In the Spotlight: Bankruptcy Stays and Guarantors

In Empire Erectors, the court did not discuss the facts of the case beyond to note that two of the defendants “are being sued as guarantors of an agreement between plaintiff and defendant Unlimited Locations LLC,” a business entity whose obligations they had guaranteed in some sort of contract. Unlimited Locations had apparently filed for bankruptcy and the two personal defendants had sought to cloak themselves with the protections bankruptcy accorded their company.'

The court held that such protections are not automatic. However, both the debtor and the debtor's guarantor can ask the bankruptcy court for additional protections. The bankruptcy court's discretion in formulating and granting those protections is enormous and generally upheld when appeals are taken. So, while the guarantor is not automatically protected, this does not mean that the guarantor will never be protected at all. If requested by the guarantors, the bankruptcy court has the authority to issue an order preventing all creditors from pursuing them while their company is under the Bankruptcy Court's protection. It is not automatic, but it is available, at least in special cases.

Even as to the automatic protections, however, the courts have made clear that under certain circumstances guarantors could indeed enjoy even the automatic protections. This, they have ruled, occurs when the debtor and the guarantor are so intertwined that in essence they cannot be told apart.'

Unusual Circumstances

In a case from the Fourth U.S. Circuit Court of Appeals, (Maryland, the Carolinas and the Virginias), A.H. Robins v. Piccinin, 788 F.2d 994 (4th Cir. 1986), the Fourth Circuit carved out an exception for “unusual circumstances” where “there is such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor.” Under those circumstances, those where the entity's assets are being held by the guarantor, the Robins court said that bankruptcy protection will protect both the Entity debtor and its guarantors.

Many readers will recognize this as the idea of “piercing the corporate veil.”'

Piercing the Veil

While piercing the corporate veil is frequently discussed, it far less frequently occurs, and is actually a relatively rarely implemented legal doctrine that almost only takes place when the very people who have set up the corporate (or LLC for that matter) form essentially ignore that form and all of the niceties that the law requires goes along with it. These niceties range from the essentially zero-effort annual shareholder and board of directors meetings, to the careful attention to keep the principals funds separate from the entity's funds. Where the principals can be shown to be using entity funds to pay the principals' own expenses, the piercing will take place and the principals will be declared to be as liable for the entity's debts as is the entity itself.

And that is what the Robins court appears to be protecting.

This, however, is an odd time for the court to be granting special protections, since the circumstances that allow for piercing the corporate veil are generally regarded as abusing the corporate privilege, in other words, misconduct. So, it seems that this doctrine at least allows, if not compels, the courts to reward misbehavior and punish virtue.

The Other Exception

The other exception that the courts grant to give guarantors protections sought by the primary debtor in bankruptcy occurs when the failure to protect the guarantor hobbles the guarantor's ability to assist the bankrupt estate. However, the courts do not give specific examples of when those circumstances would arise.

On one level, a creditor of a guaranteed debtor need not worry about the bankruptcy protection extending to the guarantor. Until the creditor is actually informed of the extension of the protection, the court will not punish the creditor for pursuing the claim.' On the other hand, there is a good deal of ground for concern because it is certainly a small step from staying prosecution of a claim against a guarantor to actually discharging that claim. This could, in extreme circumstances, mean that obtaining a guaranty from a highly worthwhile guarantor is a completely futile act. While Empire Erectors rules that the creditor is free to go after the guarantors in spite of the entity's filing for bankruptcy, Robins allows for the guarantors to be exempt from prosecution without having to file their own bankruptcy petition. Under the Robins exceptions, however rare they may be, the guarantors do not have to risk ruin to their credit standing by filing their own bankruptcy petitions. But even this rare circumstance makes the value to a creditor of a well heeled guarantor vastly diminished.

A landlord could get some protections from Robins by insisting that any prospective business entity tenant with a guarantor must provide both as part of the application process for the tenancy and the maintenance of the lease itself annual statements by attorneys as to the various formal corporate acts (shareholder meetings and such) taking place and annual statements from a certified public accountant attesting to the fact that the funds of the corporate entity and its principals are being kept strictly isolated.

Conclusion

While Robins' is not itself New York law, there is enough in Empire Erectors endorsing the Robins rationale to allow for the possibility that the New York-based courts will completely sign on to the Robins exceptions. However, a landlord taking these precautions could almost guaranty that Robins would present nothing to worry about and the beneficial holdings of Empire Erectors would provide the landlord all the coverage it needs.'

Adam Leitman Bailey, a member of this newsletter's Board of Editors, is the founding partner of Adam Leitman Bailey, P.C. Dov Treiman is the partner at the firm. He chairs the firm's landlord-tenant civil litigation practice. In guiding that area of practice, Mr. Treiman directs trial strategy and heads up the drafting of briefs, motions, and other legal documents.

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In January of this year, New York's intermediate appellate court in Brooklyn decided Empire Erectors and Electrical Company, Inc. v. Unlimited Locations LLC, 8920, 310289/10, App.Div., 1st Dept., Jan. 3, 2013, bringing to New York law the principle that unless guarantors file for their own independent bankruptcy protection, the protections that bankruptcy brings to a primary debtor do not automatically protect the guarantors.

