Let’s take the example of a lender who extends a term loan in the amount of $1 million to a debtor entity. The loan is guaranteed by the owner of the debtor. If the debtor and the guarantor are both subject to bankruptcy cases, it is agreed that the lender has a claim of $1 million (excluding 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 vs. Orr295 U.S. 243 (1935).)
But what if the debtor goes through a bankruptcy case where the lender gets a recovery, say $600,000, and the owner goes bankrupt after? Does the lender still have a claim in the case of the guarantor’s bankruptcy for $1 million, limited to a recovery of $400,000? Or is the lender’s claim in the event of the guarantor’s bankruptcy now limited to $400,000, on which the lender’s recovery is likely to be much lower?
The United States Court of Appeals for the Fifth Circuit recently ruled on this issue, finding, following our assumption, that the lender’s claim is limited to $400,000. (In re LaHayecase no. 19-30795 (5and Cir. November 12, 2021).) The result should come as no surprise. After all, when a guarantor of a term loan goes bankrupt, the guarantor is generally liable under the guarantee for the principal of the loan only on the outstanding balance at the time of the opening of the loan. case. So why was the issue even argued?
The twist of the case was that the lender claimed he never received the $600,000 recovery. The debtor’s confirmed Chapter 11 plan provided, again using our assumption, that the lender would receive the debtor’s interest in Blackacre for a credit of $600,000 on the loan, leaving a balance of $400,000 that the guarantor would pay over time. But Blackacre was never transferred to the lender, Blackacre’s value had since declined, and the guarantor never paid the balance, so the lender claimed he still owed $1 million. However, the debtor’s plan provided that the debtor was entitled to the credit of $600,000 on the loan and was released from any further liability. at the time of confirmation of the debtor’s plan, so the court ruled that the lender was bound by the plan. The lender was stuck with the $600,000 credit against the debt and the right to compel the transfer from Blackacre to the lender. The outcome 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 faced a bankruptcy case. .
The point to remember: a lender must consider the risk of accepting an unfulfilled promise from the debtor as credit against a claim in the event of a debtor’s bankruptcy without preserving all rights against any guarantor if the promise is not executed.