Daily Development for Friday, January 18, 2008
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri

LETTERS OF CREDIT; CO-GUARANTORS; CONTRIBUTION:  Party obtaining letter of credit to provide partial guarantee for real estate loan may not assert equitable contribution or subrogation claims against other loan guarantors.

Morgan Creek Residential v Kemp 153 CA4th 675, 63 CR3d 232 (2007)

Kemp and Haws,  developers of the Morgan Creek Golf Course sought to induce Lender to provide a $6.5 million loan.  They posted partial guaranties that totaled $4.8 million. Lender wanted more security than that, and so the guarantors induced the master developer of the entire Morgan Creek project, MC, to add an unconditional  letter of credit for another $1.4 million. This gave Lender a total of $6.2 million in additional security, over and above the deed of trust - enough for the loan to go through.  But, thereafter, the filing of some mechanics' liens threw matters into disarray. Lender responded to the situation by drawing down the letter of credit it was holding and using those funds to reduce the loan balance to $4.8 million, roughly what the project was then apparently worth. Because the parties regarded the loan as again in balance, the promoters refinanced a new $4.7 million loan with Citicapital, and the project was back on track.

MC sued  Kemp and Haws for equitable contribution and subrogation. The trial court sustained defendants' demurrer without leave to amend.

On appeal: Held: Affirmed.   Equitable contribution allows for loss sharing among co-obligors that share the same level of liability on the same risk as to the same principal. MC, which put up an unconditional letter of credit, was a markedly different guarantor than Kemp and Haws, who merely gave guaranties. Because liabilities inherent in these two kinds of security were markedly different, there could be no contribution or subrogation.  .

The court noted that an unconditional letter of credit given to guaranty a debt is not a form of suretyship obligation, in which the surety's liability is secondary to the liability of the principal for that application. The liability of the issuer of a letter of credit is direct and independent of the underlying transaction between the beneficiary and the issuer's customer.  It does not derive from the obligations of the obligor of the guaranteed debt.  For instance, unless there is fraud, the issuer cannot refuse to pay based on extraneous defenses arising from the underlying transaction. Thus, when Lender called the unconditional letter of credit furnished by MC, neither MC nor the issuing bank could assert any defenses other than fraud to stop Lender  from collecting.

A guaranty such as those given by Kemp and Haws,  is a form of suretyship obligation. Kemp and Haws there had defenses under CCC2=A72845 to demands by Lender that were not available to MC.  The appeals court reasoned that because Kemp and Haws had suretyship defenses available to them, and MC did not, the parties did not share the same level of liability to Lender. Accordingly, MC could not claim contribution against Kemp and Haws.

MC also claimed a right to equitable subrogation to the rights of Lender.  But the court held also that this was not a valid claim.  California law states that, to qualify for equitable subrogation, The subrogee must have made payment to protect its own interest; the subrogee must not have acted as a volunteer; and the debt must be one for which the subrogee was not primarily liable. 
In addition, the entire debt must have been paid; and subrogation must not work any injustice to the rights of others.

Although MC likely did not pay as a mere volunteer, it had a problem in that it was primarily liable on the letter of credit.  But even allowing that this did not defeat the subrogation claim (since the letter of credit was a secondary obligation, in a sense), and assuming that the requirement that the entire debt be paid was satisfied by payment of the entire letter of credit rather than the total the golf club owed Lender, the court noted that Kemp and Haws were not primarily liable on the Lender's obligation; the golf club was primarily liable. Additionally, Kemp and Haws, as mere guarantors, bargained for limited exposure.  In the court's view,  to allow Morgan Creek to recover from them would work an injustice to their rights. Using a subrogation theory to obtain apportionment from others who are not primarily liable was inconsistent with the aim of subrogation: to place the burden for loss on the party ultimately liable or responsible for it and by whom it should have been d

Reporter Roger Bernhardt's Comments:  It is certainly true that the obligation satisfied by one must have been commonly imposed upon the others: If A is liable for X's liability on a note to Y and B is liable for X's liability to Y for a personal injury, neither A nor B can make the other share any part of whatever particular loss the other one had to cover. Rather, the requirement is that the obligation is a common one, and I have never seen it read to mean such perfect equality as was required here. If A guarantees payment of $40 of X's $100 note and B guarantees payment of $60 of that same note,C2=A71432 expects that any dollar that one of them pays should be shared 40/60 with the other. The issue is whether the creditor could have turned to either of the co-obligors for payment. The facts are not entirely clear in this case, but it looks like the $6.2 million obligation to Lender was represented by a single note, with each dollar of it covered by all of the secondary security pos
ted, thus making for a common, albeit secondary, obligation. The court of appeal thought otherwise; its reason was that all of the security posted by the defendants was in the form of personal guaranties, whereas the security posted by the plaintiff was in the form of a letter of credit. That mattered for the court, since CCC2=A72787 distinctly states that a letter of credit is not a form of suretyship obligation, whereas the same section also no less distinctly merges guaranties into general suretyship obligations. Letters of credit are subject to the "independence" principal-a doctrine that makes the issuer pay even though the true obligor has good defenses; whereas guarantors, although themselves regarded as independent obligors, are not subject to that same exposure. Given that distinction, the MC secondary parties did not qualify as liable under the rules of contribution.

