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Does A Guarantor’s Bankruptcy Stop A Foreclosure Case Against the Borrower?

Sometimes when secured lenders file suit to enforce a note and a guaranty and to foreclose a commercial mortgage, the guarantor (but not the borrower) files a bankruptcy petition.  Pursuant to 11 U.S.C. 362, the collection action, as to the debtor (the guarantor), is stayed.  Some wonder whether the entire case is stayed. 

Borrower idle.  The defendant borrower may not seek bankruptcy protection if, for example, there are no assets to protect beyond the loan collateral, the value of which may not cover the debt and the collection costs.  So, while the borrower essentially throws in the towel, the guarantor runs for cover in bankruptcy court.

The issue.  The question is whether the bankruptcy stay applies only to the guarantor or whether it extends to the borrower.  The answer, generally, is no, despite the confusion that sometimes arises out of this situation.  Meaning no disrespect to state court judges, but because they rarely deal with bankruptcy issues, they sometimes conclude, perhaps intuitively, that a bankruptcy filing by one defendant will stay the case as to all defendants, at least until the bankruptcy court orders otherwise.  To be fair, this scenario has puzzled lawyers and lender reps too (including me).

General rule.  In Pitts v. Unarco Industries, Inc., 698 F. 2d 313, 314 (7th Cir. 1983), the Seventh Circuit, which includes Indiana, stated that “the clear language of Section 362(a)(1) thus extends the automatic stay provision only to the debtor filing bankruptcy proceedings and not to non-bankrupt co-defendants.”  This is because the language in Section 362 “unambiguously states that the stay operates only as ‘against the debtor.’”  Id.; 555 M Manufacturing, Inc. v. Calvin Klein, Inc., 13 F. Supp. 2d 719 (E.D. Ill. 1998); Federal Land Bank v. Stiles, 700 F. Supp. 1060, 1062-63 (Mon. 1988) (noting generally that stays pursuant to Section 362(a) are limited to debtors and that there are no special exceptions for circumstances involving a co-defendant who is jointly liable on a debt with the debtor). 

LLC’s.  The United States Bankruptcy Court for the Northern District of Iowa in In Re Calhoun, 312 B.R. 380 (N.D. Iowa 2004) addressed the issue of who was covered by the automatic stay.  An individual debtor had sought Chapter 7 bankruptcy relief.  The debtor, however, had an interest in a limited liability company (an LLC).  In Iowa, not unlike Indiana, an LLC is an entity separate and distinct from its members and managers.  The Court held that the automatic stay did not apply to the LLC.  “The separate legal existence of a corporation is respected in bankruptcy.  The automatic stay does not stay actions against separate entities associated with the debtor.”  Id. at 384.  The bankruptcy court concluded, therefore, that only the named petitioner (debtor) is protected by the automatic stay.  “None of the LLCs referred to are parties to the bankruptcy.  They are not proper parties and not protected by the provisions of the automatic stay.”  Id. at 384-385.  See also, In Re Merlyn L. Johnson, 209 B.R. 499, 500 (Neb. 1997) (a creditor generally is permitted to sue a guarantor or a co-debtor and to collect from property of a third party that is pledged to secure debts of the debtor).

Proceed.  Thus the law seems to be clear that, in general, a secured lender should be permitted to proceed to judgment against a borrower and to foreclose on a borrower’s mortgage.  Note that courts recognize limited exceptions to this general rule, not to mention the fact that the guarantor could seek an order from the bankruptcy court to extend the stay to the borrower.  There are “special circumstances” that may permit the extension of the stay, but the onus should be on the guarantor or borrower to prove them.  (A couple of recognized exceptions that the guarantor or borrower might seek to prove are, first, where the relationship between the debtor and the third-party defendant is such that a judgment against the third-party defendant will effectively be a judgment against the debtor and, second, where the litigation against the third-party defendant would cause “irreparable harm” to the debtor or estate.)  Otherwise, as long as the plaintiff secured lender and its counsel provide notice to the parties of the intention to proceed with foreclosure despite the bankruptcy filing, the plaintiff lender should be free to continue with the foreclosure case.  Thanks to my bankruptcy colleague, Chris Jacobson, for her insights.