Bankruptcy And The Personal Guarantee

A personal guarantee is a contract wherein an individual agrees to pay a business debt. A business owner will often sign a personal guarantee if a company needs to make a purchase on credit for things such as real estate, inventory, supplies, or services. By signing the agreement, the owner commits to paying the debt with personal (nonbusiness) funds if the company can’t satisfy the obligation.

Personal guarantees are standard in the business world; primarily because opening a business can be a risky endeavor. New business ventures rarely have much in the way of value or assets. Additionally, many businesses fail, leaving creditors with unpaid invoices. As a result, most creditors won’t agree to extend credit for product or enter into a property lease with a new, unestablished business without requiring more. The supplier or landlord will seek to protect payment of the debt by asking the owner to agree to pay the debt on behalf of the company, if necessary. If the financed amount is significant, a lender might ask an owner of an established business to do the same.

A business owner who consents to the arrangement will sign a contract called a personal guarantee. Once the personal guarantee is in place, the creditor can seek payment from the business owner’s personal assets if the business fails. When a company goes under, it’s common for someone who has signed a personal guarantee to wonder if there’s a way to get out of it. However, unless the lender agrees to waive it (which would be unlikely), or some fundamental flaw exists in the agreement, the personal guarantee will remain binding.

In many cases, a business owner can file a consumer bankruptcy to discharge (wipe out) the personal guarantee. Filing bankruptcy has the added benefit of wiping out other qualifying debt, as well. If the proprietor doesn’t qualify for a Chapter 7 discharge, Chapter 13 might be a possibility; however, this chapter will require the debtor (bankruptcy filer) to make payments to creditors for three to five years before the balance of a dischargeable debt will get wiped out. Also, it’s important to understand that filing a Chapter 7 bankruptcy on behalf of the business will not get rid of a personal guarantee. To wipe out the debt, the actual signer of the guarantee must file for bankruptcy.

What Happens to a Personal Guarantee in Bankruptcy?

When you guarantee a loan for your business, friend, or family member, you make yourself liable for it. Luckily, you can usually wipe out your personal liability for debt through bankruptcy; including a personal guarantee entered into for your business.

Why You Might Sign a Personal Guarantee

Most new companies don’t have much in the way of assets. To increase the odds of getting paid, a lender will require a personal guarantee before extending a property loan or another obligation, such as a lease contract or extension of credit for goods. If the business fails, the lender has two remedies to satisfy an outstanding balance: It can go after the business assets if any, and your personal assets.

How to Eliminate a Personal Guarantee with Bankruptcy

It’s relatively common for a business owner to file individual bankruptcy to get rid of a personal guarantee and most personal guarantees will qualify for discharge. If it’s a non-dischargeable debt, however, bankruptcy won’t help. Also, keep in mind that filing on behalf of the business won’t get rid of your personal obligation to pay back the guaranteed loan. In fact, in that situation, the personal guarantee will work against you. The trustee appointed to oversee the case will likely view the personal guarantee as a business asset and look to you and your assets for money to pay creditors. Similarly, if you signed a personal guarantee for a friend or family member’s loan, you’ll still be on the hook if they file for bankruptcy. You’ll have to file individual bankruptcy to get rid of the obligation. The exception is if the friend or family member pays off the debt in Chapter 13.

Liens Remain in Bankruptcy

Some personal guarantees include a security interest in your personal assets. In that case, the lender will typically have a lien on your property. A bankruptcy discharge will only wipe out your personal obligation to pay back debts not the lien. The lien will allow the lender to foreclose on or repossess the collateral regardless of your bankruptcy discharge. Even so, remedies exist depending on the chapter type you file.

Personal Guarantees in Bankruptcy Chapters 7 and 13

Each bankruptcy case is different. It’s common to have a lot of moving parts and considerations, so it’s best to meet with a bankruptcy attorney. In the meantime, here are a few things to consider.

Chapter 7 Bankruptcy

If you don’t have much in the way of income or property—primarily debt—Chapter 7 will likely be your best option. You can wipe out (discharge) qualifying debt, such as credit card debt and personal guarantees, in approximately four months. If you have non-dischargeable liability, such as a domestic support or tax obligation, you might be able to pay it over time by filing Chapter 13 immediately afterward. This strategy is known as Chapter 20.
Chapter 7 also works well if you have a substantial income, and the majority of your debt is business debt. Here’s why. The means test prevents many people from filing for Chapter 7. However, when most of your debt is business-related as opposed to consumer debt, you aren’t subject to the Chapter 7 means test income qualification. This can be a huge benefit for someone with a personal guarantee liability.

For instance, suppose that you still owe a significant amount of debt due to a personal guarantee from a failed business. However, now you’re making a sizeable income working for someone else. You might be able to discharge your debt quickly using Chapter 7 despite a salary that would generally preclude you from filing. Assuming, of course, that you aren’t concerned about losing property in Chapter 7. Find out if you’re exempt from the means test.

In Chapter 7 bankruptcy, you might be able to avoid a non-possessory, non-purchase-money lien. To qualify, the creditor can’t have possession of the collateral, and you must have owned the asset before you pledged it as collateral. This applies only to certain types of property to the extent the lien impairs your exemptions. Exemptions are the laws that allow you to protect property in bankruptcy. Non-possessory, non-purchase-money liens can be avoided on assets such as tools of your trade, household goods and furnishings, jewelry, and professionally prescribed health aids. You can’t avoid a lien on your house or car (unless the vehicle qualifies as a tool of the trade like a delivery truck).

