Loan guaranty waivers cannot be used to shield a bank from misconduct

A guarantor’s general waiver of defenses cannot be used to shield a lender from the lender’s willful breach of a loan agreement.

A guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement, a California appellate court held in California Bank & Trust v. Thomas Del Ponti.  A waiver of statutory defenses is not deemed to waive all defenses, especially equitable defenses, where to enforce the guaranty would allow the lender to profit from its own wrongful conduct.

The facts of the case were straightforward.  A developer obtained a construction loan from Vineyard Bank to develop a 70-unit townhome project with guaranties from two of the principals.  The developer contracted with a general contractor to build the project in two phases.  The project was on schedule for the first 18 months.  However, when the first phase of the project was nearly complete, the bank stopped funding approved payment applications, preventing completion and sale of the first phase units.  As a result, the developer defaulted under the loan.

The bank eventually reached an agreement with the developer, requiring the general contractor to finish the first phase so the units could be sold at auction.  The bank promised to pay the subcontractors unless they discounted their bills and released any liens.  The general contractor paid the subs out of its own pocket to keep the project lien free so the auction could proceed.  Nevertheless, the bank foreclosed against the developer.  In response, the general contractor filed an unbonded stop notice.  The bank (through its assignee California Bank & Trust) sued the developer and the guarantors under various theories for the deficiency following a trustee’s sale of the property.  The general contractor sued the developer and the bank for restitution and breach of contract.

In a consolidated case, the court found that bank breached the assigned construction contract and found that the bank breached the loan agreement with the developer, exonerating the guarantors.  The bank appealed, claiming that the guarantors had waived all defenses under the guaranty agreements.

The appellate court rejected the bank’s argument.  A pre-default waiver of the Bank’s own misconduct was not expressly waived in the guaranty agreement.  California Civil Code section 2856 permits a guarantor to waive certain legal and statutory defenses.  However, that section does not permit a lender to enforce pre-default waivers beyond those specified where to do so would result in the lender’s unjust enrichment and allow the lender to profit from its own fraudulent conduct.

In all suretyship and guaranty contracts in California, the creditor owes the surety a duty of continuous good faith and fair dealing. The court reasoned that it would be a violation of public policy to enforce the guarantors’ waivers of defenses to payment of the note where the bank willfully breached the loan agreement, causing the default.

Breach of Commercial Lease Doesn’t Trigger Loan Guaranty, Resulting in $40 Million Loss for Lender

A tenant’s refusal to pay rent and the borrower’s resulting failure to make debt service payments did not trigger a “bad boy” loan guaranty because the lease was never terminated by operation of law, a California Court of Appeal has held. 

In GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN Holdings, LLC (referred to in this Post as the “Plummer decision”), the court’s holding resulted in a heavy loss of more than $40 million for the lender.  The court’s holding demonstrates the necessity of carefully evaluating lending risks and coordinating remedies in lease and loan documents, particularly when a real estate asset has a single tenant.

Facts of the Case

In the Plummer decision, the lender loaned $44 million to a borrower.  With the money, the borrower purchased two commercial projects in Chatsworth, California.  The borrower leased the properties to Washington Mutual Savings and Loan as the sole tenant.  The loan was non-recourse, secured by the properties but not any other assets of the Borrower, subject to exceptions for borrower misconduct.  An affiliate of the borrower, Northstar, executed a loan guaranty that contained triggers that corresponded to the borrower misconduct non-recourse carve outs.

Northstar’s guaranty to the lender provided that “[t]he Loan shall be fully recourse to Guarantor, and Guarantor hereby unconditionally and irrevocably guarantees payment of the entire Loan, if any of the following occurs after the date hereof:  . . . (iv) without the prior written consent of the [Lender, either lease] is terminated or canceled.”

Washington Mutual went out of business and it and its successors stopped paying rent and abandoned the properties.  The borrower ceased making loan payments to the lender.  The lender took title to the properties through a non-judicial foreclosure sale in which it bid approximately $11 million.  The lender then brought suit against Northstar, the guarantor, for the balance due on the loan — approximately $42 million plus attorney fees and costs.

