Many CEOs and/or controlling shareholders sign commercial guarantees without fully appreciating how this single act can change, and in fact utterly ruin their financial lives within months, if not weeks. This blog post will explain how such a financial nightmare can come to fruition. This post will also explain why a personal guarantee fundamentally changes the relationship between a corporation and its lender.
The best way to illustrate the foregoing reality is to give you a front row ticket to a tragic play that is running in a law office near you: “The Rise and Fall of John Smith.” Smith is an honest and decent man, with three children, Tom, Suzie, and Tim, and a beautiful wife, Lily. For the past ten years Smith has worked seven days a week building a manufacturing concern in Orange County, California (“Smith Corp”). In FYE December 31, 2011, Smith Corp generated a $5,000,000 profit, on $25,000,000 in revenues.
Due to an overwhelming volume of new orders, Smith Corp decides to obtain financing from Friendly Bank. Friendly Bank offers Smith Corp a $6,000,000 line of credit. Draws on this line are allowed based upon the following formula: 70% financing on “qualifying” accounts receivable (“A/R”), and 50% on “qualifying” inventory.
The provisions in the line of credit agreement that describe what A/R and inventory rise to the level of “qualifying”, are complex and ambiguous. Moreover, the boilerplate in the lengthy loan agreement essentially allows Friendly Bank to move the applicable “qualifying” collateral goal posts whenever it desires, for any reason, or no reason. Let me translate this language for you: “You are in default, Smith Corp, whenever we say so.”
At the closing, Carter, Friendly bank’s top closer (and Smith’s golfing partner), walks Smith through the loan documents in a cursory, “it’s all standard” kind of review, as he pushes each piece of paper across the table for execution. During this cursory process, Smith may learn, in many cases for the first time, the following three facts (or he may not, since Carter does not intend to be late for lunch):
• First, Friendly bank is seeking a “blanket lien” on every asset of Smith Corp, not just its A/R and inventory, and it is also seeking a lien on the stock of all Smith Corp’s subsidiaries, even if the latter subsidiaries operate in a totally different business space and their financial operations are wholly separate from Smith Corp’s. At this juncture Smith or his CFO might have the temerity to ask why the bank is demanding a lien on collateral that was not purchased with funds advanced under line, or why this additional collateral is required, since the 70%/50% ratios above more than fully collateralizes Friendly Bank’s debt. In response, Carter will simply provide the less than cerebral, “it’s standard practice” response (or alternatively, “it’s bank policy”);
• Second, under the “loan documents”, all incoming collections by Smith Corp will now have to be deposited into a “lockbox” at the bank. These deposits will then be swept daily by Friendly Bank, and used to reduce the balance on the line. When Smith Corp’s CFO asks why the corporation cannot just pay down the line through a transfer from the company’s existing cash account at the bank, either monthly or weekly, he receives the same de riguer answer stated above – “it’s all standard”; and
• Third, finally and most importantly, Smith is advised that he will have to sign a personal guarantee. When Smith, a prudent man, asks why this is necessary, given the fact that the bank’s line will be over collateralized by the corporation’s collateral, he will receive the same answer – it’s standard/required. Carter may also represent that his guarantee will never become an issue, since the bank’s position will be so over-collateralized.
At this point, let’s stop the movie and ponder what Smith and Smith Corp are being asked to do:
• Smith Corp is being asked to gratuitously give Friendly bank a lien on all of its assets, notwithstanding the fact that Friendly Banks own advance rates (50% advances on inventory, and 70% on A/R), provide ample security;
• Smith Corp is being asked to relinquish the right to secure financing from other lenders, since Friendly Bank’s blanket lien will tie up all of its assets;
• Smith Corp is being asked to convey to Friendly Bank control over every penny of corporate cash. This means that Smith Corp will be unable to make payroll if the line is frozen for any reason, or no reason, which under the documents is allowed; and
• Finally, in addition to all of the other collateral that Friendly Bank is now demanding at the closing table – collateral that is not required under the ratios in its own loan documents – Smith is being asked to put all of his assets, other than exempt assets, into the corporate hopper. Stated otherwise, Smith is being asked to waive the protection of the corporate shield, which is the only reason why he incorporated his business in the first place.
This is the penultimate look-before-you-leap moment for Smith and his company. Friendly Bank is asking them to put all of their chips – both corporate and personal – on the table in return for a loan, which in this case, Smith Corp could survive without. Let’s be very clear here – I am talking about the family home, Tim’s college fund, Suzie’s private high school tuition, and Smith and Lily’s early retirement dream.
In weighing the merits of the foregoing exchange, Smith (being an optimist, an honest man, and having confidence in his good friend Carter), makes a number of assumptions. He assumes that Smith Corp will not fail, Friendly Bank will “work with him” in the event that a downturn causes a technical default (covenant default, not a non-payment default) under the terms of the loan, and finally, Friendly Bank would defer going after his personal assets until it was clear that Smith Corp’s assets were insufficient to pay off the line. Alas, none of these assumptions are valid.
