www.fdic.gov/bank/statistical/index.html).
• Refrain from withdrawing assets from your company for at least a year before applying for a loan. That will lower your debt-to-equity ratio and strengthen your position. “Pulling out a lot of assets from the company tends to drive requests for the guarantee,” says Gray. If your debt-to-equity ratio is higher than 3:1 or 4:1, your banker will be more likely to insist on a personal guarantee.
What to do if problems arise
If you already have outstanding loans with personal guarantees and your company encounters difficulty making payments, you’re in a better position if your lender knows you personally. Here are some steps to take in an effort to avoid having your personal assets seized by the bank.
• Discuss problems right away. Don’t wait until you fall behind on payments, Barrett warns. “If they hear about your problem from you, you’re in much better shape,” he says.
Many people are reluctant to discuss the situation, Gray observes. “It could be an honest distrust of the banker, or a perception the banker won’t react well,” he says. “Or the business owner may believe, ‘Maybe if I can turn this around before the banker notices, I’ll be OK.’ That’s not a good strategy. Bankers don’t like surprises.”
• Be aware that a business bankruptcy will not necessarily release you from a personal guarantee. “The guarantee is separate from the assets of the company,” says Hines. When a private company declares bankruptcy, Hines says, that “severely impacts the financial status of the owner. But, with the guarantee in place, the bank has unfettered access to them and their personal assets.”
• Ask for a meeting with senior bank personnel. If you’re worried that your loan officer will not be sympathetic, Gray suggests, ask that the bank’s chief credit officer be included in your meeting (or, at a larger bank, ask if the senior credit officer or administrator can join you). At a small bank, ask to meet with the president.
• Don’t just report the problem; offer your banker a potential solution. For example, if sales are off, margins are compressed and you are likely to have a loss, explain how you are planning to cut back. Tell your banker that you will take less of a draw. If you do so, more often than not your banker will be willing to help you get through a rough period. If you’re paying principal plus interest, the bank may allow you to pay just the interest for a while or cut back on principal. If your loan is set to amortize over three years, your bank may restructure it to five years, which would lower monthly payments.
• Ask the banker to show you the note. If you have taken a loan with a large bank that has sold off portions of its loan portfolio to Wall Street (a practice called securitzation), it will no longer physically possess the loan document, Hines explains. If that bank threatens to exercise your personal guarantee, you may be off the hook in some states, such as California, if the institution cannot produce evidence of the obligation upon request.
Other alternatives
It should be noted that there are other sources of capital that don’t require personal guarantees. Your company could seek private equity or venture capital funds, or go public. But François de Visscher, a Greenwich, Conn.-based financial consultant to family businesses, notes that each of these alternatives has its own disadvantages. Private equity and venture capital funding often require giving up an equity stake in the company and taking on an outside partner. And companies that go public must report their financial information, including profit-and-loss figures and family executives’ salaries and compensation packages.
Without question, times have been tough for many business owners, but bear in mind that banks, too, have been affected by the economic downtown. It’s as important to maintain your relationship with your loan officer as it is to keep your eye on your company’s bottom line. Even if you’re in a bind, there’s a chance you can negotiate a plan to satisfy your debts. Most banks would prefer to avoid a legal battle—but they want assurance that borrowers are dealing fairly with them. If your case is suspect, a lending institution will muster all the power it can wield.
Jayne A. Pearl, a freelance writer and editor based in Amherst, Mass., is co-author (with Richard Morris) of Kids, Wealth, and Consequences: Ensuring a Responsible Financial Future for the Next Generation (Bloomberg Press, 2010; www.kwandc.com).