If you are an investor in a company funded by a Small Business Administration (“SBA”) loan, then you may wondering whether you are liable for the company debt should the business fail. The Borrower is principally responsible for repayment of the underlying promissory note associated with the SBA loan, but what about shareholders and members (in the case of a limited liability company) — are they liable too? It depends.
Am I automatically responsible for the business debt if I am a shareholder?
No, shareholders who simply invested in the company are not automatically liable for the business debt of the company. This is true whether your business entity is a corporation or a limited liability company (“LLC”). A shareholder or member will not be liable, unless they sign an Unconditional Guarantee agreement for the SBA loan (SBA Form 148 in most cases). It is the guarantee agreement itself and not the fact they are a shareholder or member of the Borrower that creates the personal liability for the repayment of the SBA loan in the event of a default.
What is the magic percentage that triggers the SBA’s requirement for a personal guarantee on an SBA loan?
The SBA requires a personal guarantee from all owners with at least 20% ownership in the Borrower. This means of you are a stockholder or member in an LLC and own 20% or more of the company you will be asked to sign a personal guarantee.
What If my spouse owns 5% and I own less than 20%, will either of us still have to sign a guaranty agreement?
If a shareholder or member’s spouse owns 5% or more of the Borrower and the combined ownership interest of both spouses is 20% or more, then the spouse must also provide a full personal guarantee. This is set forth in SBA’s Standard Operating Procedures (SOP 50 10 5(J)).
What if I am a shareholder and I own 5% or less of the Borrower?
SBA Lenders may still require a guarantee from a shareholder or member’s spouse if they think it is necessary to perfect their lien on collateral pledged by a shareholder or member. In such cases, it may be that the lender will ask the spouse to sign SBA Form 148L which limits the spouses liability to their interest in specific collateral pledged by their husband or wife; this is called an Unconditional Limited Guarantee.
Many people contact our law firm after receiving an SBA 60-day letter demanding that they pay the entire amount due under their company’s defaulted SBA loan. And, time and time again, we hear, they protest claiming they only own 25% percent of the company and so should only be responsible for 25% of the debt, if any at all. In fact, most ask why if the company is a limited liability company (LLC) they should owe anything at all. The problem: the unconditional guarantee they signed.
Ordinarily, a member of an LLC will not be liable for the debts of the company, especially if they sign documents in their capacity as a Manager of the LLC and not as an individual. However, when one signs a personal guarantee that all goes out the window. Not only are you liable to repay the Lender and/or SBA if the company fails, but your liability is joint and several, meaning that the Lender and SBA can come after any one of you for all of the debt not just part of it. In short, your percentage of ownership has nothing to do with the extent of your liability.
Although the SBA tends to issue demand letters to all guarantors, when your loan first goes into default, the lender may sue the Borrower and all guarantors and then obtain a judgment. In some cases, the lender will pursue collection of the judgment, right away, particularly if they know that one or more of the guarantors have a substantial amount of non-exempt (unprotected) real estate with equity or a large stock portfolio not in their 401K. If this happens, the Lender might even recover most if not all of the debt from one member, leaving the others largely unscathed. In that event, while the one member may be able to seek contribution from the others, that problem is theirs alone to sort out.
Before you sign that unconditional guarantee be sure you understand what might happen if the borrower defaulted. How are you positioned relative to the other guarantors? Who is going to get hit the hardest — is it you? And, are all the members ready to share the pain with you? Its not a happy thought, but its better all guarantors consider this situation before they sign.
Scenario 1. My business may close because I don’t have enough working capital.
If you are facing an SBA loan default, then you may want to consider selling your business. If your business has a good track record, but your business is starved for working capital, a loan assumption may be an option. In some cases your loan may be assumable by a third-party buyer who can then step into your shoes, purchasing both the assets and assuming the debt creating a win-win for you and the bank.
Scenario 2. My business is doing well and we want to sell, but we have an SBA loan outstanding.
When you start a business, apart from the income it generates, there is always a need for an exit strategy. It may be that you need to move to take advantage of new opportunities or simply retire. When you have an outstanding SBA loan, you may be able to work with your bank to sell the business and achieve those goals. However, as with the first scenario, you need to be sure you really have “exited” and that no further personal liability exists under the unconditional personal guarantee you signed when the SBA loan was originated.
My loan was assumed, so why should it matter if the new borrower defaults?
Your bank will likely be happy to help facilitate a loan assumption to avoid a default. And, you banker may also be willing to work with you to help facilitate an exit for retirement. Certainly, this sounds like a win-win situation for all parties. However, the devil is in the details. It is important that you work very closely with your attorney to ensure that the SBA actually releases you from the unconditional personal guaranty you signed when you originated the loan. One would think that would be the default result, but that is not the case.
