By: Ben Reeves
Believe it or not, lenders can breach loan agreements too…and when they do, there can be significant consequences. In Great Western Bank v. LJC Dev., LLC, 726 Ariz. Adv. Rep. 21 (Ariz. Ct. App. Nov. 10, 2015), the Court of Appeals affirmed that guarantors’ “lost profits” resulting from the lender’s breach of a loan agreement completely offset the amount owed under the guaranty. Much can be learned from this unusual outcome, so please continue reading for an analysis of the facts and legal principles of this case.
The Loan Agreements
In Great Western Bank, the bank entered into an acquisition and development loan (the “A&D Loan”) with Cedar Ridge Investments, LLC (“Borrower”) to allow Borrower to acquire and begin the development of infrastructure for a fifty-home subdivision in Flagstaff, AZ to be known as Cedar Ridge. The A&D Loan was entered into in May 2007.
In January 2008, Borrower entered into a second agreement with the bank to fund the actual construction of homes (the “Agreement”). By its own terms, the Agreement expired on December 1, 2008. Both the A&D Loan and Construction Loan were supported by guarantors.
The Bank Decides to Cease Funding Construction Loans
In July 2008, the bank made an internal decision to cease all construction financing in Arizona. Accordingly, the bank advised Borrower that it “was withdrawing from the Agreement.” Id. at ¶ 4. Things only got worse from there.
The Borrower attempted to obtain alternative financing but, as will come to no surprise to those of us who were familiar with credit markets in 2008, was unable to do so. The bank ultimately foreclosed, took back the property, and sold it to another developer.
The Bank Sues for a Deficiency, But Guarantors Counterclaim
The bank then sued the guarantors to recover an alleged deficiency of approximately $2.6 million. The guarantors, however, filed a counterclaim asserting that the bank’s refusal to fund the Agreement constituted an anticipatory repudiation of the contract, breached the covenant of good faith and fair dealing, and gave rise to damages for lost profits that otherwise would have been used to pay off the loan.
The Evidence at Trial Shows that the Bank Breached
At trial, the bank argued that the Agreement did not obligate it to fund the construction of homes. Rather, it contended that the Agreement was merely a “guidance line” that left the decision of whether to fund, or not fund, the construction of any individual home up to the bank’s sole and absolute discretion. The trial court concluded that the bank’s argument was contradicted by the plain language of the Agreement. The Court of Appeals agreed, holding that “the Agreement was as much a loan agreement, i.e., a contract binding on its signatories to the lending and borrowing of money, as any loan agreement ever written, notwithstanding Borrower’s obligation to provide certain information to [the bank] before it could make a draw.” Id. at ¶ 14. Thus, the bank’s unilateral decision to “withdraw” from the Agreement breached its obligation to fund.
The Evidence at Trial Establishes Lost Profits
The guarantors went on to prove that the breach caused them damages in the form of lost profits. Three findings of fact established the guarantors’ right to lost profits.
- First, evidence at trial showed that notwithstanding the bank’s termination of the Agreement in July 2008, Borrower remained current until October 2008 and that the bank’s own records showed that Borrower’s progress on construction in August 2008 was “acceptable.” Id. at ¶ 26. Thus, the trial court found that the Borrower would have and could have performed but for the bank’s breach.
- Second, evidence also showed that notwithstanding the automatic expiration of the Agreement in December 2008, it would have been in the bank’s economic interest to extend the loan if the parties were performing. Thus, the trial court found that the bank “would have continued its arrangement with Borrower” such that Borrower would have had sufficient time to sell all the homes but for the bank’s breach. Id. at ¶ 30.
- Third, evidence showed that home sales in Flagstaff remained consistent throughout 2009 and that the Cedar Ridge development would have provided lower-cost homes in an underserved market. Thus, the trial court concluded that the Borrower would have made a profit on each home at somewhere between $42,320 and $70,000 – which in the aggregate amounted to somewhere between $2,808,000 and $3,500,000 in lost profits. Id. at ¶ 37.
Guarantors Prevail at Trial
Because the lost profits exceeded the amount of the asserted deficiency, the trial court found that the guarantors “were the prevailing parties, having ‘effectively recovered $3.1 million, absolving them of their liability’ to [the bank], and awarded [the guarantors] their attorneys’ fees and double their taxable costs[.]” Id. at ¶ 7.
Guarantors Prevail on Appeal
Although the bank disputed these findings of fact on appeal and argued that they were, at best, speculative, the Court of Appeals declined to disturb the trial court’s rulings. Thus, the Court of Appeals affirmed on all fronts and – again – awarded the guarantors their fees and costs for the appeal.
Conclusions and Take Away Points
There are a couple of interesting things to note about this decision. First, lenders should know what their agreements say and allow them to do. As the opinion confirms, the court will hold both the borrower and the lender to the terms of the contract. Second, while the notion that anyone could have made a profit by developing homes in Arizona in 2008 is somewhat baffling to those of us that lived through the Great Recession, the trial court’s conclusion was supported by evidence (from the bank’s own appraiser nonetheless) in the record – and therefore very unlikely to be disturbed on appeal. See id. at ¶ 38. The determination of lost profits, therefore, serves as a stark reminder that – as counterintuitive as it may seem – evidence of damages can be used to offset an otherwise large deficiency.
 The trial court ruled that Restatement (First) of Security § 133(1941) allowed the guarantors to claim any offset of the Borrower’s claim, and neither party contested this issue on appeal. Thus, the case does not stand for the proposition that all guarantors are entitled to claim lost profits of the borrower in all situations.