The Secured Lender - April 2009

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or this issue, we have chosen a troubling Illinois Appellate Court decision involving the application of the Sureties Act of Illinois to a guaranty, a Michigan bankruptcy court case in which a lender attempted to secure an interest rate swap agreement by purchasing an assignment of the underlying loan, and a Nevada bankruptcy court decision addressing effectiveness of erroneous tax lien notices. JONATHAN HELFAT AND RICHARD KOHN CFA CO-GENERAL COUNSEL

JP Morgan Chase Bank, N. A. v. Earth Foods, Inc., 898 N.E. 2d 718 (Ill. Ct. App. 2008) (Illinois Appellate Court held that a guarantor of a note was a “surety” for purposes of the Sureties Act of Illinois).

In 2001, JP Morgan Chase Bank, N. A. extended a line of credit to Earth Foods, Inc. All three of the co-owners of Earth Foods personally guaranteed the loans. By February 2004, Earth Foods was experiencing financial difficulty and stopped making payments on its loans. JP Morgan sent a notice of default and demand for payment in April 2004 and, after Earth Foods failed to make any further payments, filed suit against Earth Foods and the three guarantors.

At trial, the guarantors argued that JP Morgan could not recover from them because they were entitled to the protections afforded by the Sureties Act of Illinois (the “Act”). Section 1 of the Act provides:

When any person is bound, in writing, as surety for another for the payment of money, or the performance of any other contract, apprehends that his principal is likely to become insolvent or to remove himself from the state, without discharging the contract, 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; but no such discharge shall not [sic] in any case affect the rights of the creditor against the principal debtor.

740 ILCS 155/1 (West 2004). In other words, under the Act, a “surety” may demand immediate action on a contract for which its principal is likely to become

insolvent and, if the creditor does not “within a reasonable time and with due diligence, commence an action thereon,” and follow through to an enforcement of the judgment, the surety may be discharged. The three guarantors argued that they qualified as “sureties” within the meaning of the Act. One of the co-owner/guarantors claimed, at trial, that he had previously sent a letter to JP Morgan warning that Earth Foods was depleting its inventory (which was collateral for the loans) and demanding that JP Morgan take action. Therefore, the key issue before the court was to determine whether the co-owners were in fact “sureties” under the Act.

First, the court compared a surety and a “guarantor” as follows: whereas a surety is primarily liable through a joint and several contract with the principal, a guarantor undertakes an obligation “separate from the principal’s, and thus his liability is secondary to the principal’s.” JP Morgan Chase Bank,

N. A., 898 N.E. at 723 (internal citations omitted). The court, upon further review of the distinction, however, determined that “[b]ecause in either case the creditor will have no cause of action until the principal has defaulted, the actual difference between the primary liability of a surety and the secondary liability of a guarantor would … appear to be academic.” Id. at 724. The court then turned to the question of whether the legislature intended to exclude guarantors from the application of the Act by using the word “surety” in Section 1 of the Act. Deciding that the stated purpose of the Act was to compel diligence by a creditor to make certain a surety is protected against loss, the court concluded that the intent of the legislature was to apply the Sureties Act to sureties and guarantors alike.