Chapter 31
NATURE OF THE DEBTOR-CREDITOR RELATIONSHIP
RESTATEMENT
An agreement to answer for the debt or default of another is called a suretyship or guarantee. The party obligated for
the debt is the surety or guarantor. An absolute guarantor has the same obligation as a surety to pay upon the
debtor’s default. Any other type of guaranty is one in which the guarantor is held liable only after all means of
recovery from the debtor has been exhausted. Indemnity contracts are triggered by an event and are not an
obligation to pay another’s debt, as in an insurance payment.
A surety or guaranty relationship may require a written agreement to be valid. Consideration is not required when the
contracts of guaranty or suretyship are made at the same time as the original transaction.
A surety can be exonerated from liability in certain circumstances in which the creditor fails to take action. If a surety
does pay the obligation, the surety steps into the shoes of the creditor and has all the rights of the creditor in terms of
collection and repossession. The surety is also entitled to be indemnified by the principal in the event the surety
satisfies the obligation. If there is more than one surety, the surety is entitled to contribution from the other sureties
on a pro rata basis.
There are a limited number of defenses available to a surety for non-payment. Fraud is not a defense to payment
unless the creditor was involved. Defenses that are valid are that the original obligation was invalid, the principal was
discharged or the original contract was modified without the surety’s consent.
Letters of credit are agreements that the issuer of the letter of credit will pay drafts drawn by the beneficiary of the
letter. A letter of credit is an advance arrangement for financing. Letters of credit facilitate greater certainty in
payments in international trade.
Three contracts are involved in letter of credit transactions: the contract between the issuer and the customer of the
issuer; the letter of credit itself; and the underlying agreement (the contract for sale). The parties to a letter of credit
are the issuer, the customer who makes the arrangement with the issuer, and the beneficiary who will be the drawer
of the drafts drawn on the letter of credit. There may also be an advising bank if the local issuer asks its
correspondent bank to notify or advise the beneficiary that the letter of credit has been issued.
A letter of credit must be signed and in writing and can be for any length of time specified. The issuer is obligated to
honor the drafts drawn under the letter if all the conditions specified in the letter have been met. The customer must
reimburse the issuer if all the payments were made properly.
STUDENT LEARNING OUTCOMES
LO.1: Distinguish a contract of suretyship from a contract of guaranty.
LO.2: Define the parties to a contract of suretyship and a contract of guaranty.
LO.3: List and explain the rights of sureties to protect themselves from loss.
LO.4: Explain the defenses available to sureties.
LO.5: Explain the nature of a letter of credit and the liabilities of the various parties to a letter of credit.
INSTRUCTOR’S INSIGHTS
Break the chapter down into three components – related Learning Outcomes are indicated in ( ):
1. How is a credit relationship created?
2. What are suretyships and guaranty relationships and the rights of the parties involved?
Define suretyship and guaranty (LO.1 and LO.2)
3. What are letters of credit and what do they do?
Define letters of credit (LO.5)
CHAPTER OUTLINE
I. How is a Credit Relationship Created?
II. What are Suretyship and Guaranty Relationships and the Rights of the Parties Involved?
A. Definitions
1. The surety and absolute guarantor is the obligor primarily liable
B. Indemnity contract distinguished
C. Creation of the relationship
1. General contract rules apply
CASE BRIEF: Burke v. Izmirlian
Not Reported in A. 3d, 2011 WL 1661022 (N.J. Super. A.D. 2011)
FACTS: Ellen Marshall, an attorney, represented Laureen Moran, the late wife of William M. Burke, M.D.
(plaintiff) in their divorce proceedings. Marshall and Burke were involved in litigation after Burke
refused to pay her fee for the divorce case, which the trial court had awarded and for which Burke
had guaranteed payment.
In late January-early February 1999 when, during the course of his own post-divorce litigation,
Burke arranged a meeting with Marshall and Moran to discuss Marshall’s representation of Moran
in a post-divorce action initiated by Moran’s former husband, John Izmirlian. Earlier, Marshall had
conveyed to Burke her opinions that Izmirlian was dishonest, concealing his income from both the
Internal Revenue Service and Moran, and that he should be made to pay all the child support for
the daughter then living with Burke and Moran. That meeting was held at a local country club and
on February 5, 1999, Marshall and Moran signed a retainer agreement.
