Guarantor Strikes Out With Defenses To Guaranty

Defenses to liability under a guaranty are few and far between in Indiana.  General Electric Capital v. Delaware Machinery, 2011 U.S. Dist. LEXIS 53897 (S. D. Ind. 2011) (.pdf) illustrates this. 

Set up.  The General Electric opinion dealt with a lender’s motion for summary judgment against a guarantor.  In 2003, the lender and the borrower entered into a master lease agreement that obligated the borrower to make payments on certain equipment in eighty-three monthly installments.  The lender obtained a guaranty in connection with the master lease agreement.  In 2009, the borrower failed to make lease payments, so the lender accelerated the amounts due and filed suit against the guarantor.  The Court concluded that, under the unambiguous language of the guaranty, the guarantor was liable to the lender for the borrower’s obligations.  (The opinion quotes the operative language of the guaranty.) 

The guarantor asserted three arguments as to why, despite the language in the guaranty, he should not be liable: 

Fraudulent inducement.  The guarantor’s first argument was that the lender fraudulently induced him to enter into the guaranty through representations that the master lease agreement would constitute a lease agreement, and not a purchase or security agreement.  The lender countered that fraudulent inducement based on misrepresentations “of the legal effect of a document” are not recognized in Indiana.  Indiana law generally recognizes fraudulent inducement as a defense to a contract, but one exception to the rule is:

when the representation at issue, though false, relates to the legal effect of the instrument sued on.  Every person is presumed to know the contents of the agreement which he signs, and has, therefore, no right to rely on the statements of the other party as to its legal effect.

Since the alleged characterization of the subject contract was a question as to the contract’s legal effect, the guarantor had no right to rely on the alleged misrepresentations of the lender.  Strike one.

Judicial estoppel.  The guarantor’s second defense was that the lender was judicially estopped from claiming damages for more than the amount claimed in the complaint.  In Indiana, “judicial estoppel prevents a party from pursuing a theory incompatible with its original theory in the same litigation.”  The opinion sets out three factors to be considered by courts, including whether the party’s later position was “clearly inconsistent” with its earlier position.  In its complaint, the lender stated that “at present, the amount due . . . totals not less than $279,074.43.”  In its subsequent motion for summary judgment, the lender sought over $415,000.00.  The operative language in the lender’s complaint was “at present.”  The guarantor could not show that the lender’s current position was “clearly inconsistent” with its position in the complaint.  Strike two. 

Indemnification.  The guarantor’s third contention was that he should not be liable due to the lender’s failure to perfect its security interest.  According to the guarantor, “this amounts to seeking indemnification for [lender’s] own negligence in failing to perfect.”  (Evidently, the equipment was not available as a source of recovery.)  The guarantor argued that, had lender perfected its interest, the lender could have sold the subject equipment for in excess of $500,000.00 and therefore covered all of the lender’s alleged damages.  The Court focused on the language of the guaranty, which provided that guarantor’s obligations were not affected by the borrower’s “failure to . . . perfect and maintain a security interest in, or the time, place and manner of any sale or other disposition” of the equipment.  Thus the express terms of the guaranty entitled the lender to recover damages regardless of its failure to perfect its security interest.  Strike three.

Language in guaranties usually rules the day.  That certainly was the case in General Electric.  The defenses asserted by the guarantor, although creative, ultimately did not defeat the lender’s summary judgment motion.

Lender And IRS Battle Over Rental Income

I previously wrote about the priority of federal and state income tax liens on title to mortgaged real estate.  Generally, an Indiana mortgage lien on title to real estate will trump a tax lien, assuming the lender recorded the mortgage before the taxing authority recorded its lien.  The recent decision in Bloomfield State Bank v. United States of America, 644 F.3d 521 (7th Cir. 2011) involved a priority dispute over rental income arising out of the mortgaged real estate. 

Rents.  In Bloomfield, the borrower, who defaulted, granted the lender a mortgage on the borrower’s real estate plus “all rents . . . derived or owned by the Mortgagor directly or indirectly from the Real Estate or the Improvements” on it.  The IRS filed its 26 U.S.C. § 6321 lien for taxes against the subject real estate several years after the lender recorded its mortgage but before the filing of the foreclosure suit.  The receiver, during the pendency of the foreclosure case, decided to rent some of the real estate and collected about $80,000 in rents. 

