When making a commercial loan, financial institutions typically require commercial borrowers to provide additional security by obtaining personal guarantees for the repayment of the outstanding debt. When the commercial borrower defaults on the loan, the financial institution looks to the guarantors for repayment, in addition to taking all steps necessary to liquidate the collateral that has been pledged by the borrower. Faced with significant monetary judgments, many guarantors file bankruptcy proceedings to discharge their guaranty obligations to the financial institution.
A financial institution typically will proceed to liquidate the collateral pledged by the borrower while simultaneously pursuing its rights against the guarantor in bankruptcy, including its right to payment under the guaranty. Many debtors, trustees and creditors assume that if a creditor has liquidated collateral owned by a nondebtor prior to filing a proof of claim in the guarantor’s bankruptcy, then the creditor may only file a claim against the guarantor for the remaining amounts that are unpaid under the guaranty after the value of the liquidated collateral has been applied.
For example, suppose a borrower owes a secured creditor $100,000, and that debt is guaranteed by a guarantor. Suppose further that the borrower has pledged collateral in support of the debt, that the borrower defaults on that debt, and that the secured creditor liquidates the collateral owned by the borrower and receives a payment of $50,000. When the guarantor files for bankruptcy, the guarantor may argue that the secured creditor’s claim against the guarantor is $50,000 (the amount of the debt outstanding after the liquidation of the collateral). In fact, the secured creditor is entitled to file a proof of claim against the guarantor for the entire amount of the debt ($100,000), notwithstanding the fact that the secured creditor has liquidated collateral to reduce the amount of debt to $50,000. While the secured creditor may never collect more than it is owed, it can significantly increase the pro rata amounts distributed to it in the guarantor’s bankruptcy proceeding by prosecuting the full amount of the debt (here, $100,000) against the guarantor in bankruptcy until such time as the secured creditor’s debt has been paid in full.
This legal holding was first established by the U.S. Supreme Court in Ivanhoe Bldg. & Loan Ass’n of Newark, N.J. v. Orr.[1] The question squarely before the Court was “[w]hether a creditor of a bankrupt, who has recovered a portion of the debt owed him by foreclosure of a mortgage on property not owned by the bankrupt, may prove for the full amount of the debt, or only for the balance required to make him whole.”[2] The Court concluded that the creditor in Ivanhoe was entitled to prove up the full amount of the debt — despite the fact that the creditor was the winning bidder at the sheriff’s sale for the real estate that served as collateral for its debt — because the real estate was not owned by the debtor.
The Court’s holding in Ivanhoe was recently discussed by the U.S. Court of Appeals for the Third Circuit in Nuveen Mun. Trust ex rel. Nuveen High Yield Mun. Bond Fund v. Withumsmith Brown P.C.[3] The Third Circuit reiterated, “Ivanhoe thus provides that a creditor may file a proof of claim for the total amount that is owed by a debtor even if it has recovered or may recover all or a portion of that amount from a non-debtor.”[4]
Thus, while a secured creditor may never collect more than it is owed, the secured creditor can significantly increase the amount of the pro rata share to which it is entitled from the bankruptcy estate by filing a claim against the debtor in the full amount of the debt owed, notwithstanding the secured creditor’s previous, or subsequent, recovery from a nondebtor.
[1] 295 U.S. 243 (1935).
[2] Id. at 244.
[3] 692 F.3d 283 (3d Cir. 2012).
[4] Id. at 295.