If the new borrower defaults, the bank may certainly pursue them and the new guarantors; however, if neither the new borrower or the new guarantors pay up, and instead file bankruptcy, then the bank may still have recourse against you. In order to avoid this dire situation, you and your attorney should read the fine print of the legal documents together and confirm that you are expressly released. Your banker may also think that that you are released, but it is the fine print in the final documents that count. Remember, the bank, well meaning or not, does not represent you. You must look to yourself and your own attorney to protect your interests.
Our attorneys routinely work with SBA loan defaults, so we all hear a lot of stories. But, not a week goes by where we don’t get at least one caller who is absolutely shocked they received a 60-day demand letter from the SBA. You might wonder at their surprise because, after all, they defaulted on a business loan and being pursued by the lender is expected, right? But, that’s just it — the lender promised they would not sue them and they would not otherwise pursue collection of the debt. In fact, their banker had known them for years and agreed nothing would be gained from suing them. Did the banker lie?
Banks mean what they say, but don’t always say what they mean.
No, in our story above, the banker did not lie to the caller. What the bank did do was to conclude the liquidation phase of the loan default and request payment on the SBA guarantee. A lender may request payment on the SBA guaranty for loans made under most SBA programs following a 60-day uncured deficiency. However, in all loan programs SBA strongly encourages lenders to fully liquidate the loan prior to repurchase. In this case, the lender probably did complete the liquidation of the business assets by selling them at auction or abandoning the collateral if it was of inconsequential value. The lender also probably reviewed the Guarantors’ financial statements and concluded they were judgment proof (e.g., all of their assets were exempt or substantially so such that any cost of collection would exceed the anticipated recovery). At that point the loan was probably moved to charge off status. From the banker’s point of view, it is usually (not always) case closed once they are paid by the SBA.
When the other shoe drops.
The problem with an SBA loan is that the SBA guarantee is intended to benefit the bank, not the Borrower and certainly not the Guarantors. The SBA guarantee is an inducement to the bank to make such loans because its reduces their risk. But, once the loan goes bad and the SBA pays off the guarantee, the SBA steps in and the demand letter they send is the government’s way of say it wants its money back. Yes, the SBA did indeed pay the bank, but now it wants the Guarantors to make good on the debt and pay up. If the Guarantors don’t do so in a timely manner, then the SBA will promptly refer the debt to the U.S. Treasury for further collection efforts, including administrative wage garnishment (AWG), Federal tax refund intercept and more.
What are some of the lessons learned from this situation:
1. If your banker tells you the bank is not going to pursue you, that does not mean the SBA won’t.
2. If you want to be sure the SBA won’t pursue you, then you may want to explore the SBA offer-in-compromise program.
The SBA expects every 7(a) loan to be fully secured. Although, the SBA will not decline a request to guarantee a loan if the only unfavorable factor is insufficient collateral, provided all available collateral is offered. But, every SBA loan must be secured by all available assets (both business and personal) until the recovery value equals the loan amount or until all assets have been pledged (to the extent that they are reasonably available).
What ownership percentage triggers a personal guarantee requirement?
In many cases, prospective clients approach us to ask about the SBA’s personal guarantee requirement. In some cases, the inquiring party is just a minority owner and not even actively involved in the business. Regardless of day-to-day involvement, all individuals who own 20% or more of the equity of a business applying for an SBA loan must provide an unlimited full personal guarantee of the indebtedness on SBA Form 148 or an equivalent document. Moreover, each spouse owning five percent or more of the business must personally guarantee the loan in full, if the combined ownership interest of both spouses is 20% or more.
My spouse is not an owner in the business, why is she being asked to sign a guarantee?
Personal guarantees may be secured or unsecured. If real estate, for example, is being pledged by one spouse, the other spouse may have an interest in that property that would make enforcement of the lien problematic if he/she did not approve the transaction. Therefore, non-owner spouses are of often asked to sign “Limited” guarantees that provides for liability up to the amount of equity in a specific piece of real estate.
Neither I nor my spouse together own more 20% or more of the business, why are we being asked to sign a guarantee?
Although the SBA requires guarantees for all owners meeting the criteria we noted above, lenders are free to require personal guarantees of owners with less than 20 percent ownership and liens on personal assets of the principals may also be required. In these cases, though, you may have far more room to negotiate this point with your lender since this is not an SBA requirement and left entirely to the lender’s discretion.