A common concern of small business owners who have signed personal guarantees on their company’s loans is that if the company can no longer pay and has to file a Chapter 11 bankruptcy, the bank will go after their house or savings. When a company files for Chapter 11, it is the business that gets protection, not the guarantor. Your personal guarantee is a separate promise, and a lender can in theory still collect against it. Filing Chapter 11 protects the company, the debtor, and no one else. The owner’s guarantee is the owner’s own obligation.
That is the theory, and it is why so many owners lie awake over it. A guarantee does not reliably keep a struggling company out of Chapter 11, though, and once a case is filed, one of three things usually happens: the court may issue an order directing the lender not to collect for a while, the lender may agree to release the guarantor in exchange for the guarantor’s cooperation, or the lender may just never bother calling the guarantor. Each of those outcomes has played out in real cases.
The first is a court order. Consider Bray & Gillespie, a case involving 24 hotels and other real estate in Daytona Beach, Fla. The debt involved a mortgage loan and mezzanine loan for more than $350 million. The firms filed for bankruptcy protection. On the day of the filing they went to the bankruptcy court and asked for a temporary restraining order barring the lenders from going after the guarantors for at least 90 days. It was their contention, of course, that the companies would be doomed if the guarantors were distracted fighting lawsuits over the guarantees and thus unable to focus on the reorganization. The guarantors offered to contribute $1 million of their own cash into the bankruptcy plan in exchange for the injunction. They also claimed that the lenders were oversecured and not at risk of losses (which later proved not true for all lenders).
In that case the judge granted the TRO just four days after it was asked for, without receiving any information from the lenders involved. The TRO became a preliminary injunction that would last throughout the bankruptcy. The lender’s leverage was lost. The owners and their guarantors then had the luxury of several months in which to negotiate a global settlement with the lenders, without any pressure of the cost and threat of litigation surrounding the guarantees. Courts are divided on whether these injunctions should issue, and of course it depends upon the facts of a case. These injunctions are not permanent, they merely provide the parties with a breathing spell to negotiate.
The second outcome is a trade. Take the Stellar GT TIC case. The case involved an 891-unit apartment property in Silver Spring Maryland, called Georgian Towers. On it, there was about $185 million in mortgage and subordinate debt. The loans, as a group, had outstripped the value of the property when they went into default. Because of the personal exposure under the guarantee, the guarantor had little incentive to put the borrowers into bankruptcy. The subordinate lender seized the opening and used bankruptcy to sell the property quickly, “free and clear” of all the liens. The price was $168 million. The sale was exempt from transfer taxes, thanks to Section 1146 of the Bankruptcy Code.
The guarantor cooperated with the lenders. The lender, for its part, promised to release the guarantee, pay the guarantor’s legal fees, and even cough up a modest cooperation fee – all in writing and included in the plan support agreement approved by the court. And the lender was still entitled to call the guarantee at any time during the process – a tactic that kept the borrower toeing the lender’s line. Moral of the story: you can use the guarantee as a bargaining chip, trading its release for cooperation.
The third outcome is the quietest. In the Bay Limited Partnership case, the 11-story, 276,000 square-foot Class A office building in Bethesda, Maryland, was burdened with a mortgage debt of $46 million. The guarantees were from the original managing partners, and they were unwilling to file bankruptcy. The limited partner used its partnership agreement to take control of the property, filed a voluntary bankruptcy petition, and immediately proposed a plan to reduce the secured debt to the property’s market value. After lengthy, lender-liability-type litigation, the debtor prevailed and the lender never called the guarantees. A consensual Chapter 11 plan was confirmed.
Why would a lender go along with any of this? Many borrowers in distress will consider filing bankruptcy to restructure their debt or dispose of the property in any event. Smart lenders compare whether they are better off assisting a controlled bankruptcy that lets the collateral sell off as quickly as possible, rather than fighting on two fronts at once, in the bankruptcy court and in a guarantee suit. And bankruptcy offers certain advantages that no other process can, such as the transfer tax break in a disposition.
Collecting on a personal guarantee can be a time-consuming job. The lender has to first obtain a judgment on the personal guarantee itself, and then must enforce the judgment, which may involve tracking down assets. And if the bankruptcy judge believes the owner’s (or guarantor’s) joint proposal for restructuring the business is legitimate, it can become even more difficult. So a lender may prefer the more managed approach.
What’s the lesson for business owners here? Yes, the fear of personal liability makes them think twice. Many guarantors simply decide it’s better not to file. But every situation is different, and if it’s best for the business to reorganize under Chapter 11, an owner may file and ask the court to enjoin the lender from calling the guarantee, or may file for bankruptcy without the lender’s cooperation and hope that the guarantee is not called, that the case can drag on long enough to put off payment, or that the guarantor is “judgment proof.” Still, it’s probably better to get the lender’s cooperation.
So what is a guarantor to learn from these three cases? First, that the guarantee is not a wall that keeps you out of Chapter 11. Once in Chapter 11, the court might very well give a guarantor a temporary breathing spell. Or the lender might trade a release of the guarantee in return for your help. Or the lender might never call it. The guarantee is something to negotiate over, not just a threat. The guarantee provides leverage for both parties to the deal, and it is often wise to discuss the issue with professional advisers before reaching a decision.
