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Failure to Object to Release Provision in a Chapter 11 Plan May Result in Losing Your Personal or Corporate Guarantee
by Scott Blakeley
A credit executive looking to reduce credit risk in today's uncertain economic environment may look to a credit enhancement to assist in making the sale on credit terms. A credit enhancement commonly considered by a vendor is a personal or corporate guarantee. Some of the reasons a vendor may prefer a guarantee to other enhancements (such as Article 9 security interests) include generally not needing the consent of the debtor's lender, and no notice requirements to other vendors that the debtor is buying from. The purpose of the guaranty is straightforward: should the primary obligor, your corporate customer, fail to pay, you have a second pocket for payment (secondary liability). This promise to pay by the guarantor is an inducement for you to sell the corporate customer on terms.
What is the impact on your guarantee (personal or corporate) when the primary obligor, your corporate customer that received your product or service on credit terms, files Chapter 11? May the personal guarantor who is an officer of the Chapter 11 debtor and responsible for running the business, obtain an injunction from the bankruptcy court to prevent you from collecting on the delinquent account during the pendency of the Chapter 11? Can the Chapter 11 debtor confirm a plan of reorganization that bars you from collecting against the guarantor? The bankruptcy court in In re Dr. Barnes Eyecenter, Inc., recently ruled that a debtor could confirm a plan that bars a creditor from collecting from the guarantor.
A Guarantee to Pay
A key element of guarantee law is that the guarantor is not a party to the principal debt. The guarantor's undertaking is independent of the primary obligor's (your customer) promise to pay. Merely because both contracts are on the same paper, your customer's promise to pay for the goods or services, and the guarantor's promise to pay if your customer does not, does not change the independence of the agreements. However, the relationships between the customer and guarantor are intertwined. As the case discussed below highlights, a vendor must be vigilant as to its collection rights against its guarantor when the primary obligor attempts to use bankruptcy to assist a guarantor in escaping liability.
A Primary Obligor's Bankruptcy Filing
Where you have sold your customer product or service on credit terms, that customer, as the primary obligor, has a contractual duty to pay. If the customer fails to pay, the vendor may sue either the customer or the guarantor. However, should the customer file Chapter 11, the vendor's right to collect on the delinquent account is limited.
The Automatic Stay
Should the customer file Chapter 11, the vendor must cease all efforts to collect against the customer, the primary obligor, because of the automatic stay. The automatic stay is an injunction which automatically and immediately goes into effect as soon as a bankruptcy case is filed, whether the bankruptcy filing is one under Chapter 7, 11 or 13. The stay is automatic in the sense that it arises upon filing the bankruptcy case by operation of law, without the bankruptcy court having to enter an order stating that it exists. The stay is in effect even where the creditor has not been given notice that the bankruptcy case has been filed.
The automatic stay prohibits any creditor from taking action against the property of the estate and against the debtor, unless relief from stay is obtained. The purpose of the automatic stay is to give the debtor breathing room, and to protect creditors from each other by preserving the bankruptcy estate intact until property can be distributed according to the bankruptcy priority scheme and allow orderly administration of the case.
Does the Automatic Stay Extend to the Personal Guarantor?
May the personal guarantor use the automatic stay of the primary obligor, your customer that received your product or services, as a shield to stay efforts to collect from the guarantor? A personal guarantor may request the bankruptcy court stay the efforts of the vendor to collect on the guarantee during the time in which the guarantor attempts to assist in reorganizing the Chapter 11 debtor, whose debt he or she has guaranteed. The common setting for this request is when the personal guarantor is providing management services to the Chapter 11 debtor and those services are integral to the debtor's ongoing operation. The guarantor argues for injunction on the basis that to respond to the creditor's collection suit could result in a loss of value of the debtor's operations. The minority of courts that agree to enjoin the guarantor's efforts to collect limit the injunction until a plan has been confirmed.
May a Chapter 11 Plan Bar Collection on the Guarantee
Unlike the point above where the guarantor attempts to limit the creditor's right to collect on the guaranteed debt only during the pendency of the Chapter 11, in the case of Barnes Eyecenter, the debtor sought to bar the creditor's right to collect against a guarantor forever. In Barnes Eyecenter, the primary obligor was a retailer, and a lease was guaranteed by a related company. The retailer filed Chapter 11, and eventually confirmed a liquidating plan. A provision of the liquidating plan allowed for the discharge of the corporate guarantee. The provision in the plan that the creditor later challenged, sets forth:
Any claims held by Debtor's insiders, including but not
limited to Debtor's affiliate...shall be subordinated
to the claims of all other creditors of...estate, and
no distributions shall be made on account of same until
all other claims are paid in full pursuant to this Plan.
In return for the subordination of their claims, Debtor's
Insiders shall not have or incur any liability to any person
for any claim, obligation, right, cause of action or liability,
whether known or unknown, foreseen or unforeseen, existing or
hereafter arising, based in whole or in part on any act or omission,
transaction, or occurrence from the beginning of time through the
Effective Date in any way relating to DBEI, its Bankruptcy Case,
or the Plan; and all claims based upon or arising out of such actions
or omissions shall be forever waived and released.
The creditor holding the guarantee did not object to the discharge of guarantee provision in the plan. The creditor sued the guarantor to collect for the primary obligor's debt. The guarantor sought dismissal of the collection suit contending that the Chapter 11 plan barred the creditor from collecting on the guaranteed debt. The creditor responded complaining that the discharge provision contained in the plan was not specific.
The court found that the release of claims contained in the Chapter 11 plan was a key part of the bankruptcy order confirming the plan and the guarantor was specifically mentioned. The release of claims was not simply boilerplate language the court noted, but rather a necessary part of the plan. The creditor was barred from collecting on the guaranteed debt.
Lessons Learned
In today's uncertain economic climate, personal and corporate guarantees can be integral to the credit decision making to approve credit terms in making the sale, as the guarantees reduce or eliminate credit risk. However, the court's reminder is that should your customer, the primary obligor, file Chapter 11, you must be vigilant. The goods news for vendors is that the general rule is that bankruptcy courts will not permit Chapter 11 debtors to release guarantee claims, where an objection is lodged. However, it is up to the vendor to object to the release provision contained in the debtor's plan provision. Absent the vendor's objection, the release provision may ride through the plan process and be allowed to stand should the vendor sue the guarantor to collect on the debt.
To underscore, in a Chapter 11 setting, the debtor may launch a rear-guard action on behalf of the personal guarantor, who is often an officer of the debtor, to defeat the creditor's right to collect on the guarantee. A vendor must closely review the debtor's plan of reorganization and disclosure statement. The disclosure statement may contain a release provision such as the one set out in Barnes Eyecenter, or a form such as: "the confirmation of the Plan releases any guarantees of collection or obligations arising out of undertakings made or given by third parties" By being vigilant and objecting to such guarantee release provisions, the vendor can look to the guarantor's pocket and reduce the risk of loss.
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