[BROKERDIRT] DD 9/18/06 Non harmful, but material modification of guaranteed debt releases guarantor

Daily Development for Friday, September 18, 2006
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

GUARANTEES; DISCHARGE; ALTERATION OF OBLIGATION::  The execution of an escrow agreement implementing a purchase contract  results in a novation that releases guarantor if the changes are “material,” even if the changes potentially operate to the benefit of the guarantor.  Thomas-Sears v. Morris, 2006 WL 573293 (Ga.App., March 10, 2006).

Plaintiff, a licensed real estate agent, executed a sales contract with a third-party under which the third-party was to purchase Plaintiff’s house and the adjacent land.  Plaintiff owned the Property subject to an existing security deed (mortgage).. 

The Purchaser lacked the funds to close, and the parties fell upon an agreement by which the Plaintiff took back a purchase money obligation secured by a “wraparound” security interest, incorporating the first mortgage, which remained on the prooprty.

Defendant agreed to guarantee  the Note which of course stated both the additional credit toward the purchase price given by the Plaintiff and the principal and interest under and secured by a recorded mortgage.  Prior to closing, defendant indeed did execute a very simple guarantee agreement, referencing the closing documents as they then existed. 

At the closing of this transaction, the third-party did not have sufficient cash to fully satisfy the cash terms of the sale agreement.  As a result, Plaintiff and the third-party executed an Escrow Agreement, which conditioned the purchase and sale of the Property on the occurrence of several additional  enumerated contingencies.  In addition, Plaintiff and the third-party both initialed the handwritten guaranty signed by Defendant two days earlier and the third-party signed the Note and the Security Deed.  Guarantor did not sign anything at that time.

The transaction closed, but the third-party failed to secure financing to make the final balloon payment on the Note, and went into  default.  Plaintiff sought recovery for the balance of the Note from Defendant, as guarantor.

The Trial Court granted Defendant summary judgment and released him from the guaranty. 

The appeals court affirmed.  It noted that a Georgia statute provides that, a change in the nature or terms of a contract is considered a novation and discharges the guarantor in the absence of the latter’s consent.  The court indicated that Georgia decisions have stated that such a change must be material in order to result in a discharge.  But cases have also ruled that a material change releases the guarantor, irrespective of whether the change is to the benefit or the detriment of the guaranty.

The Court found that the Escrow Agreement materially changed the third-party’s, and thus the guarantor’s, obligations under the note.  The enumerated conditions set forth in the Escrow Agreement represented for the first time that payment of the Note was contingent upon the third-party obtaining financing.  Neither the Note nor the Security Deed contained any such contingency. 

Furthermore, the Escrow Agreement added a liquidated damages provision that materially altered Plaintiff’s liability exposure.  Both of these changes were material, and either was sufficient to constitute a novation to the Note.

Comment 1: The case is based upon Georgia statute, and most readers will want to know what the common law says about all this. 

In fact, the common law is in the process of evolution here, and the editor’s research turned up a pretty good discussion of the new developments in Madison and Dwyer, The Law of Real Estate Financing (Warren, Gorham and Lamont), the most recent discussion in which are probably done by Steven Bender at the University of Oregon.  The discussion of guarantors is set forth in Paragraph 14 and the discussion of discharge as a consequence of alteration of the guaranteed obligation is set forth in Section 14.04[8][c], although the editor’s edition may not have all the most recent supplements. 

The discussion here, by the way, is much stronger than in the editor’s old standby, Nelson and Whitman, Real Estate finance Law, and the approach of Madison and Dwyer is to include many more forms and practice tips in addition to a discussion of the law.

The Madison and Dwyer treatise reports that, on the question of discharge of the guarantor as a result of unconsented modification of the guaranteed obligation, the old common law differentiated between compensated and uncompensated guarantors.  Uncompensated guarantors were released by any material change in the obligation.  Compensated guarantors were released only when such change operated to their detriment.  But the more recent Restatement of Suretyship will grant discharge to either type of guarantor only to extent that the guarantor is harmed.  But the Restatement also provides that there will be a complete discharge if “the modification creates a substituted contract or imposes risks on the secondary obligor fundamentally different from those imposed pursuant to the transaction prior to the modification.”

