Steve Harms

Monday, February 10, 2014

Bankrupcy issues when a personal guaranty is involved

Questions have been raised regarding a discharge in a business bankruptcy and the recourse to a personal guarantor on a commercial debt which is discharged in bankruptcy.  In addition a question has been raised as to the application of the automatic stay to the personal guarantor when there is a bankruptcy filed by the corporate (or other artificial entity).  This blog is fortunate enough to be treated to a detailed answer to that inquiry by none other than Wanda Borges, whose credentials in this area of law are tremendous.  Her contact information follows as well.  Here is Wanda's take on the issue:

 There are several provisions in the Bankruptcy Code which address the issue of discharge:

 Bankruptcy Code §727 says “The court shall grant the debtor a discharge, unless – (1) the debtor is not an individual.  It is quite clear, therefore, that there is no discharge of a business which files a chapter 7 proceeding.  This makes perfect sense because if a business files a Chapter 7 proceeding, it closes its doors and no longer exists so there is no entity remaining that would benefit from the discharge

 Bankruptcy Code §1141(d)(1)(A) provides that Confirmation of a Plan “discharges the debtor from any debt that arose before the date of such confirmation…”

 There is no distinction in that provision between a chapter 11 of a corporate (or other artificial entity) debtor or an individual debtor.  Confirmation of a Plan bars creditors from going after that entity for anything other than what the Plan provides.

 Bankruptcy Code §362 of the Bankruptcy Code  provides that any bankruptcy petition operates as a stay, “applicable to all entities” of


1.         the commencement or continuation of any action against the debtor to collect or recover a claim which could have been commenced prior to the filing of the petition

2.         the enforcement against property of the debtor of any judgment obtained before the filing of the petition

3.         any act or action to obtain possession of property of the debtor

4.         any act or action to perfect a lien against property of the debtor’s estate

5.         any action to enforce a lien created before the filing of the bankruptcy petition

6.         any act to collect or recover a claim that arose before the filing of the petition

7.         any setoff of any debt owed to the debtor that arose before the filing of the petition

8.         the commencement or continuation of a Tax Court proceeding concerning a tax liability for a period ending prior to the filing of the petition.


Each of these provisions is specifically aimed at the bar of any action against the debtor which has filed a bankruptcy petition.

 The automatic stay does not prevent any action against the personal guarantor when the artificial entity (i.e. corporation, limited liability company, limited partnership, etc) files a chapter 7 or chapter 11 proceeding.  Creditors are within their rights to proceed to pursue the personal guarantor to collect the debt originally owed by the artificial entity.

 There is an exception to this in the case of a Chapter 13 filing.  Bankruptcy Code §1301 provides that “a creditor may not act, or commence or continue any civil action, to collect all or any part of a consumer debt of the debtor…” from a co-debtor.  However, if this co-debtor became liable as part of its own ordinary course of business (e.g. signed a promissory note individually and not merely as a co-debtor), then the creditor is free to pursue that debt.  Notice also that this only applies to consumer debts.

 Be aware, however, that although it is true that a personal guaranty will survive an artificial entity/business chapter 7 proceeding and a chapter 11 proceeding it has become commonplace for a chapter 11 debtor to include within its Plan, an exculpation clause that effectively releases an individual guarantor.  One must be extremely diligent when reading a chapter 11 plan to be certain that it does not contain a release of the guarantors.  If the Plan does contain that kind of exculpation or release language, a creditor should immediately seek advice from a bankruptcy practitioner to determine if grounds exist to object to that Plan.

 Another cautionary note is to be aware of a chapter 11 business which continues operating after confirmation of its plan.  If you have a personal guarantor and a debt from a business exists on a given date (e.g. $10,000 owing on 1/3/14), that guaranty survives the business bankruptcy for that sum of money when the bankruptcy is filed after that date.  HOWEVER, I have seen cases where a business chapter 11 has been filed so the personal guarantor's debt to the creditor is $10,000 prior to the bankruptcy filing and then the business debtor continues business operations AFTER the confirmation of a chapter 11 Plan.  I would not rely on the personal guaranty continuing in effect after the chapter 11 proceeding for new debt incurred by the post-confirmation debtor. 

 There is one final question raised which states "While the Bankruptcy Code looks pretty clear in that the automatic stay pertains to debtors (not guarantors) courts have started to jump on a catch-all in the code to support a broader premise that the automatic stay should apply to non-bankruptcy guarantors of corporate debt in some Chapter 11 situations. … the rationale of that approach is that personal guarantors typically act as a source of funding for the corporation and the preservation of their credit is instrumental in the recapitalization process. Also, personal guarantors also typically manage the corporation and having to defend themselves against debt collection action distracts them from efforts to effectively operate and reorganize the debtor entity."

 Let me address that scenario.  Bankruptcy Code §105 gives the Bankruptcy Judge broad equitable powers to do whatever it takes to enable a chapter 11 to proceed towards confirmation of a Plan.  Specifically, §105 states “The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”  In certain instances Bankruptcy Judges have expanded the automatic stay to cover the principal(s) of a debtor when the court believes that the principal needs that protection in order to properly run the business without having to fight his personal creditors (those holding guaranties).  A debtor must show extremely good cause in order to get the Bankruptcy Judge to grant this expanded automatic stay protection.  This was done in the Philadelphia Newspapers wherein the Bankruptcy Judge cited the impact that a lawsuit against the principals would have on the debtor’s ability to manage its reorganization process.  The automatic stay was extended also in the AH Robins case and in the Brier Creek case.  However, in each of these cases and in any other case wherein the automatic stay is expanded beyond the debtor, the circumstances must be such that would cause “adverse economic consequences” to the debtor or some other “unusual circumstances” which would warrant such expansion.

 On the other hand, we have recently been involved with a case in the State Court wherein we sued two corporate entities who were the primary debtors, two personal guarantors and a corporate guarantor.  The primary corporate debtors each filed chapter 11 proceedings.  The State Court Judge would not let us proceed with the litigation against the guarantors because the State Court Judge said the automatic stay of the Bankruptcy Code prohibited him from proceeding even against the guarantors.  We were compelled to file a motion with the Bankruptcy Court showing that the automatic stay is not applicable to the non-debtor guarantors except in unusual circumstances.  Citing the AH Robins case as well as Calpine and other cases of note readily persuaded Bankruptcy Judge Craig to issue an Order finding that the automatic stay was inapplicable to the third-party non-debtor guarantors. 

 As an aside, once the Bankruptcy Court Order finding the automatic stay to be inapplicable was filed with the State Court, settlement discussions ensued.






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