Chapter 13 Bankruptcy

Many business people find this chapter helpful in several situations. You, as an individual, not the business, would be filing Chapter 13—companies can’t file. Unlike Chapter 7, you can keep all of your property, and in most cases, you’ll pay a smaller portion of your personal debt over time.

Here are a couple of examples that illustrate how Chapter 13 can help.

 You’re still operating as a business, and you’re worried you could lose the company if you file for Chapter 7. It’s possible to improve your financial situation by getting out from under debt that you’re responsible for paying individually, such as credit card balances and personal guarantees. Chapter 13 lets you spend less on that debt for three to five years, and wipes out qualifying debt after completing the Chapter 13 repayment plan. Some business people find this approach helps free up assets and in turn, keeps the business going.
 The business is no longer operating, and you want to keep assets that you’d lose in Chapter 7. You can keep all property in Chapter 13. The tricky part is that you must pay creditors the value of your nonexempt property in your three- to five-year plan. But you’ll eliminate all dischargeable debt through your repayment plan. Learn more about property in bankruptcy.
 Chapter 13 has a few other benefits that aren’t available in Chapter 7. If you’re like many business people, you might have fallen behind on a house or car payment while trying to keep the company afloat. You can catch up on these payments through the Chapter 13 repayment plan and keep the home, car, or other secured property. You can also get rid of a wholly unsecured mortgage on your home using a lien strip, or reduce a 910-day old car loan balance. Also, you might be able to reduce the amount you’d have to pay on some collateral through a cram down in Chapter 13 bankruptcy. For instance, you can reduce the balance owed to the property’s actual value on some personal property, or even a business or rental property. The catch is that you’d have to pay off the reduced loan amount through your plan.

What Happens When the Borrower Defaults on a Guaranteed Loan?

If you default on your loan (usually by missing a payment), the lender has the right to ask the guarantor to take up the payments or to pay off the loan. At that point, the guarantor is subject to the same collection activities you would face under state law: telephone calls, letter demands, lawsuits, and even garnishment and property seizures. Just because the bank turns to the guarantor doesn’t mean that you will be off the hook, however. The lender can pursue you until the loan is paid in full (or you discharge it in bankruptcy). Also, if the guarantor pays the debt, the guarantor can also seek reimbursement from you. However, filing for bankruptcy will likely cut off the guarantor’s right to recover against you, as well.

Who Can Be a Guarantor?

Just about any willing person can agree to guaranty a loan taken out by someone else. In reality, most of the time when the borrower is an individual and the money is for personal or educational purposes, the guarantor is a parent, another relative, or a good friend. Additionally, creditors often require someone to personally guarantee a loan taken out by a business (primarily because of the frequency in which small businesses fail). The guarantor will have to submit to a credit check at least as rigorous as the borrower’s, have sufficient income and resources to pay the loan back if that becomes necessary.

In some institutional lending programs, like student loans and small business loans, banks and other financial institutions make the loans, but the guarantor is the federal or state government. If you default, the government agency pays off the bank and takes ownership of the loan. You will then have to deal with the government agency to rehabilitate the loan or to pay it off.

Even with a government guaranty, the lender can still request that you supply a person to provide additional surety. When the borrower is a small business, the lender will routinely expect the owners or principals of the business to personally guarantee the business loan. Doing so offers the bank and the institutional guarantor added security in the event the company falters. In fact, when the loan is guaranteed by the Small Business Administration, anyone with an ownership interest of 20% or more must personally guarantee the loan. In some cases, the lender might ask spouses of guarantors to sign also to ensure that the parties most affected are aware of their responsibilities and of the consequences they could face.

Effect of a Guaranty on a Loan

Obtaining a guarantor can save a borrower money because banks sometimes will reduce the interest rate on guaranteed loans if it lowers the bank’s risk of loss. It’s not always the case, though. Lenders often ask for guarantors when the original borrower has credit issues, which may mitigate in favor of a higher interest rate. Some financial institutions will let you borrow more if you have a guarantor. For mortgages, the lender might let you finance 90% of the value of the house or make a smaller down payment.

Considerations for the Guarantor

If you’re considering whether to guarantee a loan, you might want to answer these questions before you sign on the dotted line:
 Will agreeing to be a guarantor affect my credit score?
 If the bank forecloses on the borrower’s property, will it appear on my credit report?
 Why is the bank requiring a guarantor?
 Do I have the resources to pay the entire loan back, if necessary?
 If the borrower is a good friend or relative, am I prepared to suffer the friction that could result if the borrower can’t make payments?

Can a Guarantor Wipe Out a Guarantee in Bankruptcy?

In many cases, yes (but not all—for example, a guarantee for an educational loan won’t go away unless you can show undue hardship). In fact, it’s a common reason that people file for bankruptcy.

For instance, suppose that you took out a business loan to pursue your lifelong dream of opening a cupcake bakery. Because your business was new, the bank asked you to execute a personal guarantee. By signing the guarantee, you agreed to use your personal assets to pay off the loan if the business was unable to do so. If the cupcake business dried up and the bakery closed, you’d likely be able to wipe out the guarantee in Chapter 7 or Chapter 13 bankruptcy.