Daily Development for Wednesday, November 24, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu

GUARANTY; FRAUD: Under terms of a “fraud guarantee,” imposing liability upon a gurantor if he or the guaranteed debtor was guilty of “fraud of intentional misrepresentation,” a guarantor will be liable if he is responsible for diverting rent monies held, pursuant to the mortgage, “in trust for the benefit of the Mortgagee.”

LaSalle Bank Nat’l Assoc. v. Mudd, 2004 U.S. Dist. LEXIS 2885 (2/24/04)

The guarantor, who apparently was an officer of the borrower corporation, executed a "fraud guaranty," in which he agreed that he would be liable to the lender for fraud or intentional misrepresentation by himself or the corporate borrower in connection with the loan. The mortgage contained a provision assigning to the lender all the leases and rents, and provided that the borrower would hold the rents in an amount sufficient to discharge all sums due to the lender under the mortgage "in trust for the benefit of Mortgagee." After the borrower defaulted and the lender had accelerated and commenced foreclosure, the guarantor deliberately induced two major tenants to pay their rents in advance (in an amount in excess of $1 million) to the corporation instead of to the lender. He or the corporation then used these rents to purchase speculative investments, in violation of the mortgage provision requiring the rents to be held in trust for the mortgagee's benefit.

The Federal District Court found that: 1) LaSalle Bank, as the assignee of the original mortgage, was entitled to enforce the guaranty as successor to the original lender; 2) notice to the guarantor had been properly given, even though the guaranty did not contain an address for the guarantor (his address was set forth in the mortgage; the court noted that LaSalle had brought an action to enforce the guarantor's obligation not to commit fraud or intentionally misrepresent in connection with the loan; not so that he could cure the default on the mortgage, and even if he cured the default under the guaranty this would not cure the defaults under the mortgage); and 3) that the guarantor was liable under Illinois law for "constructive fraud," based on the breach of a fiduciary duty as opposed to actual dishonesty or intent to deceive (this duty, the court reasoned, arose out of the "express trust created by the Mortgagee to hold rents for the benefit of LaSalle").

Comment 1: The editor hasn’t seen an arrangement quite like this before. We have what works like a “non recourse carveout” where the guarantor, likely a principle of the borrower, has liability on the debt only if there was fraud. It was coupled with an imposition of a trust relationship concerning the rents, which made it quite likely that any funny business concerning the rents would be fraudulent.

Another way to skin the cat would be to call the diversion of rents waste and have a carveout for such waste. This would probably be more consistent with usual practice, but there have been some who argued that diversion of rents is not waste, although a few lower court decisions have found that diversion of rents is waste.

Comment 2: Is there a benefit to making the mortgagor a trustee for the benefit of the mortgagee with regard to the rents? If the mortgagor then misapplies the rents, can the mortgagee pursue them into the hands of third parties more readily than if the mortgagee was simply a lienholder of the rents? Remember that a typical assignment of rents, however, worded, is regarded in most jurisdictions as “inchoate” until activated. This would suggest that third parties would have no liability.

But where there is a trust imposed as soon as the rents are generated, then the mortgagee’s rights arise sooner. In this case, all of the rents were subject to the trust because the note had been accelerated. Prior to acceleration, there likely would be some doubt as to which rents fell within the scope of the trust, since the trust applied only to rents necessary to pay the obligations under the mortgage - and presumably this would mean only the currently due obligations. If a transferee of rent monies knew of the acceleration and of the trust, one assumes it would be liable to return the “embezzled” funds.

Here’s another little twist: What if the “speculative securities” investment paid off? Would the mortgagee be entitled to the gain (to the extent of the debt)? Why not? Better than just having a lien for the amount of diverted rent.

Readers are encouraged to respond to or criticize this posting.

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