Indiana Appellate Court Issues Pro-Creditor Decision Construing Personal Guaranty

In Smith v. M&M Pump & Supply, Inc.,¹ the Indiana Court of Appeals, Indiana's intermediate appellate court, upheld a trial court's grant of summary judgment that a personal guaranty of a corporate borrower's debt executed by an officer of the borrower was enforceable against the officer.

The court's decision illustrates several fundamental points about guaranties under Indiana law.

Background

In 2011, David Smith was employed as a coal mine superintendent for Lily Group, Inc. Lily executed a credit agreement with M&M Pump & Supply, Inc. Smith signed the agreement on behalf of Lily. The credit agreement was unsecured. In his individual capacity, Smith also signed a section of the credit agreement that provided that he personally guarantied the debt under the credit agreement, as well as all debts arising under any invoices owing from Lily to M&M (in addition to providing credit, M&M also supplied mining equipment to Lily).²

Lily defaulted on its payment obligations to M&M, and M&M filed suit against Lily and Smith in 2012. Lily then entered into an agreed judgment with M&M and subsequently filed for bankruptcy. The trial court granted summary judgment to M&M against Smith in the amount of $63,913.26, which included attorneys' fees, costs and prejudgment interest.

Smith appealed. The appellate court affirmed.

Analysis

On appeal, Smith made four arguments: (i) that he was not bound by the terms of the guaranty because he did not receive adequate consideration; (ii) that the trial court should not have entered summary judgment until it was determined in Lily's bankruptcy proceedings that Lily would not pay the debt; (iii) that M&M failed to perfect a security interest in the equipment sold to Lily and impaired the value of collateral that could have mitigated the guarantied debt; and (iv) that the trial court erred by holding him liable for attorneys' fees and prejudgment interest. This client alert will address each in turn.

A. Consideration.

In Indiana, a guaranty is like other contracts in that, to be enforceable against the guarantor as a matter of contract law, the guarantor must have received consideration—something in exchange for the promise to guaranty the underlying obligation. However, if the guaranty is entered into at the same time as the underlying obligation, consideration exists even if the guarantor does not derive any benefit from the underlying contract or the guaranty.³ The court in M&M Pump & Supply found that there was no dispute that Lily (the primary obligor) had received adequate consideration for entering into the credit agreement with M&M, and therefore no additional consideration was necessary for Smith's guaranty to be enforceable under these circumstances.⁴

We note that, in addition to whether consideration exists in order for a guaranty to be valid under contract law, a separate issue may exist under fraudulent conveyance statutes, which may be relevant whether or not the guarantor is the subject of bankruptcy proceedings. Although the M&M Pump & Supply court did not examine this issue, it can be a much more significant issue than whether the guarantor received consideration for contract law purposes. Under Section 548 of the Bankruptcy Code, a guaranty may be set aside as a fraudulent conveyance if (i) the guarantor was insolvent at the time the guaranty was executed or was rendered insolvent as a result of such guaranty⁵ and (ii) the guarantor did not receive "reasonably equivalent value" in exchange for the guaranty.⁶ Note that both elements must exist for a guaranty to be set aside; if one element is not present, the guaranty may not be avoided as a fraudulent conveyance. Thus, if the guarantor were solvent after taking into account the guaranty, whether the guarantor received "reasonably equivalent value" would be irrelevant. On the other hand, if the guarantor were insolvent at the time the guaranty was given, it would be necessary for a court to determine whether the guarantor had received "reasonably equivalent value." The Bankruptcy Code does not define "reasonably equivalent value." A full analysis of what would constitute such value is beyond the scope of this client alert, but we note that indirect and intangible benefits may be considered,⁷ and that courts will generally examine whether such value was received as of the time the guaranty was entered into.

B. Delaying Enforcement of the Guaranty During the Pendency of The Principal Obligor's Bankruptcy Proceedings.

Smith argued that it was improper for the trial court to have entered summary judgment against him during the pendency of Lily's bankruptcy proceedings for the reason that, until such proceedings had been completed, it had not been determined that Lily, as the primary obligor, would not pay the amount owed. The court noted that the terms of the guaranty permitted M&M to demand payment from Smith upon Lily's payment default. Therefore, M&M did not have to wait for Lily's bankruptcy to be completed before enforcing its rights under the guaranty.

