No Guarantee: Caution From Second Circuit For Lenders Relying On Unsecured Guarantees

A U.S. appellate court recently issued a cautionary decision for lenders depending on unsecured guarantees by parent companies and affiliates of their borrowers. In Leadenhall Capital Partners LLP v. Advantage Capital Holdings, LLC, the U.S. Court of Appeals for the Second Circuit vacated a district court’s preliminary injunction that froze guarantors’ assets to prevent their dissipation before final judgment. 

To reach this result, the Second Circuit applied the long-standing rule of Grupo Mexicano de Desarrollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999). In Grupo Mexicano, the U.S. Supreme Court held that federal courts have no authority to preliminarily enjoin assets absent a lien or equitable interest. The Second Circuit in Leadenhall  extended that rule to secured creditors seeking to freeze assets held by a guarantor that had not pledged any of its owncollateral.

In other words, even if a creditor is secured by the assets of the borrower, under Leadenhall, the guarantor cannot be enjoined by a federal court before judgment from dissipating its own assets that are not subject to liens. This is true even if the creditor is likely to prevail on the merits against the guarantor. The decision removes one tool that lenders may have used when trying to react quickly to maintain the status quo during chaotic situations involving possible debt evasion. 

The Second Circuit's decision

In Leadenhall, lenders had extended hundreds of millions of dollars in loans to four special purpose entities (SPEs), secured by a first-priority interest in the SPEs’ assets and equity as collateral. The SPEs’ parent companies guaranteed the loans but did not pledge any additional collateral. After receiving information suggesting that the borrowers’ collateral was inadequate or encumbered, the lenders accelerated the debt, demanded repayment of the entire outstanding balance and filed suit for breach of contract.

Concerned that the guarantors might dissipate their own assets before judgment, the lenders sought — and obtained — a temporary restraining order and preliminary injunction from the district court freezing the guarantors’ assets up to the amount of the accelerated debt. The district court justified the freeze on the theory that the lenders had sufficient contractual and equitable interests to restrain the guarantors’ property as well, reasoning that the guarantees encompassed collateral‑related obligations.

On appeal, the Second Circuit vacated the injunction. The court applied Grupo Mexicano’s rule that federal district courts lack authority to preliminarily enjoin a defendant from transferring assets in which no lien or equity interest in the assets is asserted, and where plaintiff ultimately asserts only the legal claim of breach of contract. The court of appeals reasoned that the lenders’ claim was, at bottom, one purely of breach of contract for money damages, with no entitlement to any specific property of the guarantors and no claim for other equitable relief. With neither a lien nor an “equitable interest” in guarantors’ assets, Grupo Mexicano prohibited the injunction.

Of note, the appellate court did not accept the lenders’ argument that Grupo Mexicano  was limited to “unsecured general creditors” and that they, as secured creditors (against the borrower, at least), could preliminarily enjoin the guarantors’ assets. The court was also unmoved by the lenders’ attempt to tie the guarantors to the collateral pledged by the borrowers — specifically, that the guarantors guaranteed not only the borrowers’ payment obligation but also the borrowers’ obligation to maintain their assets free of other encumbrances. The court concluded that because the secured lenders had no lien on the guarantors’ specific assets, that was the end of the matter.

Upshot

The Leadenhall  decision serves as a caution to lenders and other creditors that they may have fewer options to prevent the dissipation of assets by guarantors where the guarantees are not secured by the guarantors’ own assets. But other options remain available to lenders in this situation. 

One route for lenders is to assert a claim for an equitable remedy, such as constructive trust, accounting, unjust enrichment or rescission, because some courts have used that as grounds to distinguish the Grupo Mexicano  rule. These remedies are fallback options, granted when the primary remedy of contract damages is insufficient or unavailable. Though these claims are necessarily fact dependent and may ultimately fail, the decision to include an equitable claim at the outset, if factually supported, could provide a hook for the preliminary injunction to prevent asset dissipation. Chances of success are strengthened significantly if the lender can also identify a nexus between the assets sought to be frozen and the equitable claim. It’s important to also note that courts have held that Grupo Mexicano  does not apply to bar injunctions to freeze assets where fraudulent conveyance or equitable causes of action are pleaded in the bankruptcy context.

Additionally, as the Second Circuit itself recognized in Leadenhall, prejudgment attachment procedures provide another potential avenue to prevent asset dissipation. Attachment is a provisional remedy (in New York, authorized by C.P.L.R. 6201) that effectively creates a lien on a defendant’s property. Attachment is often used in aid of jurisdiction, to gain jurisdiction over the property of the defendant when jurisdiction over the defendant itself is not available. It is an extraordinary remedy and typically requires evidence of intent to defraud creditors or to frustrate a potential judgment, as well as posting of a bond by the creditor. Attachment contrasts with what occurred in Leadenhall. A preliminary injunction runs against the defendant, and in the case of the preliminary injunction at issue in Leadenhall, it was an order to the guarantors to restrict how they could use their property. Attachment, by contrast, runs against the property directly. And while both the federal preliminary injunction standard and New York’s prejudgment attachment rules require a plaintiff to show the likelihood of success on the merits against the defendant, attachment also requires a showing that one of the criteria in C.P.L.R. 6201 is satisfied (which does include that the defendant assigned, disposed of or encumbered assets to defraud its creditors).

As always, lenders (secured and unsecured alike) should consult experienced litigation counsel to devise and effectuate such asset-recovery strategies that make the best use of the procedures available in the jurisdictions where the assets are located.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.