Comment 2: Those still reading attentively at this point will notice that there is a blurred distinction among the concepts “material,” “harmful to the gurantor’s interest,” and “imposes risks  . . . fundamentally different.”    The Madison and Dwyer treatise goes on to speculate about how these distinctions might be worked out in practice.

Comment 3: More fundamental, of course, is the fact that all these sorts of “suretyship defenses” can be waived by language in the guarantee instrument.  Such waivers are so routine that it is possible that the failure to at least propose such a waiver to a client benefitted by a guarantee might be seen as malpractice.  Under the Restatement of Suretyship and Guaranty, the waiver “may be effectuated by specific language or by general language indicating that the secondary obligor waives defenses based on suretyship.”  But a statement tha tthe guaranty is “absolute” or “unconditional” is ordinarily not sufficient.

Comment 4: So does the Plaintiff have a malpractice remedy here?  Dollars to donuts the Plaintiff (a real estate broker) probably figured he knew enough about real estate law to take care of himself and didn’t bother to seek an attorney when getting the guarantee.  Just guessing.  Lawyers and brokers who represent themselves, as they say, have a “fool for a client.” 

Items reported here and in the ABA publications
are for general information purposes only and
should not be relied upon in the course of
representation or in the forming of decisions in
legal matters.  The same is true of all
commentary provided by contributors to the DIRT
list.  Accuracy of data and opinions expressed
are the sole responsibility of the DIRT editor
and are in no sense the publication of the ABA.


Parties posting messages to DIRT are posting to a
source that is readily accessible by members of
the general public, and should take that fact
into account in evaluating confidentiality
issues.

ABOUT DIRT:

DIRT is an internet discussion group for serious
real estate professionals. Message volume varies,
but commonly runs 5  15 messages per work day.

Daily Developments are posted every work day.  To
subscribe, send the message

subscribe Dirt [your name]

to

listserv@listserv.umkc.edu

To cancel your subscription, send the message
signoff DIRT to the address:

listserv@listserv.umkc.edu

for information on other commands, send the message
Help to the listserv address.

DIRT has an alternate, more extensive coverage that includes not only
commercial and general real estate matters but also focuses specifically upon
residential real estate matters.  Because real estate brokers generally find
this service more valuable, it is named “BrokerDIRT.”  But residential
specialist attorneys, title insurers, lenders and others interested in the
residential market will want to subscribe to this alternative list.  If you
subscribe to BrokerDIRT, it is not necessary also to subscribe to DIRT, as
BrokerDIRT carries all DIRT traffic in addition to the residential discussions.

To subscribe to BrokerDIRT, send the message

subscribe BrokerDIRT [your name]

to

listserv@listserv.umkc.edu

To cancel your subscription to BrokerDIRT, send the message
signoff BrokerDIRT to the address:

listserv@listserv.umkc.edu

DIRT is a service of the American Bar Association
Section on Real Property, Probate & Trust Law and
the University of Missouri, Kansas City, School
of Law.  Daily Developments are copyrighted by
Patrick A. Randolph, Jr., Professor of Law, UMKC
School of Law, but Professor Randolph grants
permission for copying or distribution of Daily
Developments for educational purposes, including
professional continuing education, provided that
no charge is imposed for such distribution and
that appropriate credit is given to Professor
Randolph, DIRT, and its sponsors.

DIRT has a WebPage at:
https://e2k.exchange.umkc.edu/exchweb/bin/redir.asp?URL=http://cctr.umkc.edu/dept/dirt/






-----

To be removed from this mailing list, please go to
<https://e2k.exchange.umkc.edu/exchweb/bin/redir.asp?URL=http://listserv.umkc.edu/listserv/wa.exe?SUBED1=BROKERDIRT%26A=1>
or send an email message to the address listserv@listserv.umkc.edu,
with the text SIGNOFF BROKERDIRT in the body of the message. Problems
or questions should be directed to manager@listserv.umkc.edu.

randolphp@UMKC.EDU