“Your Borrower Is In Bankruptcy: What About the Guarantors? Are They Still Obligated To Pay?” by John L. Waite III
Generally, the discharge of a borrower’s debt obligation under bankruptcy law will not impact a creditor’s right to pursue non-debtor obligors, such as guarantors. There is an exception where a confirmed plan of reorganization includes a provision that releases such co-obligors from liability. See 11 U.S.C. § 524 which generally preserves the liability of guarantors and codebtors after discharge.
In some cases, a debtor (a/k/a borrower) may seek to include release provisions within a Chapter 11 Plan that require creditors to release the debtor’s insiders, plan funders, and certain interested parties from further obligations upon confirmation of the plan. Many times this can include the debtor’s guarantors of the underlying obligations set forth in the debtor’s bankruptcy schedules, essentially leaving a creditor without the ability to pursue the borrower or guarantors for payment except as allowed under the confirmed bankruptcy plan.
However, such use of a Chapter 11 Plan is not universally recognized. There is a split of authority regarding whether the bankruptcy code allows for non-debtor obligors to be released from their respective obligations when they are not a debtor under the bankruptcy code. Currently, there are three judicial interpretations. The first is recognized by the Second, Fourth and District of Columbia Circuits that allow for the release of third parties from co-debts. These Circuits recognize that an appropriate release provision within a confirmed Chapter 11 Plan, regardless of whether or not there was consent by the impacted creditor, acts as a permanent injunction against that creditor pursuing the third party for the amounts owed pursuant to the underlying obligation.
The second interpretation, followed by the Seventh Circuit, recognizes and permits third party releases but only involving those creditors who vote for the Plan and specifically consent to the release.
Finally, the Fifth and Ninth Circuits strictly prohibit any third party releases within a Chapter 11 Plan regardless of notice and/or consent.
The Eighth Circuit does not appear to have a written opinion on this subject, but there is a case from Arkansas that may provide some guidance. See In re Sanders, 81 BR 496 (Bankr.W.D. Ark. 1987) where a non-debtor guarantor was able to enforce a confirmed Chapter 11 Plan’s release of the guaranty even though the confirmed Plan was never consummated and no payments were made to the creditor that was impacted by the release of its guarantee.