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

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.” 

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