Guarantees: hedging instruments for your credits
Considering all the parameters, a financial backer may or may not require guarantees from the entrepreneur, company, or a third party to hedge the risk relating to the granting of credits.
Why are guarantees required?
Each credit granted by a financial backer represents for it a more or less significant risk of the money not being repaid. In fact, if the debtor is no longer able to meet their commitments, it is more than likely that the financial backer will not recover the entirety of the funds lent.
It is to protect against this risk that banks and other lenders require sufficient guarantees prior to providing a credit. In case of serious problems, the use of the guarantees provided must be able to facilitate a higher level of recovery of the funds loaned.
The financial backer must use external criteria as well as its own to determine:
- the level of a transaction's potential risk
- the guarantees available and their value
- the costs of establishing guarantees
- the acceptable level of risk
- the quality and the importance of the relationship with the customer
- the remuneration desired for loaned funds
In terms of the first point, namely the risk of the transaction, this is understood to be the result of a multitude of risk factors linked to the company's activity, its sector, its financial structure, the entrepreneur's profile, the object financed, etc.
The repayment required for the funds loaned, the quality of the customer relationship and the degree of acceptable risk will be linked to the financial backer's internal parameters, as well as to the transaction's risk parameters.
In terms of the cost of providing the guarantees, it may seem surprising but it is useful to know that in certain cases the financial backer prefers to do without the guarantee, especially if the backer has sufficient belief in the project and/or considers that the costs of using a guarantee are disproportionate to the benefit gained. In such cases, the credit is granted based on reputation (without a guarantee).
However, for most SMEs, their financial structures and their reimbursement capacities will only be sufficient to meet the banks' requirements. The latter will therefore require an additional guarantee in one form or another.
The entrepreneur must be aware of certain aspects before agreeing to provide financial backers with guarantees:
- Some guarantees only concern a limited portion of the company's assets; others are more extensive, and others still even concern assets held outside the company.
- Some guarantees can be limited in time, amount or credit covered.
- The cost of establishing the different guarantees is quite variable, and can sometimes be very high
- Offering private guarantees to cover professional risks, particularly if this is a real guarantee concerning assets, is ill-advised.
- The nature of the guarantees selected is very important for the company because certain parts of the assets are no longer freely available following the establishment of certain guarantees, which links the company, sometimes in the very long term, with the beneficiary of the guarantee
Therefore, it is up to the entrepreneur to reach a compromise with their financial institution so that the latter’s requirements in terms of guarantees are met while retaining sufficient room for manoeuvre.
Different types of guarantees
We traditionally distinguish between:
- Real guarantees relating to assets having an intrinsic value
- Personal guarantees involving a debt obligation for one or more people
- Moral guarantees offering the lender no real legal guarantee
- Privileges which are established by law and are not the result of an agreement between the parties
A real guarantee is a privileged debt on a movable or immovable assets belonging to the borrower or a third party who gives the lender a preferential right to the price of this asset.
1. Real guarantees
Known real guarantees include the following:
- Pledges of business capital
- Pledges of titles or securities
- Bank guarantee
- Insurance, including credit insurance
The guarantees provided by the Brussels Guarantee Fund are also real guarantees, and the latter may be significant for the granting of financing.
The mortgage is a real right of the lender to the property concerned. In case of a lack of repayment by the borrower, the bank can insist that this property be sold to repay part of or all the remaining credit balance. In the context of a professional credit, the property used as a guarantee may be either the property financed by the credit in question, or another property belonging to a third person: the entrepreneur themselves, for example. It is generally ill-advised to provide real, private guarantees to cover professional commitments, but it is still possible to do so.
2. Personal guarantees
The most well-known personal guarantee is suretyship. The difference between a guarantee and a suretyship is that the suretyship is based on accessory liability whereas the guarantee is based on primary liability. If a debtor defaults on his obligations, the suretyship commits a creditor to respect the requirements contracted by the principal debtor. By requesting a surety, the financial institution extends the guarantee to assets outside those held by the company.
The sureties requested by the banks are generally interdependent and indivisible. Interdependent implies that, in case the sums due from the borrower are not repaid, the lender may require the surety to pay all the remaining sums, as if it were the principal debtor.
Indivisibility implies that, if several people have agreed to provide surety, the creditor reserves the right to claim the entire sum from any of the sureties. You must be very careful before offering surety, and you should limit the amount and duration if possible.
3. Moral guarantees
Moral guarantees conger no privileged debt obligation to the bank. They are essentially based on the trust shown in the borrower in terms of respecting his commitments. In case of termination of credit, the lender stands on the same footing (or in a worse position even) as the other creditors.
One of the most well-known moral guarantees is the mortgage mandate. The mandate is an agreement through which the owner of a property gives the lender an irrevocable mandate for the mortgage on a property. The possible conversion of the mandate into a mortgage can be performed without prior notice by the beneficiary of the guarantee and the mandate costs. The mandate costs are clearly lower than mortgage costs. For the lender, a mandate does not represent a real guarantee because there is nothing to prevent the borrower from agreeing to a mortgage on the same property for the benefit of another lender.
A privilege is a right granted by the law due to the specific nature of the debt which allows the creditor, in the case of "privilege competition", to be paid as a priority with the product of the equity (of a part of the latter) from the company/the debtor.
The granting of privileges is reserved for the legislator, and the latter also determines the place (rank) occupied by a specific privilege among other privileges.
A distinction is generally made between general privileges and specific privileges. Specific privileges take precedent over general privileges.
General privileges concern all equity or an abstract part of the latter and stipulate that one specific debt obligation must be paid before another. In case of specific privileges, a specific asset is used to guarantee a defined debt. The privileged debt obligation is paid as a priority with the product of this asset.
In case of financing capital goods, the bank often demands to take the place (to be subrogated) to the rights of the unpaid seller.