Tag: discharge

Illinois Guaranty Law: Increasing Guarantor’ Risk or Changing the Terms = Discharged Guaranty

In Southern Wine and Spirits of Illinois, Inc. v. Steiner, 2014 IL App (1st) 123435, the First District outlined and applied the rules governing the interpretation and enforcement of written guaranty agreements in Illinois.

The plaintiff wine distributor purchased the assets of another distributor that had previously entered into a contract with a liquor store company; a contract personally guaranteed by the individual liquor store owners.

The year after the asset purchase, the plaintiff began supplying wine to the defendants’ liquor store on account.  But neither the plaintiff nor the purchased distributor informed the guarantors of the asset purchase.  Because of this, the guarantors had no idea that the assets of the distributor were sold to the plaintiff.  The defendants also didn’t know that the plaintiff now held the guaranty given by the liquor store owners to purchased distributor.

When the liquor store defaulted on about $20,000 worth of merchandise, the plaintiff sued under the guaranty signed by the liquor store owners.

The defendants moved to dismiss on the basis that the personal guaranty wasn’t assignable to the plaintiff since defendants didn’t know they were guaranteeing the liquor store’s contract obligations to the plaintiff.  The trial court agreed and plaintiff appealed.

Result: Trial court affirmed.

Rules/Reasoning:

In Illinois, a guaranty is simply a contract where a guarantor promises to pay the debts of a “principal” (the main debtor) to a third party creditor.

A guaranty is construed like any other contract and a guarantor is given the benefit of any doubts that may arise from the language of a guaranty.  A guarantor’s liability can’t exceed the scope of what he has agreed to accept and guaranties are strictly construed in favor of the guarantor; especially when the creditor drafted the guaranty.  ¶ 16. 

Guaranty agreements are generally not assignable but a guaranty can be assigned where the essentials of the original contract are not changed and the performance required under the guaranty isn’t materially different from what was originally contemplated. 

Where (1) a guarantor’s risk is increased or (2) performance is materially changed by the assignment of a guaranty or a merger involving the plaintiff-creditor, the guarantor’s obligations can be discharged. ( ¶ 18).

The Court held that because the defendants didn’t know that the guaranty was assigned to the plaintiff and because the amount owed the plaintiff fluctuated from month-to-month (in contrast to the  fixed amount the guarantors owed the original distributor), the defendants’ risk under the guaranty was materially increased by the assignment to plaintiff.

This was deemed a material change in the terms of the agreement that defendants entered into with plaintiff’s predecessor and changed defendants’ risk from known to completely unknown.  (¶¶ 21-22).

The Court also held that the trial court properly struck key parts of the plaintiff’s affidavit filed in response to defendants’ motion to dismiss.

The plaintiff filed the affidavit of its credit manager who testified that she reviewed the payment history involving the purchased distributor and the guarantors’ liquor store business.  The credit manager attached about two years’ worth of invoices and a payment ledger to her affidavit.

But the invoices didn’t  reference the prior wine distributor and only identified the guarantors’ liquor store.  The Court found that because the affidavit attachments failed to link the plaintiff directly to either the guarantor defendants or their liquor business, the plaintiff failed to lay an adequate foundation for the invoices as business records.

Take-aways:

– A guaranty agreement should specify whether or not it’s assignable and enforceable by third parties;

– Where a guaranty is assigned to a third party, the original creditor and assignee should both notify the guarantor and make it clear that the assignee creditor plans to hold the guarantor to the terms of the guaranty;

– Where an assigned or sold guaranty either changes the guarantor’s performance or materially increases his risk, for example by increasing the payment terms or frequency, the guaranty will likely not be enforceable by a third party/assignee.

Express Trusts and Bankruptcy Discharge: some Quick Hits

Adas v. Rutkowski, 2013 WL 6865417 (N.D.Ill. 2013), illustrates the confluence of Federal bankruptcy law and state law fiduciary duty and express trust principles in a case involving a failed construction partnership.

The plaintiff and bankrupt debtor (defendant) formed a partnership to buy real estate, build a house  on it and split the profits once the house was sold.

The venture failed and the plaintiff got stuck with a sizeable deficiency judgment in a lender’s foreclosure suit.  After the defendant filed for bankruptcy, the plaintiff objected to defendant’s discharge based on defendant’s lengthy pattern of keeping plaintiff in the dark about the failed venture’s finances.  The bankruptcy court agreed and the defendant appealed.

Held: Affirmed.  Defendant’s obligation to plaintiff is nondischargeable.

Rules/Reasoning:

Normally, a bankruptcy filing gives a debtor a reprieve from creditor collection efforts and forgives (or “discharges”) most of his debts. 

An exception is where the bankrupt debtor engages in fraud, defalcation, embezzlement or larceny.  11 U.S.C. §. 523.

The creditor must show (1) an express trust or fiduciary relationship between the debtor and creditor, and (2) that the debt was caused by fraud or defalcation.  Defalcation equals (roughly) intentional conduct that’s more than negligence but less than fraud.  * 4, 8.

Express Trust – State and Federal Law

The court held that the parties’ business relationship constituted an express trust. 

In Illinois, an express trust exists where (1) there is an intent to create a trust, (2) definite subject matter or trust property, (3) trust beneficiaries, (4) a trustee, (5) a specific trust purpose, and (6) delivery of trust property to the trustee. 

While trusts are normally manifested in a writing (such as a will or property deed), it doesn’t have to be and a trust can be shown through circumstantial evidence. 

The Federal courts view the trust hallmarks as (1) segregation of funds (no commingling, e.g.), (2) management of the funds by an intermediary, and (3) the entity that controls the trust funds or property has only bare legal title to the funds.  *6.

The court found the evidence established a trust arrangement between the parties.  There was an intent to create a trust, trust property (loan funds), subject matter (the house), a trustee (defendant), a beneficiary (plaintiff) and delivery of the trust property.  *5.

Fiduciary Duty

The Court also blocked defendant’s discharge because defendant breached his fiduciary duties to the plaintiff.  Federal law defines a fiduciary relationship as one where there is an imbalance of power between parties and a stronger party takes advantage of weaker one.

Here, the defendant occupied a position of power and influence over the plaintiff and abused the position by excluding the plaintiff from all aspects of the parties business. *7.

Defalcation

Finally, the Court refused to discharge defendant’s debt to plaintiff because of the defendant’s “defalcation.”  

Defalcation applies where a debtor’s conduct is intentional or criminally reckless.  The conduct must go beyond negligence, doesn’t rise to the level of fraud, but still requires subjective intent. 

Defendant’s conduct easily met the defalcation standard.  He engaged in a pattern of secretive and ethically challenged business activity by submitting inflated sworn statements and phantom receipts, commingling funds, and hiding project data from the plaintiff.   *8-9.  

Comments:

(1)  An express trust will exist where someone gives money or property to another with explicit directions as to how to apply those funds; and no writing is required;

(3) a creditor can defeat a bankrupt debtor’s discharge if it can show the debtor intentionally or recklessly violates an obligation to the creditor – even if the debtor’s conduct doesn’t rise to the level of fraud.