Automatic Protections

The specific kind of protection is the so-called “automatic stay” that a bankruptcy court issues the moment the bankruptcy petition is filed, regardless of the merits of the bankruptcy petition. When a primary debtor files a bankruptcy petition, the act of filing itself brings about this stay that prevents any creditor (including, of course, landlords) from taking any further acts against the debtor outside of the context of the bankruptcy proceeding itself, regardless of whether the creditors know about the bankruptcy proceeding. That much is automatic.'

In Empire Erectors, the court did not discuss the facts of the case beyond to note that two of the defendants “are being sued as guarantors of an agreement between plaintiff and defendant Unlimited Locations LLC,” a business entity whose obligations they had guaranteed in some sort of contract. Unlimited Locations had apparently filed for bankruptcy and the two personal defendants had sought to cloak themselves with the protections bankruptcy accorded their company.'

The court held that such protections are not automatic. However, both the debtor and the debtor's guarantor can ask the bankruptcy court for additional protections. The bankruptcy court's discretion in formulating and granting those protections is enormous and generally upheld when appeals are taken. So, while the guarantor is not automatically protected, this does not mean that the guarantor will never be protected at all. If requested by the guarantors, the bankruptcy court has the authority to issue an order preventing all creditors from pursuing them while their company is under the Bankruptcy Court's protection. It is not automatic, but it is available, at least in special cases.

Even as to the automatic protections, however, the courts have made clear that under certain circumstances guarantors could indeed enjoy even the automatic protections. This, they have ruled, occurs when the debtor and the guarantor are so intertwined that in essence they cannot be told apart.'

Unusual Circumstances

In a case from the Fourth U.S. Circuit Court of Appeals, (Maryland, the Carolinas and the Virginias), A.H. Robins v. Piccinin , 788 F.2d 994 (4th Cir. 1986), the Fourth Circuit carved out an exception for “unusual circumstances” where “there is such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor.” Under those circumstances, those where the entity's assets are being held by the guarantor, the Robins court said that bankruptcy protection will protect both the Entity debtor and its guarantors.

Many readers will recognize this as the idea of “piercing the corporate veil.”'

Piercing the Veil

While piercing the corporate veil is frequently discussed, it far less frequently occurs, and is actually a relatively rarely implemented legal doctrine that almost only takes place when the very people who have set up the corporate (or LLC for that matter) form essentially ignore that form and all of the niceties that the law requires goes along with it. These niceties range from the essentially zero-effort annual shareholder and board of directors meetings, to the careful attention to keep the principals funds separate from the entity's funds. Where the principals can be shown to be using entity funds to pay the principals' own expenses, the piercing will take place and the principals will be declared to be as liable for the entity's debts as is the entity itself.

And that is what the Robins court appears to be protecting.

This, however, is an odd time for the court to be granting special protections, since the circumstances that allow for piercing the corporate veil are generally regarded as abusing the corporate privilege, in other words, misconduct. So, it seems that this doctrine at least allows, if not compels, the courts to reward misbehavior and punish virtue.

The Other Exception

The other exception that the courts grant to give guarantors protections sought by the primary debtor in bankruptcy occurs when the failure to protect the guarantor hobbles the guarantor's ability to assist the bankrupt estate. However, the courts do not give specific examples of when those circumstances would arise.

On one level, a creditor of a guaranteed debtor need not worry about the bankruptcy protection extending to the guarantor. Until the creditor is actually informed of the extension of the protection, the court will not punish the creditor for pursuing the claim.' On the other hand, there is a good deal of ground for concern because it is certainly a small step from staying prosecution of a claim against a guarantor to actually discharging that claim. This could, in extreme circumstances, mean that obtaining a guaranty from a highly worthwhile guarantor is a completely futile act. While Empire Erectors rules that the creditor is free to go after the guarantors in spite of the entity's filing for bankruptcy, Robins allows for the guarantors to be exempt from prosecution without having to file their own bankruptcy petition. Under the Robins exceptions, however rare they may be, the guarantors do not have to risk ruin to their credit standing by filing their own bankruptcy petitions. But even this rare circumstance makes the value to a creditor of a well heeled guarantor vastly diminished.

A landlord could get some protections from Robins by insisting that any prospective business entity tenant with a guarantor must provide both as part of the application process for the tenancy and the maintenance of the lease itself annual statements by attorneys as to the various formal corporate acts (shareholder meetings and such) taking place and annual statements from a certified public accountant attesting to the fact that the funds of the corporate entity and its principals are being kept strictly isolated.

Conclusion

While Robins' is not itself New York law, there is enough in Empire Erectors endorsing the Robins rationale to allow for the possibility that the New York-based courts will completely sign on to the Robins exceptions. However, a landlord taking these precautions could almost guaranty that Robins would present nothing to worry about and the beneficial holdings of Empire Erectors would provide the landlord all the coverage it needs.'

Adam Leitman Bailey, a member of this newsletter's Board of Editors, is the founding partner of Adam Leitman Bailey, P.C. Dov Treiman is the partner at the firm. He chairs the firm's landlord-tenant civil litigation practice. In guiding that area of practice, Mr. Treiman directs trial strategy and heads up the drafting of briefs, motions, and other legal documents.

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