The risks of director’s guarantees

With the challenges many businesses are facing in a COVID impacted business environment we are seeing an increase in the use of director’s guarantees. While director’s guarantees are a common part of business for supplier and financier arrangements, there is a danger in directors taking too little care when agreeing to them and in managing their responsibilities once they are in place.

Why do director’s guarantees exist?

A company is a legal entity capable of entering into contract. A company provides certain protections for the shareholders and the ‘controlling minds’, being the director(s) and secretary of the company.

However, a company can be incorporated with token capital- for example, the issue of one share for one dollar. That company can then legally enter significant contracts with third parties, and if the company becomes insolvent before performing its contractual obligations, then the third parties have very limited redress. For that reason, most suppliers and financiers will require a director’s personal guarantee for the company’s obligations.

So what is a guarantee?

A guarantee is a contractual obligation for the guarantor (the director, in their personal capacity) to meet the contractual obligations of the principal (the company) and given in favour of a third party (supplier). A guarantee is a contract, so like all contracts, it is very important to consider the terms.

How do they work?

Financiers almost always require a director’s guarantee when lending to a company. It is common for directors of companies to provide personal guarantees quite freely, to provide assurance to suppliers in order to secure goods and services on account.

Generally, at the start of an enterprise, the director: 

1. is also a shareholder (directly or indirectly);
2. has invested all of his or her capital in the new enterprise, so is already maximally committed; and
3. doesn’t believe a personal guarantee worsens the director’s risk profile, however is practically necessary to do business.

Assuming the director is also the shareholder of the company, then over time, as the business becomes more established and successful, the director takes cash out of the company. It is important to keep that cash safe, away from the risk of the company. With time pressures of a thriving business that seems to move from strength to strength, and the director now conditioned to regularly provide personal guarantees, the director continues to routinely assume additional personal liability for the company’s obligations.

What should a director watch out for?

It is very important that any director of a company:

1. keep a register of personal guarantees that he or she has given to third parties;
2. continually strive to reduce the director’s personal liability for the company’s obligations;
3. regularly maintain, review and update the register of the director’s personal guarantee obligations;
4. request suppliers remove the obligation for the director’s guarantee when there has been sufficient business activity to build the reputation of the company as a creditworthy customer; and
5. if the supplier will not remove the obligation for a director’s guarantee, seek to amend the terms of the guarantee to limit director’s liability by:
   1. capping the director’s liability at:
      • a fixed amount, rather than leave it unlimited. For example, the director could assume liability for a maximum amount of $10,000 only; and/or
      • a fixed period, for example expiring in two years;
   2. having terms permitting the director to terminate the director’s prospective obligations by written notice to the supplier

This is especially useful in the situation where the director sells the business by transfer of the shareholding in the company. While the benefit of the ownership of the business transfer to a new owner, the legal obligations of the company do not change. We have struck many examples where a director sells his or her interest in the company, but the director’s personal guarantees continue to personally obligate that director for a business no longer in their control and in which they have no interest. If the new business owner becomes insolvent, creditors can still require the old director to pay debts incurred by the new director and business owner.

In conclusion, directors should:

1. keep existing personal guarantees front of mind and review them regularly, try to reduce them where possible and give new ones grudgingly- personal guarantees are latent liabilities that will become present at the worst possible time;
2. not accept personal guarantees as pro-forma, ‘tick and flick’, non-negotiable documents. Think of them as contracts, and negotiate accordingly; and
3. consider drafting a pro-forma guarantee on terms the director is willing to give, rather than letting the supplier dictate the terms.

If you need advice regarding a personal guarantee, either as a guarantor or a secured party, please contact the Commercial + Property Team at Clifford Gouldson Lawyers.