What are personal guarantees?
Personal guarantees are legal documents used by lenders, landlords, or other business contractors (referred to as “creditors” here for convenience). These legal documents are used as protection in case the primary debtor, usually a corporation, defaults on payments.
Guarantees are frequently used in contracts with small businesses that may not have sufficient assets to use as collateral. Where this risk arises, the creditor may require a personal guarantee from an individual; this individual is usually closely related to the business, e.g. the owner.
At their core, personal guarantees are another form of contract. They will accompany the primary contract – such as a loan, lease, or product distribution agreement. In the guarantee, the individual promises that they will fulfill the requirements of the primary contract, should the business default. These may be unlimited in nature or may have clauses that limit the duration, monetary liability, or both.
Personal guarantees allow creditors to bypass the corporation and collect on a guarantor’s personal assets to satisfy the primary contract. The creditor is entitled to seek payment from the guarantor only as permitted by the personal guarantee. Depending on the wording of the personal guarantee, the creditor may be entitled to payment from the personal guarantor without first enforcing their rights against the business or even warning the guarantor of a default.
Why might the enforcement of personal guarantees be on the rise?
Businesses and individuals are all feeling the financial strain caused by the COVID-19 pandemic, and this includes creditors. Loans, leases, and product distribution agreements are being defaulted on more frequently by those who are indebted to creditors.
Even one default can increase the likelihood of enforcement, but coupled with the fact that creditors are facing their own financial hardships and experiencing more regular defaults, a creditor may be less lenient when faced with a default or suspicion that a business will default.
Where some creditors may offer warnings or pursue their rights against the business first, others may forego such options and immediately pursue their rights against the guarantor. The choice may be wherever the “deepest pocket” lies.
Another likelihood is that businesses will simply not be able to meet their debt obligations under the current circumstances due to COVID-19. We have already seen many businesses permanently close their doors. More may succumb to bankruptcy and insolvency or reorganization proceedings under the Bankruptcy and Insolvency Act (BIA) or the Companies’ Creditors Arrangement Act (CCAA).
As creditors have fewer options to recover through the primary contract, the personal guarantee may ensure the creditors’ interests are protected, even where bankruptcy and insolvency proceedings for the business have been implemented.
Can guarantors protect themselves?
Guarantors can protect their assets in two ways: fight or flight.
Fight: the guarantor defends against the enforcement of the personal guarantee
There are several ways in which the enforcement of a personal guarantee can be defended through statutory and common law. As the personal guarantee is a type of contract, the usual contract law defences apply, including:
- There was the absence of proper offer and acceptance
- Consideration has not been provided in creating the contract; and
- There was incapacity to enter into the contract
Defences may also arise based on the creditor’s actions or inactions, including where there has been a material change to the primary contract, and where the creditor decides to realize on the business’ assets but has done this in a manner that is not commercially reasonable.
It is important to note that most standard personal guarantees will require the guarantor to waive any defences that exist under the common law. Each personal guarantee and the circumstances that surround its enforcement will need to be reviewed to determine whether a viable defence exists.
Flight: the guarantor makes themselves creditor-proof. Another tactic a guarantor can employ is to protect their assets from the enforcement of a personal guarantee, commonly known as “creditor-proofing”. That is, even if a creditor is successful in obtaining a judgement on a guarantee, the creditor needs to find the assets of the guarantor. Some actions can place assets out of the reach of the creditor, including:
- Ensuring that title to an asset is not in the guarantor’s name or transferring title of the asset into the name of a spouse or adult child
- Creating an inter vivos trust
- Purchasing certain investment and retirement products that are exempt from enforcement proceedings
The points above come with a significant caveat: a guarantor will need to consider the possibility that, should a personal guarantee result in their own bankruptcy and insolvency proceedings, creditor-proofing actions may be reviewable and voidable. In some instances, the Court has set aside these creditor proofing transactions if they occurred within three years of the enforcement of the guarantee.
Personal guarantees are a risk to individual guarantors. The effects of the COVID-19 pandemic may result in a marked increase in the enforcement of these documents. It will be important for both creditors and guarantors to know their rights and risks.
Please reach out to one of our business law lawyers at SV Law who can help you through this and other business-related concerns surrounding the COVID-19 pandemic.
The content of this article is intended to provide a general guide to the subject matter and is not legal advice. Specialist advice should be sought regarding your specific circumstance.