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Co-debtors’ Obligations May be Treated Differently in Bankruptcy

Imagine the following common scenario:

A lender makes a commercial loan and the note is signed by two borrower entities, each of whom provides separate real property collateral as security for the loan.  The borrowers are textbook “co-debtors,” and their obligation under the promissory note is identical — at least, for now.

But before the loan is repaid, financial problems arise and the borrowers file separate Chapter 11 bankruptcy cases.  Will the borrowers’ obligations remain identical?

Not necessarily.

In each bankruptcy case, the approved plan of reorganization will govern the obligation of each borrower going forward.  And the obligations of co-debtors can, in fact, be treated very differently under each debtor’s respective bankruptcy plan.

Bankruptcy Code Section 524(e)  states that a “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.”  (11 U.S.C. §524(e).)

The Ninth Circuit “has repeatedly held, without exception, that Section 524(e) precludes bankruptcy courts from discharging the liabilities of non-debtors.”  (Resorts Intl. v. Lowenschuss, 67 F.3d 1394, 1401 (9th Cir. 1995); see also In re Jacobsen, 20 B.R. 648, 650 (B.A.P. 9th Cir. 1982) [holding there is “no limitation on the creditor’s right to sue the co-debtor” for the amount not provided for by a debtor’s plan].)  The rule that “the liability of a person who is a co-debtor with, or guarantor or in any manner a surety for a bankrupt shall not be altered by the discharge of such bankrupt” dates back to the Act of 1898 [formerly 11 U.S.C. §34].  (Underhill v. Royal, 769 F.2d 1426, 1432 (9th Cir. 1985).)

Other jurisdictions have held likewise, opining that plan confirmation for one debtor does not affect the obligations of co-debtors.   (See, e.g., Ramco-Remodel Am. Corp. v. Wallis, 536 B.R. 206, 211 (Bankr. W.D. Tenn. 2015).)  The Legislative history of 11 U.S.C. §524(e) also shows that plan confirmation for a debtor “does not affect co-debtors or guarantors.”  (In re Stoller’s, Inc., 93 B.R. 628, 635 (Bankr. N.D. Ind. 1988), quoting S. Rept. No. 95-989 to accompany S. 2266, 95th Cong., 2d Sess. 80-81 (1978); see also In re Siebe, 2009 Bankr. LEXIS 4370, *6-9 (Bankr. D. Neb. 2009) [holding that a debtor’s bankruptcy plan “has no bearing on the liability of the co-obligors”].)

While this rule might strike some as counter-intuitive at first brush, it is wholly consistent with the broader concept that confirmation of a plan of reorganization “does not result in the extinguishment of the underlying debt but merely releases the debtor from personal liability.”  (Star Phoenix Min. Co. v. West Bank One, 147 F.3d 1145, 1147, n. 2 (9th Cir. 1998).)  The terms on which one co-borrower is released from liability on a note as set forth in its own plan of reorganization can be very different from the terms on which the other co-borrower is released from liability on the same note.  Factors like ability to pay, the number of other creditors, and quality of security pledged by each borrower play a large role in shaping how the obligation is treated under each borrower’s plan of reorganization.

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