The meeting lasted two hours during which they talked almost exclusively about Moran’s legal
situation. Burke once again mentioned that Izmirlian was attempting to hide his finances and that
he wanted to ensure Izmirlian paid his support obligations. Moran said she was unable to pay for
Marshall’s services and Marshall herself knew that Moran had no steady means of supporting
herself, that Izmirlian had no money, and that Moran had previously discharged a fee obligation of
approximately $15,000 in bankruptcy proceedings. Consequently, Marshall raised the issue of
payment, asserting that litigation would be expensive and that she could not proceed without
payment. According to Marshall, Burke assured her that he was “willing to throw some money at
this, so that that little prick pays to support his kid.” With that assurance, Marshall entered into a
retainer agreement, and commenced preliminary work on the case, including arranging a meeting
between the parties, which turned out to be unproductive.
Because Moran had become very ill in the meantime, Marshall cautioned defendant and Moran
against proceeding, however, Burke urged Marshall to continue and again promised to pay, which
Marshall memorialized in a letter of December 16, 1999. Although Marshall never received
payment during her representation of Moran, she did not demand payment during Moran’s illness
because she relied on Burke’s promise and by then had only represented Moran for a short period.
Both Moran and Burke, on the other hand, deny that Burke agreed to pay plaintiff’s legal fees and
costs on behalf of Moran. Burke admits paying a forensic accountant who aided Moran in tracking
down Izmirlian’s assets.
At the conclusion of the action between Marshall and Izmirlian, Izmirlian was ordered to “pay a
counsel fee of $32,177.29 to Ellen Marshall, Esq. in accordance with the order filed February 22,
2000.” Izmirlian did not pay.
Burke filed a complaint in the present matter on March 10, 2008, alleging that Izmirlian’s breach of
court orders caused him harm, including compelling his payment of Marshall’s fees. Default
judgment against Izmirlian was entered on October 14, 2008, and vacated on July 17, 2009.
Izmirlian then moved for summary judgment in Burke’s case against him. In granting summary
judgment, the trial court found that Burke was not entitled to proceed as an equitable subrogee
because he had paid Marshall as a volunteer.
Burke appealed.
ISSUE: Was Burke a surety for the payment of his wife’s attorney’s fees? Does he step into his wife’s
shoes for rights against the non-paying debtor?
REASONING: Burke had agreed to pay his wife’s attorney’s fees. If he pays them, but his wife would be entitled to
collect those fees from someone else (her ex-husband), then Burke steps into the shoes of his wife
and is entitled to exercise the right to collect payment from the debtor. Here, Marshall needed to be
paid, an obligation that belonged to Burke’s wife, Moran. If Moran did not pay, and Burke does,
then he is entitled to collect from the debtor. Burke had the right to enforce the judgment his wife
won against Izmirlian on payment of child support. The agreement Burke had with Marshall made
him a surety for Moran’s payment. He can then collect from Moran’s debtors.
Reversed and remanded.
D. Rights of sureties
1. Exoneration – if creditor fails to take action against debtor, surety is excused
2. Subrogation
3. Indemnity – from the principal for the amount paid
4. Contribution – cosureties that pay
DISCUSSION POINTS: Thinking Things Through
Pro Rata Shares for Co-Sureties
AFC: $90,000 loan – Anna – $45,000; Frank – $60,000; Charles – $75,000
Default balance: $64,000 – Frank owes “0”
$ 45,000
75,000
$120,000
45/120 x $64,000 = $24,000 – Anna
75/120 x $64,000 = $40,000 – Charles
E. Defenses of sureties
3. Suretyship defenses (See Figures 32-1 and 32-2 in text)
a. The original obligation was invalid
CASE BRIEF: California Bank & Trust v. DelPonti
232 Cal. App. 4th 162 (Cal. App. 2014)
FACTS: Five Corners Rialto, LLC (Five Corners), obtained a construction loan from Vineyard Bank (Bank)
to develop a 70–unit townhome project (Project), with guaranties from Thomas DelPonti and David
Wood, the principals of Five Corners (Guarantors). Five Corners contracted with Advent, Inc., a
general contractor, to build the project in two phases. Everything went according to schedule for the
first 18 months. However, when Phase I of the Project was nearly complete, the Bank stopped
funding approved payment applications, preventing completion and sale of the Phase I units,
which, in turn, caused Five Corners to default on the loan.
The Bank reached an agreement with Five Corners, requiring Advent to finish Phase I so the units
could be sold at auction, and promising to pay the subcontractors if they discounted their bills and
released any liens. Advent paid the subcontractors out of its own pocket in order to keep the project
lien-free, so the auction could proceed. However, the Bank foreclosed against Five Corners. The
Bank (through its assignee California Bank & Trust), sued Five Corners and the Guarantors under
various theories for the deficiency following a Trustee’s Sale of the Deed of Trust, while Advent
sued the developer and the Bank for restitution for the amounts it paid out of pocket.
