When a guarantor becomes aware that the borrower is at risk of defaulting under the loan, the guarantor’s natural inclination might be to keep his mouth shut and hope the problem works itself out. However, a recent Illinois case demonstrates just the opposite: it may be better to inform the lender as to the facts and demand that it take immediate action.
Leonard DeFranco (“DeFranco”) was one of three guarantors of a line of credit provided in 2001 by JP Morgan Chase Bank (“Lender”) to Earth Foods, Inc. (“Borrower”), of which DeFranco was an owner. Prior to Borrower’s default under the line of credit, DeFranco sent the Lender a letter in which he warned that Borrower was dissipating its inventory, which was pledged as collateral to Lender. In his letter, DeFranco demanded that the Lender take action.
Borrower defaulted on its obligation to the Lender in February 2004. Lender sent a notice of default to Borrower and to the guarantors, including DeFranco, in April 2004. Soon after, Borrower transferred its assets to a third party, and Lender filed suit against the guarantors in June 2004.
DeFranco took the position that he was entitled to the benefit of Section 1 of the Illinois Sureties Act (the “Act”), which provides in pertinent part:
When any person is bound, in writing, as surety for another for the payment of money . . . apprehends that his principal is likely to become insolvent . . . if a right of action has accrued on the contract, he may, in writing, require the creditor to sue forthwith upon the same; and unless such creditor, within a reasonable time and with due diligence, commences an action thereon, and prosecutes the same to final judgment and proceeds with the enforcement thereof, the surety shall be discharged . . . .
DeFranco claimed that his guaranty should be discharged based on the Lender’s failure to take prompt action to prevent the Borrower from selling off its inventory without using the proceeds to pay down the line of credit due to the Lender. The trial court disagreed, pointing out that DeFranco was a guarantor, not a surety, and therefore not entitled to invoke the Act to discharge his guaranty obligation.
On appeal, DeFranco argued that the distinction between a surety and a guaranty was purely technical. The Lender took the position that the Legislature should have included guarantors in the Act if it intended a guarantor to avail itself of the remedy. The Appellate Court acknowledged there is an academic distinction: a surety is primarily liable for the debt on the same basis as the original obligor, whereas a guarantor becomes liable secondarily, i.e., only after the original obligor does not pay. But, after reviewing the practical implications, the legislative history of the Act, the fact that the distinction is blurred even within the legal community, and the fact that guarantors are a subset of sureties, the Appellate Court held that DeFranco could claim the protection of the Act. In November 2008, the Appellate Court remanded the case to the trial court where the judge will ultimately determine whether the facts of the case will result in a discharge of DeFranco’s guaranty.
Representation of borrowers and lenders is a routine part of our practice. If you need advice as to the actions to be taken in anticipation of a default or with respect to a guaranty, please do not hesitate to contact us.