New California Appellate Court Decision Impacts Construction Lending and Loan Guarantees

On December 9, 2014, the Fourth District Court of Appeals issued a decision in California Bank & Trust vs. Del Ponti impacting loan guarantees and lending behavior in the wake of a defaulted construction loan.

In Del Ponti, the Court held that a lender was liable to a general contractor under the original loan agreement’s contingent assignment of construction contract because the lender, after declaring a default, engaged in misleading payment conduct and assumed the contract through various email communications with guarantors. The Court also exonerated guarantors from their obligations under guarantees, holding that the guarantors’ waiver of defenses was limited to legal and statutory defenses expressly set out in the guarantee agreements. Although the guarantees contained broad waivers pursuant to Civil Code Section 2856, the Court found that the guarantees did not waive equitable defenses, such as unjust enrichment or unclean hands.

For a link to the full decision, which was certified for partial publication, click here:
http://www.courts.ca.gov/opinions/documents/E053187.PDF


 

FACTUAL BACKGROUND
The case arose out of a 70-unit townhome project in Rialto, California (“Project”) that was funded by Vineyard Bank (“Vineyard”). When Vineyard failed, California Bank & Trust (“CB&T”) stepped in as a result of a receivership in which CB&T received an assignment of Vineyard’s assets. CB&T was not involved in any of the underlying misconduct, but was held liable for it, given its assignee status. The decision collectively refers to Vineyard and CB&T as the “Bank”.

On February 6, 2006, Five Corners Rialto, LLC (“Borrower”) entered into a construction loan agreement to borrow $22.5 million for purposes of developing the Project. Two principals of the managing member of Borrower (“Guarantors”) also entered into commercial guarantees for repayment of the loan (“Guarantees”).
Like most construction loans, the loan agreement called for incremental advances of funds, upon approval of monthly payment applications. The balance of the loan would remain undisbursed and available upon submission of proper draw requests, provided the loan was not in default. The general contractor would submit payment applications to Borrower based on a percentage of completion. Borrower would then inspect, review, and approve the payment application and forward it to the Bank. The Bank would conduct its own inspection, and if it was satisfied with the percentage of completion, it would approve the application and transfer the funds to a fund control account for disbursement to the general contractor.

The loan agreement also included an assignment of the construction contract, which gave the Bank the authority to step into the shoes of the contractor in order to complete the Project in the event of a default by Borrower or a foreclosure.
All went well for the first 18 months of the Project. At that point, beginning in late 2007 and continuing through early 2008, four payment applications totaling approximately a million dollars went unpaid, even though they were approved by Borrower. The Bank initially responded to Borrower’s inquiries that it was working on the payment requests.

On February 11, 2008, the Bank executed a Declaration of Default and Demand for Sale, signifying that the loan was in default. However, it did not record it until April 2008. It also did not serve it upon Borrower, nor provide them a Notice to Cure, as required by the loan agreement before a default could be declared. On February 28, 2008, the loan matured, and Borrower could not pay it. Despite this, the Bank asked Borrower to continue working on the Project, as this would preserve the collateral for everyone.

The Bank then began taking a more active role. Borrower and the Bank met and agreed on a “global strategy” that was memorialized in a critically significant email. On April 9, 2008, following a conference call with Guarantors, the Bank’s special assets manager sent an email summarizing the meeting, outlining the “global strategy” for the project, and stating bullet points upon which terms were “agreed”. Among other things, the parties agreed to do a marketing auction of units, the Bank made changes to portions of the Project’s work (such as installing a permanent fence, upgrading units, changing specification levels, and altering payment terms), the Guarantors were to obtain discounts from the general and subcontractors to get them paid current and avoid mechanic’s liens, and the Guarantors would continue to work on the project in order to mitigate damages to the Bank and themselves. The Bank also demanded 100 percent of the sale proceeds for homes sold and in escrow, instead of the 70 percent originally required by the loan agreement. The Borrower understood that if they complied with the Bank’s direction it would result in a modification of the loan or a release of the guarantees.

After Guarantors, working with the general contractor, helped arrange for discounts, and after deducting what the subcontractors agreed to discount, the general contractor remained owed approximately $815,000.

