The Risk-shifting Effect of Business Bankruptcy: a Statutory Solution to Provide Additional Protections for Personal Guarantors of Debts by Closely-held Business Ventures

• Publication year: 2015

The Risk-Shifting Effect of Business Bankruptcy: A Statutory Solution to Provide Additional Protections for Personal Guarantors of Debts by Closely-Held Business Ventures

Jason Gordon

Robert J. Landry III

THE RISK-SHIFTING EFFECT OF BUSINESS BANKRUPTCY: A STATUTORY SOLUTION TO PROVIDE ADDITIONAL PROTECTIONS FOR PERSONAL GUARANTORS OF DEBTS BY CLOSELY-HELD BUSINESS VENTURES

Jason Gordon^* Robert J. Landry, III^**

Abstract

Startups often require personal guarantors when securing credit relationships. Third parties often enter into guarantee agreements unaware of the detrimental effect of bankruptcy filing on their rights. A primary goal of bankruptcy protection is to shift the risks associated with debt arrangements among the interested parties to allow for the equitable distribution of assets among creditors of the bankrupt individual or entity. Filing bankruptcy may increase the risk to the guarantor beyond what she anticipates at the time of personally guaranteeing the debt. This Article explores the preference liability of personal guarantors of a closely-held business in bankruptcy and makes a statutory proposal to remedy the inequitable risk-shifting effect of the bankruptcy of the closely-held business.

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Introduction

Entrepreneurship and policies encouraging entrepreneurial activity are vital to the United States' economy.¹ An antecedent to the decision to pursue a new venture is the availability of financial capital.² Early stage entrepreneurs often rely on diverse sources of capital to fund the venture.³ Important to this research, new ventures often cannot secure debt financing due to the high risk of business failure.⁴ Individual or institutional lenders providing capital to fund startup ventures often require personal guarantees of the debt from either the entrepreneur(s) or other third parties.⁵ The personal guarantee provides additional protections to lenders if the underlying business fails or defaults on the loan obligation.⁶

A calculable risk contemplated by a lender is the effect of the startup venture filing for bankruptcy.⁷ This situation generally results in losses for the

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unsecured creditors of the business.⁸ Frequently, the entrepreneur will seek bankruptcy protection for herself and the business entity, as the interests and assets of the entrepreneur are frequently closely aligned with the business entity.⁹ In such a situation, the liability for the business debt may fall upon third party guarantors. Like the lender, the guarantor understands that guaranteeing a business obligation assumes the risk that the business will default.¹⁰ The guarantor may not, however, understand the extent of the risk associated with guaranteeing debt that is included in the bankruptcy estate of the debtor business. While bankruptcy serves as a "safety valve of an economy oriented around entrepreneurship and risk-taking,"¹¹ the presence of the personal guarantee has a risk-shifting effect that may not be fully contemplated by the parties to the agreement.

A primary goal of bankruptcy protection is to shift the risks associated with debt arrangements among the interested parties.¹² Bankruptcy law achieves this goal by providing for the equitable distribution of assets among creditors of the bankrupt individual or entity.¹³ In pursuit of this objective, an important tool in the Bankruptcy Code (the "Code")¹⁴ is the ability of a trustee or debtor-in-possession

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("trustee")¹⁵ to recover, for the benefit of the estate and all of its creditors, preferential payments made to individual creditors of the estate leading up to the bankruptcy filing.¹⁶ The recovery of preferential payments is often the subject of litigation between the trustee and the creditor in receipt of an alleged preferential payment.¹⁷ In the context of preference litigation, the guarantor of a business debt may lack the protection she anticipates under bankruptcy law. In fact, filing bankruptcy may increase the risk to the guarantor beyond what she anticipates at the time of personally guaranteeing the debt.

This Article explores the preference liability of personal guarantors of a closely-held business in bankruptcy. Following this Introduction, Part I discusses an overview of priority and preferences, Parts II and III we offer an overview of preference liability generally and then specifically to guarantors. In Part Iv, we analyze the extent to which preference liability increases the risk to the guarantor beyond the parties' expectations. In Part V, we call for a statutory solution to the inequitable risk-shifting in the event that a closely-held business goes bankrupt.