Now, that is a conclusion that would not have occurred to me. If the lender told my client to purchase a letter of credit to further secure a borrower's loan that already was guaranteed by someone else, I probably would have told my client (had I thought of it) that the differences between her letter of credit and the other person's guaranty meant she would be more likely to be called on first, but not that those differences would destroy any right or liability to contribution if only one of them was called on to pay, as this case holds. I would have expected those differences to matter vis a vis the lender, but not vis a vis the borrower or vis a vis the two secondary parties. Had I been really cautious, I would have suggested an agreement between these two secondary parties-to settle all of the details of contribution between them-but not to create a right that would not otherwise exist because of their different levels of liability. But from now on, all of us had better insist
on such an agreement. After this decision, who can say, for instance, whether there are contribution rights between two guarantors, one of whom has posted a deed of trust to secure his guaranty and the other had given an unsecured guaranty (or a guaranty secured by personal rather than real property)? Will there still be contribution if one guarantor has waived all defenses and the other has not?
When common liability was the only prerequisite to contribution, it did not matter that the theories or amounts of liability were different, and there was no great need for attorneys to make the agreements say more. But now that the standard is higher and narrower, attorneys should create contractual rights to contribution to fill in these gaps of equitable contribution (and hope that the courts will permit that to be done). Will that be hard to do?

Since, generally, neither party will be able to predict which one will be first called on to pay, it should not be hard to draft an agreement both will accept. It's probably what any two parties under such a veil of ignorance would want in any case: If one pays, the other shares. I would suggest boilerplate language, such as:

The parties agree that the principle of contribution shall apply to any obligation they share in common in this transaction, notwithstanding the fact that their obligations are determined to be at different levels of liability or otherwise different.

Reporter Dan Schechter's Comment: I disagree.  It is true that a bank that issues of a letter of credit is not a surety and is not entitled to seek contribution. But the applicant for the letter of credit was certainly a surety: It incurred a contingent obligation (the reimbursement of the issuer of the letter of credit) in support of the primary debtor's obligation to the lender. There is no authority for the idea that an applicant for a standby letter of credit cannot qualify as a surety. Here, the applicant and the guarantors were co-sureties, entitled to contribution. The applicant is as much of a surety as someone who does not assume personal responsibility for the debt but who puts assets at risk in a nonrecourse hypothecation. See, e.g., Pearl v General Motors Acceptance Corp. 13 CA4th 1023, 16 CR2d 805 (1993) .

The cases cited by the Morgan Creek court were inapposite: They dealt with the rights of letter of credit issuers, rather than the rights of applicants. In fact, although the court placed primary reliance on the California Supreme Court's opinion in Western Sec. Bank v Superior Court15 C4th 232, 62 CR2d 243 (1997) , the court later dismissed one of the applicant's arguments that was based on language in Western Security by noting that "[t]he dispute in Western Security Bank was between the parties to the letter of credit transaction." Exactly! Western Security is off point, and the court erred by reading too much into that opinion.

The facts of this case were particularly egregious: The guarantors apparently (1) got the benefit of the applicant's money and then (2) sold the property to themselves with a reduced debt load in a "sweetheart" deal. Although the facts of this case are strange, the underlying issue is of great commercial importance: What rules govern the contribution rights of co-sureties? Does the use of a letter of credit (a common device in large transactions) alter those rules?

Whatever happens in this case, however, I also predict that this problem will not arise very often in the future: From now on, sophisticated letter of credit applicants in this situation will demand express contractual contribution agreements from their co-sureties.

Roger Bernhardt is a professor at the Golden Gate Law School in San Francisco.  His comments, originally appearing in the California CEB Real Property Reporter  are excerpted with permission. 

Dan Schechter is a professor at the Loyola Law School in Los Angeles.  His comments, originally appearing on Westlaw at 2007 Comm Fin News 60. Westlaw holds the copyright on his materials, and they are reproduced in part here with Westlaw's permission.

The editor heavily modified and rearranged both Roger's and Dan's stuff, and is responsible for any errors, omissions, or stupidity. 

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