The prevailing practice of asking for personal guarantees from the shareholders needs a clear rethink by all involved parties like banks, entrepreneurs, investors, regulators and authorities.
--By Kishore Dhungana
I woke up with my cell phone ringing in my ears. The call was from a close friend who had not been in contact for a long time. He wanted to ask me about a personal guarantee he had been asked to make on behalf of a company where he was one of the promoter shareholders. He was trying to get in touch with me knowing my decade-long banking background, particularly dealing with credit management.
He told me the story behind the personal guarantee. About five years ago, he was asked by some hydropower entrepreneurs to invest in a project. The proposed 40MW scheme had a total project cost of around Rs. 10 billion and the equity portion was around Rs. 2.5 billion. He decided to invest Rs 5 million as it was an amount he could afford. The project gradually moved forward at its own pace. During this period, my friend was contacted now and again and he was told to pay his portion of the investment.
So far he had paid Rs. 3 million. He explained that there were over a hundred investors in the project in different capacities.
The story goes on. The project is on the verge of financial closure with a consortium of banks ready to finance 75 per cent of the total project cost. During negotiations, the bank had asked for personal guarantees from the promoters to the extent of the bank’s exposure and the leading promoters of the project decided to take personal guarantees from all the promoters for up to their commitment. This meant that an individual investor needed to provide a guarantee up to three times the sum he had committed.
My friend is in a dilemma. If he pays the guarantee his personal liability will increase to Rs. 20 million and if he does not then the outcome of the financial closure will be at stake. Since he is already in his late fifties, his earning capacity is already diminishing and he fears the amount will be a huge liability. Basically, since hydropower has been seen as a good investment, he wanted to invest in this project in order to create a perennial source of income after retirement. But the recent devastating earthquake has shaken his belief in the long term viability of the project. It’s fairly obvious that the success of the project is dependent on future events and despite knowing the leading promoters, he is not in a position to say how the project will fare in terms of cost and overruns.
If he opted to leave the project, who will be ready to buy out his portion of the investment? How much of his investment is he going to get back as he has the opportunity cost as well as time value of money? Even more, why should he let this opportunity go?
After listening to his story, I couldn’t say anything immediately and just said that I would get back to him after a day or so as I really needed to think more to give him a workable solution.
His questions made me think about it from a different perspective. During my time as a banker working for a long time in the credit department, we had also done something similar and had asked for personal guarantees from principal promoters for the total exposure to protect the bank’s interest. In those days, I was more concerned about keeping the bank’s money safe and secure.
I asked some of my friends who are still in banking and got a mixed response. One senior banker from a leading commercial bank said that since the company is a limited liability company, and a person has invested in the company thinking that he will have limited liability to the extent of his share, providing such a guarantee will kill the basic significance of the limited liability concept. He also figured that the project team (the company) should negotiate with the bank and try to convince them.
Another experienced banker from one of Nepal’s prominent banks came up with a different view. He said that his bank had financed different hydro projects and that entrepreneurs were of a different breed, so it was hard to rely solely on the project in the long term. They had come across a case where the project was still to be completed but the financial status of the principal promoters had significantly improved despite investing huge sums of money in the project with no other source of income.
In such cases, if any adverse situation arises, only the financiers (banks) are going to suffer and not the promoters, as they (promoters) make money risk-free. Because of this, unless and until the entire portion of the debt is cleared by the company, the bank should hook in the promoters; hence a personal guarantee is a must.
I also tried to understand the situation from the project perspective and asked some hydro entrepreneurs. They felt that the promoters were active in project implementation and had to take on a lot of responsibilities and even some personal risk. In some cases, banks asked for a personal guarantee from the key stakeholders and directors which they provided, as it is required in order to complete the project. They also felt that when all the shareholders, irrespective of their stake, start to make a profit when the project becomes successful, then why should only the directors or key shareholders take up the liability?
Sounds good, as everyone becomes responsible. But what about the concept of limited liability? What about someone with only a limited source of income wanting to invest an amount he can afford without taking on any further liability? What are they supposed to do in such a situation?
Fundamentals of Personal Guarantees
Going back to the fundamentals of personal guarantees, it’s generally noted that “a personal guarantee is an agreement whereby the guarantor agrees to repay the debts of another person (the debtor) to a lender (the creditor). Typically the bank will be the creditor to whom money is owed by the debtor.” Usually, the obligation being guaranteed will be that the principal will repay the third party a sum of money on or by a particular date. In a guarantee, the guarantor promises the third party that, in the event of the principal not performing its obligation, the guarantor agrees to perform it instead.
In general, a personal guarantee is sought by the banks in the following cases: low credit rating of the principal borrower, doubtful marketability of security, risky ventures etc. In the context of Nepal, the practice of obtaining personal guarantees has been going on for a long time. Banks obtain such guarantees to make credit more secure and to make a person behind the project more responsible.
If we look back at how Nepal's businesses worked in the recent past, most of them were family-held private firms and companies and thus obtaining such guarantees from family members and relatives was not really difficult. There is also the practice of obtaining the guarantee jointly and severally from different individuals who are part of the business. But the situation has changed and people have started doing business using different financing tools as we see in the proliferation of private equity funds for the big projects in the market.
The Legal View
Since I had to advise my friend about his future course of action, I thought of looking at it from a legal perspective. So, I talked with a lawyer friend who has worked in three commercial banks for more than 20 years. Firstly, I clarified the clause ‘joint and several liability’ which is also superseded by another clause ‘limiting liability up to the certain amount only’. This implies that any liability will be limited only up to the specified amount.
Regarding personal guarantees in business, being a banker, he noted that since the key promoters know the project and the associated risks, they are in the driving seat and have envisioned the future to some extent. And since they are involved in the major decisions that determine the future course of action, these people are supposed to provide the personal guarantee for the venture. Banks hesitate to finance a project without taking a personal guarantee as technical knowledge about the venture remains with some of the key shareholders and board of directors and hardly any of the information is carefully verified by the banks.
With the change in the business scene and the introduction of private equity funds in the market, the prevailing practice of asking for personal guarantees from the shareholders needs a clear rethink by all involved parties like banks, entrepreneurs, investors, regulators and authorities.
Dhungana is Associate Director, MBA Day Programme in Apex College.