Contract Mistakes You’re Making: Personal Guarantees
Of all the things I see in my practice, a client’s personal guarantee of a corporate obligation is among the few things that keep me from sleeping at night, really. I loathe personal guarantees, and for good reason.
1. Corporations are (quasi) people. In every American state, corporations are legal entities or “beings” in the same way that you and I are beings. As such, corporations are afforded certain privileges and responsibilities. The most common form of responsibility is the obligation to file and pay income, sales and other taxes. Privileges include the opportunity to engage in any lawful business, pursue profits on the one hand, and avail lawful remedies through our bankruptcy code, on the other. My point is this: the corporation stands on its own and creditors should base decisions solely upon the wherewithal of the corporation.
2. Inadequate security. This is where things get silly for me. More often than not, when I see a personal guarantee of an officer\owner for a corporate obligation, the guarantor often lacks adequate security to cover the guaranteed obligation. I’ve long thought that the purpose of the guarantee is not so much to provide the guaranteed party the actual assurance of payment in the event of the corporations default; rather, it is a tool used to scare\intimidate the guarantor.
3. Veil piercing. Unlike the foregoing points, this is where things get scary for me as a lawyer representing a client-guarantor. Our law allows plaintiffs and creditors to reach outside the corporate asset fence and into the personal assets of officers and guarantors under a doctrine called “piercing the corporate veil.” Parties attempting to veil-pierce must demonstrate certain factors before a court will pierce. These factors include: absence or inaccurate corporate records, undercapitalization, siphoning of corporate funds by dominant shareholders, failure to pay dividends, failure to observe corporate formalities, co-mingling owner and corporate assets, failure to maintain arms-length distance between affiliated companies, and a shareholder’s personal treatment of the corporate assets.
Personal guarantees—in my opinion—give rise to a veil piercing argument in that they could be used to argue that the corporation is undercapitalized and\or the comingling of funds. Further, and although I have not seen a veil piercing argument framed in this manner, I’ve long believed that a plaintiff could use the existence of a personal guarantee between a defendant and a third party to pierce the corporate veil. In other words, a personal guarantee of a corporate obligation to a party could potentially be used by another plaintiff to pierce the corporate veil and reach the guarantor’s personal assets.
As a rule, I advise clients not to provide personal guarantees for corporate obligations. I won’t go so far as to say that they should never give them, but at best, it should be done only in very limited circumstances.