Ohio Practical Business Law : Columbus Ohio Business Lawyer & Attorney : Teri Rasmussen : Plunkett Cooney Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

Suppose a foreclosing lender had to come up with the CASH for EVERY deposit required in foreclosure sales in which it was the foreclosing plaintiff and successful bidder at sheriff's sale.  It shouldn’t take long to realize that we are talking about a MESS OF DOLLARS here.  Could that cause a cash flow issue and maybe slow down the pace of foreclosures?  Well maybe. 

About a year ago, Ohio made several significant changes to its foreclosure law.  Then and probably even more now, foreclosures (particularly of the residential variety) were widely being perceived as increasingly serious epidemic.  And so various foreclosure mediation programs were born, backlogs legitimately produced delays, and courts in some areas of the state started instituting procedures such as referring every single foreclosure case to a magistrate which promised to slow the entire process down considerably. 

Now from a lender standpoint, none of this was good news.  But apparently, in the view of some, this wasn’t enough.  And so, in some courts now – primarily in northeast Ohio which has been hit hardest, additional measures have been taken to make foreclosure a more difficult process for lenders. 

I mentioned the other day that I’d made a trip down to a Franklin County, Ohio sheriff’s sale in a pending foreclosure case I am handling for a client.  And part of the reason I went myself was that it involved bidding for a junior lienholder in a situation in which we were anticipating contested bidding. Which squarely raised the question: could I credit bid on behalf of this junior lienholder or was my client going to have to come up with the full amount of the deposit typically paid by third party purchasers?

Now, you think you know things… and then you find out that well, maybe, you don’t or at least the whole world isn’t the way you thought – and if you’re anything like me, that starts to concern you at least a wee little bit ‘cuz now you start to worry ‘bout what you CAN rely upon.  And what I learned this week was that while fortunately here in Franklin County, the world of foreclosures and sheriff’s sales was indeed precisely as I thought, it’s a “whole ‘nother ball game”  elsewhere in Ohio.  

Specifically what I found out was that the concept of “credit bidding” whereby a lienholder did not have to come out of pocket so long as the amount of its bid was no more than the amount owed it was not quite so universal a truth as I had heretofore believed.  Here in Franklin County and Central Ohio, sanity – from the lender perspective – reigns.  First lienholders needing or wishing to bid in a property brought to sheriff’s sale in a foreclosure proceeding need only bring a much smaller specified amount to successfully “bid in” property.  In addition, junior lienholder (such as my client) are also not required to pay more than this.

In Cuyahoga County (i.e. Cleveland), it’s a whole different story.  There, NO ONE is allowed to credit bid AT ALL.  Local Rule 27 governing foreclosure sales requires a 10% deposit (based on the appraised value of the property being offered) to be made by the successful bidder at sheriff’s sale.  It also states: 

When the purchaser is the lien holder after the lien of costs, taxes and assessments, the Court  may order, if the lien holder or assignee is the successful bidder at sale, that the required deposit be waived and thar all costs, taxes and assessmenof ts be paid upon receipt of a statement from the Sheriff of Cuyahoga County

However, the Foreclosure Terms of Sales available on the Cuyahoga County Sheriff’s website make it absolutely clear that NO WAIVERS willl be granted, stating "There shall be no waiver of Deposit for any Sheriff Sale.".

A similar procedure has also been adopted in Erie County.   In Lucas County (i.e. Toledo), however, lienholders are only reqired to come up with $1000 plus the amount of real estate taxes due.  And in Montgomery County, Local Rule 2.23 permits credit bidding for first lienholders, but not for jumior lienholders,  So I suppose the practice point here is to be sure to check the local rules before showing up at a sheriff's sale. 

