Practical Bankruptcy: Protecting Yourself from Your Co-Signer
Bankruptcy has ways for you to protect your co-signer. But what if instead you’re the one who needs protection from the co-signer?
Your Separate Obligations to the Creditor and the Co-Signer
It’s important to understand that you have two distinct legal obligations when you’ve either co-signed on someone else’s debt or someone co-signed for you on your debt. First, you owe the creditor based on your signing for the debt itself. And you likely have some legal obligation, or at least a significant risk of one, to the co-signer, based on what was either clearly agreed between the two of you or may have been implied.
On this second potential obligation to the co-signer, if the other person co-signed to help you get credit, then there is likely an understanding between the two of you that if you did not pay the debt and the co-signer had to do so, you would have to reimburse the co-singer for whatever he or she had to pay. There may or may not be this understanding, it may have been communicated clearly or vaguely, but there is at least the risk that your co-signer could pursue you if he or she had to pay the debt.
If on the other hand you are the one who co-signed to help the other person, and you got no benefit from the credit used, you may have no legal obligation to the other person. But because you may not know what the other person was thinking in the transaction, in most situations there would still be some risk of liability, which would be good to cover.
Here’s an illustration of how bankruptcy can protect you from your liability to a co-signer.
Five years ago Christina, a bookkeeper, was invited by her well-off uncle, Ronald, to go into business with him. He offered to put up some money, and his credit, for her to run a new tax preparation and bookkeeper business in the town where he lived in a neighboring state. He committed to have her do the tax and bookkeeping work for him and for his own established business, and to refer other business to her from the many businesspeople he knew in the area. Christina was very interested in starting a business because she was tired of working for 20 years as an employee and not being paid enough, but was reluctant to move hundreds of miles away to Ronald’s town. He made clear that was non-negotiable, and so Christina decided to accept his offer. In setting up the business, Ronald and Christina both signed a $75,000 business loan with Ronald’s longtime local bank, as well as a 5-year lease on a modest office on the town’s main street from a business acquaintance of Ronald. Ronald also personally lent Christina $50,000 for start-up costs.
Things did not go well. Their timing could not have been worse, opening the business right before the Great Recession hit. Christina just could not build up an adequate client base. The area’s businesses cut their expenses and stayed with their in-house or contract bookkeepers and tax preparers instead of hiring Christina. Ronald’s own business was hit very hard, so the work that he and his business sent to her was much less than either had expected. Also, he referred very little other local business to her. In spite of all of her efforts to generate income and keep her expenses as down, within two and a half years Christina had spent the entire proceeds of the bank loan and Ronald’s loan, and was struggling to make her payments on them and on her other business and personal obligations. Three years after starting the business, she closed it, returned to her own city and back to a job very similar to what she had before.
For a year after closing the business she made the payments on the bank loan, but stopped when she became under greater and greater financial pressure to pay some of the other debts from the failed business. So Ronald has made the bank loan payments for the last year on the bank loan to avoid hurting his own credit, and also paid many months of the business lease until another business rented the space. Ronald has gotten more and more demanding about trying to get her to pay the bank loan, to pay him for what he had paid on the business lease, and to pay his personal loan which she has not paid on since closing the business. Christina just received a letter from Ronald’s attorney threating to sue her if she didn’t make “satisfactory arrangements for payment of these three debts within the next 30 days.”
The Bankruptcy Solution
Christina had a consultation meeting with an attorney, who counseled her about her options, and she decided to file a Chapter 7 “straight bankruptcy” case.
Less than four months after her bankruptcy case was filed, the discharge (legal write-off) that she received relieved her of her obligations to the bank and to the business landlord.
The discharge also relieved her of any potential obligations to Ronald. The two of them had not put anything into writing about what would happen if Christina could not pay the two co-signed obligations. They hadn’t even talked about it. Christina just assumed that Ronald would take care of his legal obligations to the bank and the business landlord if the business venture did not succeed—since it had all been his idea and he had the means to pay it and knew she certainly didn’t. Ronald instead assumed that her signing for these obligations meant that she would have to reimburse him if he ever had to pay on them. So Ronald made some noises about objecting to her discharge of his perceived obligations to him. But he was advised by his attorney that he had no basis for doing so and would be wasting his money to try, so he reluctantly conceded to eating his losses, and to not object in her bankruptcy case. He did take Christina off his holiday gift list!
So Christina’s Chapter 7 filing allowed her to put a very difficult period of her life behind her, unencumbered by debts that would have been financially debilitating for many years to come.