Court’s Decision

The principal legal issue was whether the tenant’s ceasing to pay rent and abandoning the property terminated the leases, triggering the guarantor’s duty to pay the amount owning on the loan if the leases were “terminated” “without the prior consent of Lender.”  The trial court concluded that the leases were terminated without the lender’s consent and the guarantor was liable. 

The Court of Appeal disagreed, holding that the guarantor was not liable under the guaranty.  When the tenant stopped paying rent and abandoned the premises, the leases were not terminated as a matter of law.  Both leases contained provisions, pursuant to California Civil Code section 1951.4, that the leases continued in effect for so long as the landlord did not terminate the tenant’s right of possession, notwithstanding the tenant’s breach of the lease.  The leases expressly provided:  “No act by Lessor other than giving notice of termination to Lessee shall terminate Lessee’s right of possession.”  The borrower never gave notice of termination of the leases.  (Why would the borrower do so under these facts?)

As a result of the lease provisions and operation of California Civil Code section 1951.4, the leases did not terminate and the guaranty was not triggered.  The court reasoned that its interpretation of the guaranty was consistent with the parties’ intent, expressed in the deed of trust and other loan documents, to  carve out exceptions to the loan’s non-recourse provision only in the event that borrower committed certain “bad boy acts” that pose particular risks to the lender’s interests and collateral.  Those same acts could trigger the liability of the guarantor.  But in this case, because none of the express “bad boy” acts occurred, so the lender’s sole recourse was to the collateral. 

The lender tried to argue that although the lease termination provision in the guaranty resembled a “bad boy” guaranty it should operate like an absolute guaranty because full recourse is triggered regardless of whether the lease is terminated by the tenant or the landlord (i.e., the borrower).   However, the court did not accept that argument, stating that the leases were never terminated and only the borrower held the right to terminate the leases, which the borrower did not do.  For the same reasons, the tenant’s repudiation of the leases did not trigger the guaranty.   The leases expressly provided they could not be terminated by an act of the tenant. 

Analysis

Do you think the lender believed, at the time the loan was made, that the guarantor had no obligation if the borrower stopped making debt payments on the grounds that its sole tenant decided to walk from the lease?  The answer to this question is almost certainly no, but the court’s decision doesn’t provide any facts to help us understand the thinking of the loan officer or loan committee.  Did the lender underwrite this loan believing that Washington Mutual was essentially at no risk of default?

Going forward, lenders and their counsel will want to pay close attention to remedies in leases and loan documents.  Lenders may be tempted to require their borrowers to include lease continuation provisions in order to continue collecting rents from a defaulting, creditworthy tenant.  However, as this case instructs, if a tenant suffers a financial calamity and goes out of business, those lease continuation provisions have little utility and can actually be harmful if a “bad boy” guaranty is not properly structured.

The language of a loan guaranty should also be carefully reviewed so that it reflects the expectations of the parties.  Does the lender expect that the single tenant will provide the sole source of funding for the loan?  Or does the borrower need to back up the loan and have incentive to find a replacement tenant?  If the latter is so, the guaranty could have provided that any abandonment of the premises by its single tenant combined with a failure of the borrower to make debt service payments triggered the guaranty.   The trigger would not be “termination” of the lease, but abandonment of the premises regardless of whether the lease was “terminated.”  If the original tenant goes out of business and abandons the property, the borrower should find a replacement tenant and continue to make debt service payments during the search.  Then, the incentives are properly aligned between the borrower and the lender:  both want a stable rental stream.  Of course, there are circumstances where a lender may be willing to take on the additional risk after extensive underwriting of the single tenant, but the pricing model for the loan would likely have to be adjusted to account for the additional risk.  The Plummer case offers a unique view into decisions that were made during the real estate finance bubble prior to 2008 and their heavy financial consequences.