On July 10, 2008, the Bank issued a Notice of Trustee’s sale for the property. At the time, it explained to Borrower that it was merely preserving its rights and would move forward with the auction. Shortly thereafter, the general contractor issued a stop notice to the Bank. Borrower’s manager attempted to move forward with the auction prior to the foreclosure sale, but was unsuccessful. On August 12, 2008, a Trustee’s Deed Upon Sale was recorded. (Although the decision is not clear, it appears to have been recorded in favor of the Bank upon a successful credit bid.)

As expected, the Project resulted in a rash of consolidated litigation between the lender, the Borrower, Guarantors, contractors, and affiliated entities. By the time it reached trial (it was a bench, and not jury trial), there were two remaining disputes: (1) the general contractor’s cause of action against the Bank on the stop notice and for payment of unpaid invoices and (2) the Bank’s action against Guarantors for a deficiency judgment. Significantly, after the close of evidence, the contractor made a motion to amend its complaint to conform to proof and add the Bank as a defendant in its breach of contract action and add a cause of action for promissory estoppel against the Bank.

The trial court granted the contractor’s motion to amend and further ruled in favor of the contractor, finding that the Bank breached the loan agreement with Borrower and was liable to the contractor as an assignee of the prime contract. The court also determined that the Bank had taken over the construction contract, accepting both its benefits and its burdens. This had the effect of creating a new contract with the contractor that was enforceable by a cause of action for promissory estoppel. The trial court also found in favor of the Guarantors in the Bank’s action.

The Bank filed an appeal from the judgment, and the general contractor also appealed a portion of the judgment rejecting its stop notice claim.

REASONING

The Court of Appeals ruled against the Bank with respect to both the general contractor’s case and the case involving Guarantors.

As to the general contractor’s case, the Court of Appeals affirmed the trial court’s decision, finding that the trial court properly granted the contractor’s motion for leave to amend its complaint to conform to proof, rejecting an argument that there was judicial misconduct, and concluding that substantial evidence supported the judgment.

In reaching this conclusion , the Court of Appeals rejected the Bank’s argument that it was not liable to the general contractor because the assignment of the construction contract was an assignment for security only, which transferred the rights but not the obligations under the contract. The Court explained that “a voluntary acceptance of the benefit of a transaction is equivalent to consent to all the obligations arising from it, so far as the facts are known or ought to be known, to the person accepting.” The Court also explained that the interpretation of a contract is a legal question for the Court. Although the Bank witnesses provided testimony that the assignment was for security only, the Court stated that the “language of the assignment of the construction contract does not indicate it was for security only.” The Court further explained its reasoning by stating that “No person can be permitted to adopt that part of an entire transaction which is beneficial to him or her, and then reject its burdens. [citations omitted]. The Bank’s effort to characterize the assignment of the contract as for security purposes only was contradicted by the evidence that it had stepped into the developer’s shoes.”

After rejecting the Bank’s assignment for security argument, the Court of Appeals then rejected the Bank’s argument that it did not assume the assignment in writing, as required by the terms of the loan agreement. The clause at issue stated, in part, “that from and after the time of any such default, Lender immediately shall become entitled, but shall not obligated, to exercise any rights of Assignor under the Construction Contract and at Lender’s option, to perform Assignor’s obligations under the Construction Contract, if any.” The Court stated that, “Nothing in the language of this assignment requires the Bank to execute a writing in order to make it effective.”
In addition, the Court of Appeals explained that the email from the Bank’s special assets officer to the Borrower’s principals outlining a global strategy was evidence that the Bank exercised the Assignment in writing. “To the extent the Bank felt a written exercise of the assignment was required, [Bank’s] email satisfied any such requirement. After all, without the assignment, the Bank would have no authority to demand any performance by the general contractor or the subcontractors under the construction contract. By emailing its direction for further work on the Project to the borrowers, requiring the borrowers to obtain the Bank’s approval before making any decisions, the Bank exercised the assignment.”

Next, the Court of Appeals also used the “global strategy” email and resulting course of action to affirm the trial court’s promissory estoppel ruling. The Court of Appeals explained that “only a very strained reading of the bullet points in [Bank’s] email could support a conclusion that the Bank was not promising to pay for the additional work. [Bank’s] use of the words, ‘Here is what we agreed upon’ indicates a contractual promise.” It was clear from the testimony of all the witnesses that the general contractor and Guarantors were not undertaking to do this work for free. In addition, the Court explained that an assignee of a contract becomes bound to perform its obligations without express agreement when full performance has been received by him. “Assumption of the obligations may be implied from acceptance of benefits under the contract.”

