Virtually every business and individual borrows money at some point. Although there are many different loan types available, some universal concerns apply to every loan. Borrowers need to understand these issues and know that they may be able to limit their risk through negotiating their loan documents.
“Borrowers don’t always fully appreciate the risks they are taking when borrowing,” says Catherine A. Marriott, a member at Semanoff Ormsby Greenberg & Torchia, LLC. “Often, a default which could have been avoided can result in acceleration of a loan, putting personal and business assets at risk.”
Smart Business spoke with Marriott about what provisions counsel should review, whether or not he or she participates in the negotiations.
What are issues borrowers should consider?
Often, borrowers extend lines of credit via a simple modification document, without reviewing the documents signed when the loan was first obtained. In doing so, they run the risk of violating representations and warranties that were true when the loan was first made, but are not necessarily true when the loan is modified. Further, borrowers may not be aware of operating and financial covenants that apply to their business, and often think that because they have not had any issues in the past, there is no need for concern now. While that may be true, reviewing the initial documents is critical in avoiding defaults going forward, as circumstances and goals may have changed.
For new and existing loans, borrowers must be sure that they understand:
- All business terms, such as the monthly payment obligation, interest rate, amortization term, prepayment penalty, and operating and financial covenants.
- What collateral is pledged for the loan, including security interests in equipment, inventory and accounts receivable, and, most importantly, personal guarantees.
- The remedies that the lender has upon a default, including confession of judgment for money or possession of real property, and what effect enforcement of these remedies could have on business and personal assets.
What should be considered regarding personal guarantees?
Many borrowers form entities to keep business and personal assets and liabilities separate. Notwithstanding this goal, principals of small and midsize businesses are almost always required to personally guarantee business loans, resulting in risk to personal assets. Although these individuals are aware of their personal liability, the extent of their exposure may not truly be appreciated.
How does confession of judgment work to increase borrower risk?
Confession of judgment is a powerful remedy available to commercial lenders in Pennsylvania. It allows a lender to immediately obtain a judgment against a borrower or guarantor (or both) for money or possession of mortgaged property. The money judgment will include the accelerated amount of the balance of the loan, plus interest, late fees, attorney’s fees and costs of collection. A borrower or guarantor will have the opportunity to open the judgment only after it is entered, rather than defend the matter before it becomes a judgment. An attorney can advise of the risks and consequences of confession of judgment.
When should counsel be reviewing the loan documents?
Certain loan provisions are legal in nature, so borrowers should consult with an attorney to understand the legal risks. By doing so at the outset, counsel can advise not only on whether borrowers are receiving market terms, but also can assist with modifying or eliminating provisions that are negotiable. Counsel can make sure that borrowers understand their obligations, and that the loan terms adequately address the borrowers’ needs and business goals. The later counsel gets involved, the more difficult it becomes to improve the loan terms.
Even if a borrower has never had problems with its loans or lender, things can happen. Considering what is at stake, all borrowers should strive to minimize their risk. Spending a little time and money now to protect business and personal assets in the future is invaluable.
Catherine A. Marriott is a member at Semanoff Ormsby Greenberg & Torchia, LLC. Reach her at (215) 887-0200 or email@example.com.
Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia, LLC
Business failure has historically been a risk insurance carriers have assiduously avoided. Other than trade-credit insurance and limited credit-enhancement policies, the risk of default of a business is typically borne by the business owner.
In today’s lending environment, as banks look to mitigate their own exposures to risk, nearly all small and midsize business owners must sign a personal guarantee to secure financing. The result is that, if the business fails, the business owner’s personal assets are used to cover the loss.
This is obviously an extremely angst-inducing, emotionally charged decision, which, if it ends badly, can cause significant hardship — including loss of the owner’s home.
But with the introduction of personal guarantee insurance, a new category of coverage is now available to help business owners manage personal risks — and sleep better at night.
Smart Business spoke with Sergio Bechara, president and CEO of Millennium Corporate Solutions about how personal guarantee insurance works, how it can help business owners, and what features to look for in this coverage.
What is a personal guarantee?
A personal guarantee is essentially a signed blank check without an expiration date. But with the introduction of personal guarantee insurance, business owners can manage their personal risks — and enjoy the peace of mind that comes with knowing their personal assets will not be used to cover the loss if their business fails.
Why is personal guarantee insurance important?
Insurance practitioners are the guardians of their clients’ assets, both personal and professional. They manage, mitigate, isolate, insure and have contingency plans if bad things happen.
As part of that task, they work with lawyers to create barriers to limit liability through corporations, LLPs, LLCs and trusts. For remaining liability exposures, there is general liability, auto liability, professional liability and a host of other coverage types, all of which are used in the name of protecting assets. For property exposures, the insurance practitioners negotiate special forms coverage for their clients.
Despite the great efforts of the insurance carriers, underwriters and brokers, bankers can destroy much of their good work with one stroke of the pen. In their efforts to mitigate their own risk exposure, banks have penned personal guarantee requirements that tie the business owner’s assets to the business itself. These requirements, which most small and midsize business owners must meet in order to receive financing, have the effect of taking down the walls your insurers have so diligently erected, allowing for the unthinkable.
Since a personal guarantee gives the banker access to a business owner’s personal assets (often including a spouse’s) if a business loan is in default, bankers have traditionally had the upper hand in these situations — until now.
How does personal guarantee insurance help business owners?
Personal guarantee insurance (PGI) helps neutralize the impact of the required guarantee. It puts back the wall between the business and personal assets by covering a substantial portion of the liability of the personal guarantor in the event the loan guarantee is ever called.
With this policy, everyone can be satisfied: the bank receives the personal guarantee to complete the loan, while the client’s personal assets are protected by the insurance policy.
As a benefit to bankers, one provision of the PGI policy is that the proceeds can be assigned to the lender, thereby improving the collateral position of the bank. Now, the bank has an even better position — it has the business as collateral and a signed personal guarantee, which is backed by an insurance policy to which it is a beneficiary.
What features should business owners expect as part of this coverage?
Some features of the new insurance are:
- PGI is typically issued within six months of a loan origination or material modification.
- It can be designed to pay up to 70 percent of a deficiency judgment in the event of a loan default.
- It can typically be underwritten based on the same information the bank uses when making the business loan.
- While it adds cost to the overall loan transaction, it provides a tremendous backstop in the event personal assets are ever called into play.
- Since the bank is likely in a better position if the proceeds are assigned to the lender, it may be able to offer a more attractive interest rate on the loan once the coverage is put into place to help offset the cost of the insurance.
How can insurance brokers and risk managers ensure the personal guarantee insurance is working as it should?
As we undertake the managing of risks for our clients, a review of the personal guarantee should be included in exposure-review checklists, just like we review employment practices, environmental or cyber-liability exposures.
Sergio Bechara is president and CEO of Millennium Corporate Solutions. Reach him at (949) 679-7120 or firstname.lastname@example.org.