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The disaster of unlimited guarantees: A lesson from the Finsac experience
Published: Friday | March 4, 2011 1 Comment
Dr Marshall Hall, Guest Writer
Dr Marshall Hall, Guest Writer
The concept of a limited liability company is essential to development in a private sector free-enterprise economy. The concerns by borrowers coming out of the Finsac enquiry dramatises what happens when the concept of a limited liability company is overridden by unlimited personal guarantees oftentimes by the principal shareholder of the borrowing company.
When a limited liability company fails, it can be deemed insolvent and any debt is covered only to the extent that it has assets to cover the liabilities.
The personal guarantee of the guarantor, if unlimited, will continue to accumulate with interest. It is clear from the wailings in the Finsac enquiry that guarantors did not fully appreciate the implications of an unlimited guarantee.
The problem was, of course, exacerbated during the period of dazzlingly high interest rates. On a loan poorly serviced with interest of 45 per cent, the balance in four years could be as large as J$4 million, without penalty interest.
While the compounding is less severe when interest rates are of the order of the current 14 per cent, the amount owed after four years of poor service could be greater than 160 per cent of the original loan.
Oftentimes, interest rates are not fixed, and if adjusted upwards increase the likelihood of poor repayment and, of course, magnifies the loan balance outstanding.
The Finsac disaster of unlimited guarantees must impact negatively on the willingness of guarantors to guarantee and, therefore, must limit the development of the small and medium-sized companies (SMSC).
All agree that a steady flow of new projects by SMSCs is necessary for economic growth and the dangers to the guarantors when unlimited guarantees are required must mean that the system, as presently administered, will see fewer people willing to act as guarantors and consequently fewer projects.
Banks and other financial institutions, quite properly, are not going to lend to start-up projects in small companies without significant assets, without guarantees.
In other words, the limited liability of the SMSC and the known very high failure rate of start-up projects require prudent financial institutions to seek guarantees outside the start-up company. It is now standard for business loans to be supported by non-company property or personal guarantees.
Legal constraints
The question, then, is whether legal constraints should be imposed on banks and other lending institutions on the amount and type of guarantees they are allowed to impose.
An individual guarantees a loan of J$5m knowing that reluctantly they can absorb a J$5m claim and six years later, because the loan is poorly serviced, discovers that at today's interest rates their exposure is a multiple of the J$5m.
In summary, it is recognised that the very important principle of limited liability militates against SMSC's getting loans without guarantees that can be invoked outside of the limited liability of the company.
The limited liability concept should be extended to guarantors.
Before presenting some suggestions, it is well to remember that in countries like the United Kingdom and United States the limited liability provision is used quite frequently when companies cannot meet their financial obligations.
The insolvency goes before the courts and the creditors get paid out if there is no other guarantee in proportion to the assets of the company.
Frequently, this is a few cents on each dollar of the loan or liability outstanding.
Pleading chapter 11 insolvency in the US by a company does not carry a stigma of shame as it is recognised that business failure is normal. Florida law, for example, recognising that guarantors should not be wiped out of savings and home, prohibits the use of the family homestead as security for business loans.
The Finsac experience exposed the dangers of unlimited guarantees and very high interest rates. But even in ordinary times the unlimited, or frustratingly high, guarantees are inimical to the growth and development we so sorely need.
Under no circumstances should a loan guarantee, regardless of the net worth of the guarantors, be uncapped. Financial institutions must accept that after a certain period the loan must be capped, the company put into receivership and the guarantee realised. The guarantee, if not paid, should be pursued through the courts but the loan balance should not be allowed to grow year in year out.
Some suggestions:
1. Make unlimited guarantees illegal;
2. All guarantees should be for a fixed amount - say a maximum of the principal plus six months' interest;
3. Guarantors should be provided with a document that simply and succinctly identifies their maximum exposure;
4. Where property or other assets are used to underpin the guarantee, the maximum amount of the guarantee that the property or asset is to be used for must be clearly stated;
5. Interest rates that are adjustable should not be permitted to increase by more than, say, 10 per cent of the original interest rate in any year.
In thinking through these suggestions, it is well to remember that the guarantor is normally the principal in the company, a relative or a friend.
We want a system that does not discourage financial institutions from lending, but broadens the principle of limited liability to the guarantor where that liability is specific and clear to lender, borrower and guarantor. A failure to do this is likely to result in preacher, teacher and financial adviser encouraging all to avoid giving guarantees.
If the loan goes sour, the loan should be capped and the guarantees called. If the lender is disposed to allow the loan balance to increase beyond the permitted limit, then the guarantor should be required to formally agree to the additional exposure governed, of course, by the same constraints of the original loan.
Financial institutions must call and cap the loan exposure when the original loan plus interest outstanding exceeds, say, six months.
These guidelines would not only have prevented the horror stories of Finsac but will serve to preserve, to a degree, the important principle of limited liability that underpins the free-enterprise system.
