- Modifications to Loan May Discharge Guarantors
- May 1, 2012 | Authors: Edward J. Ashton; Paul O. Woodall
- Law Firm: Jones, Walker, Waechter, Poitevent, Carrère & Denègre L.L.P. - Birmingham Office
The Alabama Supreme Court issued an opinion this month that serves as a reminder that modifying a guaranteed loan can have unexpected results. In that case, the Borrower took out two loans from a bank, both secured by a mortgage on the same real property. The first loan ("Loan A") was fully guaranteed by the two principals of the Borrower and that guaranty is not involved in the case. Loan A was also guaranteed under limited guaranties signed by the parents of one of the principals (the "Eagertons"). The Eagertons did not guarantee the second loan ("Loan B").
Several years after the loans were made, the Borrower defaulted and filed a bankruptcy petition under Chapter 11 of the bankruptcy code. The Borrower’s plan of reorganization provided for Loan A and Loan B to be combined into one consolidated loan. Other modifications lowered the interest rate, reduced the amount of the installment payments, and extended the maturity by two years. The Borrower defaulted under its plan and the bankruptcy court dismissed the bankruptcy case.
The bank foreclosed on the real property and applied the proceeds of the foreclosure sale to the consolidated loan. The bank also sued the Eagertons for approximately 71 percent of the deficiency (the original principal amount of Loan A was approximately 71 percent of the sum of the original principal amounts of Loan A and Loan B). The trial court entered summary judgment in favor of the bank. The Eagertons appealed.
In a ruling that many lenders and lenders’ lawyers may not have expected, the Alabama Supreme Court reversed the trial court’s decision, finding that the combination of the two Loans resulted in a discharge of the Eagertons under their limited guaranty agreements. In reaching its decision, the Court first set out the general rule: a material alteration of a guarantor’s obligation will discharge the guarantor. Moreover, the Court found that the rule is so strict that the guarantor will be discharged, regardless of whether the alteration is favorable or unfavorable to the guarantor.
The bank argued a guarantor may consent in advance to alterations in the guarantor’s obligations. The Court analyzed the limited guaranty agreements signed by the Eagertons. The guaranties provided for the guaranty of "Loan A and any extensions, renewals or replacements thereof" and defined the quoted language as the "Indebtedness." According to the Court, the omission of "modifications" from the definition of Indebtedness was fatal. The bank argued that the consolidated loan was a "replacement" and, therefore, included in the Indebtedness secured. The Court held that the consolidated loan was not a replacement of Loan A; rather, when consolidated with Loan B it was a modification of Loan A —in effect a new indebtedness. Because the modifications to Loan A were not included in the definition of "Indebtedness," the general rule applied and the Eagertons were discharged.
Like most lender-friendly guaranty forms, the Eagertons’s guaranties provided that their liability would not be affected "by any modification of interest rates, maturities, or other contractual terms applicable to any Indebtedness." That didn’t help; because the Court held that modifications of the Loan A are not included in the definition of Indebtedness, the "not affected by" clause referred to in the preceding sentence was not applicable. The combination of the loans constituted a material modification made without the consent of the guarantors. As such, the Eagertons’ guaranty obligations were discharged.
What are the lessons of the Eagerton case? For starters, if your form of guaranty does not expressly include "modifications" in the definition of the guaranteed indebtedness, that term should be added. In addition, a provision should be added to make it clear that a modification of the guaranteed debt includes modifications resulting from a combination of guaranteed debt with any other debt of the Borrower, whether the other debt is guaranteed or not.
Regardless of the language of the guaranty, the best practice is never to modify a guaranteed loan without the written consent of the guarantor. Any material change in the debt modifies the guarantor’s obligation and may give a guarantor who did not consent to the change an opening to argue that he or she has been released. As we see in the Eagerton case, a clever debtor’s lawyer might find a loophole in even the most carefully drafted guaranty agreement.