Although the court did not characterize it in this manner, what Smith seemed to be alleging was that his guaranty was a sort of guaranty of collection rather than a guaranty of payment. In general, a guaranty of collection requires the creditor to first pursue remedies against the primary obligor before being able to pursue the guarantor for any amount left unpaid after its pursuit of remedies against the primary obligor.⁸ However, for a guaranty to constitute a guaranty of collection, the guaranty should clearly say so.⁹ Smith's guaranty did not.

The rules governing the interpretation and construction of contracts generally apply to the interpretation and construction of a guaranty in Indiana.¹⁰ There was nothing in Smith's guaranty that supported the interpretation that he proposed. Therefore, M&M was entitled to demand payment when the guaranty specified, upon the primary obligor's payment default.

C. Impairment of Collateral.

Smith argued that M&M failed to take a purchase-money security interest in the equipment it sold to Lily, and thereby impaired the value of collateral that could have been applied to the underlying debt.

Because a guarantor is subrogated to the rights of the creditor against the primary obligor with respect to the underlying obligation upon the creditor being paid in full, any collateral that the primary obligor pledges to the creditor protects the guarantor. For this reason, one of the many suretyship defenses traditionally available to guarantors has been a defense if the creditor impairs the value of any collateral that secures the primary obligation, whether by failing to perfect a security interest or otherwise, on the grounds that such impairment harms the guarantor's recourse.¹¹

However, it is clear that the impairment of collateral defense applies only in situations where the underlying obligation is secured. Here, as the court noted, the underlying obligation was not intended to be secured. The court held that M&M could not have impaired the value of collateral that it did not have. M&M also did not have an obligation to take collateral in this case.

Although not discussed by the court, we note that the impairment of collateral defense is one that a guarantor may waive prospectively.¹² It is good practice for creditors to include such waivers in their guaranty documents. Note that merely stating that a guaranty is "unconditional" will not suffice as such a prospective waiver.¹³ A guarantor may also consent to any impairment at the time it occurs.¹⁴ It is also good practice for a creditor to obtain guarantor consents or reaffirmations at the time of any release of collateral or other modification of the primary obligation.

D. Scope of Guarantied Obligations.

Smith argued that the trial court erred by holding him liable for attorneys' fees and prejudgment interest. Smith argued that the agreement only allowed M&M to collect such amounts from Lily.

The credit agreement clearly provided that Lily was obligated to pay all costs of collection if Lily failed to pay, as well as interest on the amount borrowed, and the terms of Smith's guaranty provided that he would pay any amount owed by Lily. The court also referred to a 1935 case decided by the Court of Appeals, Smith v. Ostermeyer Realty Co.,¹⁵ where the court held that a guarantor was liable to pay attorneys' fees where the underlying contract contemplated payment of attorneys' fees, despite the fact that the guaranty itself did not specifically refer to attorneys' fees.

The M&M Pump & Supply court concluded that the trial court did not err by holding Smith liable for these amounts. This result is sensible; the primary obligor was liable to pay all costs of collection (including any such costs involved in pursuing a guarantor), and the guarantor had therefore guarantied the payment of such costs.¹⁶ Nonetheless, creditors may wish to draft their guaranties to clearly cover costs of collection against the guarantor.

Final Observations

The court's decision in M&M Pump & Supply serves as a useful reminder to creditors in Indiana about several basic points of the law applicable to guaranties. Lenders in Indiana may wish to consider their documentation practices for guaranties in light of this decision.

