Authored by: Edwin E. Smith of Morgan Lewis
Re-printed with permission. The original article can be found by clicking here.
Consider a lender that extends a term loan in the amount of $1 million to an entity debtor. The loan is guaranteed by the debtor’s owner. If both the debtor and the guarantor become subject to bankruptcy cases, it is settled that the lender has a claim of $1 million (ignoring interest and expenses) in each bankruptcy case. However, the lender cannot recover more than $1 million in total in the two cases combined. (Ivanhoe Building & Loan Ass’n of Newark, NJ v. Orr, 295 U.S. 243 (1935).)
But what happens if the debtor is subject to a bankruptcy case in which the lender obtains a recovery, let’s say $600,000, and the owner’s bankruptcy occurs afterwards? Does the lender still have a claim in the guarantor’s bankruptcy case for $1 million, limited to a $400,000 recovery? Or is the lender’s claim in the guarantor’s bankruptcy case now limited to $400,000, on which the lender’s recovery will likely be much smaller?
The US Court of Appeals for the Fifth Circuit recently weighed in on this issue, holding, in following our hypothetical, that the lender’s claim is limited to $400,000. (In re LaHaye, Case No. 19-30795 (5th Cir. Nov. 12, 2021).) The result should not be surprising. After all, when a guarantor of a term loan becomes subject to a bankruptcy case, the guarantor is generally liable under the guaranty for the principal of the loan just on the unpaid balance at the time of the commencement of the case. So why was the issue even litigated?
The twist in the case was that the lender claimed that it never received the $600,000 recovery. The debtor’s confirmed Chapter 11 plan provided, once again using our hypothetical, that the lender would receive the debtor’s interest in Blackacre for a credit of $600,000 against the loan, leaving a $400,000 balance that the guarantor would pay over time. But Blackacre was never transferred to the lender, the value of Blackacre had since declined, and the guarantor never paid the balance, so the lender claimed that it was still owed $1 million. However, the debtor’s plan provided that the debtor was entitled to the $600,000 credit on the loan and was released from further liability at the time of confirmation of the debtor’s plan, so the court held that the lender was bound by the plan. The lender was stuck with the $600,000 credit against the debt and a right to compel the transfer of Blackacre to the lender. The result was no different than if the lender had received $600,000 in cash in the debtor’s bankruptcy case, reducing the principal balance to $400,000, before the guarantor became subject to a bankruptcy case.
The takeaway: A lender should consider the risk of accepting an unperformed promise from the debtor as a credit against a claim in a debtor’s bankruptcy case without preserving full rights against any guarantor if the promise is not performed.