SMALL BUSINESS OWNERS: Backed into a corner

The economic situation we face has hit small business owners broadside and many are scrambling to figure out how to get relief. Developers who specialize in building upscale homes were particularly troubled by the recession. Although home sales in the Lexington and Bluegrass area remain more stable than much of the country, folks appear to be shying away from building those half-million to million dollar abodes. These builders are proving especially vulnerable to what I describe below because they rely so heavily on secured loans. However, other small businesses are finding themselves in the same circumstances. The vulnerability of which I write is having one’s personal residence secured against primarily business loans.

Here is the general scenario which appears over and over again: Small Business Owner (SBO) goes to the bank to get a loan to either purchase a business or purchase a new asset, such as land to develop. The bank is glad to lend money to SBO after looking over the business proposal and sets up a time to close the deal. SBO drops by the bank and is told, by the way, granting this loan is contingent upon SBO giving their personal guaranty on the loan AND granting a security interest against their personal residence for the full value of the loan. Now, not all banks wait until closing to announce this, but a few persons I have talked with stated they had no idea they would have to put their own house up until they showed up at the bank. At that point, the whole business deal was dependent on getting that loan soon. Due to time constraints, SBO acquiesces to the security interest. “After all,” they think “the debt is primarily secured by the land owned by the business which will increase in value.” And there is the kicker.

Land values decreased and only now are increasing slightly. So, many of the loans are “under water”; that is, the land providing the primary security interest end up bringing less than the amount of the loan. The SBO faces having any excess debt of that business loan remain against their personal property. As the banks know, now the SBO cannot simply let their business fail while remaining safe in their home; they must navigate the personal debt gauntlet as well. Has their income been low enough to file a Chapter 7? Do they have sufficient income to even qualify for a Chapter 13, and if so, could they fund a plan? Could they afford a Chapter 11 and would it bring the relief they need personally? Throughout all those considerations the main question is: can I keep the home that I have worked so hard for so that my family has a home?

Unfortunately, there is often no clear course where I can confidently tell them that, “yes, you will keep your home.” If they have a primary debt that secures the home close to the allowed homestead exemption (currently over $21,600.00 per person; over $43,200.00 for a married couple), and their income is low enough, then they may be able to reaffirm on that home purchase loan and strip off the business debt. It is a different analysis if the business debt is secured first against the developed lot and secondarily by the builder’s personal residence which would otherwise have over $100k in equity. That means they have far too much equity for a Trustee to ignore when the debt securing so much of it is contingent. In other words, depending on the value of that developed lot, they may have $100k in equity or they may have zero equity and anything in between. Those details often do not become defined until after the bankruptcy has been initiated. They could attempt a Chapter 13, but their plan must still show that the unsecured creditors would do just as well or better than in a Chapter 7.

There are a few points I wish to highlight with the scenario I have briefly outlined: 1) Do your best, if you are a SBO, to avoid letting your personal residence secure a business loan; 2) If you do not have the clout or leverage to avoid using your residence as collateral entirely, negotiate limiting the amount of the personal guaranty to a manageable level if your business did fold; 3) Consult with an attorney, preferrably one familar with bankruptcy law, before signing on the dotted line any deal that directly involves the assets of your family; 4) Remember that bankruptcy can be far more complicated for a Small Business Owner, so if you find yourself facing a debt crisis, seek out an attorney that will meet with you personally and discuss all aspects of your financial and family situation. Pre-deal planning with an attorney is so much more cost efficient than bringing one in after the crisis.