As is almost always the case, principals of a distressed business have personally guaranteed the debt on a credit line or property or equipment lease. When a business files bankruptcy, an automatic stay is imposed against any adverse actions taken against the business entity, the Debtor. But what about the owners of the business? Often, I find myself seeking to extend the automatic stay injunction to those principals. This issue came up in a recent case we had pending in the Fourth Circuit. We were compelled to find case law regarding the standard for relief.
A factual example would be as follows: A distressed business ABC Recylcing owns a building, and the building has a mortgage on it in favor of Meanie Bank, N.A. The business falls behind on payments. Meanie Bank initiates a foreclosure action to set an auction to sell the building. Jake, the owner of the business had to sign a guaranty in order for ABC Recycling to get the loan with Meanie Bank. ABC Recycling still operates with the faint hopes of reorganizing through a Chapter 11 bankruptcy. Once the Chapter 11 is filed, the foreclosure action is stayed as to ABC Recycling, but now the Meanie Bank is going after Jake. Help, my clients say.
ISSUE: Pursuant 11 U.S.C. §105 and §362 of the Bankruptcy Code, is a court likely to grant an injunction to protect the principal of a bankrupt business?
CONCLUSION: Where the principal Jack is a primary guarantor of the mortgage and Meanie Bank now intends to secure a judgment against the principal, the principal will only be able to obtain an injunction by demonstrating a mutuality of identity with the Debtor such that allowing Meanie Bank to proceed against Jake will substantially deprive the Debtor of a primary asset (its owner’s time and attention). In Plain English, how important is the principal Jake to the Debtor’s operations? A four-part test is employed to make that determination.
While automatic stay proceedings are usually only available to the Debtor, under unusual circumstances, the Fourth Circuit has held that the Bankruptcy Court can enjoin proceedings against third parties. In re F.T.L. Inc., 152 B.R. 61 (Bankr. E.D. Va. 1993). However, where no compelling or unusual circumstances exist, then under §362 the Debtor’s guarantors must file their own bankruptcy petition in order to be protected by the Bankruptcy laws. Id. at 63. (this also happens often).
A court is only likely to grant an injunction to a third party non-debtor principal in the unusual circumstance that it is evident that the identity of the debtor and the non-debtor third party is so interconnected that it is clear that the creditor is proceeding against the debtor. Under such circumstances, the court may apply a four-part test and equitably grant an injunction where the court finds that:
- the plaintiff principal has a greater likelihood of succeeding on the merits;
- plaintiff principal has shown that lack of relief will result in irreparable injury;
- an injunction will not substantially harm other interested parties, and;
- preserving the status quo until the merits of the controversy is decided will serve public interests. Id.
In re F.T.L., the primary secured creditor to a car wash company debtor, secured a judgment lien against the debtor’s guarantors, the plaintiffs. Plaintiffs are the primary owners and guarantors of the car wash and the creditor perfected its lien against plaintiffs’ personal residence. Id. at 62. Noting that the collection activities against the owners arose from the car wash’s debt to the creditor, the court applied the four-part test and found that the debtor was likely to succeed on the merits by proposing a confirmable chapter 11 plan; the debtor’s chapter 11 plan would be impossible if the owners were forced to file their own chapter 11 petition; very little harm was likely to come to the creditor if it was enjoined from collection activities against the owner, and; lastly the creditors as a whole were best served if the debtor were allowed to propose a plan for reorganization. Id. The Court extended the injunction to the owners.
If you own a business and are wondering the same questions, you should review the facts and circumstances of your workout with your attorney. I think, by and large, the automatic stay is difficult to extend in Bankruptcy Court. You have to make a really compelling argument that the principal will be so consumed with his or her own bankruptcy that the Chapter 11 reorganization will suffer.