Creditors often compromise disputed claims against debtors and their guarantors. In connection with the settlement of claims against a debtor and its guarantor, the creditor may give the debtor and the guarantor written releases from further liability in exchange for a settlement payment. But what if the creditor later surrenders a portion of the payment in settlement of a preference recovery action? Can the creditor revive the guarantee notwithstanding the release?

In a recent opinion,1 the United States Bankruptcy Appellate Panel of the Ninth Circuit held that the creditor may revive a guarantee in such a situation, provided that the release has been carefully drafted to permit such revival.

Creditor Settles $180 Million Claim and Releases Guarantor

Centre Insurance Company held $180 million in unsecured claims against affiliates of Superior National Insurance Group (SNIG). SNIG had guaranteed the obligations of the affiliates. In a December 1999 settlement of Centre's claims against SNIG and the affiliates, the affiliates paid Centre $163.4 million, and Centre executed written releases releasing SNIG and the affiliates from all further liability on the claims and under the guarantee.

Creditor Surrenders $110 Million of Settlement Payment

All would have been well for Centre if SNIG and the affiliates had remained viable business enterprises. But in March 2000, the Insurance Commissioner for the State of California placed the affiliates in conservation, and, in April 2000, SNIG filed for bankruptcy. In January 2002, the Commissioner brought a state-law preference claim against Centre to recover the $163.4 million settlement payment. Centre agreed to settle the claim by surrendering $110 million of the settlement payment to the Commissioner. The state court overseeing the conservation of the affiliates approved the settlement between Centre and the Commissioner in February 2005.

Creditor Asserts Claim against Guarantor; Bankruptcy Court Sustains Trustee's Objection to Claim

In March 2005, Centre filed an amended proof of claim in SNIG's bankruptcy case asserting a claim under SNIG's guarantee on account of the $110 million that Centre had paid to the Commissioner. The SNIG bankruptcy trustee objected to the amended claim, arguing that Centre's release of SNIG had extinguished SNIG's liability under the guarantee and that Centre's post-petition settlement with the Commissioner could not revive a claim that had been extinguished as of the date of SNIG's bankruptcy filing. The bankruptcy court sustained the trustee's objection and disallowed Centre's claims. Centre appealed the bankruptcy court's order to the United States Bankruptcy Appellate Panel of the Ninth Circuit (BAP).

Ninth Circuit BAP Reverses Bankruptcy Court

The BAP began its analysis of the bankruptcy court's ruling by carefully parsing the terms of the settlement agreement between Centre and SNIG. In the settlement agreement, the parties had agreed that:

In the event that any court of competent jurisdiction...enters a final order, judgment or other finding that...[a payment under the settlement agreement]...constitutes a voidable or preferential transfer,...an improper or disproportionate payment,...or is otherwise in violation of law or subject to a claim [of] preference, then [Centre] may in its sole discretion, in addition to any other remedy provided by law..., declare the [settlement agreement] to be null and void in its entirety....

The trustee argued that the foregoing provision required a finding that the $163.4 million payment had been a preferential transfer, a finding that the state court had not made, as a predicate to revival of the SNIG guarantee. The BAP held that the provisiosn merely required a finding that the payment was subject to a claim of preference, a finding that the state court had made when the state court approved the settlement between Centre and the Commissioner.

The BAP then held that, under applicable law, the return of a preferential payment by a creditor generally revives the liability of a guarantor. The BAP rejected the trustee's argument that SNIG's guarantee could not be revived under this doctrine because Centre had voluntarily returned the $110 million payment to the Commissioner. The BAP held that a payment made in settlement of contested litigation is not voluntary and therefore Centre had the right under applicable law to enforce the guarantee to the extent of the $110 million payment.

Finally, the BAP rejected the trustee's argument that Centre's post-petition settlement payment could not revive SNIG's guarantee because Centre's claims had to be determined as of the date of SNIG's bankruptcy. The BAP held that, as of SNIG's bankruptcy, Centre held a contingent claim against SNIG under SNIG's guarantee and that such claim was properly allowed as a prepetition claim when the contingent claim later became fixed.

The BAP reversed the order of the bankruptcy court disallowing Centre's $110 million guarantee claim and remanded the case to the bankruptcy court for consideration of Centre's claims for post-petition attorneys' fees, which claims are the subject of this month's second article.

Creditors Must Craft Guarantee Revival Clauses Carefully

Centre narrowly escaped the disallowance of its claims against SNIG based on the trustee's narrow reading of the provisions of the settlement agreement providing for revival of the SNIG guarantee. Creditors that insert revival provisions in guarantees or releases of guarantors should take heed and confirm that their agreements adequately provide for the revival of a guarantee in the event a payment made by the primary obligor is wholly or partially returned on account of the assertion of, or in settlement of, a preference claim, and not just as a result of a finding of liability. A provision providing for the revival of a guarantee if a payment made by the primary obligor "must be returned" as a result of a preference claim, or something similar, may be insufficient to revive a guaranty if a payment is returned in a settlement, as such a provision may be interpreted as requiring a judicial or similar finding of liability. Creditors should have their guarantee revival provisions reviewed by experienced bankruptcy counsel to ensure their efficacy.

Related Article from the January 2008 Insolvency Notes:

Prepetition Unsecured Creditor Defeats Objection to Claim for Post-petition Attorneys' Fees