When a business is struggling business owners often think ahead and wonder what would happen if they had to close the business, either with or without a bankruptcy filing.
One of the first considerations is whether the principals of the company signed any personal guaranties. A personal guarantee is a contract in which an individual agrees to pay a business debt. A business owner will often sign personal guarantees when the company needs to make a purchase on credit.
A business line of credit or loan often has a personal guarantee attached to it.
The personal guarantee is usually a one-page addendum to the main lending documents. By signing the personal guarantee agreement, the owner commits to paying the debt with personal (nonbusiness) funds if the company can’t satisfy the obligation. All of the personal assets of the owner could be subject to the creditor’s claim.
I have been practicing bankruptcy law for almost 30 years. Many times, I have run into situations where the owners of a business do not even know that they signed personal guarantees.
Default of personal guarantees will result in collection/lawsuits.
So, what happens when there is a default with a personal guarantee? The lender/creditor usually makes a demand for payment on the company. If not paid then after a certain amount of time, a lawsuit is filed. When the lawsuit is filed, it is common for the creditor to sue both the company and the owner personally on the personal guarantee. Note that a default under a personal guarantee does not only address the non payment of the obligation – the guarantor is also guaranteeing performance of certain obligations/covenants as set forth in the promissory note such as any collateral shall not be transferred, no dissolution of the corporate entity or change of ownership, etc.
If a company files bankruptcy, it is common for the creditor to continue to collect on the personal guarantee against the owner of the company.
I just filed a corporate bankruptcy for a local restaurant. It shut down when the COVID-19 lockdown started. It never opened back up. We listed all of the corporate debt and obligations. After the bankruptcy was complete, certain creditors came after the principals to collect on their personal guarantees.
If the owners/principals have limited assets and income, they can file personal bankruptcies to deal with the situation.
Often, however, a principal may have substantial personal assets which make a bankruptcy filing out of the question. In those instances, negotiation and settlements are needed. Otherwise a personal bankruptcy can be the answer.
David A. Arietta is a certified specialist in bankruptcy law and routinely assists individuals and businesses with various debt and insolvency issues. He can be reached at (925) 472-8000.