Why is this happening?    it arises from the interpretation of revised Ohio Rev. Code 2327.02 which provides in reelvant part:

 If the property is sold under an order of sale or transferred under an order to transfer, the officer who conducted the sale or made the transfer of the property shall collect the recording fee and any associated costs to cover the recording from the purchaser or transferee at the time of the sale or transfer and, following confirmation of the sale or transfer and the payment of the balance due on the purchase price of the property, shall execute and record the deed conveying title to the property to the purchaser or transferee. For purposes of recording that deed, by placement of a bid or making a statement of interest by any party ultimately awarded the property, the purchaser or transferee thereby appoints the officer who makes the sale or is charged with executing and delivering the deed as agent for that purchaser or transferee for the sole purpose of accepting delivery of the deed

Not certain the statute actually forbids credit bidding?  Well, neither am I. Now, rationally and logically, here is what I can see.  If counties want a deposit to be made to cover real estate taxes, well O.K. maybe I can see that.  However, beyond that, when it comes to the first lienholder, it doesn't even make sense to require additional payments into the Court,  It doesn’t make sense because the lienholder is PAYING ITSELF at this point!! 

For junior lienholders, I suppose I can see some logic here, but as a practical matter , it still makes very little sense.  Junior lienholders in one case are likely to be seniore lienholders in another case so it is unlikely that there will be any actual problem with payment of these amounts at the time the deed is ready.  And not infrequently, given the delays experienced in completing the foreclosure process, the successful lender bidder will have already assigned its bid and sold the property to a third party in any event , thus complicating the financial accoounting for these transactions.       

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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.   

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How would Peanuts’ Linus manage without his trusty security blanket? Depending on the result, the Sixth Circuit reaches in a recently appealed cognovit judgment case, financial institutions such as banks and others relying on cognovit notes, and perhaps ordinary promissory notes as well, may well have to face a similar question.

Every guaranty I’ve seen has some variation of what is sometimes called an “indulgence” clause. These provisions essentially say that a guaranty remains in effect even if the Bank waives a default by the primary obligor or errs in its collection efforts. Now a federal district court, applying Ohio law, has snatched this security blanket away, saying that such a clause does not allow the lender to ignore the credit terms of a loan with impunity. 

In Huntington National Bank v. Wallace, 2009 WL 2023891 (N.D. Ohio 2009) (Case No.09CV408, Carr, J.), decided August 19, 2009, the defendant guarantor alleged he had a meritorious defense justifying vacation of the cognovit judgment taken against him. His argument was that because the Bank made a “material alteration” to the terms of his guaranty by continuing to allow advances even though the amount outstanding exceeded the prescribed “maximum amount”, his guaranty obligation was rendered invalid. 

The Bank has now appealed the case to the Sixth Circuit (Case No. 09-4172).  If upheld, the decision may have far reaching consequences beyond cognovit notes.  The district court decision suggests that the ONLY modification to an obligation that a lender may comfortably do is an extension of time unless the guarantor agrees.  It could also be taken as meaning that even if the guarntor consents, such modifications would release the guarantor of all liability

Factual Background

The underlying fact scenario is a common one. In August 2007, a company known as Bellepointe entered into a First Amended and Restated Loan and Security Agreement “Loan Agreement”) with the Bank. The Loan Agreement governed three separate obligations – a term note, a line of credit, and a “Guidance Line” involving draws on letters of credit. Michael Wallace (“Wallace”), the father of the company’s owner, executed a guaranty of Bellepointe’s indebtedness to the Bank; the son also executed a guaranty, but the case pertains only to the father’s guaranty.

The guaranty excluded any liability for the term loan indebtedness and also capped the maximum amount of liability with respect to the Line of Credit. The crux of the case focused on the proper interpretation of certain language found in the Loan Agreement and the Guidance Line cognovit note, to wit: 

Notwithstanding anything to the contrary contained herein, the maximum amount available under the Guidance Line shall be as follows:

from the date hereof through and including 11/30/07 - $865,000

12/1/07 through and including 12/31/07 - $250,000

1/1/08 and thereafter - $550,000      

These provisions obviously required a substantial reduction in the amount outstanding as of December 1, 2007. It is not altogether uncommon for lines of credit to require a substantial reduction in the amount outstanding at least once a year. 

