Understanding personal guarantees in corporate insolvency proceedings

Karl Hodson of  UK Business Finance looks at what this agreement means for directors if their business enters an insolvency… 

When a business is incorporated as a limited company it is afforded the benefit of limited liability. This creates a protective shield between a company and its directors and shareholders. Limited liability ensures that the debts of the company belong to the company, and the responsibility for ensuring these are repaid remains solely with the company and cannot be transferred to its directors.  

While limited liability is a huge positive for company directors, for those lending money to limited companies, limited liability poses a very real risk that should the borrowing company become insolvent before the loan is settled, there is little chance of the bank being able to recover the remaining balance.  

Understanding personal guarantees 

In order to mitigate the level of risk to the lender, a personal guarantee is often requested as a condition to any proposed borrowing from a bank to a limited company. A personal guarantee means the signer of the guarantee (typically a director of the company) assumes responsibility for repaying the loan should the company be unable to do so. A personal guarantee provides the bank with a valuable layer of security in the event of the company being unable to repay the loan amount as agreed.  

Personal guarantees are extremely likely to be requested of start-up companies or those without a long trading history, however, as banks tighten their lending criteria, more and more companies are finding themselves being asked to provide this type of security. Personal guarantees may also be requested for leases or other types of business contracts, however, they are less likely to be asked for when arranging invoice finance or other varieties of asset-based lending. 

Signing a personal guarantee comes with significant risks, however, in many cases it is the only way for a company to secure the funding it needs. 

What happens to personal guarantees when a company is insolvent? 

Providing a personal guarantee does not automatically have any repercussions on the director; as long as the company is able to make the repayments on the borrowing in full and on time until the balance is cleared, the personal guarantee will simply sit in the background and not come into effect.  

When a company becomes insolvent and enters formal insolvency proceedings, however, the personal guarantee crystalises and responsibility for repaying the remaining balance falls to the guarantor.   

If more than one director has provided a personal guarantee for the loan, this does not mean that the liability is split equally between them. Instead, lenders are free to pursue any guarantor for the full amount owed; this is typically the guarantor with the highest level of personal assets. 

What happens if I cannot afford to settle the personal guarantee following insolvency proceedings? 

It is an unfortunate fact that experiencing financial problems with a company, often means a corresponding negative impact on the directors’ personal financial position. When it comes to having to repay a personally guaranteed loan, therefore, many former directors find themselves in the position where they are simply unable to do this.  

When a personal guarantee comes into effect lenders typically request the full amount on demand. Depending on your personal financial position and your ability to repay what is owed, you may be able to enter into negotiations with the lender when it comes to the repayment terms. After all, it is preferable to all parties to keep the matter out of court if at all possible. If you refuse to cooperate with the lender, however, you should fully expect them to take further action to recover the outstanding balance.  

Will insolvency affect my personal credit record? 

Being the director of a company which has defaulted on a loan or even entered into formal insolvency proceedings will not have an impact on their personal credit record. This is because, as previously mentioned, the financial affairs of a limited company are kept distinctly separate from the financial affairs of its directors. However, a personal guarantee has the potential to change this. 

Once a personal guarantee crystalises during insolvency proceedings, the loan will no longer be classed as the responsibility of the company, but rather the liability for the loan will transfer to the guarantor. From this point, the loan will be treated as any other form of personal borrowing would be. This means that if any default is registered, this will go on the guarantor’s personal credit report.  

Likewise, when it comes to collection efforts, the lender can actively pursue for repayment and can take legal action once all other options for recovery have been exhausted. At its most severe, this could involve the lender petitioning the courts to make the guarantor bankrupt.   

Personal insolvency after corporate insolvency 

If a crystalised personal guarantee is unpayable, and negotiations with the lender have failed, it may be necessary for the company’s former directors to enter into personal insolvency proceedings. This may involve an Individual Voluntary Arrangement (IVA) whereby outstanding liabilities are restructured into an affordable payment plan which will typically run for 5 years; it is likely that some debt will be wiped out as part of the process. 

If an individual is unable to offer a meaningful contribution towards their debts, however, it may be the case that bankruptcy is the only remaining option.  

Providing a personal guarantee comes with a huge amount of risk to the guarantor on both a business and a personal level. Careful consideration, as well as legal advice, should be taken before any personal guarantee is put into place. 

To learn more about UK Business Finance, visit their website.