More Mistaken Moments

Last month I discussed how a mistake in a Contract can destroy it. This month I present Part Two.

On December 15, 2008, David Duckworth borrowed $1.1 million from the State Bank of Toulon. The bank’s loan officer prepared loan docs.

The Note was dated and signed December 15, 2008, but the Security Agreement was dated two days earlier – December 13, 2008. The Note referenced the Security Agreement. But the Security Agreement had a critical mistake. It stated that it secured a Note dated December 13, 2008. Not December 15, 2008.

There was no Note dated December 13, 2008.

David Duckworth filed a Chapter 7 bankruptcy petition, and the Trustee defended the Bank’s position that the mistaken date did not defeat the Bank’s secured position. The bankruptcy court issued two decisions in favor of the Bank, essentially validating the Bank’s collateral position.

The Trustee appealed both decisions to the US District Court, where the appeals were assigned to different judges. Both district judges affirmed, and the Trustee again appealed.

The Trustee’s basic argument was that extrinsic testimony (we call this “parol evidence”) should not used to correct the mistake in the Security Agreement. And that the Bank’s error should not be overlooked.

The Bank claimed an enforceable security interest, and even if there was a mistake it was readily apparent to anyone who had reviewed the papers. And, that it was a minor error. Also, that there was no question but that the Bank had loaned Duckworth $1.1 million, Duckworth had signed a Note and Security Agreement, Duckworth had defaulted and filed bankruptcy, and the Bank needed to seize its collateral under its Security Agreement.

The US Court of Appeals reviewed the Security Agreement and concluded that the Security Agreement could not secure the December 15 Note. The Court then further concluded that although the parol evidence rule could have fixed the mistake as between the Bank and Duckworth, the same legal theory could not be used against the bankruptcy trustee to correct the error.

The Appellate Court reasoned that bankruptcy trustees are in the unique position of maximizing the recovery of unsecured creditors. To assist in the job, trustees exercise a “strong-arm power,” which allows them to avoid secured interests that a subsequent creditor could have avoided.

Further, bankruptcy trustees  may “. . . void security interests because of defects that need not have misled, or even have been capable of misleading, anyone.”

And so the US Appellate Court determined that the mistaken identification of the debt to be secured cannot be corrected against the US bankruptcy trustee by using outside-the-contract testimony or evidence. The judgments of both US District Courts were reversed. The Trustee wins as the debt is converted from secured to unsecured; the Bank loses its collateral.

See In Re: David L. Duckworth; State Bank of Toulon v. Charles E. Covey, Trustee; No. 1:13-cv-01258-JBM and 1:13-cv-01087-JES; US Court of Appeals, 7th Circuit; November 21, 2014.

Lessons learned:

1.         Proofread your Leases, Contracts, correspondence, emails, texts, listings, buyer and tenant rep agreements, brokerage contracts, commission agreements, everything. Read it all closely. Then wait at least one hour before you read it again.

2.         Catch a mistake somewhere, even a minor one? Fix it now via an Amendment. If the previous doc was recorded (think Deed, Memo of Lease, Deed of Trust, etc.), then be sure the Amendment is also recorded.

3.         Practice Point: On the really important stuff, enlist the help of a buddy to proofread too.

Reprinted with the permission of North Texas Commercial Association of REALTORS®, Inc.

Indemnity Equals Guaranty

Michael Smuck and Edwin White wanted to purchase an apartment complex known as “The Falls,” located generally in the southeast quadrant of I-30 and Loop 820 in Fort Worth. They formed a special purpose entity (SPE) called MBS-The Falls, Ltd. for that purpose, and yet another SPE to serve as the general partner of MBS-The Falls.

To acquire the apartments, MBS-The Falls signed a $9 million note, deed of trust, security agreement and other loan docs pledging the real estate. Wells Fargo Bank became the owner of the loan docs through an assignment.

The loan provided for non-recourse financing. As such, the liability of MBS-The Falls was limited to its equity in the apartment complex, unless a non-recourse exception was triggered. The non-recourse exceptions that could impose liability upon MBS-The Falls were listed in the Note.

MBS-The Falls defaulted on the Note, and Wells Fargo foreclosed. Wells Fargo filed suit in Tarrant County alleging waste and that the owner allowed liens to be filed against the property, which impaired the value of Wells’ collateral.

At trial in Tarrant County, Wells Fargo obtained a judgment against MBS-The Falls for $10+ million. With that judgment in hand, Wells Fargo then sued Messrs. Smuck and White in Harris County for that amount. Wells Fargo claimed that Smuck and White were 100% liable for the judgment obtained in Tarrant County against the owner of the apartments.

The basis for Wells’ Harris County lawsuit is contained in a document signed personally by Smuck and White captioned “Non-Recourse Indemnification Agreement.” In that agreement both Smuck and White agreed to indemnify the lender for all losses incurred.

Smuck argued that he would be liable to Wells Fargo only if a third-party asserted a claim, and not merely if Wells Fargo had incurred losses.

White claimed that the judgment rendered in Tarrant County was not based on the non-recourse exceptions, and further that Wells Fargo failed to establish that any non-recourse exceptions had been triggered.

The Harris County court agreed with Smuck and White. Wells Fargo appealed.

The Harris County Court of Appeals first looked at the Indemnification Agreement. Despite the terminology of “Indemnity,” the Court had little problem concluding that it was essentially a “Guaranty,” for which Smuck and White were jointly and severally 100% liable for all losses suffered by Wells Fargo.

And from there it wasn’t difficult for the Court of Appeals to toss out all the secondary arguments used by Smuck and White.

The Harris County Court of Appeals reversed the trial court’s judgment. Wells Fargo won; Smuck and White lost.

See Wells Fargo Bank, N.A. v. Smuck and White; No. 14-12-00574-CV; Texas 14^th Court of Appeals, July 9, 2013.

Lessons learned:

1.   It’s easy to be lazy and not carefully read loan docs, leases and contracts; goodness knows they are as boring as watching a little league baseball game. In August. In Texas. With a 4p start time. The only surprise here is that Smuck and White were able to convince a trial court that the Indemnity Agreement they signed did not impose liability on them for Wells Fargo’s substantial losses.

2.  Don’t assume that non-recourse means no liability can be imposed. There is a new theory being used across the nation right now that even diminishment in value caused by recessionary market conditions can impose personal liability. Most of us don’t think that was the real purpose of non-recourse, “bad boy” or “carve out” provisions but at least some Courts do not agree.

3.  Come see me at the NTCAR Commercial Real Estate Expo on August 28 at the Sheraton in downtown Dallas, and tell me how I can approve these articles and what I should write about. I’ve got a booth!


Reprinted with the permission of North Texas Commercial Association of REALTORS®, Inc.