Forms of Business Ownership

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NOVEMBER–DECEMBER 2010 COMMERCIAL LENDING REVIEW 27

Gregory L. Prescott is a Senior Instructor of Accounting at the University of

South Alabama in Mobile. Contact him at [email protected].

Ellen K. Madden is an Instructor of Accounting at the University of South

Alabama in Mobile. Contact her at [email protected].

R. Mark Foster is an Instructor of Accounting at the University of South

Alabama in Mobile and a Partner with Allen, Allen, and Foster, LLP.

Contact him at [email protected].

Forms of Business Ownership: A Primer for Commercial Lenders By Gregory L. Prescott, Ellen K. Madden and R. Mark Foster

A review of the risk factors associated with the most common forms of business ownership.

When starting a new venture, deciding on the form of business ownership is one of the most basic decisions a business owner makes. Although many businesspeople do not real- ize the impact of the business ownership structure decision, the chosen form of business ownership can result in signifi cant ramifi cations for the owner as well as for the business itself. For instance, the chosen structure will affect the cost and ease of establishing the business entity, the liability of the owners for the entity’s debts, the continuity of the business upon the death or withdrawal of an owner, the nature of management control, the ease of raising additional capital after inception and the income tax implica- tions associated with the entity’s earnings/losses.

Commercial lenders should have a basic knowl- edge of the most popular forms of business ownership and the corresponding implications for the business as well as the business owners. This article aims to provide commercial lenders with a basic understanding of the primary advantages and disadvantages of the most common forms of business ownership structure and to highlight the resulting risk factors that lenders should consider as they manage their lending relationships with commercial entities.

Forms of Business Ownership The most common forms of business ownership structure include the following: sole proprietorships, general partnerships, limited partnerships, corpora- tions (both C corps and Sub S corps), limited liability companies and limited liability partnerships. Each

structure has its own distinct advantages and dis- advantages as well as associated risks for lenders (summary, Exhibit 1).

Sole Proprietorship A sole proprietorship (or simply, “proprietorship”) is an unincorporated business conducted by the owner in his or her individual capacity. It is the simplest form of business ownership, but it is important to know that the sole proprietorship is not a separate legal entity. From a legal standpoint, the business has no existence apart from its owner. The owner main- tains complete authority over the management of the business, and title to the entity’s assets is held in the name of the proprietor. The primary advantage of the sole proprietorship structure is that it is the easiest and least expensive ownership structure to organize. Plus, the owner maintains complete control over the business, and the entity is relatively easy to dissolve. The primary disadvantages of this form are that the owner has unlimited personal liability for the debts and obligations of the entity and that it is diffi cult to raise additional equity capital (if necessary) due to ownership being vested in a single individual.

28 COMMERCIAL LENDING REVIEW NOVEMBER–DECEMBER 2010

Forms of Business Ownership

Exhibit 1. Forms of Business Organizations

Sole Propietorship

General Partnership

Limited Partnership Corporation

S Corporation

Limited Liability Company

Limited Liability Partnership

Legal Status

Not a sepa- rate legal

entity

Some at- tributes of separate legal entity

Separate legal entity

pp Separate legal entity

Ownership One indi- vidual

At least two general partners; no limit on p

number of partners

At least one general partner and

one limited p

partner; no limit on pp

number of partners

Sharehold- ers; may have only

one share- y

holder

Sharehold- ers; maxi- mum of 100 shareholders allowed

Members; no maxi- mum on number of owners al- lowed

Usually restricted to

certain pro- fessionals

Liability of Owners

Unlimited personal li- ability p

Each part- ner jointly

and sever- j y

ally liable

Each gen- eral parnter

jointly and pp

severally li- j y

able; limited y

partner en- joys limited li p

liabiltiylti j yj y

Sharehold- ers enjoy limited legal

j yj y

liability

Shareholders enjoy limited legal liability

j yj y Members enjoy lim- ited legal

j yy

liability g

Partners not normally liable for

acts of other partners

Profi tfitss andd Lossessess

s andts aPProfi t es of the osseslo sloosses of t

entity are ntien reported

on the sole p

proprietor’s personal p p

income tax return

Partnersner share profi ts shar profits and losses

in propor-opo tion totio to contribu-co bu- tions unless otherwise stated in partnership agreement

