December 15, 2011
In This Issue:
- Subordination Agreement At Odds With Dragnet Clause in Mortgage
- Third Party Lender Liability in Actions Brought by a Guarantor
- Lender’s Maryland Tort Claims Dismissed Due To Virginia Choice of Law Provision
- Tip of the Month: SBA Lenders with Delegated Authority Must Register with Credit Alert Reporting System by December 31, 2011
Subordination Agreement At Odds With Dragnet Clause in Mortgage
A Massachusetts court ruled that a subordination agreement between two construction loan lenders prohibited the subordinated lender’s claim to excess proceeds from the foreclosure of the senior lender’s mortgage.
Group East Financial Services Inc. held two mortgage liens on a property. The mortgages were recorded before Butler Bank recorded two mortgages on the same property. Group East subsequently agreed to subordinate mortgage liens to the liens of Butler’s mortgages, both of which were recorded in connection with construction loans Butler made. However, both Butler mortgages contained a "dragnet" clause, whereby the mortgages secured "all other obligations of mortgagor to mortgagee, now existing or hereafter arising." The subordination agreements between Group East and Butler did not reference the dragnet clauses.
When Butler foreclosed on its second mortgage, the sale proceeds were greater than the outstanding balance of the Butler second construction loan. Group East sued Butler, claiming that it was entitled to receive the excess proceeds from the Butler second construction loan, pursuant to its security interest under Group East's two subordinate mortgages. However, at trial, Butler asserted that the dragnet clause in its mortgages also secured all amounts outstanding on the Butler first construction loan. Accordingly, Butler argued that the subordination agreements gave Butler the right to apply proceeds from the foreclosure towards the satisfaction of both Butler loans, in priority over the liens of both Group East mortgages.
The trial court ruled in favor of Butler and Group East appealed.
On appeal, the Massachusetts Court of Appeals rejected Group East's main argument—that the subordination agreements between Butler and Group East subordinating Group East’s two mortgages to the Butler second mortgage did not refer to any dragnet clause contained in the Butler second mortgage. The Court of Appeals affirmed the trial court’s decision and reasoned that Group East could not claim that it was a victim of unfair surprise because it received notice of the terms of Butler's second mortgage when Butler gave notice of its intent to foreclose the second mortgage.
This case illustrates the need for lenders to review the terms of each other's loan documents prior to entering into subordination agreements with each other.
This case is cited as Group East Financial Services, Inc. v. Butler Bank, 79 Mass. App. Ct. 1102, No. 10-P-670 (Mass. App. Ct. 03/09/11, unpublished).
Third Party Lender Liability in Actions Brought By a Guarantor
A Texas court recently dismissed a third-party action brought by a guarantor because the claim the guarantor brought against the third party was separate and independent of the lender's claim against the guarantor.
Steel Stadiums, LLC entered into an aircraft lease with Wachovia Financial Services, Inc. (which has since merged with Wells Fargo Bank, N.A.) with Sherrill Pettus, its principal, serving as guarantor. Subsequently, Steel Stadiums filed for bankruptcy and an automatic stay was imposed on all collection actions against Steel Stadiums and its property. Wachovia filed for, and was granted, relief from the automatic stay allowing it to take action against Steel Stadiums. After which, Wachovia repossessed the aircraft, accelerated the remaining rental balance and ended the lease. Wells Fargo then filed suit against Pettus for breach of his guaranty, seeking damages totaling approximately $7.9 million.
Pettus in turn brought in, or impleaded, Meridian Bank N.A. as a third-party defendant under Rule 14 of the Federal Rules of Civil Procedure. “Impleader” is used when a defending party wishes to bring another party into the lawsuit that it believes is liable to it for all or part of the underlying claim. A third-party defendant is properly impleaded when “the third party’s liability is in some way derivative of the outcome of the main claim.”
Pettus alleged that but for Meridian’s illegal management of the loans it made to Steel Stadiums, he would not have breached his guaranty obligations. Pettus asserted numerous claims against Meridian, such as breach of fiduciary duty, breach of contract, negligent misrepresentation, statutory fraud and civil conspiracy. In support of these claims, Pettus contended, among other things, that Meridian:
- Made burdensome revisions to the terms of the loans, even though Steel Stadiums was current on payments;
- Breached its duty of privacy to Steel Stadiums by publicizing the company’s financial difficulties;
- Sent letters to Steel Stadiums' customers requesting them to send all payments due to Steel Stadiums to it;
- Accelerated Steel Stadiums loans in error; and
- Brought a garnishment action in error.
The court granted Meridian’s motion to dismiss the third-party action as improper. The court found Pettus’ third party action improper because his claims against Meridian were “separate and independent, not derivative, of Wells Fargo’s claim against” him. The court explained that “Wells Fargo’s" principal claim in this case is that Pettus breached his guaranty of the aircraft lease to Steel Stadiums. In contrast, Pettus alleges in his third-party action that Meridian breached the terms and duties of separate agreements—the loans it made to Steel Stadiums and Pettus. The fundamental flaw in Pettus’ argument is that his obligations to Wells Fargo were in no way dependant on Meridian’s obligations to him.”
This case is cited as Wells Fargo Bank, N.A. v. Pettus, 2011 WL 3586405 (N.D. Tex. 08/16/11).
Lender’s Maryland Tort Claims Dismissed Due To Virginia Choice of Law Provision
The U.S. District Court for the Eastern District of Virginia dismissed a lender’s tort claims under Maryland statutory law, finding them improper in view of choice of law provisions in the closing documents selecting Virginia law.