Contentions.  The IRS claimed that its tax lien took priority over the mortgage lien on the rentals because they were received after the filing of the tax lien.  The argument of the IRS focused on 26 U.S.C. § 6323(h)(1), which gives a mortgage interest in rentals priority over a tax lien only if the property secured by the mortgage was “in existence” when the federal tax lien was filed.  The IRS asserted that the relevant property was the rentals – which did not exist at the time the federal tax lien attached.  The lender, on the other hand, claimed that the relevant property was the real estate - which did exist 

What existed and when?  The Court sorted through the “existence” issue:

The “property” that must be in existence for a lender’s lien to take priority over a federal tax lien is the property that, by virtue of a perfected security interest in it, is a source of value for repaying a loan in the event of a default; it is not the money the lender realizes by enforcing his security interest.

The Court reasoned that there essentially is no difference between lien-enforcement proceeds taken the form of sale income versus rental income.  “To say that a parcel of land is ‘sold’ rather than ‘rented’ just means that the owner sells the use of the land forever rather than for a limited period.”  In Bloomfield, the real estate that generated the subject rental income existed when the borrower granted the mortgage (and thus before the tax lien attached).  The rental income was proceeds of the such property, which preexisted the tax lien.

Not like A/R.  The result would have been different had accounts receivables been the lender’s collateral.  The Court noted that a security interest in accounts receivables does not exist and thus does not trump a subsequently-filed federal tax lien “until a buyer of goods or services from the grantor of the security interest becomes indebted to the grantor.”  If the lender in Bloomfield did not have a mortgage on its borrower’s real estate, but just a lien on rentals, then until the rentals were received “the property on which the bank had a lien would not have come into existence.”  Instead, the lender had a lien on the real estate.  The rentals provision in the mortgage “created a perfected security interest in rentals received at any time.”  Ind. Code § 32-21-4-2(c).  The Court said:

By virtue of the rental-income provision in the mortgage, the bank had a separate lien on the rents, but that is not the lien on which it is relying to trump the tax lien.  The lien on which it is relying is a lien on the real estate.  If an asset that secures a loan is sold and a receivable generated, the receivables become the security, substituting for the original asset.  The sort of receivable to which the statute denies priority over a federal tax lien is one that does not match an existing asset; a month’s rent is a receivable that matches the value of the property for that month.

The lender thus prevailed in its priority dispute with the IRS.  Bloomfield reminds us that, generally, Indiana is a “first in time is first in right” state.  More specifically, the opinion points out that in Indiana a mortgage attaches, not only to the land and improvements, but also to any proceeds from the sale or rental of the real estate. 

What Is A Vendor’s Lien?

Workout professionals and their foreclosure counsel often encounter unexpected liens on, or claims to, the subject real estate.  One of the purposes of my blog is to identify such liens and discuss recent Indiana case law dealing with them.  Wachovia v. Dune Harbor, 2011 Ind. App. LEXIS 712 (Ind. Ct. App. 2011) is one such case, and the opinion teaches us about a “vendor’s lien,” something that we certainly don’t encounter every day.

Setup.  If you are interested in learning about the convoluted facts, circumstances and cast of characters in Wachovia, I recommend that you read the opinion.  Here is how the Court summarized the case and the issue:

This case involves lenders who contend priority for their liens in the foreclosure of a failed real estate development project  . . ..  [Lender] appeals from a trial court’s summary judgment in favor of Lefty’s Co-Ho Landing, Inc. (“Lefty’s”).  [Lender] raises four issues for our review, of which we find the first dispositive and restate as:  whether a vendor’s lien was created in favor of Lefty’s and in force when [Lender]recorded its mortgages. 

Lien for unpaid purchase price.  The Wachovia Court articulated Indiana’s general rules related to this uncommon claim against real estate:

Ordinarily a vendor (seller) of realty has an implied lien for the amount of the unpaid purchase price.  A vendor’s implied lien, as distinguished from a lien expressly reserved, or from the security which the vendor has while he holds the legal title under an unexecuted contract to convey, is the equitable right, which by implication is accorded to one who has conveyed the title to land without reserving a lien thereon, and has taken no security for the purchase money other than the personal obligation of the purchaser, to subject the land in equity to the payment of the purchase price.  The lien is not dependent on any agreement between the parties other than the contract to pay the purchase money, and it is presumed to exist in all cases in which such a lien is allowed by law in the absence of a showing of an intent to the contrary.