Footnotes

^{1 2015 WL 4647143 (Ind. Ct. App. August 6, 2015).}

^{2 That section provided as follows:}

^{The individual who signs below personally guarantees to M & M Pump & Supply Company, Inc. that if the Business Organization identified above fails to pay any of the amounts owed either under an invoice or under this Agreement, the individual will pay to M & M Pump & Supply Company, Inc. that amount owed within 30 days after written demand is received from M & M Pump & Supply Company, Inc. The individual who signs below understands that credit would not be extended without this guarantee and waives any right to notice of default or presentment.}

^{3 See Jackson v. Luellen Farms, Inc., 877 N.E.2d 848, 858-9 (Ind. Ct. App. 2007); Vanek v. Ind. Nat'l Bank, 540 N.E.2d 81, 84 (Ind. Ct. App. 1989), aff'd 551 N.E.2d 1134 (Ind. 1990). This rule is consistent across many states, and is consistent with Section 88 of the Restatement (Second) of Contacts and Section 9 of the Restatement (Third) of Suretyship & Guaranty.
Note that, with respect to the liability of an accommodation party on a negotiable instrument, no consideration is required. Indiana Uniform Commercial Code ("UCC") §3.1-419(b). However, to be an "accommodation party" with respect to a negotiable instrument, a person must be a party to the instrument itself; if the party guaranties the instrument in a separate document, it is not an accommodation party and the general law of suretyship would apply to determine the rights and duties of the guarantor. See Indiana UCC §3.1-419(a); Official Comment to 3 to UCC §3-419. Among other things, an "accommodation party" is a party that signs a negotiable instrument "without being a direct beneficiary of the value given for the instrument. . . . ." Indiana UCC §3.1-419(a).}

^{4 Note that the rule finding consideration in the underlying obligation would not apply if the guaranty was entered into subsequent to the underlying contract. See Luellen Farms, supra, at 859. In such a case, in order for the same consideration used to support the underlying obligation to serve as consideration for the guaranty, one of five conditions must exist: "(1) The guaranty was executed pursuant to an understanding had before and was an inducement to the execution of the principal contract; or (2) The guaranty was delivered before any obligation or liability was incurred under the principal contract; or (3) The guaranty was made pursuant to a contract provision; or (4) The principal contract does not become operative until the execution of a guaranty; or (5) The guaranty expressly refers to a previous agreement between the principal debtor and creditor which is executory in its character and embraces prospective dealings between the parties." Id. (citing Merchants Nat'l Bank & Trust Co. of Indianapolis v. Lewark, 503 N.E.2d 415, 417 (Ind. Ct. App. 1987), transfer denied).}

^{5 "Insolvent" is defined in 11 U.S.C. §101(29)(A). We note that it is common for creditors to include savings clauses in their guaranties that limit the liability of the guarantor to an amount that would avoid its insolvency in order to mitigate the risk of fraudulent transfer avoidance.}

^{6 11 U.S.C. §548(a)(1)(B). In addition to the avoidance power under 11 U.S.C. §548, under the "strong-arm" power given to the bankruptcy trustee under 11 U.S.C. §544(b), the trustee may use state fraudulent transfer law to attack guaranties. Trustees frequently do so, in part because the statute of limitations applicable to state fraudulent transfer laws can be longer than under the Bankruptcy Code provision.}

^{State fraudulent transfer laws include Ind. Code § 32-18-2-1 et seq., which is derived from the Uniform Fraudulent Transfer Act. Note that, in 2014, the National Conference of Commissioners on Uniform State Laws amended the Uniform Fraudulent Transfer Act in certain respects, including changing the name of the model statute to the Uniform Voidable Transactions Act. The Indiana version of the statute has not been amended to reflect the 2014 amendments as of the date of this client alert.}

^{Under Ind. Code §§32-18-2-14 and 32-18-2-15, a guarantor must receive "reasonably equivalent value" for its guaranty.}

^{7 See, e.g., In the Matter of Xonics Photochemical, Inc., 841 F.2d 198, 201 (7th Cir. 1988); In re Image Worldwide, Ltd., 139 F.3d 574, 578 (7}th Cir. 1998).