William Finagin, Jr., the majority shareholder of the National Wrecking Corp., founded National Excavating Corp. to be a successor to NWC. After NEC’s formation, NWC transferred many projects to NEC and leased some of its equipment to NEC. Dynasty Capital Advisors suggested to Finagin that he could cash out of the business by doing a leveraged employee buyout through an employee stock ownership plan.
Dynasty valued NEC at $11.42 million. An independent valuation firm found the value of the business to be about $10.2 million. To effect the leveraged employee buyout, National Excavating Corp. Employee Stock Ownership Trust was formed to buy Finagin’s shares of NEC for approximately $10 million ($3 million in cash and $7 million in the form of a promissory note from NEC). NEC borrowed the $3 million from MainStreet Bank, signing a promissory note secured by part of Finagin’s real property and all of NEC’s assets. Prior to making the loan, MainStreet, Finagin, NEC and NWC all signed a commitment letter stating, among other things, that Virginia law would govern the loan transactions and related agreements. At closing, MainStreet and NEC (but not Finagin or NWC) signed a secured credit agreement and a promissory note, each containing choice of law provisions choosing Virginia law. Finagin’s and NWC’s role in the transaction was referenced in the loan documents even though they did not execute the documents.
NEC’s first loan payment was late, and MainStreet was notified that NEC’s business had declined significantly. NEC did not have enough cashflow to make the second loan payment and Finagin made the payment on its behalf. Shortly thereafter, MainStreet foreclosed on NEC’s equipment, machinery and real estate, but contended it was still owed $1.5 million on the promissory note. MainStreet sued, alleging four fraudulent conveyance claims under Maryland law.
Finagin and NWC moved for dismissal of the four claims, arguing that the Maryland statutory claims were improper because the commitment letter and loan documents stated Virginia law would govern. Mainstreet argued that Finagin and NWC lacked standing to enforce the choice of law provisions because they did not sign the closing documents. Finagin and NWC countered, first, that the court needed only rely on the choice of law provision in the commitment letter (which they had signed) and, second, that they had standing to enforce the choice of law provision in the closing documents as intended third party beneficiaries of the closing documents.
The court was not persuaded by Finagin and NWC’s first argument, finding the choice of law provision in the commitment letter was no longer enforceable. The court said that, even though the closing documents did not contain a merger clause, reading the commitment and the closing documents together, it was clear that “the closing document were intended to supersede and extinguish any obligations in the commitment letter.”
However, the court was persuaded by Finagin and NWC’s second argument, and found that Finagin and NWC were intended third party beneficiaries, entitled to enforce the choice of law provisions as if they were signatories to the closing documents. The court noted that nonparties generally cannot enforce contracts unless they are intended third party beneficiaries. In this case, the court said, the closing document required NEC to use the proceeds to purchase Finagin’s stock in NEC, and Finagin could have sued NEC based on covenants in the closing documents if it failed to do so, thus making them intended beneficiaries.
MainStreet also argued that even if Finagin and NWC had standing to enforce the choice of law provisions in the closing documents, the provisions were not broad enough to cover MainStreet’s tort claims. The court disagreed, noting that “where a choice of law clause in the contract is sufficiently broad to encompass contract-related tort claims, such as fraud or fraudulent inducement, courts have honored the parties’ intent to have related tort claims covered by the choice of law provision in the contract.” In this case, the choice of law provision in the note “required the parties to ‘submit to the exclusive jurisdiction of any Virginia state court or federal court sitting in the Commonwealth of Virginia with respect to any suit, action, or proceeding related to this Note.” The court found this language sufficiently broad and therefore dismissed MainStreet’s Maryland statutory tort claims.
This case is cited as Mainstreet Bank v. National Excavating Corp., No. 1:10cv1230, 2011 (E.D. Va. 06/08/11).
Tip of the Month: SBA Lenders with Delegated Authority Must Register with Credit Alert Reporting System by December 31, 2011
The Small Business Association’s SOP 50 10 5 (D) became effective October 1, 2011. One of the revisions to the SOP addressed additional procedures that delegated 7(a) lenders' need to follow regarding verification with CAIVRS as to whether any business or individuals subject to CAIVRS review were delinquent on other federal debt (which may make the loan ineligible for SBA guaranteed financing). The SBA gave delegated lenders until December 31, 2011 to meet the SOP requirements to use CAIVRS for 7(a) and 504 loans processed under delegated authority (PLP).
On November 21, 2011, the SBA released Procedure Notice 5000-1227 to assist lenders in this regard. The notice includes instructions for lenders to sign up and use CAIVRS in its 7(a) loan underwriting. Please remember that access to the system and issuance of a password are not immediate (it may take a week to ten days). It is imperative for all PLP lenders to apply for access and passwords well before the December 31, 2011 deadline in order to be in compliance with the requirements of the SOP. Also, passwords are only good for 21 days and must be reset by the lender before they expire. The lender should set up a tickler system to reset the password before it expires. The Notice is accessible via the SBA lending website at http://www.sba.gov/sites/default/files/5000-1227.pdf.
Remember, the review of delinquent federal debt extends to: (i) the borrower; (ii) any business in which an associate of the borrower owned, operated or controlled a business that incurred delinquent federal debt or caused a prior loss; (iii) any business controlled by the same person who controls the business that incurred delinquent federal debt or caused a prior loss; or (iv) any guarantor who has (or guaranteed) a delinquent federal debt or caused a prior loss. The lender should document its findings in its credit file.
For more information about the new SBA SOP, see “Summary of SBA New SOP 50 10 5(D) Changes.”
