As mainstream lenders remain cautious about whom they issue funds to, expressing specific reluctance towards seemingly ‘high risk’ clients wanting to obtain funding for SMEs, the requirement for directors to personally guarantee loan repayments is on the rise.

A recent survey, conducted by personal asset lender borro, found that directors of SMEs are now just as likely to turn to secured loans for funding as they are  an extended overdraft facility or unsecured bank loan. Even more so, when applying for secured credit, one in ten business owners over the past year used their personal property as security on a loan in order to raise capital for their business and continue trading throughout 2011.

A personal guarantee operates as additional pledge of collateral in conjunction with the initial security for the commercial loan. Should the loan go into arrears, the director(s) will make themselves personally liable to repay the debt which may mean their own high valued assets or even their home is at risk if the company defaults.

So, under what circumstances may they be required?

We spoke to Jonathan Newman, Senior Partner at Brightstone Law LLP and Chairman of the AOBP, who talked us through the growing need for a personal guarantee. He said: “Lenders take more comfort in issuing commercial loans to businesses if directors personally guarantee the loan. There are many instances where a borrowing company is a single purpose vehicle with no filed accounts or trading history so a personal guarantee is widely considered to be essential in these cases.

“For borrowers, there are significant advantages in sitting behind the corporate veil because it protects their individual assets; however, the covenant is more attractive to lenders if directors are willing to stake their own personal assets on the deal.”

The types of assets provided as a guarantee are often unspecified, as Jonathan further explained: “Technically a personal guarantee isn’t a charge on the Director’s home – although it can end up that way once pursued, and can also attach to any high value personal property.”

As a result of this vague definition, here lies a significant grey area for the guarantor. If a lender does begin foreclosure proceedings on personal assets and they do not cover the shortfall of the loan’s initial security, in some circumstances this could mean that the guarantor’s home is at risk of repossession.

Furthermore, the FSA offer very little protection to the guarantor in such instances.  Stated within the FSA’s online information for smaller firms  (Mortgage Conduct of Business rules and related matters: Scope of regulation),  the Authority  provides the following guidelines for firms obtaining commercial funding: “…where an individual customer provides a personal guarantee to a bank covering the liabilities of a limited company, this will not be a regulated mortgage contract. This is true even where the individual's guarantee liability is secured by a first charge over his residential property. This is because we think the bank is not providing credit to an individual. (It may be providing credit to the company, but this doesn't satisfy the definition of a regulated mortgage contract).”

And so, the scope of FSA regulatory protection does not extend to those who provide their homes as collateral for a commercial loan. As an unregulated transaction, there is potential for business owners to be hasty in guaranteeing a loan in order to continue trading in tough economic climates - notably, there is no requirement for a ‘cooling off period’ as with regulated loans. It is therefore vital that the guarantor is fully aware of their contractual obligations to repay the loan on behalf of the firm.

Jonathan highlighted the importance of the guarantor in understanding the gravity of such commitments: “The impact of personal guarantee is very strong for any director as enforcement may lead to bankruptcy, which is a very serious prospect for an individual with widespread commercial interests undertaking sophisticated borrowing. Often guarantors have more to lose than the debt on the single property transaction. Such persons cannot entertain bankruptcy as this will have a dramatic impact on their wider business dealings, not to mention reputational risk.”

Yet, this may be considered a worst case scenario as lenders will turn to the principal loan security first and will typically look to the guarantee as a last resort. Lessening the adverse associations, we also spoke to Hinesh Varsani, Partner at Bellevue Mortlakes Chartered Surveyors, who maintained that personal guarantees are very much commonplace and generally limited to 20 per cent of the debt, reflecting the tensions within the current lending market.

Hinesh explained: “Personal guarantees are nearly always unsupported and we are unaware of lenders asking for a charge over a director’s own home in order to support the guarantee.”

He gave the following example: “If a client buys a £1,000,000 property and obtains a 70 per cent mortgage, then if the client’s business fails or the lender foreclosed for any other reason, they would initially look to sell the business premises. If they obtain more than £700,000, then the loan is repaid and the guarantee discharged. If however the lender suffers a loss (say the property only sells for £650,000), the lender will write to the client and ask how he will deal with the £50,000 shortfall. The client has the choice of how he raises the £50,000 and lenders rarely call in guarantees, preferring to work with a client.”

The guarantor is thus given a degree of freedom in choosing which of their assets may be used to cover the shortfall of the loan security. Moreover, the guarantee will only be acted upon as a last resort, which may only be a small percentage of the entire loan facility. Providing a personal guarantee will give lenders an increased confidence and only in a small number of cases will this guarantee be detrimental to personal finances. Responsible lenders will express due diligence by adequately assessing the individuals personal liability and the ability to repay fully, without this being a significant obstacle should the foreclosure process begin.

A personal guarantee, as a supporting assurance to lenders, can often be a huge advantage for small business looking to obtain finance; however, personal guarantees should only be provided subject to extensive and independent legal advice ensuring the individual is fully aware of the implications. 

By Alexandra Jones