Out of the Frying Pan and Into the Fire: Considerations for Guarantors of Companies in Financial Distress

By C. Daniel Lins

The year was 2003. Credit flowed freely. Lenders, flush with cash and permissive lending authority, handed out loans and lines of credit at record pace. Borrowers, enticed by low interest rates and dreams of early retirement, signed line after dotted line as if the piper need never be paid. For those on an entrepreneurial high, the form guaranties included in lenders' standard loan closing packets seemed just that--a formality.

How times have changed. The collapse of the credit and housing markets in 2008 knocked many borrower companies to their knees. Those that withstood the initial flurry found themselves struggling to cash flow, to make payroll, to service debt--in short, to survive. And many lenders, scarcely weathering the storm themselves, sought to right the ship by adopting a renewed focus on collection of past-due debt, even at steep discounts, in order to minimize losses. The resulting lawsuits typically named both the borrower company and guarantors as defendants, however, in many cases the lender's true objective was collection from the guarantors.

There are typically few, if any, defenses to a properly drafted and executed guaranty. If a guarantor is unable or unwilling to pay the debt when due, his or her options generally are threefold: work out a settlement with the lender, submit to an adverse judgment in state or federal court (and the execution thereof), or file for bankruptcy protection. This article outlines a few important considerations that guarantors should keep in mind when faced with these alternatives.

Honesty is the best policy.

Loan officers, and the people to whom they report, are business people. The good ones apply reasonable business judgment to collections and workouts, regardless of any feelings of disenchantment they might harbor toward a delinquent borrower (or its principal). A lender's goal is always, at least in part, to maximize the recovery and minimize the risk associated with a collection. If a lender is convinced that a guarantor is offering it a better outcome than it would receive in bankruptcy, such an offer must be considered. How best to convince a lender that your offer is as good as it gets? The answer is often to be as forthcoming as possible. Provide every scrap of financial information and paper the lender requests. The downside to such disclosure is minimal, for if bankruptcy is your only realistic alternative, your finances will become public record soon enough. If you can convince your lender that all your cards are on the table, a workout may not be as unlikely as you think.

Make informed decisions.

When a guarantor is trying to determine whether an individual bankruptcy filing is his or her best alternative, a critical variable in that equation is the extent to which the guarantor's assets are reachable by creditors. If most of your personal assets (for example, home, cars, bank accounts) are owned by you and your spouse as joint tenants by the entireties, those assets are generally unavailable to creditors seeking to enforce a judgment or pursue a claim against you in bankruptcy court. Other assets, such as 401(k) and other qualified retirement accounts are also usually exempt from creditors and generally not part of the bankruptcy estate. The potential debtor should always consult an attorney to determine the exemptions available in the jurisdiction where the debtor lives. But to the extent you and your lender have clarity as to which of your assets can and cannot be touched, the more likely a fully informed decision can be made by all parties.

Without a doubt, one of the primary purposes of bankruptcy is to discharge debts and afford debtors a "fresh start." And as a general rule, debtors come out the other side of bankruptcy with no liability for discharged debts. However, the right to a discharge is not absolute, and some types of debts, such as alimony, child support, and certain taxes, are not discharged. Moreover, a bankruptcy discharge does not extinguish liens on property. This means that, after discharge, even if you are no longer liable to a lender for a debt, the lender can still enforce its lien by foreclosing on its collateral, which could leave you out of house and home. Because discharges in bankruptcy are subject to these and many other exceptions, debtors should consult competent legal counsel to make sure they are fully informed before filing.

Be willing to think outside the box.

Upon the filing of a bankruptcy petition, the automatic stay immediately stops nearly all actions by creditors to collect prepetition debts, including lawsuits, foreclosures, and collection efforts of every kind. However, under 11 U.S.C. § 362(a), the automatic stay only provides protection for actions against the debtor, and typically does not stop creditors from demanding payment from third parties, such as non--debtor guarantors. Given the clear statutory language in Section 362, it is unusual for a bankruptcy court to extend the automatic stay to principals and guarantors of the debtor. However, the United States Supreme Court has long held that trial courts have inherent power to "control the disposition of the causes in its docket with economy of time and effort for itself, for counsel and for litigants." Landis v. N. Am. Co., 299 U.S. 248, 254-55 (1936). And in situations where a lawsuit is pending against both the company and guarantors in state or federal courts, some courts have granted "discretionary stays" to these third parties, particularly where the debtor and guarantor's rights and obligations are closely intertwined. Such stays are not common, but are worth discussing with counsel and pursuing where circumstances warrant.

Be aware of potential conflicts of interest.

Companies in financial distress and their principals (who often have guaranteed the company's debts), typically seek out an insolvency lawyer when faced with an immediate problem, such as a pending hearing or foreclosure action. Once retained, good lawyers will seek not only to address the problem at hand but also to devise a global strategy--or path through the minefield-to achieve best outcomes for the company and its principals. In the event bankruptcy filings for the company and guarantors become increasingly likely, conflicts of interest may develop between the company and its guarantors. For example, if money is owed between a company and a guarantor, a bankruptcy filing would render one a bankruptcy creditor of the other, which precludes a lawyer from representing both parties unless the conflict was waived.

Conflicts of interest can also arise between two guarantors of the same debt. This typically occurs where one guarantor's assets are substantially exempt from the reach of creditors and another guarantor's assets are not. In this situation, the company's ability to pay its debt (and thus reduce the liability of the guarantors) becomes much more meaningful to one guarantor than the other. When the best interests of the parties diverge, it can become untenable for one law firm to represent all the affected parties. Your lawyer should be aware of these potential and realized conflicts and talk to you about them--in many cases, these conflicts can be overcome. However, never be afraid to raise these issues if you begin to question how the larger strategy for the company might affect you individually.

When faced with a properly drafted and executed guaranty, a guarantor's options are limited, but not completely so. Filing for bankruptcy protection is one possible alternative to consider. Workouts or settlements are another--and these can take many forms, including forbearances or payments over time (if financials show cash flow will support such payments), negotiating (or renegotiating) the terms of the deal, and even buying the note or the lender's position if another source of funds is available. Although the guarantor's plight is a common one, the surrounding circumstances are often quite distinct. To achieve the best possible outcome in any situation, the best course is nearly always to take an honest look at the facts, be willing to think outside the box, and consult competent legal counsel to make sure you are fully informed before making the tough decisions.