Dear constituency list members of the Insolvency Law Committee:
The following is a case update written by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLP, analyzing a recent decision of interest:
In Matter of LaHaye, ___ F.3d ___, 2021 WL 5276367 (5th Cir. 11/12/2021 (“LaHaye”), the United States Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) held that the Chapter 11 plan of an LLC grocery business did not improperly discharge a portion of the debt of the LLC’s guarantors to the guaranty’s beneficiary by providing that upon confirmation of the plan the guarantors’ liability was reduced by the value of the LLC’s real property through either post-confirmation foreclosure by the beneficiary or transfer of the property to the beneficiary.
LaHaye can be found by clicking here.
The LaHayes owned a small grocery business through an LLC. The LLC owned the real property on which it conducted its business (the “grocery property”). It borrowed $350,000 from a bank, securing the loan with the grocery property. In addition, the LaHayes guaranteed that debt, securing the guaranty with their home. Later, the bank sold its position to a third party, New Falls Corporation. The business suffered financial reverses, so it filed a Chapter 11. The LLC proposed a plan that among other things provided that for a credit of $250,000 against the loan balance and on the guaranty, effective upon confirmation of the plan, either the LLC would transfer the grocery property to New Falls, a step that would require the cooperation of the LaHayes, or New Falls could foreclose on the grocery property. The LaHayes would also make monthly payments on the remaining $100,000 of the debt. The $250,00 figure for the value of the grocery property was set by a valuation hearing. New Falls filed a claim and participated in the confirmation proceedings. It did not object to confirmation of the plan. The bankruptcy court confirmed the plan. At no time thereafter did the LaHayes enable transfer the grocery property to New Falls, nor did New Falls foreclose on it. The parties disputed who was at fault for the LaHayes’ failure to transfer the grocery property.
Sometime after confirmation, the LaHayes themselves suffered financial distress. In response, New Falls commenced foreclosure on their house. They then filed their own Chapter 11 case. By that time the value of the grocery property had declined substantially. New Falls filed a claim in the LaHayes’ case for the full $350,000 of the original guaranty. However, the bankruptcy court reduced New Falls’ claim by the $250,000 credit from the LLC plan to $100,000 and confirmed the LaHayes’ plan. New Falls appealed to the district court, which affirmed. New Falls then appealed to the Fifth Circuit. It, too, affirmed.
On appeal, New Falls made two arguments. First, it contended that because the grocery property had not yet been conveyed to it, the $250,000 could not be credited against the guaranty. Second, it asserted that in any event a plan cannot discharge a third party obligation such as that between it and the LaHayes. The Fifth Circuit rejected both theories.
The Fifth Circuit first focused on the language of the LLC plan. The plan expressly provided that surrender of the grocery property and the credit would be effective “upon confirmation of this plan.” That outcome was not tied to actual transfer of the grocery property. In that connection, the court noted that even if the lack of transfer were the LaHayes’ fault, there was nothing to prevent New Falls from foreclosing on the property, something it chose not to do (probably because of its view of the decline in the value of the property). That the plan elsewhere authorizes the LaHayes and New Falls to take steps to effect the transfer of the grocery property does not change the overriding plan provision that makes the credit effective on the date of confirmation.
Next, the Fifth Circuit considered New Falls’ contention that the plan improperly discharged the third party debt between New Falls and the LaHayes because Bankruptcy Code section 524(e) provides that the “discharge of a debt of the debtor does not affect the liability of any other entity.” Thus, New Falls argued, the plan could not discharge the debt of the LaHayes to New Falls; it could only discharge the LLC’s debts. But, the Fifth Circuit rejoined, the plan does not discharge the guaranty. To the contrary, it merely requires New Falls to accept (or foreclose on) the grocery property in partial satisfaction of the guaranteed debt while expressly preserving the guaranty and the LaHayes’ remaining $100,000 liability on it. The provisions of a plan requiring a creditor to accept certain assets in partial satisfaction of a debt is neither impermissible nor novel, the court noted, citing several of its earlier cases.
Finally, the Fifth Circuit pointed out that under the Bankruptcy Code confirmation of a plan binds the debtor and its creditors. Thus, the confirmation order was res judicata (or its equivalent) as to New Falls with regard to the plan’s provisions affecting the LLC-related debts with which it dealt. If New Falls wanted to avoid this result, it could and should have objected and sought to modify the offending provisions (or at least preserve the issue for appeal). It did not do so.
The lesson of this case is patent: a creditor should not let an objectionable provision of a plan slip past it. New Falls’ fundamental mistake in LaHaye was its failure to object to the plan provisions purporting to require it to accept the right to have the grocery property transferred to it – some day – in turn for an immediate reduction in the liability of the LaHayes on the guaranty. It also could have objected to the provision that made the guaranty credit effective on confirmation, insisting instead that it be conditioned on actual transfer of the property (and on terms that required the transfer to be made within some acceptable period of time, with jurisdiction reserved to the bankruptcy court to compel that result if need be). It is not clear that such objections would have been grounds for a successful appeal However, had New Falls pointed out these plan infirmities to the bankruptcy court, it is certainly possible that that court would have insisted on protective changes for New Falls so that it was not subjected to undue risk in return for the burdens placed upon it. Perhaps New Falls saw the indicated terms of the plan as giving it the opportunity to speculate on the grocery property’s value while giving it the right to insist on payment in cash by the LaHayes if developments pointed that way. If it did, it misread the plan in the process.
The plan’s mandate that New Falls accept the grocery property by transfer or foreclosure as at least partial satisfaction of the guaranteed debt put New Falls in no different position than it would have been outside the plan except, of course, to avoid the risk of devaluation of the grocery property it could have chosen to sue for cash on the guaranty or foreclose on the house (or both). In other words, while the plan did not discharge the guaranty outright, it did effectively narrow New Falls’ remedies, imposing on it additional risk of nonpayment in full on it. Whether a plan can do that is a subject for another day. Perhaps it is permissible. Is that what a plan does which strips excess collateral from a secured creditor?
This article was authored by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLP, a member of the ad hoc group, with editorial assistance by Meredith Jury, (bankruptcy judge, C.D. Cal. (Ret.)), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.