I. Overview of Preferences

A. Priority, Preferences and the Trustee

Establishing a credit relationship is a form of lending. Inherent in this relationship is the concept of priority.¹⁸ Priority refers to rights of creditors to payment with respect to other creditors.¹⁹ Specifically, it provides for the order

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in which creditors are entitled to repayment from the debtor in the event of liquidation.²⁰ Priority is determined either by statute or by a contractual relationship between the parties.²¹ Importantly, priority represents a level of risk as compared to other creditors, and it strongly influences the terms under which a credit relationship exists.²² That is, creditors extend credit to obligors with an understanding of their priority of repayment and their rights upon default.

A preference refers to inequitable treatment of one party above another. In the context of bankruptcy, a preferential payment is defined as a payment:

(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(4) made—

(A) on or within 90 days before the date of the filing of the petition; or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider, and

(5) that enables such creditor to receive more than such creditor would receive if—

(A) the case were a case under chapter 7 of this title . . . ;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title . . . .²³

Preference is, therefore, either the failure to treat creditors in accordance with their statutory or contractual priority or the inequitable treatment of similarly situated creditors with regard to their claims against the business.²⁴

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The trustee in bankruptcy is charged with protecting the rights of creditors during the bankruptcy process.²⁵ The trustee collects assets of the bankruptcy estate for the benefit of creditors.²⁶ As stated above, preferential payments by a debtor diverge from the legally protected priority afforded to creditors. As such, the Code empowers the trustee to collect preferential payments by the debtor to creditors when those payments run afoul of the aforementioned priority or otherwise harm similarly situated creditors.²⁷

B. Preference Challenges

As a matter of procedure, any payment of a debt made to a business creditor within ninety days prior to filing for bankruptcy is subject to challenge by the trustee as a preferential payment.²⁸ The trustee has standing to sue and bring a preference action.²⁹ The process, as with most litigation, usually begins informally with the trustee informing creditors of any suspected preferential payments and by sending out blanket claims of preferential payment to all creditors in receipt of funds within the ninety-day window. If the trustee recovers the preferential payment, then the previously preferred creditor loses all priority in payment and becomes a general unsecured creditor of the bankruptcy estate for the amount of the recovered payment.³⁰ This demotion in priority from paid-in-full creditor to an unsecured creditor can be devastating, as unsecured creditors generally receive pennies on the dollar for unsecured claims against the bankruptcy estate.³¹

The ninety-day period is an arbitrary amount of time created under the assumption that a debtor in bankruptcy may have prepared to file for bankruptcy by making preferential payments to creditors that hinder the rights of other business creditors.³² A payment within the ninety-day window is not

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assumed to be preferential.³³ However, the trustee's practice of sending blanket preferential payment notices shifts the burden of defending the preferential payment claim onto any creditor who received payment during the ninety-day period. While the intent of the provision is to generally protect creditors of the bankruptcy estate,³⁴ a blanket challenge to any payment negatively affects creditors in receipt of non-preferential payments.

C. Defenses to Preference Challenges

The creditor may assert a number of defenses against the trustee's claim of preferential payment. These defenses include the assertion that (1) the purported preferential payment was a contemporaneous exchange for new value,³⁵ (2) the debt and payments were made in the ordinary course of business and according to ordinary business terms,³⁶ (3) the debtor provided a security interest in collateral acquired with the new value,³⁷ (4) the debtor provided payment to a creditor providing new value,³⁸ (5) the payment created a perfected security interest in receivables,³⁹ or (6) the payment made was less than $600 for consumer debts or less than $6225 for non-consumer debts.⁴⁰ These are affirmative defenses that the creditor must raise to rebut any claim that a payment is preferential under § 547(b)(1)-(5). Asserting any of these defenses, however, may be difficult and costly to the creditor due to legal fees incurred and a lack of availability of information.⁴¹ Faced with the prospect of losing any of the trustee's contested and incurring extensive legal costs, creditors are tempted to simply settle the claim for a...