At this juncture, Smith needs a visit by Dickens “Ghost of Christmas future”. This spirit would enlighten Smith to the nightmare that is just over the horizon. Two years after the loan is made, Friendly Bank will decide that its capital reserves must be increased due to the onset of a recession, and due to higher than anticipated loan losses. To achieve its liquidity goals, Friendly Bank decides that Smith Corp must repay its loan. Since the loan does not mature for another nine months, Friendly Bank will advise Smith Corp that some of its A/R, which has already been financed, was not “qualifying” A/R, and consequently the related loan advances must be paid back. Friendly Bank will further advise Smith Corp that this inappropriate advance places Smith Corp in a default position, which allows Friendly bank to reduce the 70%/50% ratios in the line of credit agreement to 40% and 60%. Finally, Friendly advises Smith Corp that no further advances will be made until the incoming collections allow the bank recapture the over-advance and rebalance the loan based upon the lower collateral ratios.
The foregoing actions create a cash flow crisis at Smith Corp: The corporation has no money to make its weekly payroll (since it all in the lockbox and line advances are frozen), it cannot buy the inventory needed to ship its partially completed orders, and it cannot pay its rent. Notably, Smith Corp is still solvent and profitable. It simply has no cash due to the lending straitjacket that it donned at the request of Friendly Bank. Smith, being a good corporate steward, recognizes that if this wholly unnecessary crisis continues, he will lose key customers, suppliers and employees, and that these events will further reduce A/R and inventory. These further reductions will then result in more pay down demands by the bank, plunging the corporation into a death spiral.
In an effort to stop the needless destruction of ten years of work, Smith puts a call into Carter, his golfing buddy, and “relationship” banker at Friendly Bank. Not only does this call go unreturned, Smith will be advised that Carter is now prohibited from talking with him about the credit. His new contact with the bank is “Bruno” in the bank’s “special asset” department. Bruno’s mantra is very straightforward: If you sign a document releasing all claims against Friendly Bank, pledge $500,000 of your personal cash, and reaffirm your guarantee, I will “discuss” the possibility of unfreezing the line.
Unwilling to countenance the needless destruction of his business, Smith complies with Bruno’s demands, and this secures him the promised meeting wherein the bank does indeed “discuss” unfreezing the line. However, during this meeting Smith is advised that any “potential” relief by the bank will require yet another substantial reduction in the line balance from Smith’s personal funds. Bruno insists this second pay down is necessary, since the bank no longer has confidence in Smith Corp’s financial future. When Mr. Smith advises Bruno that he has no more available cash to pay down the loan, his erstwhile “financial partner” “goes dark,” which generally means that the file has been transferred to the bank’s lawyers.
Now here comes the final act in the above nightmare. Instead of allowing Smith and Smith Corp to at least wind up the business that the bank has now all but destroyed, and thereby pay back the line, Friendly Bank moves to actively thwart this rational course. The following events will now occur in rapid succession:
• Smith will receives a call from the bank’s lawyer, in his capacity as a guarantor of the loan, advising him that the lawyer will be appearing in California Superior Court in the morning seeking an order either attaching or freezing all of Smith’s personal assets. If this relief granted, then it will bar withdrawals from all of Smith’s account. In the face of this seemingly impossible threat (assuredly an unconstitutional taking in the mind of most clients), Smith calls his lawyer, who unhappily explains that the relief sought by Friendly Bank is “routinely granted”;
• In the foregoing phone call from the bank’s lawyer, Smith will also be advised, in his capacity as a corporate officer of Smith Corp, that Friendly Bank will be asking the court to appoint a keeper or receiver to seize control over Smith Corp, and to liquidate its assets. Smith learns from his lawyer that although the court may defer the appointment of the receiver for a week, if Smith Corp opposes this relief, the court will impose restrictions on Smith Corp’s use of cash during the interim that will only exacerbate the corporation’s free-fall. Smith’ lawyer will also advise him that the receiver/keeper, being chosen by Friendly Bank, will heed the bank’s directions, and ignore Smith’s input on the best means of liquidating Smith Corp.
At this juncture, Smith comes to critical, but belated realization: A lender whose recourse is limited to the assets of its corporate borrower has a vested interested in the success of its obligor; in contrast, a lender who knows that its debt will be paid by assets of the guarantor, whether the corporate/primary obligor succeeds or fails, does not. In fact, I can tell you from experience that in some instances a lender can potentially make a larger profit if the primary obligor (the corporation) fails, than in a full repayment scenario.
Now, Mr. Smith, having seen the potential nightmare to come – the destruction of your business and the depletion of your personal wealth – do you really want to sign that guarantee? Although you may be advised that every small businessman must operate under this financial sword of Damocles in order to obtain critical operating capital, in fact there are alternatives that many banks find acceptable. Moreover, there are ways to mitigate your downside in the event of a future disaster. However, you must take these steps, which are neither exotic nor unlawful before you enter into the loan agreement and sign a guaranty.
The bottom is this: When you execute a personal guarantee, you place all your personal chips on the table, under conditions that offer you almost no protection. There are other alternatives, and there are ways to mitigate your risk. Explore them before you sign on the dotted line.