Partnersne share profi ts e and losses

in propor-n p tion totion to contribu-conntr bu- tions unless otherwise stated in partnership agreement

Profi ts and losses are calculated at the entity the en level; divi-el; i i- dends may nds may be paid to

sharehold- pp

ers

Profi ts and losses fl ow through to shareholderss

Profi ts and losses al- located in proportionio to members’to memb rs’ p p

contribu-ontribu- tions unless otherwise stated in operating agreement

Partners share profi ts and losses

in propor- tion totion to contribu-conntribu- tions unless otherwise stated in partnership agreement

Taxation Pass-through entity; all profi ts

and losses p

reported on owner’s per- sonal income

tax return

Pass- through en- tity; profi ts

and losses y pp

reported on partners’ personal p

income tax return

Pass- through en- tity; profi ts

and losses y pp

reported on partners’ personal p

income tax return

Corpora- tion itself

fi les and pays federal income tax; sharehold- ers pay tax on divi-

p yp

dends

Pass-through entity; prof-

its and losses y pp

reported on sharehold-

ers’ personal income tax return

Can elect either part- nership or

corporate tax status

Pass- through en- tity; profi ts

and losses y pp

reported on partners’ personal p

income tax return

The sole proprietorship is considered a pass- through entity for state and federal income tax purposes, meaning that the business does not pay income taxes itself; instead, all profi ts and losses of the business are included in the owner ’s personal income tax return. While there is no legal distinction between the business entity and the sole proprietor, to monitor operating performance and the fi nancial condition of the business, accountants can and do

prepare entity fi nancial statements. However, the commercial lender should be aware that the net income (or net loss) reported on the entity’s in- come statement does not allow for any income tax expense at the entity level, as any tax liability is the responsibility of the sole proprietor. Therefore, when assessing a proprietorship’s debt-servicing ability, an adjustment for the related income tax liability of the entity should be taken into consideration.

NOVEMBER–DECEMBER 2010 COMMERCIAL LENDING REVIEW 29

Forms of Business Ownership

General Partnership

A general partnership is the association of two or more persons or entities acting as co-owners of a business for profi t. While a general partnership is considered a separate legal entity for some limited purposes (it can sue and be sued and hold property in its own name), for most purposes it is treated as a group of individual partners with each being jointly and severally liable for partnership obligations. Joint and several liability refers to the concept that each partner is liable for the total amount of any partner- ship debt, regardless of his or her ownership interest in the partnership. No formal fi lings or documents are required to form a general partnership. A general partnership may be formed by an oral or written agreement. For obvious reasons, the partnership agreement should normally be in writing. The part- nership is generally governed by the decision of a majority of the partners, but the partners have the fl exibility to agree otherwise. However, a partner cannot transfer a partnership interest without the consent of all the existing partners. For income tax purposes, a partnership is a pass-through entity, not subject to income tax at the partnership level. Instead, the income and losses of the partnership flow directly to the partners, who report their proportionate share of the income or loss on their personal income tax returns.

The primary advantages of a general partnership include the ease of formation, the ability to pool resources with other individuals and the fact that the general partners have the option of taking an active role in managing the affairs of the entity. The main disadvantages of a general partnership are the joint and several liability feature of the individual partners as well as the lack of transferability of a partnership interest without the consent of all the other partners.

Limited Partnership A limited partnership is made up of one or more general partners and one or more limited partners. The internal operations of a limited partnership are governed by a limited partnership agreement among the partners. The limited partners are typically pas- sive investors who are restricted from participating in the active management of the entity; as a result,

they are afforded limited liability protection for the partnership’s debts and obligations (their liability is limited to their capital contributions). The general partner or partners are responsible for managing the partnership and are jointly and severally liable for the partnership’s debts. There is no requirement that a general partner be a natural person; it can be a corporation or other entity. As was the case for sole proprietorships and general partnerships, the limited partnership is considered a pass-through entity for income tax purposes.