^{8 See Restatement (Third) of Suretyship & Guaranty §15(b) (specifying that a "guaranty of collection" exists "if the guarantor's obligation is, upon default of the principal obligor, to satisfy the obligee's claim with respect to the underlying obligation, if: (1) execution of judgment against the principal obligor has been returned unsatisfied; or (2) the principal obligor is insolvent or in an insolvency proceeding; or (3) the principal obligor cannot be served with process; or (4) it is otherwise apparent that payment cannot be obtained from the principal obligor"). With respect to negotiable instruments, a definition similar to the Restatement definition of a guaranty of collection has been codified in Section 3.1-419(d) of the Indiana UCC. Note that even under a guaranty of collection, the creditor could enforce the guaranty when the primary obligor became insolvent or entered into an insolvency proceeding; it would not need to wait until the insolvency proceeding had concluded before proceeding against the guarantor.}

^{9 Cf. Section 3.1-419(d) of the Indiana UCC (indicating that an accommodation party's signature on a negotiable instrument must be "accompanied by words indicating unambiguously that the party is guaranteeing collection rather than payment" in order for the guaranty thereof to be a guaranty of collection). Article 3 of the UCC is limited by its terms to negotiable instruments. Under Indiana law, guaranties that are not included on negotiable instruments are interpreted under the common law. Farmers Loan & Trust Co. v. Letsinger, 652 N.E.2d 63, 65 (Ind. 1995). However, note that Official Comment 2 to Section 3-104 of the UCC states that in cases not involving negotiable instruments, "it may be appropriate, consistent with the principles stated in [UCC §1-103], for a court to apply one or more provisions of Article 3 to the writing by analogy, taking into account the expectations of the parties and the differences between the writing and an instrument governed by Article 3. Whether such application is appropriate depends upon the facts of each case." We are not aware of an Indiana court having so applied Article 3 to a guaranty whereby the guarantor did not sign a negotiable instrument as an accommodation party. Official Comment 2 also states that the parties to a non-negotiable instrument "may provide by agreement that one or more of the provisions of Article 3 determine their rights and obligations. . . ."}

^{10 S-Mart, Inc. v. Sweetwater Coffee Co., Ltd., 744 N.E.2d 580, 585 (Ind. Ct. App. 2001).}

^{11 See, e.g., Letsinger, 652 N.E.2d at 66-67; Cole v. Loman & Gray, Inc., 713 N.E.2d 901, 904 (Ind. Ct. App. 1999). Cf. Section 3.1-605(d) of the Indiana UCC, with respect to negotiable instruments. As to subrogation generally, see Indiana UCC §3.1-419(f) ("An accommodation party who pays the instrument . . . is entitled to enforce the instrument against the accommodated party") and Official Comment 5 to UCC §3-419 ("Since the accommodation party that pays the instrument is entitled to enforce the instrument against the accommodated party, the accommodation party also obtains rights to any security interest or other collateral that secures payment of the instrument"); see also Restatement (Third) of Suretyship & Guaranty §27.}

^{12 See Restatement (Third) of Suretyship & Guaranty §48 and (with respect to negotiable instruments) Section 3.1-605(f) of the Indiana UCC. In the Letsinger case, supra, the Indiana Supreme Court found that the guarantors in that case had not waived the impairment of collateral defense, but noted that waivers of such defense were "quite common." Letsinger, 652 N.E.2d at 67 n.3.}

^{13 See Letsinger, 652 N.E.2d at 67 n.3; Cole, 713 N.E.2d at 904 n.2.}

^{14 We note that any advance waiver will not be effective to waive rights that the guarantor may have that arise in connection with any enforcement against collateral under Article 9 of the UCC, to the extent such defenses cannot be waived under Article 9. See Official Comment 9 to UCC §3-605.}

^{15 197 N.E. 743 (Ind. Ct. App. 1935).}

^{16 In reaching its conclusion on this issue, the court also quoted some language from S-Mart, supra ("'The terms of a guaranty should neither be so narrowly interpreted as to frustrate the obvious intent of the parties, nor so loosely interpreted as to relieve the guarantor of a liability fairly within its terms.' S-Mart, Inc., 744 N.E.2d at 585-86.")}

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