By Joel H. Levitin, Cahill Gordon & Reindel LLP and Michael R. Carney, McKool Smith, P.C.
Many finance lawyers believe that a creditor is entitled to assert the full face amount of its claim against a guarantor in bankruptcy, without having to reduce such claim to reflect any partial payments by the primary obligor on the underlying debt.1 Thus, there is a traditional notion in bankruptcy practice that a creditor is entitled to receive a distribution from the guarantor based on the full face amount of its debt, potentially obtaining a recovery in excess of those received by other holders of claims with the same priority of payment that have received partial payments from the debtor.
Consider two creditors of a debtor that will pay 50% of amounts owed to its creditors, one with a $100 guaranty claim and the other with a $100 non-guaranty claim, where the holder of the guaranty claim received a partial payment of $50 from the primary obligor, and the other claimholder was paid $50 on its claim by the debtor, prior to bankruptcy. Under the conventional view, the holder of the guaranty claim would be allowed to assert a claim of $100, despite the $50 payment, entitling it to recover an additional $50 from the debtor's estate for a total of $100 in full satisfaction of its claim. In contrast, the other creditor, whose claim has the same priority, would be required to reduce its claim by the $50 payment, recovering only $25 on its remaining claim of $50, for a total of $75. If the claim against the guarantor were limited to the $50 remaining amount unpaid, however, it would receive only an additional $25 distribution from the debtor's estate, like other similarly-situated creditors with net unpaid claims of $50.
The U.S. Supreme Court's 1935 decision in Ivanhoe Building & Loan Association of Newark, N.J. v. Orr2 is cited in support of the accepted position. However, Ivanhoe is not necessarily definitive on the issue, and other decisions offer a potential departure from the traditional view. As explained in greater detail below, it is at least arguable that a creditor should not be required to reduce its claim for guaranteed debt by the amount paid by the primary obligor.
In Ivanhoe, the Supreme Court held that a creditor was entitled to an allowed claim for the full amount of a mortgage bond under which the debtor was obligated, notwithstanding that such creditor's claim already had been satisfied in part by a recovery through foreclosure on the mortgaged property then owned by a third party.3The Ivanhoe decision rests upon an interpretation of the defined term “secured creditor” under Bankruptcy Act §1(23) and makes no reference to applicable non-bankruptcy law.4
Bankruptcy Act §1(23) (as in effect in 1935) provided that a
[s]ecured creditor shall include a creditor who has security for his debt upon the property of the bankrupt of a nature to be assignable under this Act . . . or who owns such a debt for which some indorser, surety, or other persons secondarily liable for the bankrupt has such security upon the bankrupt's assets.5
Further, Bankruptcy Act §57e provided that “claims of secured creditors” were to be allowed only for sums owing “over and above” the value of their collateral. According to the Court, the creditor in Ivanhoe did not fit within the definition of “secured creditor” under Bankruptcy Act §1(23) because the debtor no longer owned the collateral at issue at the time of foreclosure, so such creditor's claim was not subject to mandatory reduction by the value of such collateral under Bankruptcy Act §57e.6
Although Ivanhoe did not involve a guaranty claim, it has been interpreted to apply to such claims, at least in the context of a foreclosure on collateral. For example, in In re F.W.D.C., Inc.,7 a Florida bankrutpcy case, Chase Manhattan Bank received a payment on outstanding debt from certain primary obligors by foreclosing on collateral in a state-law foreclosure proceeding.8 The debt owed to Chase was guaranteed by affiliates of those obligors, and Chase asserted the full amount of the underlying debt as an unsecured claim in the guarantors' bankruptcy cases, without reducing such claim for the value received as a result of the foreclosure.9
Certain creditors moved for substantive consolidation of the bankruptcy cases of the obligors and their affiliated guarantors, with the primary purpose of reducing Chase's claims by the value previously received through the foreclosure.10 The movants—noting that Bankruptcy Code §506(a) emphasizes secured “claims,” as opposed to its predecessor's reference to “secured creditors”—argued that Ivanhoe's analysis of the meaning of “secured creditor” under the Bankruptcy Act, and how such creditors' claims were treated thereunder, should be inapplicable to cases filed under the Bankruptcy Code. 11
The F.W.D.C. court rejected the movants' argument, without significant analysis, finding that Ivanhoe was controlling because Bankruptcy Code §506(a) has the same effect as Bankruptcy Act §§1(23) and 57e, and because the movants cited no case law in support of their position.12 Consequently, the F.W.D.C. court concluded that, as a general proposition of bankruptcy law under Ivanhoe, “a claim against a debtor-guarantor … need not be reduced to reflect a creditor's receipt of a third party's collateral securing the third party's indebtedness guaranteed by the debtor.”13
NGET and ET Power objected to Liberty's claims, arguing, among other things, that Liberty should not be permitted to assert claims against both for $140 million when the actual amount required to make it whole was, at most, $17 million.19 The bankruptcy court held that the claims could proceed for $140 million (capping any recovery at $17 million).20
On appeal, the United States Court of Appeals for the Fourth Circuit looked first to Ivanhoe to determine whether the full amount of the claim could be asserted, as a bankruptcy matter, and then turned to state law to determine the amount of such claim.21 The court characterized the issue before it as follows:
Because Liberty is currently owed only approximately $17 million, the debtors argue its claim should be limited to this amount. The debtors' argument is foreclosed by the combination of Ivanhoe Building & Loan Ass'n of Newark v. Orr, 295 U.S. 243, 55 S. Ct. 685, 79 L. Ed. 1419 (1935), and New York law, which governs pursuant to the Agreement. In Ivanhoe, the Supreme Court held that a creditor need not deduct from his claim in bankruptcy an amount received from a non-debtor third party in partial satisfaction of an obligation. Thus, as a matter of bankruptcy law, ET Power's debt to Liberty is not reduced by the amount which Liberty received from GTN. However, this merely leads to the question of what the value of ET Power's debt is, and New York law provides the answer to this question.22
Specifically, Section 15-103 of New York's General Obligations Law (codified as N.Y. Gen. Oblig. L. §15-103), which incorporates section 3 of the Model Joint Obligations Act,23 provides:
The amount or value of any consideration received by the obligee from one or more of several obligors, or from one or more of joint, or of joint and several obligors, in whole or in partial satisfaction of their obligations, shall be credited to the extent of the amount received on the obligations of all co-obligors to whom the obligor or obligors giving the consideration did not stand in the relation of a surety.24
The Court found that “whether GTN's payment to Liberty must be deducted from ET Power's obligation turns on whether GTN was a surety or a co-obligor.”25 Because the Court determined that GTN was a surety, the authority set forth above did not require that the claims be reduced: “[W]e conclude that … GTN was a surety for ET Power's obligations to Liberty. Accordingly, the value of ET Power's debt to Liberty under state law is not reduced by the $140 million received from GTN.”26
By implication, however, had GTN not been a surety, but either an obligor or a co-obligor, Liberty's claims in the bankruptcy cases would have been reduced, under the “combination of Ivanhoe … and New York law.”27 Thus, at least according to the analysis in National Energy & Gas, the provision of consideration by a co-obligor, which is a denomination of borrower affiliate guarantors in sophisticated financing arrangements more common than surety, reduces the obligation of other obligors (whether primary or secondary obligors or sureties) to the extent of the amount or value of consideration received,28 and once that obligation is so reduced, claims against such other obligors in bankruptcy arguably should be reduced as well.29
Mr. Levitin is a partner in the business restructuring and bankruptcy practice group at Cahill Gordon & Reindel LLP , and Mr. Carney is an attorney in the bankruptcy litigation practice group at McKool Smith, P.C.
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