May 25

Guarantees To Pay Another Person’s Debt In Bankruptcy

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The process of getting a fresh start through bankruptcy covers quite a broad spectrum of things. The things people think of first are the unsecured debts incurred for consumer goods and services; the burdensome credit cards that have high interest rates and extra charges for any infraction of a multipage agreement written in fine print to which one agrees by simply using the card. Other commonly understood debts are things like hospital bills, bills for medical services, lab tests, prescriptions or debts owed for other services like carpentry work or yard care or legal services. There are of course a myriad of ways for a person to get into debt in our society. They all seem like a good idea at the time.

According to the bankruptcy code, a “debt” is a liability on a “claim” and a claim is, in simple terms, a right to payment of money. Debts, otherwise known as claims for the payment of money, can be discharged in bankruptcy. Debts can be fixed, meaning the money is owed right now, or they can be contingent, meaning something has yet to happen before the creditor can collect on them. A credit card bill is an example of a fixed debt. A personal guarantee to pay the debt of another if they do not pay is an example of a contingent debt. Many small business owners who do business as corporations or partnerships run into this situation. For example a bank will not lend the business money, or vendors extend trade credit without the personal guarantee of the corporation’s shareholders or the partners of the partnership. So in our business we see small business owners who are personally liable for tens or even hundreds of thousands of dollars, sometimes millions of dollars worth of debt, for business obligations. Sometimes the only way to obtain the equipment or a premises needed to operate a business is to give a personal guarantee. Other examples of accommodations or personal guarantees we have seen are auto loans guaranteed for children or friends, and student loan obligations that required someone outside the immediate family to guarantee the loan so a child could attend college. There are many other examples of ways people can get into financial trouble by trying to help out friends, and relatives or making a business succeed.

The bankruptcy law defines the contingent liabilities listed above as debt. Consequently these contingent liabilities are subject to discharge in bankruptcy. What makes this remedy particularly powerful for people who were only trying to help a friend or a relative or even a spouse is that even if the primary debt cannot be discharged in bankruptcy, the contingent liability, the obligation under the guarantee can be. One example was discussed in a case called “In re Perea” in the Bankruptcy Court of Colorado in 1988. In that case the husband had obtained a loan by fraud, which for understandable reasons could not be discharged in bankruptcy. However, the wife’s guarantee of the loan was dischargeable, even though the underlying debt was not. This same logic should apply to other underlying debts that cannot be discharged such as student loans, support obligations, taxes, restitution and the other debts listed under 11 USC section 523. If a person has guaranteed the payment of a nondischargeable debt owed by another, the contingent liability, the debt in connection with the guarantee can be discharged. This rule applies even if the debt that was accommodated or guaranteed was not in default at the time the discharge was granted. For example, suppose a small corporation had three shareholders and in order to obtain a piece of heavy machinery needed for the business to operate each had to personally guarantee either a lease or a loan to acquire the equipment. Two of the shareholders had a lot of wealth but not much knowhow and one of the shareholders had a lot of knowhow but not much wealth. They are all equally liable to pay for the machinery if the business fails. The business does not fail but it does not generate enough money to pay the owners. For the time being the business is paying the debt service on the machinery, but just barely and it is uncertain that it will continue to be able to do so because the economy is turning down. The one shareholder who had a lot of knowhow but not much money is now in bad shape because he is not getting paid and has used all of his savings to live off of and make additional contributions to the company. Thus person has to declare bankruptcy. The obligation under the guarantee will be discharged in bankruptcy even though at the time the discharge is entered the equipment loan or lease was current and had not been defaulted upon.

So we find that we are able to help people who were just trying to help a friend or get a business off the ground to get a fresh start without the threat of a debt owed by another person or entity springing up sometime in the future to set them back again. Just as long as the contingent liability has been fully disclosed and listed in their bankruptcy petition.

This blog simply contains my thoughts and ruminations on certain subjects. They are thoughts in general and are not intended to be given or taken as legal advice. If anything in this entry piques your interest or seems to apply to your situation please do not hesitate to contact us through our website at http://www.schinzelaw.com/
or directly by telephone at (760) 510-4900.

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