In Wachovia, the alleged vendor’s lien arose out of an exercised option to purchase real estate.  The heart of the case involved an examination of the option’s language, or lack thereof, and the actions or inactions of the parties in the wake of its execution.

Created upon transfer.  As noted in Wachovia, a vendor’s lien is created “when title to land is transferred before payment is completed . . ..”  Under such circumstances, “the seller has lent money to the buyer in the form of a purchase-money mortgage, and the seller retains an automatic security interest in the property.”  The creation of a vendor’s lien occurs “at the moment the seller of the land completes a transfer of title to the buyer and the purchase price or a portion thereof remains unpaid.”  It’s like an invisible mortgage. 

Unrecorded, and thus problematic.  The Court confirmed that, to be effective, a vendor’s lien does not need to be recorded:

We also acknowledge the controversy surrounding vendors’ lien law, particularly the relatively unique characteristic that vendor’s liens need not be recorded to be effective . . ..  The Seventh Circuit Court of Appeals has commented on a related quandary:  “[t]he doctrine [of a vendor’s lien] arbitrarily advances the vendor over the vendee’s other creditors, and complicates real estate financing.  It has been abolished in a number of states, but not in Indiana.”

Release?  Once created , a vendor’s lien “may be expressly or impliedly abandoned or extinguished, thereby cutting off any future obligations to the vendor.”  The Wachovia opinion wrestled with whether the vendor’s lien had been abandoned or extinguished before the date of the lender’s mortgages.  The inquiry is fact sensitive. 

Wachovia holding.  Genuine issues of fact remained as to whether a vendor’s lien was created in favor of Lefty’s, and if so, whether it was abandoned or extinguished before Lender recorded its mortgages.  Due to the claimed vendor’s lien, the Court remanded the case for trial.  I’m sure the Lender never expected such a mess when it made its loan. 

Liens Arising Out Of Sewer Connection Penalties

In 2008, I wrote about the Indiana Supreme Court’s decision in Pinnacle Properties v. City of Jeffersonville, which related to delinquent sewer fee liens.  In Baird v. Lake Santee Regional Waste and Water District, 2011 Ind. App. LEXIS 535 (Ind. Ct. App. 2011), the Court of Appeals addressed liens for sewer connection penalties.  There are many different debts that can lead to a lien against real estate, and a sewer connection penalty, not unlike a sewer fee, is one such debt.

The dispute.  In 1999, the Lake Santee Regional Waste and Water District (“District”), an Indiana municipal corporation formed under I.C. § 13-26, adopted three ordinances requiring owners of real estate to discontinue use of septic tanks and to connect to a sewer system.  The ordinances established connection fees and corresponding penalties for the failure to connect.  Defendant Baird did not connect to the sewer system.  The District assessed statutory penalties and later recorded liens on her real estate.  The District then filed a complaint to foreclose the liens that eventually led to the Baird opinion. 

Broad powers.  Baird contested the District’s scheme on constitutional due process grounds.  I’ll spare you the technical analysis.  Essentially, the Court in Baird held that a municipality’s liens against property for utility fees are constitutional.  The Court concluded that there is no significant difference between unpaid penalties for failure to connect to a sewer system and unpaid sewer fees.  I.C. § 13-26, including specifically §§ 5-2, 12, and 14-1, established the District’s right to set up penalties, impose liens and foreclose.  The ordinances, including the $25 per-day penalty, were “rationally related to [legitimate legislative goals of public health, safety and welfare].” 

Priority.  Unlike Pinnacle Properties, Baird did not deal with the issue of priority, namely whether the liens maintain a super priority status.  I am currently involved in a case where another such district has asserted similar penalties and has claimed that its liens have priority over our client’s mortgage lien.  Although the law is not 100% clear, there appears to be a solid argument that liens of this nature are treated like delinquent real estate taxes so as to hold senior lien status.  (See my October 24, 2008 post for more.) 

Unlike sewer lien fees, which typically are fairly nominal, these connection penalties can become quite substantial given their per-day calculation.  In a foreclosure scenario, unless a third party acquires the property at the sheriff’s sale, as a practical matter lenders will get stuck with these penalties.  Secured lenders in Indiana should proceed with their eyes wide open accordingly.