A secured lender’s primary source of recovery when a project goes bad usually is the loan collateral. Secondary sources could be the assets of a guarantor, a surety or an accommodation party, labels that often are used interchangeably to describe a person who signed a loan document but who did not directly benefit from the loan. (See, March 23, 2007 post, Liability of Guarantors or Accommodation Parties when the Original Obligation Is Materially Altered). The April 24, 2007 decision by the Indiana Court of Appeals in John T. Irish v. F. Lawrence Woods, 2007 Ind. App. LEXIS 786 (IrishOpinion.pdf) addresses some general rules applicable to these secondary sources and also provides a good suretyship vocabulary lesson.
Backdrop. Plaintiff Irish and defendant Woods formed LLC. Lender Old National Bank loaned LLC about $500,000. Both LLC and Irish were named borrowers on the note, but Irish did not directly benefit from the loan. Only LLC did. Woods guaranteed the note and, interestingly, also signed a separate guaranty of Irish’s debt under the note. LLC defaulted but evidently was judgment proof. Irish settled with Old National for the total amount due by purchasing the note. Irish then sued Woods for the debt, claiming Woods was liable as the guarantor of the note. Irish also asserted a contribution claim against Woods based on the guaranty of Irish’s obligation under the note.
7 things to know about Indiana suretyship law.
1. A borrower is a “principal obligor” – here, the LLC. Id. at 6.
2. When a party places a signature on a note solely for the benefit of another party, and without receiving any direct benefit, he or she is an “accommodation party” – here, Irish. Id.
3. An accommodation party is considered a “surety.” When the term surety refers to a person, it is a person who is liable for the payment of a debt, or performance of a duty, of another person. Id. (The words “guaranty” and “guarantor” are synonyms for “suretyship” and “surety.” Id. at 7, n.4.)
4. The liability of an accommodation party only is relevant in the event of a default by the accommodated party. Ind. Code § 26-1-3.1-419(e). In such event, the accommodation party’s suretyship status allows him to seek reimbursement from the accommodated party. As a party with recourse against another party, the accommodation party’s suretyship status is equivalent to that of a “secondary obligor.” Id.
5. A “cosuretyship” occurs when two secondary obligors agree that, as between themselves, each should perform part of its secondary obligation or bear part of the cost of performance. The test of cosuretyship is a common liability for the same debt or burden. Id. at 8-9.
6. A “subsuretyship” occurs if two secondary obligors agree that, as between themselves, one (the ‘principal surety’ – here, Irish) rather than the other (the ‘subsurety’ – here, Woods) should perform or bear the cost of performance. Id. at 9.
7. Whether a particular party is a cosurety with, or a subsurety to, another party affects rights of contribution. The right of contribution operates to make those who assume a common burden bear it in equal proportions. In a cosuretyship, one cosurety is entitled to contribution from the other cosureties so that all cosureties bear the burden in equal, or otherwise agreed to, proportions. With regard to subsuretyships, if the principal surety performs on the obligation, it is not entitled to contribution from a subsurety. But, if the subsurety performs on the principal obligation, the subsurety is entitled to reimbursement from the principal surety. Id.
The upshot. The lender, Old National, was well-served by having Irish co-sign the note. Even though the direct beneficiary of the loan (the LLC) defaulted, Old National evidently still recovered the debt from Irish, an accommodation party. There was no need for Old National to pursue the guarantor, Woods. Because Irish anted up, Woods got off scot-free.
Irish, as principal surety, “purchased” the note for the amount of his liability and then sought to enforce the guaranty of Woods, the subsurety. But a principal surety cannot “purchase” his own debt and unilaterally create liability for a subsurety, who would not otherwise be liable. Id. at 13. The Court also determined that Woods, as guarantor of the note, only was secondarily liable. Irish, as principal surety, was primarily liable for the cost of performance on the note. In other words, in what may have been a close call for the Court, the judges ruled that the note’s co-signor (Irish) was on the hook but that the note’s guarantor (Woods) was not.