Marshall Hall is former managing director of Jamaica Producers Group.
mmh@jpjamaica.com
Published: Friday | March 4, 2011 1 Comment
Dr Marshall Hall, Guest Writer
Dr Marshall Hall, Guest Writer
The concept of a limited liability company is essential to development in a private sector free-enterprise economy. The concerns by borrowers coming out of the Finsac enquiry dramatises what happens when the concept of a limited liability company is overridden by unlimited personal guarantees oftentimes by the principal shareholder of the borrowing company.
When a limited liability company fails, it can be deemed insolvent and any debt is covered only to the extent that it has assets to cover the liabilities.
The personal guarantee of the guarantor, if unlimited, will continue to accumulate with interest. It is clear from the wailings in the Finsac enquiry that guarantors did not fully appreciate the implications of an unlimited guarantee.
The problem was, of course, exacerbated during the period of dazzlingly high interest rates. On a loan poorly serviced with interest of 45 per cent, the balance in four years could be as large as J$4 million, without penalty interest.
While the compounding is less severe when interest rates are of the order of the current 14 per cent, the amount owed after four years of poor service could be greater than 160 per cent of the original loan.
Oftentimes, interest rates are not fixed, and if adjusted upwards increase the likelihood of poor repayment and, of course, magnifies the loan balance outstanding.
The Finsac disaster of unlimited guarantees must impact negatively on the willingness of guarantors to guarantee and, therefore, must limit the development of the small and medium-sized companies (SMSC).
All agree that a steady flow of new projects by SMSCs is necessary for economic growth and the dangers to the guarantors when unlimited guarantees are required must mean that the system, as presently administered, will see fewer people willing to act as guarantors and consequently fewer projects.
Banks and other financial institutions, quite properly, are not going to lend to start-up projects in small companies without significant assets, without guarantees.
In other words, the limited liability of the SMSC and the known very high failure rate of start-up projects require prudent financial institutions to seek guarantees outside the start-up company. It is now standard for business loans to be supported by non-company property or personal guarantees.
Legal constraints
The question, then, is whether legal constraints should be imposed on banks and other lending institutions on the amount and type of guarantees they are allowed to impose.
An individual guarantees a loan of J$5m knowing that reluctantly they can absorb a J$5m claim and six years later, because the loan is poorly serviced, discovers that at today's interest rates their exposure is a multiple of the J$5m.
In summary, it is recognised that the very important principle of limited liability militates against SMSC's getting loans without guarantees that can be invoked outside of the limited liability of the company.
The limited liability concept should be extended to guarantors.
Before presenting some suggestions, it is well to remember that in countries like the United Kingdom and United States the limited liability provision is used quite frequently when companies cannot meet their financial obligations.
The insolvency goes before the courts and the creditors get paid out if there is no other guarantee in proportion to the assets of the company.
Frequently, this is a few cents on each dollar of the loan or liability outstanding.
Pleading chapter 11 insolvency in the US by a company does not carry a stigma of shame as it is recognised that business failure is normal. Florida law, for example, recognising that guarantors should not be wiped out of savings and home, prohibits the use of the family homestead as security for business loans.
The Finsac experience exposed the dangers of unlimited guarantees and very high interest rates. But even in ordinary times the unlimited, or frustratingly high, guarantees are inimical to the growth and development we so sorely need.
Under no circumstances should a loan guarantee, regardless of the net worth of the guarantors, be uncapped. Financial institutions must accept that after a certain period the loan must be capped, the company put into receivership and the guarantee realised. The guarantee, if not paid, should be pursued through the courts but the loan balance should not be allowed to grow year in year out.
Some suggestions:
1. Make unlimited guarantees illegal;
2. All guarantees should be for a fixed amount - say a maximum of the principal plus six months' interest;
3. Guarantors should be provided with a document that simply and succinctly identifies their maximum exposure;
4. Where property or other assets are used to underpin the guarantee, the maximum amount of the guarantee that the property or asset is to be used for must be clearly stated;
5. Interest rates that are adjustable should not be permitted to increase by more than, say, 10 per cent of the original interest rate in any year.
In thinking through these suggestions, it is well to remember that the guarantor is normally the principal in the company, a relative or a friend.
We want a system that does not discourage financial institutions from lending, but broadens the principle of limited liability to the guarantor where that liability is specific and clear to lender, borrower and guarantor. A failure to do this is likely to result in preacher, teacher and financial adviser encouraging all to avoid giving guarantees.
If the loan goes sour, the loan should be capped and the guarantees called. If the lender is disposed to allow the loan balance to increase beyond the permitted limit, then the guarantor should be required to formally agree to the additional exposure governed, of course, by the same constraints of the original loan.
Financial institutions must call and cap the loan exposure when the original loan plus interest outstanding exceeds, say, six months.
These guidelines would not only have prevented the horror stories of Finsac but will serve to preserve, to a degree, the important principle of limited liability that underpins the free-enterprise system.
Marshall Hall is former managing director of Jamaica Producers Group.
mmh@jpjamaica.com
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