A Lender's "Indulgences" Curtailed?
When I hear the word "indulgences", my mind immediately goes to something "sinful" and well, probably fun. In this case, however, I'm talking about that ubiquitous provision found in loan documents designed to allow lenders to continue to hold borrowers and gurantors liabile notwithstanding the lender's failure or inability to abide by the letter of the loan documents or to exercise all or some subset of its rights upon default in a manner saitsfactory (usually with the benefit of 20-20 hindsight) to the borrower and/or gurantor. Does this stuff really worK?
Suppose you have this deliquent borrower - let's call him "B" -- on a promissory note (though it could be any obligation) and collateral not worth enough to pay you off in full. But then you also have this guarantor -- let's call him "G". Somewhere along the line one of your folks messed up in that "commercial reasonable sale" thing that's supposed to happen when you repossess and liquidate collateral. Or maybe you let a financial covenant default here and there pass for the time being. Or perhaps you just extended the maturity date or went interest only for B for a while. Question is whether you're still OK because you can hold G - who does have assets - liable for the obligation.
Most, if not all, bankers and their counsel would say "yes" because both the UCC and our loan docs say we can. Which is why Huntington National Bank v. Wallace, 2009 WL 2023891 (N.D. Ohio 2009) -- now on appeal to the Sixth Circuit and the subject of my last post -- is an important case to watch.
In a nutshell, the Bank had allowed advances to the Borrower to fund draws on letters of credit in excess of a "maximum amount" specified in the loan documents and the Bank was pursuing one of the guarantors, Bank took cognovit judgment and guarantor sought relief from judgment Federal district court held that the indulgence clause was not sufficient to preclude relief from judgment.
Initially, as a lender-oriented attorney, the case concerned me. It seemed to suggest that lenders permitting any sort of modification -- other than the most vanilla extension of time sort --would now be accepting a substantially greater risk that such forbearance would relieve any guarantor not explicitly consenting from liability. In addition, the manner in which it brushed aside the waivers contained in the “indulgence” clause as inapplicable sent a cold shiver down my spine. And the logic of the ruling would be applicable not just to cognovit notes, but really any sort of obligation. So, taken as a whole, if upheld by the Sixth Circuit, the decision seemed likely to convince many lenders that it simply was not in their best interests to work with delinquent borrowers.
As I've thought about it more, however, I've begun to think this decision makes more sense and is less alarming than I had first surmised. The decision in fact makes an important distinction between the nature and extent of the obligation intended by the parties to be guaranteed on the one hand and mistakes and errors made by the lender in enforcing the guaranty on the other. In this particular case, the guaranty was never intended to be unlimited - there was a clearly stated unambiguous cap on the amount of credit to be extended to the borrower at particular times. In continuing to permit advances to fund letter of credit draws, the Bank exceeded this previously agreed limitation on the amount for which the guarantor had accepted responsibility for seeing was paid.
When read closely, the language itself – and certainly the concept originally underlying inclusion of such a clause – is about the consequences of the Bank’s inaction or failure to take appropriate steps to ensure the obligation guaranteed could be satisfied from sources other than the guarantor. When viewed from this perspective, the decision leaves largely intact a lender’s ability to rely on indulgence clauses with respect to events and actions occurring during the course of a workout situation. It is only a lender’s decision to continue extending credit to the borrower beyond an explicitly agreed–upon point that becomes a problem.
Granted, the ruling is still worrisome. In asset-based lending, a lender may unknowingly extend credit beyond the “availability” permitted pursuant to a borrowing base calculation formula. And in the Wallace case, the Bank was obligated to honor letters of credit previously issued and really did not have the ability to refuse to make further advances.
What also makes things a bit problematic for me in this case is that the “cap” in question was only for a very short, almost temporary, period of time and was substantially less than it was at other times. Had the events occurred but a couple of months earlier or later, the cap would not have come into play.
For me, the take-away lessons for now from this case are:
- If at all possible, obtain guarantor consent to any modifications or waivers at the time the modifications are made or waivers given. I already do this anyway, but now it will be even more important.
- If a lender wants the guaranty to truly be unlimited and/or cover over-advances, the guaranty should say so very explicitly.
- Problems arising due to lack of perfection, release of collateral or other obligors, or other events and circumstances connected with an aspect of the lending relationship that do not pertain to the amount advanced are probably still within the protection of indulgence clauses.
