By: Lyndsey A. Torp and Sean M. Sherlock
A general waiver by a guarantor of “all defenses” does not actually waive “all defenses.” California Bank & Trust v. Del Ponti, — Cal.Rptr.3d —, 2014 WL 6908141 (Cal.App. 4 Dist.). That was the holding in a recent opinion wherein the California Court of Appeal affirmed judgment against a lender, holding that the bank could not recover on its loan guaranties because it had breached the underlying loan agreement.
In California Bank & Trust v. Del Ponti, borrower obtained a construction loan from Vineyard Bank (which was later assigned to California Bank & Trust) to develop a townhome project, with guaranties from two principals of the borrower. When the market tanked the loan-to-value ratio exceeded 75%, creating an event of default under the loan. The bank stopped funding payment applications, but the bank did not provide a notice of default to the borrower. Instead, the bank engaged in negotiations with the borrower and general contractor, documented in numerous e-mails, in an attempt to mitigate the parties’ losses.
The bank eventually foreclosed on the project, and sued the guarantors for the deficiency. The general contractor sued the borrower and the bank. The trial court awarded judgment in favor of the general contractor, finding that some of the bank’s e-mails during workout negotiations constituted promises and agreements that the bank had breached. Further, the trial court found that by refusing to fund the loan the bank breached the loan agreement, thus exonerating the guarantors. The Court of Appeal affirmed.
The Court of Appeal found that there was substantial evidence to support the trial court’s finding that the bank materially breached the loan agreement by refusing to honor four payment applications that had been approved. Because the loan agreement required the bank to give the borrower a notice of default and 15 days to cure upon any event of default, the bank was not justified in refusing the payment applications, and thus had breached the loan agreement. In addition, the bank led the guarantors to believe they would be released from liability if they performed all items listed in the summary email from the bank.
The bank did not challenge the trial court’s factual findings, but instead argued that judgment was in error because the guarantors waived all of their defenses under the guaranty agreements. The Court of Appeal disagreed. Civil Code section 2856 provides that any guarantor or other surety, including a guarantor of a note secured by real property, may waive rights and defenses that would otherwise be available to the guarantor. But “a guarantor cannot be held liable where a contract is unlawful or contravenes public policy.”
The Court of Appeal found the waiver at issue was a pre-default waiver of the bank’s own misconduct, which was not expressly waived in the guaranty agreement. While Civil Code section 2856 permits a guarantor to waive certain legal and statutory defenses as specified in the code, the Court of Appeal would “not read Civil Code section 2856 to permit a lender to enforce pre-default waivers beyond those specified, where to do so would result in lender’s unjust enrichment, and allow the lender to profit from its own fraudulent conduct.” The Court of Appeal agreed with the trial court “that public policy precluded an interpretation of the guaranty agreement that resulted in a waiver of all defenses.” Rather, in applying the rule of strict construction, the Court of Appeal held “that a guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement.” The Court of Appeal refused to deem a waiver of statutory defenses as a waiver of all defenses, “especially equitable defenses, such as unclean hands, where to enforce the guaranty would allow a lender to profit by its own fraudulent conduct.” (Emphasis in original.)
The case provides two valuable lessons. First, it underscores the importance of making careful, measured responses when a loan goes into default. These include the need for a timely notice of default, pre-negotiation letter, and clear reservations of rights. Second, lenders should be aware that broad waiver language in guaranty agreements may be applied narrowly, and may not effectively waive “all defenses.” Given the holding in California Bank & Trust limiting waivers to only legal or statutory defenses particularly set forth in the guaranty, in drafting guaranties, lenders should be sure to specify particular defenses to be waived, including equitable defenses.