Guarantors are treated like the fools in Tennessee. In fact, courts often reference the well settled princple that "the fool with the pen is entitled to no mercy." In short, a guarantor has very few defenses to an action by the creditor. Fraud in the inducement is always a good one; however, Tennessee courts state the the lender does not have a duty to provide information. What happens when the borrower commits fraud on the lender, and the lender keeps lending money even though it knows about the fraud. That is the question in this case.
The facts are simple. The two guarantors were the owners of a trucking business. The business obtained a line of credit loan secured by accounts receivable. To draw money on the line, the company submitted draw requests that included a certification of the amount of the outstanding accounts receivable.
The owners sold the business. At the time of the sale, the balance owed on the loan was $1.5 million and the values of the accounts receivable was $1.8 million. Rather than payoff the loan, the owners allowed the loan and their guaranties to remain in place.
Rather quickly after the sale, the business ran into financial trouble. To keep the company alive, the president submitted false reports to the bank about the accounts receivable. At some point, the bank discovered that these reports were false. The bank continued to lend money to the company even though it knew that these reports were false.
Ultimately, the bank stopped lending money and the company ceased to exist. Predictably, the bank sued the guarantors for payment of the loan. In response, the guarantors asserted fraud by the bank (presumably in continuing to lend money) and breach of the implied covenant of good faith and fair dealing.
After extensive discussion of procedural issues, the court of appeals held that the findings of fact made by the trial court were contradictory and entered an order remanding the case. Thus, the court of appeals did not reach the merits of the case.
The problem is this. Guarantors are fools. Under well-settled Tennessee law, banks do not have an obligation to communicate with guarantors. There is no assertion that the bank lied to the guarantors about the loan or the collateral value of the loan. More importantly, so what? If there was fraud, that fraud was by the borrower on the bank. The bank was free to waive that fraud without contacting the guarantors. And, that is exactly what the bank did. Further, once the bank became aware that the draw requests were false, there was no longer fraud. So whether or not the company defrauded the bank is irrelevant to the issue of the enforcement of the guaranties.
Further, the court of appeals remanded the case as there was no findings of fact on the covenant of good faith and fair dealing. That covenant does not apply to guaranties -- or does it?
This decision creates a number of questions for banks even though it is all dicta. Specifically, does a lender owe a duty to the guarantor to stop lending to the borrower:
a. when the lender knows that the borrower is lying about a material fact?
b. when the lender knows that the borrower cannot repay the debt and is merely digging a bigger hole?
c. when the lender knows that the debt is increasing beyond the amount that the guarantor would have owed at a prior date?
THIS CASE SIGNALS A POSSIBLE MAJOR CHANGE IN TENNESSEE LAW.
See Securamerica Business Credit v. Schledwitz and Lynch.
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