The cases were consolidated and tried. The court awarded judgment in favor of Advent. The court
found that the Bank breached the loan contract, exonerating the Guarantors. The court awarded
attorneys’ fees to Advent and the Guarantors.
The Bank appealed.
ISSUE: Were the Guarantors discharged on their obligations?
REASONING: The Guarantors did everything expected of them and performed according to the new agreement to
the extent the Bank permitted. The Bank does not discuss or challenge the trial court’s factual
findings, including the court’s finding that the Bank was guilty of willful misconduct. Instead, the
Bank argues that the judgment was in error because the Guarantors waived all their defenses
under the guarantee agreements. We disagree.
A guarantor cannot be held liable where a contract is unlawful or contravenes public policy. The rule
against enforcement of illegal transactions is founded on considerations of public policy. Using this
reasoning, it has been held that a pre-default waiver of notice by a guarantor is unenforceable as
void.
A guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the
agreement. A waiver of statutory defenses is not deemed to waive all defenses, especially
equitable defenses, such as unclean hands, where to enforce the guaranty would allow a lender to
profit by its own fraudulent conduct. In all suretyship and guaranty relations, the creditor owes the
surety a duty of continuous good faith and fair dealing. This duty was not waived by the Guarantors
in the agreement. The trial court found that public policy precluded an interpretation of the guaranty
agreement that resulted in a waiver of all defenses. We agree.
The judgment is affirmed in full. Advent and the Guarantors are awarded costs on appeal.
DISCUSSION POINTS: Ethics & the Law
When the Creditors Rule the Debtor
Creditors have significant power in extracting promises from management and in motivating boards to take action.
However, the shareholders’ interests are often ignored as certain creditors are appeased or favored. The focus of
management is satisfying creditors rather than managing the business for long-term success and return on the
business investment.
Creditors use the loan covenants to ensure control for purposes of repayment. Without some covenants, the creditor
takes a back seat to all other interests.
Ethically speaking, the issues are those of balance and the importance of the company’s preservation.
III. What are Letters of Credit and What Do They Do?
A. Definition (See Figure 31-3 in text)
CASE BRIEF: Louisville Mall Associates, LP v. Wood Center Properties, LLC
361 S.W. 3d 323 (Ky. App. 2012)
FACTS: In 2007, Wood Center Properties (WCP) entered into a Purchase and Sale Agreement to buy five
shopping centers from Robert B. Greene (Greene) and Louisville Mall Associates, LP, and several
other mall property groups (collectively, the “Mall Appellants”). While performing its due diligence,
WCP discovered environmental contamination at the Crestwood Shopping Center, one of the
shopping centers it intended to purchase. A prior shopping center tenant, Crestwood Coin Laundry
(Tenant), spilled hazardous chemicals used in its dry cleaning business. As a result of the
contamination, WCP chose not to purchase Crestwood Shopping Center, and the parties amended
the Purchase and Sale Agreement to reflect WCP’s decision.
Shortly thereafter, Greene offered to provide WCP with an irrevocable Letter of Credit, issued by M
& T Bank, in the amount of $200,000.00. The Letter of Credit’s purpose was to insulate WCP from
liability and fund the environmental cleanup if the Tenant failed to do so. With that inducement,
Crestwood Shopping Center was put back in the contract as one of the properties being purchased
by WCP. Paragraph two of the amended contract provided:
At closing, Robert M. Greene, individually, shall deliver an irrevocable letter of credit for
the benefit of Wood Center Properties, LLC, in the amount of Two Hundred Thousand
Dollars ($200,000.00) drawn on M & T Bank. This letter of credit shall extend for one (1)
year from the date of Closing, and shall automatically renew for one (1) additional year
unless Notice of Nonrenewal is given to [WCP] at least 60 days prior to the expiration date
on the face of the Greene Letter of Credit.
On June 13, 2007, M & T Bank issued the Letter of Credit for the benefit of WCP. The Letter of
Credit contained an original expiration date of June 12, 2008, that provided:
It is a condition of this credit that it shall be deemed automatically extended without
amendment for one (1) year from the expiration date hereof, or any future expiration date,
unless sixty (60) days prior to any expiration date M & T Bank notifies [WCP] in writing that
M & T Bank elects not to consider this credit renewed for any such additional period.
On April 7, 2008, M & T Bank automatically renewed the Letter of Credit for a second year and
provided WCP and Greene with a letter of renewal, notifying them that the Letter of Credit’s new
expiration date was June 12, 2009. On March 6, 2009, M & T Bank sent a second renewal letter to
WCP and Greene, again giving notice that it was automatically extending the Letter of Credit for a
third year and its new expiration date was June 12, 2010.
