A Guarantor's Waiver of Defenses Doesn't Protect a Bank From Its Own Misconduct

A recent decision was issued by a California appellate court that, while not controlling in the State of Ohio, is worth mentioning as it could prove useful to guarantors in other jurisdictions in similar straits. In California Bank & Trust v Thomas Del Ponti, the trial and appellate courts refused to deem the waiver of statutory defenses that are typical in loan and guaranty agreements as waiving ALL defenses, particularly equitable defenses, if the result of enforcing the guarantee would be the unjust enrichment of the bank.

The above case involved a construction loan by California Bank & Trust’s predecessor-in-interest, Vineyard Bank. The loan was for the construction of townhome project in two phases, and was guaranteed by two principals of the developer.  About the time the first phase was nearly complete, the bank stopped funding the construction draws, which prevented the construction on the first phase from being completed, and obviously resulted in a developer default under the loan.

The bank eventually reached a deal with the developer and required the general contractor to complete phase one so it could sell completed townhome units at auction. However, the bank wanted the subcontractors to take a haircut on their invoices and release their mechanics liens. The general contractor instead paid the subcontractors out of its own funds so the units could proceed to auction lien-free. Despite all of this, the bank proceeded to foreclose on the developer and sold the units through a trustee sale. It then sued both the developer and guarantors through California Bank & Trust, as its assignee, to seek payment on the deficiency balance. The general contractor joined the fun and sued both the bank and the developer due to breach of contract and seeing restitution the losses it suffered.

The court consolidated the bank and contractor cases and found against the bank on both holding that the bank breached the assigned construction contract AND breached the loan agreement with the developer, absolving the guarantors of liability.

The bank appealed claiming that the guarantors’ waived of all of their defenses in the guaranty agreements. The appellate court disagreed. The guaranty agreements did not expressly waive the bank’s own misconduct and the court was not about to read that into the agreement.  The court held that to enforce such a sweeping interpretation would violate public policy as it would result in the guarantors’ being forced to pay the deficiency balance on the note to the bank when it was the bank who willfully breached the loan agreement causing the default.

This action would likely play out the same way in most courts in Ohio or elsewhere in the Midwest. The courts expect all parties in a transaction to act in good faith, and absent an express language the states otherwise, typically won’t stand for a party to be unjustly enriched by its own misconduct.

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Watch Your Language With Commercial Lease Guarantees

 (“Say what you mean, precisely, or a judge will decide what you meant” #7)

As established in other “Watch Your Language” articles for this Blog, as a general rule, courts will uphold language in a commercial lease (and ancillary lease documents such as assignments and guarantees), unless it is contrary to statutory law or public policy. Because of this judicial deference to lease language, you must say what you mean, precisely, or a judge will decide what you meant. Failure to follow this axiom left the landlord in Brogan v. Coughlin Servs., Inc., 2014-Ohio-469 (10^th Dist. Ct. of Appeals, Franklin County) without an enforceable guarantee.

In Brogan, SES Realty Co. ("SES"), as landlord, entered into a lease agreement with Coughlin Services, Inc. ("Coughlin Services"), as tenant, for property located on Schrock Road in Columbus, Ohio. Albert and Melody Coughlin, the appellees signed a "guaranty of lease" agreement ("guaranty"). The guaranty was a "continuing guaranty," not to be affected "by reason of any extension of time that may be granted by the Landlord to the Tenant." There were a number of lease extensions (4) between the original landlord and tenant. Thereafter, Coughlin Services (the original tenant) sold its business and assigned its tenant rights under the lease to a company we’ll call “Assignee A”, who subsequently assigned the lease to “Assignee B”. Meanwhile, SES sold the building (and assigned landlord’s rights under the lease to the plaintiff-appellants, Sean and Barbara Brogan. When the Brogan’s tenant (Assignee B) defaulted, the Brogans attempted to collect on the Guaranty originally given by the Coughlins. The Coughlins refused to pay on the Guaranty and the Brogans sued. The trial court found that the Guaranty was unenforceable, at least against the Coughlins, and the Brogans then appealed to the 10^th Dist. Ct. of Appeals.

The Coughlin Guaranty, provided, in pertinent part: “[the Coughlins] shall guarantee the performance by Tenant, its personal representatives, successors and assigns, of all covenants and conditions of the Lease Agreement to be performed by Tenant."

The appellants (the Brogans) argued that the personal guaranty of appellee Coughlin remained in full force and effect until the expiration of the term of the lease which, by virtue of amendment, was still a year away (from the filing date of the lawsuit). Even though there were two assignments of the lease, the appellants used prior case law that established the lessee "is still in privity of contract with the original lessor" and the assignment "does not relieve the lessee of its express obligation to pay rent “.

