The Restructuring Report

Small business owners commonly guaranty certain obligations of their businesses. This stages a potential domino effect if the business is unable to satisfy its obligations. A failed business triggers a creditor to pursue the personal guaranty of the business owner, which can cause the business owner to file a bankruptcy petition if they do not have the ability to satisfy the guaranty. In those scenarios, the guaranty liability is a primary cause of the business owner’s bankruptcy and discharging that guaranty liability is the primary goal.

Sometimes the reverse occurs. A business owner who has personally guaranteed the obligations of the business may experience financial distress that is not directly connected to the business. In those situations, the business owner may file a bankruptcy petition and not currently owe anything on the guaranty or not realize that they have contingent liability under the guaranty. Sometimes personal guaranties are buried in a supplier’s credit application.

What happens if the business later incurs additional obligations after the business owner received a bankruptcy discharge? Does the business owner have liability under the guaranty, or has the bankruptcy discharge cut off future liability under the guaranty?

The District Court for the Eastern District of Wisconsin recently addressed this situation, reversed the Bankruptcy Court, and firmly held that the business owner’s bankruptcy did not discharge future liability under a guaranty. Reinhart Foodservice LLC v. Schlundt, 646 B.R. 478 (E.D. Wis. 2022). In Reinhart, the debtor owned a restaurant and guaranteed the restaurant’s obligations to a supplier. The debtor filed a bankruptcy petition and received a discharge. He did not identify the supplier as a creditor and the creditor did not otherwise have notice of the bankruptcy case. Unaware of the owner’s bankruptcy, the creditor continued to sell goods to the restaurant on credit. When the restaurant failed four years later, the creditor sought to enforce the debtor’s guaranty and the debtor asserted that his obligations under the guaranty had been discharged.

The District Court held that, although the guaranty was made prepetition, the liability in question did not arise until the purchases were made–after the debtor’s bankruptcy case–and therefore the liability was not discharged. The District Court did not reach the lack of notice issue. The debtor has appealed the decision to the Seventh Circuit Court of Appeals.

Interestingly, the supplier stated that if it had known that the guarantor had filed for bankruptcy, it would not have provided credit to the restaurant without a reaffirmed guaranty. While likely true as a factual matter, this undercuts its legal argument: a reaffirmed guaranty is not necessary under the legal rule it advocated and that the District Court adopted, nor does it matter that the creditor did not receive notice of the bankruptcy case. (From the creditor’s perspective, however, it should always insist on a reaffirmed guaranty as opposed to relying exclusively on this holding.)

This result is not without precedent, including a case where the “lack of notice” argument was not present, which presents the issue in sharper focus. In In re Schaffer, 585 B.R. 224 (Bankr. W.D. Va. 2018), two individual owners of a business personally guaranteed payment of their business’s obligations to a supplier. Both owners filed Chapter 7 bankruptcy cases, properly identified the supplier as a creditor and obtained discharges. Their business continued to operate and to obtain goods from the supplier on credit. When the business later failed, the supplier sought to enforce the guarantees for all of the business’s post-petition purchases. The Bankruptcy Court held that the guarantees remained in force. The liability was not discharged because it was not a prepetition claim. It only arose when the credit was extended post-petition. Critical to the Bankruptcy Court’s analysis was its determination that the guarantors did not revoke or terminate the guarantees. One might think that filing for bankruptcy and properly scheduling the guaranty liability (to the extent it existed at that time), would be enough to revoke a guaranty. Instead, the Bankruptcy Court seemed to think that the business’s continued orders, which the guarantors apparently knew about and benefited from, sent the opposite message.

Not all cases reach this conclusion. For example, Judge Rhodes held in In re Lipa, 433 B.R. 668 (Bankr. E.D. Mich. 2017), that all liability under a prepetition guaranty is a contingent claim that is subject to discharge, even liability for future purchases that occurred after guarantor’s bankruptcy filing. The court reached that conclusion in part to effectuate the policy of the Bankruptcy Code to provide the debtor with a fresh start.

There are a few practice points to take away from these decisions to limit future liability for the guarantor:

First, identify all guaranteed debts on the schedules.

Second, if the primary goal is to limit the individual’s liability, best practice is to send a notice disclaiming future liability under the guaranty to the creditor. This has the risk of causing “upstream” problems; the creditor may refuse to provide credit to the business without a reaffirmed guaranty (as suggested in Reinhart). But if a debtor chooses not to send this notice, it needs to be prepared to make a later argument that the bankruptcy discharge cut off future liability under the guaranty or that the bankruptcy itself effectively revoked the guaranty–arguments that have had uneven success.