Impairment Of Collateral Defense Denied

If your financial institution is seeking to collect a business debt from a guarantor that is asserting an “impairment of collateral” defense, the recent decision by the Northern District of Indiana in LEAF Funding v. Brogan, 2009 US Dist. LEXIS 65203 (N.D. Ind. 2009) (Leaf.pdf) should help you understand the defense and help you convince the guarantor that the defense may not apply. 

The situation.  Plaintiff LEAF, equipment lessor (lender), sued defendant Brogan, equipment lessee, for breach of a medical equipment lease.  Dines, also a named defendant, was the guarantor of the lease.  Brogan had defaulted on the lease for a failure to make payments.  LEAF had been unable to repossess the equipment, as allowed under the lease, because Brogan’s landlord had changed the locks to Brogan’s plant.  And a court order arising out of a separate state court lawsuit froze all of Brogan’s assets, which order contributed to LEAF’s inability to repossess the equipment.

The argument.  Dines’ only contention in response to LEAF’s motion for summary judgment was that LEAF impaired the collateral (the equipment) when LEAF “failed to take timely possession of and to promptly liquidate the leased property after Dines made two phone calls to LEAF requesting that LEAF make arrangements to come and retrieve the Equipment.”  Dines sought to be discharged from liability.

The defense, generally.  LEAF identified several Indiana points of law applicable to the defense:

 The guarantor’s liability [could be] discharged if the facts establish that the creditor’s conduct unjustifiably impaired the collateral securing the debt.

 The guarantor has the burden of proving the impairment (damage/loss of value), and impairment to the collateral is a necessary element of the defense.

 When a creditor releases or negligently fails to protect security put in his possession by the principal debtor, the surety is released to the extent of the value of the security so impaired.

Indiana case law focuses on the conduct of the creditor.  The creditor (the plaintiff) must have acted improperly and caused harm to the collateral.  Absent a reduction in value of the collateral attributable to the creditor, the defense will not apply.  The Court also cited to the UCC at Ind. Code § 26-1-3.1-605(g), which says that impairing value of an interest in collateral includes:

 (1)  failure to obtain or maintain perfection or recordation of the interest
 in collateral;
 (2)  release of collateral without substitution of collateral of equal value;
 (3)  failure to perform a duty to preserve the value of collateral owed,
 under IC 26-1-9.1 or other law to a debtor or surety or other person
 secondarily liable; or
 (4)  failure to comply with applicable law in disposing of collateral.

No discharge.  While some Indiana cases suggest that the guarantor’s debt can be fully discharged upon proof of the defense, in actuality Indiana law provides that the guarantor will only be released “to the extent of the value of the security so impaired.”  Indiana favors a “pro tanto [for so much] approach that measures the amount of the impairment at the time of default” as opposed to allowing for a complete discharge of any liability.

Not applicable in LEAF.  After taking inventory of Indiana’s rules and policies applicable to the impairment of collateral defense, the Court in LEAF concluded that the defense should fail and that Dines remained jointly and severally liable to LEAF for the damages resulting from Brogan’s breach.  The inaccessibility of the collateral was not the result of actions taken or caused by LEAF, which was unable to repossess the equipment due to circumstances outside of its control.  Moreover, the lease specifically provided that Brogan had an obligation to deliver the equipment to LEAF upon default.  LEAF had no duty to retrieve the equipment at Brogan’s request.  Finally, none of the UCC § 605(g) elements were present in LEAF. 

Guarantors in lien enforcement cases may try to duck or delay collection efforts by asserting the impairment of collateral defense when, in my view, the defense should only apply in very limited circumstances in which the plaintiff/lender/creditor has actually caused harm to the collateral while the collateral was in its possession or control.