Appellees, on the other hand, argued they had only promised to guarantee the lease obligations of Coughlin Services, as tenant, and such tenant's heirs, personal representatives, successors or assignees, namely, Assignee A. Assignee B was not an assignee of the tenant (Coughlin Services), but an assignee of Assignee A..

The 10^th District Court of Appeals upheld the trial court’s decision in favor of the appellees (the Coughlins). In reaching its decision, the court first cited prior case law (including decisions of the Ohio Supreme Court) reinforcing our “Watch Your Language” principle; namely that "[i]n construing the terms of a written contract, the primary objective is to give effect to the intent of the parties, which we presume rests in the language that they have chosen to employ." The court then reasoned since Ohio courts "construe guaranties, and releases thereof, in the same manner as they interpret other contracts,” their job would be simply to interpret the guaranty language.

In considering the terms of the guaranty, both the trial court and the appellate court found the language to be "clear and unambiguous," and that "Coughlin's obligation to [appellants] for delinquent rent is only triggered by his default as the tenant under the original Lease or the default of Coughlin's heirs, personal representatives, successors or assigns." In other words, the guaranty only guaranteed performance of the tenant and the tenant’s assignee (Assignee A), not the assignee of tenant’s assignee (Assignee B). The 10^th district further distinguished this case from the case argued by the appellees (Morse & Hamilton Ltd. Partnership v. Gourmet Bagel Co., 10th Dist. No. 99AP-1253 (Sept. 29, 2000). “While Gourmet Bagel addresses the relationship between a lessor and lessee following an assignment under a lease agreement, that case does not deal with a guarantor relationship such as the present.”

What is the moral of this story? Presumably, the original landlord intended for the Coughlins to guaranty the tenant’s performance, as well as the performance of all assignees down the line. Certainly, the Brogans thought their guaranty would be enforceable against all assignees. However, the guaranty, according to the court, did not grant the landlord (and the landlord’s assignees) such rights. In other words, “Say what you mean, precisely, or a judge will tell you want you meant.”  Ohio commercial contract cases are replete with their own warnings to “watch your language.” As aptly stated by the 2^nd District Court of Appeals (regarding guarantees) in a recent 2013 decision: "It is well established in Ohio law that a guarantor is only bound by the precise words of his contract." As a result of these cases, guarantees must specifically provide for whose obligations are being guaranteed, not just “the what”.

Understanding Risks Unique to Personal Loan Guarantees

Personal guarantees are commonplace in loans of all types and sizes. However, there are issues that are unique to personal guarantees provided by individuals that need to be taken into consideration when negotiating a loan.

 

The death of an individual guarantor typically triggers an event of default on the loan he or she guaranteed. While a lender might agree to a period of time for the borrower under the loan to provide a suitable substitute guarantor, the grace period will be limited (usually 60-90 days) because if no such substitute guarantor is found, the lender must place the loan into default in order to file a claim against the decedent guarantor’s estate. The claim must be filed within 6 months of the guarantor’s death.

 

To avoid probate (and creditors), a guarantor may transfer his or her assets into a trust.  Even if the intent is solely to avoid probate, it also puts the assets beyond the reach of lenders to whom personal guarantees have been provided, as well as other creditors, including any co-guarantors. A balanced approach needs to be negotiated into the guaranty that protects the lender’s interests while accommodating the guarantor’s desire to put his or her estate in order

 

Too often a guarantor that is also a significant equity owner of the borrower, without giving any thought to whether his or her guaranty agreement permits it, transfers small percentages of equity to a child or grandchild or takes other actions to put his or her estate. The lender would then be entitled to call the loan in default.  When negotiating a personal guarantee, a guarantor needs to negotiate carve-outs in the guaranty agreement to allow for some ability to make minimal transfers of equity that do not affect control of the borrower.

 

Co-guarantors have special concerns as lenders are not obligated to pursue all guarantors equally. Plus, if one guarantor dies, the loan may go into default, causing a problem for all of the guarantors. If the decedent guarantor transferred his or her assets out of everyone’s reach into a trust, the co-guarantor may be out of luck in exercising any common law right to obtain contribution. When there are 2 or more guarantors (or even when there is one guarantor but more than one significant equity owner in the borrower, including the guarantor), then a cross-indemnity or contribution agreement should be considered. Any such agreement should include limitations on the transfer of assets that are not at FMV or to a spouse or into a trust. Each party’s estate should also be bound by the terms of this agreement. Other limitations or special disclosure provisions should be considered to help ensure assets are not transferred out of reach of a co-guarantor seeking contribution.  Finally, if one guarantor is more involved in the operation of the borrower’s business than another guarantor, the non-involved guarantor will want to limit any contribution obligations for defaults directly caused by the action or inaction of the involved guarantor.

 

The issues surrounding individual guarantees require special attention but are not insurmountable. With careful drafting of the covenants and other provisions, the interests of both guarantor and lender, plus any co-guarantor, can be balanced to reasonably protect everyone’s concerns.

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