As to the Bank’s case against Guarantors, the Bank argued that the trial court’s judgment was in error because the Guarantors waived all their defenses under the guarantee agreements pursuant to Civil Code Section 2856. The Court of Appeals rejected this argument as well.

The Court explained that a guarantor cannot be held liable where a contract is unlawful or contravenes public policy. The Court stated that “We read Civil Code section 2856 to permit a guarantor to waive certain legal and statutory defenses, as specified in the code that would otherwise be available….But we do not read Civil Code section 2856 to 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.” The Court then held that “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 from its own fraudulent conduct.”

In reaching this conclusion, the Court also relied on the duty of good faith and fair dealing, which it also found could not be waived. It explained that a creditor continuously owes the surety this duty in all suretyship and guaranty relations. “This duty was not waived by the Guarantors in the agreement….and public policy precluded an interpretation of the guaranty agreement that resulted in the waiver of all defenses.” The Court further explained that “Public policy requires us to read Civil Code section 2856 in a manner that prevents one party from capitalizing upon its own fraud and willful misconduct.”

AUTHOR’S COMMENTARY

The age-old saying, “you can’t get a little bit pregnant” comes to mind when analyzing this case. It is clear that the Bank confronted a challenging situation in which it wanted to preserve the value of the collateral and its contractual rights in face of a default. But that is the situation with every troubled loan. A few things made this case different. First, the timing of the Bank’s decisionmaking coincided with the onset of the Great Recession and a time-period in which the original lender was only a few months away from failing and being shut down by government regulators. As such, the financial strain, the political temptations, and the desire to maximize profit was likely extreme and may have clouded the judgment of the various participants. This likely led to the second distinguishing factor, as the Bank interjected itself to a large degree in the Project. By changing specifications for interiors of the home, movement of fences, marketing requirements, it acted more like a developer, and not a lender. Third, by doing this, the Bank led everyone down a course of action in which the parties expended resources and efforts, and carried out their sense of the bargain, only to find themselves flushed away when the Bank chose to foreclose. While the Bank probably believed it held the ultimate trump card in the exercise of its contractual and statutory rights, the court did not allow the Bank to profit at everyone else’s expense. It used the evidence before it to conclude that the Borrower, Bank, Guarantors, and contractor were all in the same maze together. For this reason, the Court believed that the original construction loan agreement was effectively altered into a different bargain by virtue of the parties agreeing and performing a global strategy at the Bank’s direction that was memorialized in a key email. To allow the Bank to foreclose, and the contractor to get stiffed, would be to go too far. Although this reasoning makes sense from a “fairness” standpoint, it is always difficult precedent when a court uses fairness to rewrite a contractual bargain.

As to the exoneration of guarantors, the Court’s holding is eye-opening. Civil Code section 2856 provides that a guarantor may waive “any rights or defenses” that arise under Civil Code sections 2787 to 2855. This includes Civil Code section 2810, which exonerates a guarantor if the principal is not liable “for any reason.” This seems to be a broad authorization of waiver, including a waiver due to illegality of the underlying contract that is at odds with the Court’s holding here.

Could the Court’s holding that the guarantees did not provide a specific waiver of equitable defenses be modified through better contract drafting? Unfortunately, the Court did not set out the language of the guarantees in the decision, so it is not possible to pinpoint any pejorative scrivening. But it is doubtful that an express waiver of all legal, statutory, and equitable defenses (even to the point of identifying each potential equitable defense) would be upheld under this ruling. To do so, under the Court’s logic, would be to create a moral hazard as illegal behavior could be sanctioned, and defenses to it waived.

At bottom, market participants are urged to stick to the fundamentals. In the case of a troubled loan, the lender should avoid getting emotional, come up with a plan of action at the outset, and investigate to what extent it is feasible legally. The lawyers will need to remind the business people of what can and cannot be achieved, a difficult task given divergent case-law that is now being published as a result of the Great Recession and the ever-present desire to please a client seeking to reduce further losses. In the end, the most fruitful are those who follow common sense and remember that pigs get fat, hogs get slaughtered, and nobody likes the smartest guy in the room if it seems unfair.

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