While not a pleasant thought, an increasing number of solvent businesses or individuals who acted as guarantors or sureties are finding themselves in litigation, cast as defendants with a bankrupt co-defendant. Such a situation creates potential pitfalls for the non-debtor co-defendant.

When a debtor files a protection under the U.S. Bankruptcy Code, it is entitled to have all pending litigation or adverse legal action against it stayed, or stopped. This is referred to as the "automatic Stay" provision. If a court or other party takes legal action against a debtor during the automatic stay, the action, whether it be a court order, a judgment, a foreclosure of real property, or some other adverse legal action, is void and of no effect. Unfortunately for the non-debtor co-defendant, only the debtor receives this protection; the automatic stay provision does not extend to anyone other than the debtor.

So, what can the non-debtor co-defendant do? The first thing is to ask the bankruptcy court to lift the automatic stay. The effect of lifting the stay is that the plaintiff can proceed against the debtor defendant even though it is bankrupt, and the non-debtor can assert any causes of action it may have against its co-defendant.

If the bankruptcy court refuses to lift the automatic stay, the second option to is to show the trial court that the assets of the estate of the bankrupt co-defendant would be jeopardized in allowing court proceedings to proceed against the co-defendant. To be entitled to this exception, however, the co-defendant must demonstrate either that (1) there is such identity between the debtor and the co-defendant that the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor or that (2) extending the stay against the co-defendant contributes to the debtor's efforts of rehabilitation.

If a non-debtor co-defendant finds itself in this situation, it is critical that the proper steps be taken to either lift the automatic stay or obtain a judicial determination that the automatic stay should be applied to the co-defendant. If this is not done, more likely than not, the non-debtor co-defendant will be left "holding the bag."