Steven Enright and his wife borrowed money from a bank to buy dairy cows and other improvements for the family dairy farm. The bank loan was secured by assets of the Enrights, and also guaranteed by Steven’s parents, with the parents’ guarantee secured by a mortgage on the dairy farm itself (which was owned by the parents).
A second lender, Great Lakes Agri-Services, also extended credit to the Enrights to purchase feed, with the credit secured by real estate owned by the Enrights. The Enrights proposed a Chapter 12 plan that treated Great Lakes as unsecured since its liens were junior to the bank’s liens. In response, Great Lakes argued that the parents’ guarantee and mortgage should be treated as collateral of the bank subject to marshaling. If marshaling was applied in this manner, the bank would remain fully secured, but Great Lakes would have a security interest in the remaining assets.
The equitable doctrine of “marshaling assets” is generally applied in circumstances where the junior creditor has a security interest in one property, while the senior creditor has a security interest in not only that property but other additional property. Under the doctrine of marshaling, the senior creditor is required to first attempt to collect from the additional property so that there is a greater likelihood that the junior creditor will be able to collect something from the common collateral.
In Wisconsin the elements of marshaling are:
- Two creditors of the same debtor.
- Two funds belonging to a common debtor.
- Only one of the creditors has access to both funds.
- Absence of prejudice to the senior creditor if marshaling is applied.
The parties agreed that there were two creditors of the same debtor and only one had access to both funds. However, the bank argued that the two funds did not belong to a “common debtor,” since the real estate securing the parents’ guarantee was not an asset of the debtors.
Generally, when an individual guarantees a company debt, the company and the guarantor are not considered a common debtor. Consequently, marshaling does not apply. However, there is a “Wisconsin Exception” which allows marshaling collateral owned by a guarantor where (1) the corporate veil could be properly pierced so as to ignore the separate identities, and (2) a shareholder’s property is deemed to be a capital contribution. In particular, when the guarantor’s property is pledged to secure not only the guarantor’s obligation but also the corporate obligation, it may be regarded as a contribution to capital of the corporation that is subject to marshaling. The court notes that this exception to the general rule requiring a common debtor is controversial and has been criticized.
Regardless, in this case the court concluded that the exception was not applicable. Even if there had been inequitable conduct, there was no corporate veil to pierce. Further, there was no allegation that the Enrights had dominion and control over the parents’ property. In fact, the exact opposite appeared to be the case. The parents had not relinquished control over the dairy farm (notwithstanding discussions of succession planning), the mortgage of their property secured only their personal guarantee not the Enrights’ entire debt, and the parents began refusing to guarantee future loans after a point in time.
After discussing a case where a guarantee was viewed as a capital contribution when the sole shareholder guaranteed a corporate loan and the secured creditor relied solely on the guarantor for repayment, the court noted that “it can confidently rely on the fact that [the parents] are not controlling shareholders of [the Enrights], or as noted above, vice versa.”
Finally, “marshaling will not be applied to the detriment of a third party with equity equal or superior to that of the person seeking to invoke the rule.” Here the court found that equity favored the parents, and application of marshaling would be “undeservedly detrimental” to them.
At the end of the day, the junior creditor’s motion for summary judgment was denied, and its objection to confirmation of the Enrights’ plan based on a demand for marshaling was overruled.
As noted in prior blog posts, bankruptcy law often turns to state law for determination of rights to property. Although marshaling is a widespread concept that generally follows along the lines outlined above for Wisconsin, there are often state variations that may mean the difference between success and failure of a claim for marshaling. It is important that you know local law in trying to evaluate how conflicting claims to collateral will play out.