The primary advantages of the limited partner- ship structure include the advantages of the general partnership form detailed earlier as well as the fact that the limited partners’ liability for the partner- ship’s debts is limited to their capital contributions. However, limited partners who become actively involved in the management of the partnership risk losing their limited liability status. The primary disadvantages of this structure are that the limited partners are required to be passive investors and general partners are subject to the risks associated with the joint and several liability feature.

Corporation There are two distinct types of corporations: C corpo- rations and S corporations. Both the C corp and the S corp are so named due to the subchapter portions of the Internal Revenue Code outlining the require- ments associated with each form. The C corp is the standard corporate form with which most people are familiar. We will fi rst address the C corp structure and then focus on the S corp form.

A distinguishing characteristic of the corporate form is that it is organized as a legal entity separate and distinct from its owners under the laws of in- corporation of the state in which the corporation is organized. A corporation is the most complicated type of business form to organize and operate due to the large number of formalities normally man- dated by state law. Ownership in a corporation is represented by shares of stock, which are generally transferable at the stockholder’s option. The own- ers of the corporation are known as stockholders or shareholders. The corporation is a separate legal entity, so its liability for its obligations is limited to the extent of its corporate assets. Thus, sharehold- ers are not personally liable for the corporation’s

30 COMMERCIAL LENDING REVIEW NOVEMBER–DECEMBER 2010

debts; this concept is known as limited liability of the stockholders and is a primary advantage of this form of business ownership.

By being able to sell shares of stock in itself, a corporation has the potential to raise vast sums of capital. The basic form of a corporation may issue more than one class of stock and is not restricted by the number or types of shareholders it can have. Cor- porations are often managed by boards of directors, with day-to-day operations performed by offi cers elected by the board. A corporation adopts bylaws setting forth internal governance. Except for electing directors, nonemployee stockholders are not active in the management of the corporation.

The key advantages of the corporate form of business ownership include the limited liability protection for stockholders, the ability to raise un- limited amounts of capital and the legal existence of a corporation that is separate and distinct from its stockholders. The most important disadvantages of this ownership structure include the fact that cor- porations are subject to a substantial array of state corporation laws, regulations and fi ling require- ments. Also, the profi ts and losses of the corporation are taxed at the corporate level. Signifi cantly, any dividend distributions subsequently made to stock- holders are also taxed at the individual level, giving rise to the so-called double taxation associated with C corporation income.

An S corporation is a special form of a corporation that allows the entity to avoid the double taxation feature of a C corporation as discussed above. The stockholders of a corporation may elect Sub S status—assuming eligibility requirements are met— for federal income tax purposes. In doing so, the stockholders elect to have the corporation treated as a pass-through entity for income tax purposes with the stockholders taxed on their proportionate share of the income or loss of the corporation. S corpora- tions do not pay income taxes at the entity level.

Due to this signifi cant advantage over the basic corporate form, there are strict eligibility require- ments that must be met before a corporation can be classifi ed as a Sub S entity. For instance, all shareholders in a Sub S corporation must be indi- viduals, estates, certain defi ned trusts or certain tax-exempt organizations. The individual stock- holders must be citizens or residents of the United States. An S corporation can have no more than 100

shareholders (a husband and wife are treated as a single shareholder). The entity must be a domestic corporation that is organized under the laws of any state or U.S. territory, and the entity can issue only one class of stock.

The advantages and disadvantages of the S corporation form are similar to those of the basic corporate form except that the earnings of S corpo- rations are not subject to taxation at the corporate level, thereby avoiding the double taxation feature of C corporations.

Limited Liability Company The limited liability company (LLC) form of business ownership is a relatively new option for businesses in the United States. The fi rst state to recognize the LLC structure was Wyoming in 1977. By 1996, all 50 states and the District of Columbia had passed statutes recognizing the LLC structure and creating statutory frameworks for addressing the formation, operation and dissolution of LLCs.