After receiving M & T Bank’s March 6, 2009, letter, Greene told M & T Bank his view that the Letter
of Credit was only valid for two years and should expire on June 12, 2009. Greene requested that
M & T Bank not renew the credit. Despite Greene’s request, M & T Bank did not send a nonrenewal
notification to WCP. WCP sought payment under the Letter of Credit and submitted the documents
to M & T that were necessary for payment.
On July 27, 2009, Greene contacted WCP claiming the Letter of Credit had expired on June 12,
2009, and requested that it be returned. WCP filed a declaratory judgment action seeking the
court’s ruling that WCP was entitled to draw on the Letter of Credit. The court entered summary
declaratory judgment in WCP’s favor. Greene appealed.
ISSUE: What are the rights of the party when the contract terms contradict the letter of credit? What are
the parties rights and responsibilities in such a case?
HOLDING AND
REASONING: The issue of whether WCP was entitled to draw on the letter of credit had to be resolved by
interpreting the letter of credit without reference to the parties’ underlying purchase agreement. The
The letter of credit allowed payment based upon the submission of the documents noted in the
letter of credit regardless of renewals. The parties were at a different place in terms of their
B. Parties (See Figure 31-4 in text)
1. Issuer
2. Customer who makes arrangements with the issuer
C. Duration – time specified therein
D. Form – signed writing required
E. Duty of issuer
1. Can pay on drafts only according to terms
F. Reimbursement of issuer – when proper payment is made
ANSWERS TO QUESTIONS AND CASE PROBLEMS
1. Letters of credit and payment. A letter of credit constitutes an enforceable obligation by the issuer in favor of the
beneficiary. The duty created in the letter of credit is wholly independent of the underlying contract between the
Article 5 of the UCC governs the letter of credit transaction. However as pre-revision § 5-102(3) aptly points out,
the “Article deals with some but not all the rules and concepts of letters of credit as such rules or concepts have
2. Letter of credit payment. First Bank had no choice. Although there was a clear non-payment by the buyer, the
bank has to honor the paperwork demands of the letter of credit. Without the original, LaBarge was not entitled
3. Suretyship defenses. Dori’s promise was original and specific to her business. It was not a general guaranty of
credit. The plain language in the guaranty of credit was one intended to cover Dori Leeds while she owned and
4. Defense to enforcement. Judgment for Fern Schimke. The guarantee contract was executed by Schimke at a
5. Suretyship defenses. No, a surety is there precisely because there can be bankruptcies. [Alien, Inc. v.
6. Suretyship payment. Add the total sureties together and compute their shares:
A 25%
B 50%
If B is bankrupt, determine the share by using 12,000,000 – A pays 25%; C and D split 3,000,000 or 1,500,000
each.
7. Suretyship payment and defenses. The court held that: (1) principals could assert bank’s failure to dispose of
corporation’s collateral in a “commercially reasonable” manner, as required under Article 9 of Washington version
8. Letters of credit. Issuer of two standby letters of credit (LOCs) wrongfully dishonored beneficiary’s draws on
LOCs where beneficiary made conforming demand for payment under terms of LOCs and issuer had no
9. Letters of credit. Citibank cannot pay on the letter of credit. A bank can only pay according to the terms of the
letter of credit. If the bank cannot comply completely with the letter of credit, it must not release funds because it
10. Defenses of the surety. Judgment for the surety. The concealment of the price of the shingles was not significant
in that it would not lead to any loss or prejudice. The advance was prejudicial, as it equaled the profit the
11. Subrogation. Judgment for the St. Paul-Mercury Indemnity Company. After paying the principal’s debt, the surety
12. Creation of the relation. No. The statute of frauds requires that promises to pay the debt of another (contract of
13. a. Defenses of the surety. Belton could argue that the original contract was modified without the surety’s
b. Rights of the surety. Belton, after paying the bank, is entitled to indemnity from Longdon.
14. Rights of contribution; surety. The co-sureties contribute their pro rata share of the debt, but they are never
liable for more than they agreed to. Formula is:
Amount co-surety guaranteed
Total amount of surety’s pledge x Amount of debt up or default
Ellen Weiss: 50,000
Allen Fox: 75,000
15. Creation of surety relationship. No, Industrial cannot collect the debt from Siemens. Nowhere in the fax did
Siemens guarantee the debt of any specified entity or state that Siemens was agreeing to indemnify anyone or
pay the obligations on behalf of anyone else. This fax failed to identify the principal debtor whom Siemens
management system for classroom use.