If you are settling with some—but not all—obligors on a debt, be sure to expressly reserve all of your rights against the non-settling co-obligors. Failure to do so may be deemed a release of the non-settling co-obligors.
The facts. A lender made a loan to a company, evidenced by a promissory note. The company's two principals also signed the promissory note, as "Maker." When the company filed for bankruptcy, the lender settled with and released the company, and then sued the principals to recover the unpaid balance. One of the principals moved for summary judgment. The trial court denied the motion, but the appellate court reversed and dismissed the complaint against her.
The underlying law. Under New York law, if a lender knows or should know that a settling obligor is bound to reimburse a co-obligor for payment of the obligation, then the lender's settlement with the settling obligor will prevent the lender from recovering the balance of the debt from the non-settling obligor to the extent of the reimbursement obligation—unless the lender expressly reserves its rights against the co-obligor (a simple thing to do). The reason for this rule is that under these circumstances, allowing the lender to recover the balance of the debt from the non-settling obligor would render meaningless the settling obligor's deal with the lender, because the settling obligor would remain liable to reimburse the non-settling obligor. The settling obligor should only be stuck with the reimbursement obligation if the lender made clear that it may proceed against the non-settling obligor notwithstanding the settlement.
The decision. The company's reimbursement obligation to the principal was the key factor in this decision. The appellate court found that the principal was an "accommodation maker," which New York law defines as one who signs an instrument in any capacity for the purpose of lending his or her name to the instrument for another party. As an accommodation maker, the principal was liable to the lender even though she did not receive any of the consideration recited in the note. But she was not equally liable with the company, which was the primary debtor. Rather, the company was bound to reimburse her for any payments she made to the lender. The court effectively held that the lender knew or should have known that the principal was not an equal obligor. Since the lender had failed to reserve its rights against the principal when it settled with the company, it could not recover the balance of the debt from her.
What the decision means for you. By settling with the company but not reserving its rights against the principal (who was entitled to recover from the company any payments she made to the lender), the lender had unwittingly limited its recovery to the amount due to it in the settlement with the company. This rule can be a trap for the unwary where there are non-settling co-obligors, such as guarantors, who are entitled to reimbursement from the settling obligor for payments they may make to the creditor. Therefore, when settling a debt with fewer than all of the co-obligors, be sure to expressly reserve your rights against any non-settling co-obligors, in order to preserve your ability to recover the remainder of your debt from them.
If a lender has not reserved its rights when settling with fewer than all obligors, the only way out of this trap is to establish that it did not know or have reason to know that the settling obligor was bound to the co-obligors to pay the obligation. There is no need for a lender to allow itself to be placed in such a predicament. Instead, unless it intends to forego collection from the non-settling obligors, it should simply reserve its rights against them.
For further information regarding these or other lending issues, you may contact Paul Rubin (212-592-1448 or firstname.lastname@example.org).
Herrick's Bankruptcy, Business Reorganization and Creditors' Rights Practice Group represents a broad range of clients having varied interests in the bankruptcy, workout and reorganization arenas. From Fortune 500 corporations to small public and private companies, our clients include all of the major players in the bankruptcy process: debtors, creditors' committees, secured and unsecured creditors, trustees, financial institutions, investment banks, asset-based lenders, insurance companies, pension funds, purchasers of assets, landlords, claims traders, equipment lessors and licensors.
Copyright © 2006 Herrick, Feinstein LLP. The Lending and Restructuring Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.