We interviewed a bankrupt recently who has now lost all of his divisible assets because his business became insolvent. He could not trade or otherwise fund payments to creditors. Losing his own assets to repay his creditors is what the Bankruptcy Act is all about, but this story gets worse for him.
He has also lost the assets of his two grown children and his parents. They were not part of the business, had no ownership interest, took no control in the management or trading of the business, or received any money from the business. They all had signed third party guarantees to support the bankrupt’s business borrowings. They were innocent bystanders to the business disaster, who had happened to have signed an agreement with the financiers.
Are the guarantees valid and enforceable? Probably. Will any of these people – or all of them together – be able to pay this debt? Probably not. Maybe if they sell their houses and get good prices.
This is something that we see fairly often, though rarely to this extent. Usually a spouse or a parent signs a guarantee for some small obligation. Sometimes we see someone (commonly an aged parent) bankrupted because they guaranteed a large debt to help a child. But this was a whole family affair.
That leads us to make a few observations:
1. Lenders will often seek guarantees from company directors for loans to a company. They figure quite naturally and probably rightly, that if the director of the company has so little confidence in the ability of the company to pay back the debt they he or she will not guarantee it, why should the lender have any confidence that they will be paid back.
The large difference in this ‘associated’ party guarantee is that the director is in control of the trading of the company. They make the decisions and benefit from the good results, so it is not unreasonable to ask that they take the risk of a bad result.
2. But this is not the same with third party guarantors. Lenders usually only want third party guarantees in circumstances where the other available security and/or the budgeted cash flows do not stack up. That is, where there is excessive risk from the lender’s point of view.
Lenders enter the deal with the view that the loan is more likely to be a risk and greater ‘security’ – used in every sense of the word – is required. Is there anything wrong with lenders taking that position? No. They are being asked to lend money into some venture and they have a right to set the terms, just as the borrower has the right to so ‘no’ and look for funding elsewhere. Getting the guarantees is just good business from their point of view.
Indeed, when asked by a lender, I always recommend obtaining security and guarantees from everyone who will sign them. The lenders are doing exactly what they believe they need to do to protect their commercial position.
3. But if lenders, who stand to make a dollar out of the loan, who are experienced and know what they are doing, and who have first ‘bite of the cherry’ when things go wrong, cannot convince themselves to go ahead without third party guarantees, then it should be obvious to the borrower that the deal must be so much more risky for the guarantors.
Borrowers are being asked to find other people to risk their assets and money to secure a debt because the lender does not believe that the business, the business owner or the company director – as the case may be – has the capacity to make good. “The risk is too great here, so let’s move it to guarantors”.
The borrowers are asking family members to risk everything for them.
4. Most third party guarantors have virtually no input into the trading of the business, the use or purpose of the borrowings or have any input into what happens when things go wrong. They rarely have access to trading information and it is almost impossible to limit or even monitor the actions of the borrower before loan goes bad, or the actions of the lender when push comes to shove, comes to demand, comes to plaint.
It should be obvious to the guarantors that they are entering a risky situation, but either it is not obvious, it is not explained to them, or they are willing to take the risk to help.
Many times the guarantors have forgotten that they even guaranteed a loan by the time that a call is made under it. Many times the borrower has not warned them that trading is not great and that there is a chance of the guarantees being called so the demand is a surprise (probably a great shock). Many times the guarantors do not even know the level of debt that they are liable for.
Guaranteeing the debts of relatives is perhaps the most risky of all deals because the decision can be made on sentiment rather than objectivity. Parents want to help their children, spouses want to be supportive of each other – after all it is only a signature and they have been assured by the family member that everything will be alright.
I do not gamble, but the analogy seems appropriate. When playing roulette you have control over how much you bet and where your place your chips. You can decide when to walk away. The turn of the wheel and where the little white ball lands is (supposedly) chance, but you have some control in the game. You also have the chance of winning something. Most third party guarantees do not even give you even those choices, and there is nothing to win.
If the risks warrant the lender asking for third party guarantees, the risks probably warrant the third parties refusing to provide the guarantees, especially when they do not have the money to throw away.