An LLC is generally considered a hybrid between a partnership and a corporation. It is normally a pass- through entity for income tax purposes—similar to the partnership forms discussed earlier—but it affords its owners the limited liability protection associated with the corporate form. An LLC is formed by fi ling a formation document that complies with a state’s statutory requirements. The internal operations are generally governed by an operating agreement. The formation and the fi ling process as- sociated with LLCs are generally more complex and formal than that of a general partnership.

Instead of stockholders, the owners of an LLC are generally referred to as members. Unlike an S corporation, an LLC may have more than one class of membership interests, with no restrictions on the types of members. Also, unlike limited partners, members may participate in management without risking personal liability for the entity’s debts.

The reasons for the popularity of the LLC struc- ture should be readily apparent. LLCs combine the advantages of the corporate form (the limited liability of the entity’s owners, the ease of raising capital and the fact that owners can be involved in the management of the entity’s operations) while avoiding the double taxation feature of the basic corporate form. Furthermore, unlike the Sub S

Forms of Business Ownership

NOVEMBER–DECEMBER 2010 COMMERCIAL LENDING REVIEW 31

structure, there are no limitations on the number and types of parties that can be member owners of an LLC. The only real disadvantage of this ownership structure is that the process of forming an LLC is typically more cumbersome than that of most other forms of business ownership.

Limited Liability Partnership Like the LLC, the limited liability partnership (LLP) is a relatively new form of business entity in the United States. It is the creation of state law, and ownership is usually limited to certain types of professions, for example, attorneys, CPAs, etc. With an LLP, partners are afforded limited liability protection even if they take an active role in the business of the partnership. All partners enjoy lim- ited liability exposure. In order to enjoy this limited liability, the partnership is normally required to maintain general liability insurance to cover pos- sible injured parties. The LLP is a pass-through entity for federal income tax purposes. The LLP itself does not pay income taxes. Instead, profi ts and losses pass through to the partners’ individual income tax returns.

Implications for Lenders The decisions regarding business ownership struc- tures have implications for commercial lenders in three key areas: (1) the assessment of the debt- servicing ability of a commercial entity, (2) the assessment of the allocation of profi ts and losses, and (3) the assessment of the level of risk inherent in a personal guarantor’s business interests. One of the fi rst steps in the process of evaluating a commercial loan request is assessing the debt-servicing ability of the borrowing entity. During this process, it is imperative that the lender take into consideration whether the borrower is a pass-through entity or a taxable entity for income tax purposes. For instance, the net income reported by a basic C corporation on its income statement prepared in accordance with generally accepted accounting principles should be net of the related income tax expense. On the other hand, the net income reported on the income state- ment of a Sub S corporation would not be net of the related income tax expense, since the earnings of an S corporation are not taxed at the business level. It is

common practice for S corporations to declare and pay cash dividends to their stockholders suffi cient to allow the stockholders to meet their income tax obligations related to the corporation’s earnings. However, dividend distributions are not treated as an expense for accounting purposes and, therefore, are not deducted on the income statement in arriving at reported net income.

Being aware of this distinction between taxable and nontaxable entities, many fi nancial institutions require that an adjustment be made to the earnings reported by pass-through entities in the process of assessing debt-servicing ability. Depending on the magnitude of the pass-through entity’s reported earnings and whether or not the entity’s home state has an individual income tax, the adjustment typically ranges from 20 percent to 40 percent of the pass-through entity’s reported earnings. To ignore this consideration is to view the tax liability on the pass-through entity’s earnings as a discretionary item—not a required obligation.

