One of the easiest ways to secure funding for your early-stage start-up is to borrow money. Some of your personal or professional contacts may be willing to act as guarantors for this loan. However, there exist risks to this setup. Several court rulings make such personal guarantors liable even when the business is undergoing bankruptcy proceedings. In this post, Compliance Calendar simplifies the legal concepts around securing a business loan by way of a personal guarantee while also simplifying the risks assumed by a guarantor of business loans.
Person agreeing to repay loans in case of default - A personal guarantor is an individual (and not usually a company) who acts as the surety in a contract of guarantee to a corporate debtor. Put simply, this person agrees to repay any shortfalls arising out of the original debtor's inability to pay the loan.
Banks are allowed to recover - In case a loan-taker defaults in repaying either the principal or the interest component of their loan, the bank may recover the shortfall (with penalties) from the personal guarantor of the loan.
A personal guarantor can be a friend, mentor or investor- However, in rare cases, an individual may become the personal guarantor of their business loans themselves. In this case, their own assets are pledged against the company’s loan.
Raise loans without a solid credit history or collateral - It helps businesses access funding, even with inadequate collateral security or lack of credit history. Thus, small companies and individual entrepreneurs may find it worthwhile to secure funding through contracts of personal guarantees.
Assures creditors - Personal guarantors may be suppliers, stakeholders or friends of the businessman, adding a layer of protection to the credit issuers.
Personality influence of the guarantor - In many cases, an influential or known person acting as a guarantor for the business loan, helps the business in securing funding easily. This is also a positive image building exercise that convinces others of the potential interests in the business.
The distinguishing factor that separates a regular business contract from a personal guarantee is the vulnerability of personal assets of the guarantor. The person acting as guarantor agrees to repay the loan from his or her own personal assets such as one’s house, car, savings and fixed account balance, real estate etc. Unlike the core of the Companies Act, 2013 that protects personal assets of the directors or shareholders, the personal guarantor’s assets become liable to offset shortfall in loan repayment.
Personal guarantee, as the name suggests, is granted by an individual to the debt of another individual or company. However, a corporate guarantee is typically a guarantee for payment given by a large corporation.
Based on the outcome of the 52nd GST Council Meeting, a new sub-rule - Rule 28(2) has been inserted. A crucial difference between a personal guarantee and corporate guarantee is in the levy of indirect tax.
In case a personal guarantee is provided by the director of the company to bank/ financial institutions for sanctioning of credit facilities to the said company without any consideration, the same would not be taxable. However, if corporate guarantee is provided by a related person, or by the holding company for sanction of credit facilities to its subsidiary company, even when made without any consideration, it will be treated as a taxable supply. In such cases, the value of supply will be higher by 1% of the amount guaranteed or the actual consideration.
In a regular loan transaction with a company, if the company defaults, the bank may not be able to seek the remaining balance from personal assets of directors or employees. This is because of a separate legal identity given by law to the company, which ring-fences the debts of the company from being recovered from personal assets.
Unlike this feature, in a contract of personal guarantee, the creditor may take the debt from personal assets of the person guaranteeing the loan. This helps creditors mitigate the risk of default in lending.
The Insolvency and Bankruptcy Board of India was set up in the year 2016 to help entrepreneurs, companies, partnerships struggling to sustain their business in resolving bankruptcy issues. It is in this context that we bring to you important grounds from recent rulings. These decisions highlight how personal guarantors may be held liable for recovery for loans under the Insolvency and Bankruptcy Code (IBC).
The IBC, along with the National Company Law Tribunal provides a timed resolution of stressed assets of businesses. It not only passes orders for winding up, but also suggests non-adversarial procedures for uplifting stressed firms.
It is the NCLT which is empowered to deal with the bankruptcy of companies and LLPs.
During the pendency of proceedings of bankruptcy against a firm, a committee of creditors is appointed to accept resolution plans. This also allows non-defaulting promoters, other agencies to bid for the assets of the business. Such assets may also include the assets of the personal guarantors.
The Supreme Court has stated that even when a resolution plan under IBC is accepted, the liability of the personal guarantor is not exhausted. This is because, the contract between the debtor, lender and guarantor is governed by provisions of Section 126 of the Indian Contract Act, 1872.
Under the Indian Contract Act, if the debtor fails to repay the debt to the creditor, the burden falls on the guarantor to pay this amount.
Thus, Justice Ravindra Bhat has clarified that the creditor or bank or any other institution can move against the personal guarantors, even if the insolvency proceedings under IBC are pending.
A creditor also has the option to initiate insolvency proceedings against the personal guarantor of a corporate debtor under Chapter III of the Insolvency and Bankruptcy Code
First claim against the personal guarantor directly is also valid - In Industrial Investment Bank of India Ltd. v. Biswanath Jhunjhunwala, (2009) 9 SCC 478, it was held that a decree-holder can enforce claim against the guarantor without first proceeding against the principal borrower (or the company in whose name the loan was taken)
Arbitration clause for personal guarantee - If there is an arbitration clause in the personal guarantee agreement, the arbitration clause will be given full effect. This was held in Tata Motors Financial Solutions Ltd. v. Vijay Shreekant Gokhale, 2018 SCC OnLine Bom 11534.
Interest until repayment awarded by courts - In case of unconditional and irrevocable personal guarantee for an amount, the interest clause will also be upheld. In this case, the court ordered a reasonable rate of 15% interest till the actual payment or realization of the total sum decreed to be paid (JBF Industries Ltd. v. Bhawanishankar H. Sharma, 2016 SCC OnLine Bom 6691)
Compliance Calendar’s advice for personal guarantees - Carefully reading the fine print Whether you’re someone acting as a personal guarantor, or a seeker of such guarantees for business loans, our advice would be to read the fine print before you sign the contract. Personal guarantees can also be “limited” by way of clauses in the agreement. In this scenario, not more than a certain specified amount may be recovered. In case of an unlimited guarantee, a lender may recover the full amount due from the debtor from a guarantor. Hence, negotiating the right clauses before securing funding is extremely important.
Our legal experts at Compliance Calendar have assisted diverse businesses in securing funding and can help you understand risks and advantages of a contract of personal guarantee.