We Cannot Rewrite Contracts When The Economy Suffers A Severe Downturn.

December 9, 2011

By Antonio P. Garcia, Jr., Esq.

As the title suggests, a strained economy often is accompanied by strained interpretations of contracts. Such was the case encountered by the California Court of Appeal, Third Appellate District in Gray1 CPB, LLC v. Kolokotronis, No. C064954 (December 2, 2011).

Guaranty or Demand Note?

A guaranty is a promise to answer for the debt, default, or miscarriage of another person, and one who makes such a promise is a guarantor. In Gray1, Kolokotronis signed a contract entitled "Continuing Guaranty" through which he agreed to pay for a borrower's real property-secured debt in the event the borrower failed to pay. The loan documents specifically stated that the lender extended credit to the borrower because of the Continuing Guaranty, and that Kolokotronis was responsible for the loan if the borrower could not pay it. The borrower defaulted on the loan. The promissory note evidencing the loan eventually matured, but neither the borrower nor Kolokotronis did anything to cure the default. The lender subsequently assigned the promissory note to Gray1. Instead of suing the borrower or foreclosing on the property, Gray1 chose to pursue Kolokotronis for breach of the Continuing Guaranty. Gray1 prevailed at the trial court.

On appeal, Kolokotronis argued that Gray1 could not pursue him first for the amount due because the Continuing Guaranty was not a guaranty but actually was a "demand note" (a note that was payable whenever the creditor wanted to be paid). Essentially, Kolokotronis argued that he was not a guarantor of the loan, but was an original obligor of the loan. The consequences of his position were 1) the demand note was protected by California's anti-deficiency statutes and one-action rule, and 2) he could not have waived his right to compel a lender to foreclose on the security first before pursuing him for the debt.

What Are California's Anti-Deficiency Statutes And One-Action Rule?

California Code of Civil Procedure Sections 580a through 580d constitute the anti-deficiency statutes. These laws prohibit secured lenders, under certain circumstances, from pursuing a borrower personally for the unpaid balance of the borrower's secured debt (the "deficiency") when the proceeds from a foreclosure sale do not fully pay the amount of the debt.

California Code of Civil Procedure Section 726a provides the one-action rule. Under this law, a secured lender is prohibited from pursuing any judicial cause of action, such as suing a borrower directly, without first foreclosing on the real property that was pledged to secure a loan. In addition, a lender could bring only one action against the borrower, and the result of that action must be used as the main source to repay the loan.

Hence, if the Continuing Guaranty was construed to be a demand note, then as a primary obligor Kolokotronis would be protected by these laws and Gray1 could not pursue him first for a judgment.

The Court's Interpretation of the Contract

The Third District affirmed the judgment. The appellate court found that this was a case concerning the meaning of the Continuing Guaranty. The court first pointed out some basic rules of contract interpretation. When interpreting a contract, the court's role was "simply to ascertain and declare what is in terms or in substance contained therein, not to insert what has been omitted, or to omit what has been inserted . . . ." In addition, the court emphasized that "a contract must be interpreted so as to give effect to the mutual intention of the parties, and the whole of a contract is to be taken together, so as to give effect to every part, it reasonably practicable, each clause helping to interpret the other."

Using these principles, the Third District evaluated the Continuing Guaranty's plain language. The court found that Kolokotronis agreed to guarantee the loan to induce the lender to extend credit to the borrower. The Third District also noted that Kolokotronis' liability was coterminous to the borrower's liability, that his pledge was unconditional, and that it was continuing. Further, Kolokotronis agreed to waive certain rights and defenses, such as the right to require Gray1 to proceed against the borrower and the right to have any security for the loan first applied to satisfy the debt. This waiver meant that the lender could collect from Kolokotronis without first foreclosing on the real property. The agreement also expressly acknowledged that the borrower's obligations were independent of the guarantor's obligations. Consequently, Gray1 could bring a separate action against Kolokotronis, against the borrower, or any other guarantor for the unpaid debt.

To support his position, Kolokotronis relied upon three phrases in the Continuing Guaranty. He pointed to the language ""whether due or not due," "on demand," and "not contingent upon and are independent obligations of the Borrower" to show evidence of an intent by the parties to create a demand note. For example, the language "due or not due" suggested that the Continuing Guaranty was a demand note because while the borrower was not obligated to pay off the loan for two years under the promissory note's terms, he was obligated to pay the full amount of the loan "from day one, long before it was due." In Kolokotronis' view, his obligation to pay before the borrower was obligated to pay meant that he was an original obligor, not a guarantor, of the loan.

The Third District found Kolokotronis' argument unavailing. First, the Continuing Guaranty stated that the credit to be extended was to the borrower, not Kolokotronis. Kolokotronis also ignored the essential feature of the contract, which was a guaranty relating to the future liability of the principal. Hence, Kolokotronis guaranteed the borrower's future obligations and liabilities under the loan before actual performance was due. Second, the "due or not due" language had to be read in the context of the parties' agreement that Kolokotronis would cover the borrower's obligations at the time the Continuing Guaranty was executed and for any future credit extended by the lender. The language meant that Kolokotronis was obligated to answer for future debts assumed by the borrower. Third, the phrase "on demand" meant that Kolokotronis' obligation to pay did not arise until the lender demanded that Kolokotronis step in to answer for the borrower's debt. Finally, the phrase "not contingent upon and are independent obligations of the Borrower" provided the lender with the option to enforce the Continuing Guaranty following the borrower's default without first securing a judgment against the borrower. Hence, "[b]y reading the document as a whole, and giving force and effect to every clause and every word, it is clear the Continuing Guaranty is, in both form and substance, a guaranty."

The Third District concluded that Kolokotronis' interpretation would have the court "render meaningless many of the provisions of the written agreement" and violate the court's duty "to give effect to every part of the contract, considered as a whole."

The Lesson Learned In Gray1

Gray1 is a straightforward example of the importance of using precise language in a contract to demonstrate the intent of the parties to a transaction. Kolokotronis could not get around the precise language in the Continuing Guaranty that spelled out the rights he waived and his obligations to the lender. However, if the guaranty had been drafted poorly, then a court could have adopted Kolokotronis' strained interpretation of the contract, and he would have escaped the obligations he had agreed to perform before the economic downturn occurred.

So if you contemplate entering into a contract or become embroiled in a dispute over the meaning of a contract, then you should seek the guidance of attorneys who would analyze the contract, fully inform you of your contractual rights and obligations, advise you of any defenses to which you would be entitled, and warn you of the potential legal problems that lie ahead.