In addition to assessing the tax liability of pass- through entities, commercial lenders should be aware of profi t and loss allocations and possible loss limitations of pass-through entities, especially if in- come tax losses are being included as part of future cash fl ow analyses. For example, partnership oper- ating agreements should be examined for covenants describing allocation of profi ts and losses. Gener- ally, profi ts and losses are allocated to the partners based upon their proportion of ownership interest. However, the allocation of profi ts and losses does not have to be the same as the partners’ ownership percentages. The partnership may have agreed to allocate a larger percentage of profi ts and losses to a partner than his or her ownership percentage, which should be described in the operating agreement. As a result, the allocations to partners can be signifi - cantly different from ownership percentages. For example, assume a partnership has two partners, each contributing assets to the partnership such as cash that result in each partner having a 50-percent ownership interest. The operating agreement may state that Partner A receives a 60-percent alloca- tion of profi ts and losses and Partner B receives a 40-percent allocation. This information can also be found on the partner ’s Form K-1 that he or she receives each year from the partnership that docu- ments the partner ’s share of income and expenses

Forms of Business Ownership

32 COMMERCIAL LENDING REVIEW NOVEMBER–DECEMBER 2010

for the partnership. Form K-1 typically reveals the allocation percentages as well as the total amount of the allocation.

Partners may also receive guaranteed payments from the partnership in exchange for services ren- dered to the partnership or for the use of invested capital. These payments are deductible expenses to the partnership and as a result decrease partnership income. The guaranteed payment to the partner is taxable to him or her and does not reduce his or her basis because it is not considered a distribution.

Losses incurred by partnerships are normally al- located in accordance with ownership percentages or specially allocated as previously described. If a partner has suffi cient basis, he or she may potentially offset income from other sources with this partnership loss, dependent upon at-risk rules and passive activity limitations. At-risk basis is the regular partnership basis plus the partner’s responsibility for partnership liabilities, typically recourse debt. This effectively increases the amount of losses that the partner may deduct on his or her personal return. The nature of the partner’s activity in the partnership may affect the de- ductibility of losses if that activity is deemed passive. Passive losses are not deductible but may be carried forward until such time as the partner disposes of the entire interest in the passive activity.

With the use of accelerated and bonus depreciation that is allowed by tax regulations, many partnerships may report losses not solely as a result of operations but because of the use of accelerated depreciation methods. This is especially the case in real estate partnerships. The at-risk and passive activity rules may preclude some partners from deducting some of these losses, especially if their basis is reduced to zero or is negative. The tax code does not allow a partner to deduct losses for tax purposes without sufficient basis. Because of the potential loss of deductions, many partnerships are now inserting clauses in their operating agreements that allow for special allocations of losses to partners who have suffi cient basis to use losses when other partners have zero or negative basis. Again, the operating agreement and addendums should be reviewed for these and other important clauses that may affect the potential allocations to partners.

Just as partnerships may have loss limitations, S corporations and LLCs also have loss limitations. Generally, owners of pass-through entities can

write off losses only to the extent of basis, and the defi nition of basis differs between the two choices of entity. For example, basis for an S corporation is defi ned as ownership of stock plus any funds loaned to the corporation directly by the stockholder. Losses beyond this basis are not allowed to pass through to the owners. Basis for an LLC is defi ned more fa- vorably. For an LLC, basis in debt is not limited to personal loans. Basis for an LLC includes ownership of stock plus the member’s share of debt, including third-party debt. Thus, a member of an LLC has the potential to pass through more of a loss than the shareholder of an S corporation.

Commercial lenders and others involved in the credit-granting process within lending institutions should also consider the risks inherent in depending on the financial strength of a personal guaran- tor who has business interests in addition to the borrowing entity associated with a pending loan request. For instance, assume a commercial lender is considering a loan request from ABC Corpora- tion with a personal guaranty of the fi rm’s sole stockholder, Mr. Smith. Smith’s personal fi nancial statement refl ects a signifi cant net worth, includ- ing his interests in various closely held entities. If Smith is a general partner in multiple partnerships, it will be necessary to evaluate the extent to which Smith is contingently liable for those partnerships’ debts and obligations. Even though Smith may have only a 10-percent general partnership interest in a real estate project, he may be jointly and severally liable for all the partnership’s debts—instead of being liable for only his proportionate share of 10 percent. If joint and several liability applies, lend- ers are not required to take action against each personal guarantor when a loan goes into default; instead, lenders often focus on any guarantor or guarantors with substantial liquidity—the ones most likely to have the capacity to perform under their guaranty agreements. Lenders who do not perform their due-diligence responsibilities when assessing an individual’s personal guaranty may be surprised to learn that the guarantor ’s fi nancial strength is greatly impaired when another lender obtains a legal judgment against the guarantor for the entire amount of an unpaid loan, despite the fact that the guarantor had only a minor interest in the partnership.