Procedural History

Procedurally, the case is a bit complicated. Apparently there was some discussion back and forth between Wallace and the Bank concerning his liability prior to any lawsuit being filed. When those talks broke down, Wallace filed a declaratory judgment action in the Southern District of Ohio federal district court against the Bank on February 11, 2009. Two days later, the Bank took a cognovit judgment against Wallace in Lucas County Common Pleas Court. The Bank said it had no knowledge of the declaratory judgment action when it took the cognovit judgment. 

Wallace promptly removed the state court cognovit judgment action to federal district court for the Northern District of Ohio, apparently on diversity grounds that he was a resident of Florida, and sought relief from judgment. After the Northern District federal court granted the motion to vacate the cognovit judgment, the Bank appealed to the Sixth Circuit where the case is now pending. It appears likely that the Southern District declaratory judgment action will be consolidated with the pending Northern District cognovit action.

The Decision 

Wallace alleged that the Bank continued to make advances on the Guidance Line in December 2007 even though Bellepointe had failed to reduce the amount outstanding as required.  Consequently, he contended that the Bank’s actions caused a “material alteration” in the nature of his guaranty obligation, thereby relieving him of liability under his guaranty. The Bank did not dispute that the advannces exceeded the "maximum amount."  However,it countered by pointing out that its loan documents had one of those “indulgence clauses” which stated:

Guarantor hereby promises that if one or more of the Obligations are not paid promptly when due, he will pay the Obligations to Bank, irrespective of any action or lack of action on the Bank's part in connection with the acquisition, perfection, possession, enforcement or disposition of any or all Obligations....   Guarantor agrees that no extension of time, whether one or more, nor any other indulgence granted to [sic] Bank by [sic] Debtor, or to any other gurantor, or any of them, and no omission or delay on Bank's part in exercising the right against, or in taking any action to collect from or pursue Bank's remedies against Debtor or any other guarantor, or any of them, will release, discharge or modify the duties of guarantor hereunder.

In addition, the Bank insisted that it was obligated to pay the draws on outstanding letters of credit in any event and that the definition of “advances” used in the line of credit differed from the definition of “maximum amount available” for precisely this reason. It also argued that the “indulgence” provisions in Wallace’s guaranty allowed it to ignore Bellepointe’s default in any event.  

So what happened? The federal district court agreed that the provisions of the loan documents did allow the Bank to continue making advances in December 2007. However, the court also noted that “Wallace’s burden is only to allege a meritorious defense, not to prove that he will prevail.” It went on to say:

Even if Wallace had initially failed to allege sufficient facts to support his defense, he has subsequently submitted an affidavit describing the above referenced facts, Wallace alleged sufficient facts for this court to evaluate whether his defense is meritorious.

And the reason? The Court cited Toland v. Key Bank of Wyoming, 847 P.2d 540 (1993) and Frost National Bank v. Burge, 29 S.W.3d 580 (Tex. App. 2000) for the proposition that “’indulgence’ is limited to extensions of time for payment and contract terms permitting indulgences do not waive suretyship defenses.” That’s it!  Really isn’t any further analysis or discussion. 

What IS interesting and informative are the briefs of the parties filed in the federal distriuct court case.  Leaving out exhibits, but including affidavits,here they are:

• Wallace's Motion to Vacate
• Bank's Responsive Memo in Opposition
• Wallace's Reply
• Bank's Sur-reply

Now I think the district court got this wrong and I’d really have appreciated a little further analysis of the pertinent provisions in the loan documents so I could fully understand the Court’s reasoning.  However, I also think the Sixth Circuit proceedings will be rather interesting to follow in the months ahead for lender attorneys everywhere. I’ll share my thoughts about the decision in more detail in my next post. 

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