Daily Development for Thursday, August 22, 2002

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

MORTGAGES; GOOD FAITH AND FAIR DEALING: Where mortgagee reserves discretion to make determinations relating to whether borrower has met specific standards for further construction advances, mortgagee has implied duty to be reasonable in making such determination, but otherwise does not have a duty of good faith and fair dealing in invoking the standards.

Storeck & Storeck v. Citicorp Real Estate, Inc., 122 Cal. Rptr. 2d 267 (Cal. App. 2002)

Mortgagee and borrower, already in an unhappy relationship concerning a troubled $200 million dollar loan for renovation of some downtown buildings for offices, entered into a new loan agreement through which lender would provide a final $9 million to complete work, including tenant improvements relating to leases on the properties. There were many aspects to the agreement, but the one element in greatest dispute concerned the requirement that borrower's construction schedule be "in balance" as a precondition to any further advances.

After the loan moved down the road a bit more, and a number of advances were made, lender determined that the loan was "out of balance" in that the estimated balance of committed loan funds was not sufficient along with funds already made available by borrower, to meet the estimated cost of completion of the construction. Lender notified borrower that the loan was out of balance and that it did not regard itself as obligated to continue to make advances. Nevertheless, lender did advance monies for a while longer to pay certain expenses, including interest on existing monies owed to lender and certain tenant improvements to preserve existing leases. Only about $900,000 of the total $9 million committed remained undisbursed. Nevertheless, lender refused to make advances to pay the leasing staff, and consequently that staff resigned. The project did not rent up as mortgagor hoped, and mortgagee foreclosed and acquired the property by bidding in the debt.

Thereafter, mortgagor sued mortgagee for damages for breach of the implied duty of good faith and fair dealing. Apparently, in this case, there was no dispute that this fact was objectively true. The borrower, however, argued that the lender had violated its duty of good faith and fair dealing in refusing to make further advances unless borrower "topped off" the funds it contributed to bring the schedule back into "balance." The mortgagor alleged several particulars:

1. Mortgagee deliberately set the standards for the loan being "in balance" so low that it could make an out of balance determination at any time.

2. (As a more particular detail of the allegation set forth in 1:) At the time the negotiations were completed for the $9 million advance, a number of tenant improvements already in place were "out of balance"

and contributed to the ultimate situation. In short, all through the time that the mortgagee made additional advances, it knew that the loan was "out of balance, yet continued to make advances."

3. After the mortgagee declared the loan out of balance, it "continued to fund items that would benefit its own interests (i.e., "hard" costs for physical improvements plus interest payments to mortgagee on [prior loans] while cutting of "soft" costs (such as salaries for the leasing staff) that were needed to keep the project operational."

At a jury trial, the jury determined that there had been a breach of the implied duty of good faith and fair dealing, and awarded damages in the amount of $900,000 (the amount of undisbursed loan proceeds) for breach of the implied covenant and $41 million for fraud. On appeal, the Court of Appeals reversed the entire judgment, but published only its opinion on the good faith and fair dealing issue.

On this issue the court held first that there was no duty of good faith and fair dealing in California with respect to issues as to which the parties had specifically delegated contractual rights under the agreement.

Consequently, the mortgagee did not need to show a good motive or lack of malicious or self serving intent to support its invocation of its right to withhold further advances, so long as the contract conferred that right.

Further, the court noted that the lender disbursements for particular purposes following its declaration that the loan was out of balance, while withholding other advances, also was in accordance with the express rights the parties had conferred upon it in the contract.

The fact that the certain expenses relevant to the "balance" computation already had been made prior to the execution of the agreement did not mean that these expenses could not be taken into account in reaching the determination, so long as this was part of the formula the contract provided (it was).

On the other hand, the court noted that in making the determination as to whether the stated facts existed (i.e. whether the loan was in fact out of balance), California law indicated that with respect to determinations other than those based upon taste or artistic sense - such as financial determinations like these - the party making the determination had a duty to be objectively "reasonable" - more than just "sincere and in good faith." This requirement existed where some standard is required in order to make the contract more than an "illusory contract." Where the parties have specifically bargained for a "standardless determination" such as in an option contract, there is no such requirement. The instant case was one in which it was necessary for the court to impose a standard of determination, since without it the borrower would have transferred consideration to the lender (in the form of settlement of earlier disputes and, presumably, a loan fee) while the lender, not bound by any duty to lend, would be providing no promissory consideration in return.

Comment 1: To make sense of the case, it is important to differentiate this "implied duty to be reasonable" from the implied duty of good faith and fair dealing. The duty to be reasonable requires only that there be reasonable objective support for the determination by the party vested with the right to decide the issue that certain facts are true. The party making the determination may be a complete skunk and invoking the determination in order to do callous and "unfair" advantage of a situation, but if the other side has already conferred upon that party by contract the right to do this, there is no breach of the implied duty of good faith and fair dealing.

.

Comment 2: Note that the borrower (so far as we know from what's printed) entered into this agreement with its eyes open, and knew or should have known the degree of discretion it was conferring upon the lender. The editor agrees that when parties in the commercial marketplace enter into such arrangements, they should live with the consequences. Any other approach would lead to expensive, contentious, and wasteful battles as to motive and "marketplace fairness," issues that are almost impossible to resolve easily, consistently, or completely. Why should the courts, funded by the taxpayers, bail commercial parties out of bad deals that they knowingly entered? No good reason in the editor's mind. There's always bankruptcy (whoops - the mortgagors tried that here, but relief was granted to the mortgagee to proceed to foreclose.)

Comment 3: In essence, the mortgagor was arguing that the mortgagee was engaged in bad faith during the original negotiations, when it formulated its "scheme" to strip the borrower of its project by setting standards that the borrower couldn't meet. Of course, the immediate response would be - if you couldn't meet the requirements, why'd you sign the contract. The borrower's response probably lies in those fraud allegations that we're not allowed to see. Without that, however, the borrower has few legitimate answers to this question.

Comment 4: The editor has been provided with an excellent and insightful analysis of the case in terms of California precedent prepared by DIRTer Stevens Carey of Pircher, Nichols and Meeks. The editor believes that Steve agrees with the above synopsis of where the court came out, but takes issue both with how the court expresses its views and supports them.

He notes particularly that prior courts, and even this court, are not so clear about the line of demarcation as to whether a duty of reasonableness is part of or separate from the implied duty of good faith and fair dealing. Further, there is not much clarity on the edges as to when a "reasonableness" standard applies to a given determination and when a "good faith" standard applies, or whether in some cases both apply.

As the editor, a former appeals court clerk, and an educator of many more, knows only too well, judicial clerks often are responsible for providing this support, and frequently are not up to the task. Judges who are less than cautious often find unintended consequences of such sloppy opinions ring down through history as precedent.

Comment 5: What the editor likes particularly about this opinion is that the court eschews the invitation to extend the duty of good faith and fair dealing to the negotiation stage. Whatever the alleged motives of the mortgagee during negotiations, it had every right to present certain contractual language to the borrower (absent fraud) and it was up to the borrower to figure out the degree of risk and decide whether that risk was worth taking. Right!!!

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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