Forms of Business Ownership

continued on page 54

54 COMMERCIAL LENDING REVIEW NOVEMBER–DECEMBER 2010

Forms of Business Ownership continued from page 32

The only effective means of addressing these risks is to obtain and review complete information on the guarantor’s other business interests as part of the due-diligence process of establishing a new lend- ing relationship. The lender should require that the guarantor provide complete documentation of his or her various business interests along with any related contingent liabilities associated with those business interests. Moreover, even a well-intentioned guaran-

15 SFAS 167, ¶A51. 16 FASB Interpretation 46(R), Consolidation of Variable Interests,

November 2003, ¶7; SFAS 167 Amendments to FASB Interpreta- tion No. 46 (R), June 2009, ¶7.

17 SFAS 167 Amendments to FASB Interpretation No. 46(R), June 2009, ¶23.

18 SFAS 167 Amendments to FASB Interpretation No. 46(R), June 2009, ¶7.

19 SFAS 167, ¶7. 20 SFAS 167, ¶A17. 21 FASB Accounting Standards Codifi cation (ASC), Topic 810,

Consolidations, 810-10-55-18, Identifying Variable Interests. 22 FASB Accounting Standards Codifi cation (ASC), Topic 810,

Consolidations, 810-10-55-19, Identifying Variable Interests, Amendment to SFAS 167, ¶B4.

23 FASB Accounting Standards Update (ASU) 2010-10, February 2010, paragraphs 2; ASC 810-10-55-37, Other Service Contracts, Amendment to SFAS 167, ¶B22.

24 FASB Accounting Standards Update (ASU) 2010-10, February 2010, ASC 810-10-55-37A, Amendment to SFAS 167, ¶3.

25 SFAS 167 Amendments to FASB Interpretation No. 46(R), June, 2009, ¶14 A(b).

26 SFAS 167 Amendments to FASB Interpretation No. 46(R), June, 2009, ¶A 25.

27 SFAS 167 Amendments to FASB Interpretation No. 46(R), June, 2009, ¶14 C.

28 SFAS 167, ¶A51. 29 SFAS 167, ¶14 C. 30 FASB Accounting Standards Update, No. 2010-10, February

2010, Consolidation (Topic 810), Amendments for Certain Invest- ment Funds, ¶4.

31 FASB FSP FAS 140-4 and FIN 46 (R)—8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities, December 2008.

32 SFAS 167 Amendments to FASB Interpretation No. 46 (R), June 2009, ¶22 B–26.

tor may incorrectly assume that because he has a 10-percent ownership interest in a partnership, he is responsible only for 10 percent of the partnership’s debts. In order to avoid such misunderstandings— and to correctly assess a guarantor’s total exposure to contingent liabilities—the lender should confi rm the nature and magnitude of any existing (and contemplated) lending relationships the guaran- tor’s business interests have (or plan to have) with other lending institutions. Such confi rmations should include the level of contingent liability exposure of the individual under review. The personal guarantor will have to approve and should be willing to facilitate the necessary communications between the fi nan- cial institutions. In this way, the lender will be in the best position to avoid any unpleasant surprises with respect to an individual guarantor’s exposure to contingent obligations.

It is important to note that even personal fi nancial statements prepared by the individual’s accounting fi rm often are not complete in that they do not always include a full description and disclosure of contin- gent liabilities. Consequently, lenders should not assume that personal fi nancial information prepared by an accounting fi rm is suffi cient when assessing a personal guarantor’s exposure to the obligations of his or her other business interests.

