Limits on the Protection of a Personal Guarantee

The Benefit of a Personal Guarantee When Extending Credit

Many of our clients, whether in the construction industry or another commercial context, require the unconditional personal guarantee of a company owner before entering into a contract. The insistence on a personal guarantee (often written as “guaranty” in many financial documents) most commonly arises when credit or financing is being extended to a customer or client. While securing a personal guarantee in these situations is a good way to protect against the risk of default by a corporate entity, it is important to understand its limitations.

Limitations of the Personal Guarantee

Primarily, it should be kept in mind that if the person giving the guarantee, known as the “guarantor”, has bad credit and limited means to satisfy the obligations for which the guarantee is being given, the guarantee will not offer much protection. Leaving aside this overarching problem, there is a less obvious limitation that arises after the decision to extend credit and accept a personal guarantee has already been made. Specifically, that a personal guarantee in New Jersey is generally not enforceable as to credit extended after the person who provided the personal guarantee files for bankruptcy and obtains a bankruptcy discharge.

The Impact of Bankruptcy on the Personal Guarantee

As most people with a rudimentary understanding of the bankruptcy process know, with certain exceptions, debts owed by a debtor existing prior to the filing of a bankruptcy petition no longer exist once a debtor obtains a bankruptcy discharge. But what happens to the personal guarantee itself? If credit is extended after the bankruptcy to the company benefiting from the guarantee, is that debt still guaranteed by the personal guarantee signed before the bankruptcy? In New Jersey, the short answer is no.

Primarily, the pre-petition guarantee is likely to be deemed subject to, and terminated by, the bankruptcy discharge because it falls within the definition of a pre-petition contingent claim against the bankruptcy estate. As the United States Bankruptcy Court for the District of New Jersey has explained,

The issue of whether an obligation must be designated as a pre-petition or post-petition claim does not depend on when the damages from the harm accrued. Rather, the issue is when the cause of action arose. The cause of action arises when a cognizable "interest" arises, i.e., when "a legal relationship relevant to the purported interest from which the interest may flow" is established. Schweitzer v. Consolidated Rail Corp., 758 F.2d at 943; In re Radio-Keith-Orpheum Corp., 106 F.2d 22, 26-27 (2d Cir.1939), cert. denied, 308 U.S. 622 (1940).

In re Gullone, 301 B.R. 683, 687 (Bankr. N.J. 2003).

In In re Radio-Keith-Orpheum (“RKO”), a case discussed in Gullone and elsewhere by the Third Circuit, the establishment of the pre-petition legal relationship between the debtor and the claimant in the form of guarantor-guarantee was the point at which the contingent claim arose. In RKO, the post-petition default of the primary obligor did not reinstate the debtor's pre-petition guarantor obligation, which was discharged in the debtor's confirmed reorganization plan. While the relevant case law identifies some theories that would support exceptions to the discharge of a pre-petition personal guarantee, no such exceptions have been specifically recognized in the Third Circuit to date.

The Importance of Knowing When a Personal Guarantee Is No Longer Enforceable

Given the state of the law, or even generalized assumptions about bankruptcy, a creditor, upon hearing of a guarantor’s bankruptcy, might respond by ceasing to extend credit to a company, rendering the pre-bankruptcy personal guarantee irrelevant. However, there are number of scenarios in which the creditor would understandably have other reactions:

• The creditor may be unaware of the guarantor’s bankruptcy.
• The company benefiting from the personal guarantee may be able to honor its obligations despite the bankruptcy of the guarantor.
• The creditor’s contract with the company, as could be the case in a commercial lease, may require the creditor to continue performing during and after the guarantor’s bankruptcy proceedings.

One can also conceive of scenarios where, even if the creditor temporarily ceases to extend credit as a result of the guarantor’s bankruptcy, there may be business reasons for resumption after the discharge. In any of these scenarios, the important thing to realize, at least in New Jersey, is that the bankruptcy discharge will in most situations operate to terminate the personal guarantee that existed prior to the guarantor’s bankruptcy filing. Accordingly, while abiding by the rules protecting bankruptcy debtors, it is advisable to secure a new guarantee from the guarantor after the bankruptcy or obtain an alternative means of security for the company’s debt or other contractual obligations.

The Law Office of Bart J. Klein, located in Maplewood, New Jersey, counsels clients throughout New Jersey regarding contract and construction related disputes. Our staff includes construction lawyers and commercial litigation lawyers. We welcome you to contact us for further information.