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Lenders Beware: Personal Guaranties Are No Guarantee When Borrower Files Bankruptcy

March 06, 2013, 07:00 AM

As part of the security for their loans, secured lenders often obtain the guaranty of one or more of a borrower’s principals. One of the advantages to a lender of obtaining personal guaranties is that even when a borrower files for bankruptcy and the automatic stay of the Bankruptcy Code prohibits collection actions against the borrower, the lender can still pursue actions against the individual guarantors. Or can it?

Some courts, including two recent cases decided in the U.S. Bankruptcy Court for the Northern District of Illinois, have temporarily stayed actions against non-debtors, including guarantors when a borrower filed for bankruptcy. Although the Bankruptcy Code’s automatic stay by its terms applies only to debtors themselves, some courts have effectively broadened that stay based on their statutory power to “issue any order … that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]” under section 105 of the Bankruptcy Code.

This issue typically arises at the inception of the borrower’s bankruptcy case when the debtor petitions the court to enjoin state or federal actions against non-bankruptcy guarantors of a corporate debt. Corporate debtors commonly ask courts to enjoin collection actions against guarantors for two reasons. First, it is argued that the guarantors, who are typically insiders, are a source of funds for the debtor’s reorganization and that preservation of their credit will play an important role in the debtor’s efforts to recapitalize. Second, guarantors argue that the time necessary to defend themselves in the collection actions will distract them from their efforts to reorganize the debtor.

Courts willing to entertain the notion of enjoining lawsuits against guarantors will only do so when the following four prerequisites are met: (1) there is a substantial likelihood of a successful reorganization; (2) there is a substantial threat that the debtor will suffer irreparable harm to the estate or the debtor’s ability to reorganize; (3) the threatened injury to the debtor outweighs the threatened harm which an injunction would cause to the creditor; and (4) the extent to which the public interest is advanced in issuing the injunction, and in particular whether the public interest in successful reorganizations is advanced.

Courts have interpreted these requirements differently. For example, the Seventh Circuit Court of Appeals does not require a showing of irreparable injury but instead requires a showing of interference with the effective reorganization of the debtor. Other courts consider all four factors. Moreover, the overwhelming influence of one factor may negate the presence of other factors.

In In re Gander Partners LLC, at al., 432 B.R. 781 (Bankr. N.D. Ill. 2010), the debtor heard testimony from the debtors’ four principals and guarantors who were sued in state court lawsuits for recovery on their personal guaranties of the debtors’ obligations. The guarantors testified that they spent anywhere between 20-45 hours per week managing the debtors’ businesses and would be unable to continue doing so if they had to divert their time to defending the state court actions. The four guarantors also testified that they contributed between $200,000 to $8 million to the debtors in the past, and would continue to contribute funds to the debtors’ reorganization efforts.

Based on this testimony, the court granted a preliminary injunction which enjoined the bank’s state court guaranty actions for 120 days. The court ruled that there was limited harm to the bank in delaying the state court lawsuits, which was outweighed by the significant harm to the debtors since they could lose access to the funds and time of their principals. The court went so far as to say that the temporary delay actual benefited the bank since it would recover all amounts owed to it if the debtors were able to refinance the bank’s debt.

Creditors whose enforcement actions are stayed by a bankruptcy court would be well-advised to closely monitor the assets of any personal guarantors. Since a judgment debtor is prohibited from transferring any assets once state collection proceedings are commenced, a delay in the entry of a judgment gives an unscrupulous guarantor more time to transfer assets.

If courts strictly interpret the law, secured creditors should be able to defeat a debtor’s efforts at obtaining an injunction prohibiting the creditor from pursuing their actions against guarantors outside of bankruptcy cases. Creditors have bargained-for, non-bankruptcy rights under the guaranty which exist independent of any bankruptcy case or reorganization effort. Nonetheless, lenders should be aware that some courts may be willing to restrict the enforcement of guaranties in certain circumstances.


The materials made available in this Blog have been prepared for general informational purposes only. The information contained in this Blog is general in nature and does not constitute legal advice or an opinion of counsel. Each legal problem is different, and past performance does not guarantee future results. You should not act on any of the information contained in this Blog without first consulting legal counsel. The choice of a lawyer is an important decision and should not be based solely upon advertisements.

Timothy S. McFadden
Partner | Barnes & Thornburg LLP
Timothy S. McFadden is a partner in Barnes & Thornburg LLP’s Chicago office and a member of the firm’s Finance, Insolvency and Restructuring Department. McFadden concentrates his practice on matters related to bankruptcy and restructuring, creditors' rights, commercial finance and workouts, and commercial litigation.

McFadden represents debtors, secured and unsecured creditors including banks and financial institutions, insurance companies, franchisors, real estate investors and service and manufacturing companies in bankruptcy proceedings of virtually all sizes. His litigation experience includes advocating his clients’ interests in matters involving preferential and fraudulent transfer actions, single asset real estate cases, executory contract rejection and assumption disputes, claim objections, objections to discharge, and motions to dismiss involuntary bankruptcy proceedings.

McFadden received his B.A. from the University of Notre Dame in 1996, and his J.D. from the University of Notre Dame Law School in 2001. He is licensed to practice in the state of Illinois, and before the U.S. District Court for the Northern District of Illinois, the U.S. Supreme Court, and the U.S. Court of Appeals for the 4th Circuit. He is a member of the American Bankruptcy Institute, the Turnaround Management Association, and the Chicago Bar Association. He is also heavily involved with the Lymphoma Research Foundation, the Notre Dame Alumni Association, and the Chicago Coalition for the Homeless.
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