In light of the information confi rmed with the guarantor ’s other lending institutions and in an effort to prevent any further dilution of the indi- vidual’s guaranty, the lender may conclude it is necessary to limit the guarantor ’s ability to increase his or her exposure to contingent liabilities during the term of the lending relationship under consid- eration. This would normally be accomplished via a covenant to the loan agreement governing the proposed lending relationship.

Summary From the standpoint of the business owner, the cho- sen form of business ownership has wide-ranging and long-lasting implications. The decision should be made in light of the business’s vulnerability to lawsuits, the level of control the businessperson wishes to have over the entity, the likelihood that the entity will need to raise sizable amounts of capital and the most advantageous business structure from an income tax perspective.

NOVEMBER–DECEMBER 2010 COMMERCIAL LENDING REVIEW 55

Utility companies. It can be benefi cial to order util- ity companies not to demand additional deposits or to discontinue service unless pre-receivership bills are not paid. Again, this is not necessarily legally enforceable but often effective. Receiver’s authority to sell. Depending on the circumstances, the lender may want to include this, since certain constraints—such as envi- ronmental issues—make it risky for the lender to hold title. Temporary restraining order (TRO). A TRO ex- cludes defendants and others from the property and orders them to cease collecting any rents and profi ts and to turn over security deposits, books and records. Retaining legal counsel. Aside from routine evictions or collection matters, most judges do not want receivers to automatically retain legal counsel. If the need for separate legal counsel for the receiver is expected, the pur- pose should be carefully detailed to facilitate

Troubled Assets continued from page 36

A commercial lender must consider the legal, fi nancial and tax implications of an individual’s various business interests when assessing the ben- efi cial contribution associated with the personal guaranty of an individual. It is imperative for the lender to thoroughly document a guarantor’s expo- sure to contingent obligations associated with the individual’s other business interests. Relying on the information included with the guarantor’s personal fi nancial statement is not suffi cient; the full mag- nitude of the guarantor ’s exposure to contingent obligations should be confi rmed with the fi nancial institutions having both existing and contemplated lending relationships with the guarantor ’s other business interests. In addition, the commercial lender should gain a thorough understanding as to the allocation of profi ts and losses and any possible limitations regarding the ability to pass through losses to the owners. Partnership agree- ments should be examined for possible covenants describing allocation of profi ts and losses, and the defi nition of ownership basis should be clarifi ed for the particular choice of entity being analyzed.

court approval. An experienced receiver should not need to consult with legal counsel for most receivership issues.

The receiver should be able to offer the lender and its client a list of circumstances that may transpire and suggest language for inclusion in the Order Ap- pointing Receiver to avoid additional trips to court. For example, if a lender is dealing with defaulted loans that include operating businesses—such as res- taurants and hotels—the Order Appointing Receiver should be drafted with this in mind, as it is critical to view these entities primarily as a business and secondarily as a real estate asset. Among the subjects to be included in the Order Appointing Receiver are bank accounts, inventories, franchise agreements, liquor licenses, unusual vendor relationships, books and records and personal property.

Lenders Must Examine Prospective Receivers’ Qualifi cations

Relatively few lawyers and judges deal with receiv- ership. The court’s lack of familiarity on the subject combined with an inexperienced receiver can result in a fraudulent sale, expensive fees, lender exposure to liability and numerous other problems.

Considering the stakes, it is surprising that most states do not have specifi c requirements or formal training mandates for receivers. Most states simply stipulate that the individual must be an unbiased third party and 18 years or older with no crimi- nal record. Although receivers play a critical role for lenders, virtually any person or company can claim to be in the receivership business, regardless of expertise.

A good receiver shields the lender not only from borrower claims of liability but also from “deep- pocket syndrome,” which inevitably emerges when other creditors expect the lender to make everyone else whole.

By understanding the authority and responsi- bilities of the receiver and by carefully examining a candidate’s credentials and qualifi cations, a lender/ servicer can be certain that the receivership will serve as a powerful tool to protect a property and generate maximum loan recovery.

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