A. The Role of Guaranties

Thomas S. Hemmendinger, Hillman on Commercial Loan Documentation

B. Rights of the Creditor Against the Guarantor

F.T.L., Inc. v. Crestar Bank (In re F.T.L., Inc.)

Problem Set 22

Problem Set 22

22.1. Pleased with your advice in Problem Set 21, your friend Tertius Lydgate comes by this morning to discuss another round of financial difficulties. He says that he has found one bright spot in one of his transactions and wants to tells you about it. Lydgate is the guarantor of a large loan from Bulstrode Bank to Middlemarch Medical Clinics, Inc. (“MMC”). MMC has just closed its doors after protracted litigation with Bulstrode. Although Lydgate is depressed at the failure of MMC - MMC has no remaining assets to pay Bulstrode or any of its other creditors - Lydgate tells you that he gets some satisfaction out of the knowledge that Bulstrode spent $400,000 in legal fees pursuing MMC. Lydgate said that he was reading the terms of his guaranty agreement last night (which is identical to the Continuing Guaranty in the assignment) and figured out that Bulstrode cannot collect those legal fees from Lydgate under his guaranty. Lydgate explains that he has read Section 13 of the Continuing Guaranty carefully and understands that it allows Bulstrode to recover the litigation expenses of a suit against Lydgate, but not the expenses of a suit against MMC. Is Lydgate correct? Continuing Guaranty §§ 1, 2, 13; Promissory Note § 9.

22.2. California Fidelity Bank (CFB) has issued a $20 million line of credit to Jaffe Investments, Inc., a business operated by Wendell Jaffe and Carl Eckert. Although Jaffe runs the day-to-day affairs, Eckert provides most of the capital for the business. Accordingly, CFB took a continuing guaranty from Eckert in the terms set forth in the assignment. Yesterday morning, a grand jury indicted Jaffe on charges of embezzling funds from the company’s clients. Yesterday afternoon, Jaffe’s sailboat was found floating off the Santa Barbara coast. There was a suicide note, but police suspect that Jaffe fled to avoid his legal problems. This morning, Mac Voorhies (the loan officer at CFB) received a hand-delivered letter from Eckert, stating: “I hereby terminate the Continuing Guaranty that I have signed with respect to your loan to Jaffe Investments, Inc., and abjure any further liability whatsoever with respect to any future advances under that loan.”

Voorhies is concerned about the effects of the notice, mostly because he doubts that Jaffe left any assets in the company and because Eckert is his only likely source of payment. CFB currently has $2 million outstanding on the line of credit, which is accruing interest at about 13% per annum. More seriously, CFB has another important transaction pending under the Jaffe line of credit: CFB issued letters of credit backing up $10 million of short-term commercial paper that Jaffe Investments, Inc. issued almost two months ago. The paper matures next week. If Jaffe Investments fails to pay the holders of the paper the $10 million that they are owed at that time (and Voorhies has no reason to think that Jaffe will make that payment), the holders of the paper will be entitled to payment from CFB.

Voorhies says that Eckert easily has the assets to pay off the entire amount. Voorhies wants to know if the notice will limit Voorhies’ ability to pursue Eckert for the amounts CFB might have to pay on the commercial paper or subsequently accruing interest. What do you tell him? Continuing Guaranty § 4.

22.3. Jude Fawley (your wealthy stone-mason friend) comes to consult you about some serious problems with his business, Obscure Wessex Headstones (OWH). Several years ago you organized Jude’s business as a corporation, with Jude as the sole shareholder. Jude has guaranteed OWH’s $1.2 million line of credit with Wessex Bank (which contains a provision similar to § 8 in the Promissory Note in Assignment 19). Over the last six months, OWH’s net monthly income has decreased from $20,000 to only $2,000. At the same time, operating expenses have caused OWH to draw down its entire line of credit, so that it now owes Wessex the entire $1.2 million. OWH has only $10,000 cash on hand right now. Its current obligations include a $10,000 monthly payment due to Wessex on the first of the month and $8,000 in overdue bills from suppliers.
Jude tells you that he would feel terrible if he did not pay his suppliers, many of whom have been doing business with him for decades, but that he doesn’t want to do anything that would worsen his personal financial situation. He also tells you that he doesn’t mind all that much if he loses the stone-mason business, as long as he can keep the rest of his assets (which include a multi-million dollar business syndicating walking tours of rural Britain). What should he do?

22.4. Ben Darrow (your friend from the early days of the book) calls you in distress. He read in the paper this morning that one of his borrowers, Matacora Pipelines, Inc., was hit yesterday with a $1 million tort judgment. The judgment resulted from a tragic accident in which a Matacora employee working on construction of a new pipeline was killed by an exploding dynamite charge. Ben knows that Matacora does not have enough assets to pay the judgment and is worried about his $250,000 loan to Matacora (for which Ben has no collateral). On further questioning, Ben tells you that he has a personal guaranty from Bud Lassen, the independently wealthy owner and operator of Matacora. Ben also tells you that he believes the entry of the tort judgment is a default on the loan to Matacora, because it constitutes a “material adverse change” in Matacora’s financial condition. What is your assessment of Ben’s situation? Will the situation change if Matacora files for bankruptcy?

22.5. Impressed with your work on the Jude Fawley matter (in Problem 22.3), Wessex Bank retains you to handle a proposed restructuring of one of its loans. For several years, Wessex has been lending to a growing chain of specialty stores called We-R-Red, which specialize in bright red clothing and accessories. Until now, the business has been operated as a sole proprietorship owned by Diggory Venn. Because of Venn’s considerable wealth, Wessex traditionally has considered the relationship a safe one even though the loan is unsecured.

Venn recently learned that the Environmental Protection Agency has decided to list as a toxic substance the chemical that Venn uses to makes his products (reddelic acid). Venn believes that the resultant dye (ordinary “reddle”) is completely safe, but is worried about the possibility of some accident that would result in environmental liability that would wipe out all of his assets. In response, Venn has decided to incorporate the business under the name of We-R-Red, Inc. Venn will remain the controlling shareholder and chief executive officer. Venn would like to transfer the loan to the new entity, but is willing to issue a guaranty of the loan himself. The loan officer at Wessex, Eustacia (“Stacy”) Vye, wants to know what you think about Venn’s proposal. What do you say?

Assignment Update

No update is needed at this time.