August 2010
Our
Professionals
Welcome to the Commercial Lending Bulletin, a newsletter published by the Commercial Lending Group at Lerch,
Early & Brewer as a service to our clients. Here, you will find articles written by our attorneys covering a variety
of current legal issues as they affect lending
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Lawrence G.
Lerman
Chair
In This Issue:
Email
301-657-0163
Stated Per Annum Interest Rate Trumps Terms Providing for Calculation on 365/360 Basis
In a split decision, an Ohio Appellate Court found that the terms of a note relating to the method of
interest calculation did not permit the lender to charge interest in excess of the stated per annum rate.
Ambiguous Loan Application Language Stalls Collection of Fees
A recent case from Washington State illustrates the need for specificity when entering into commitments
for related loan transactions. At issue is whether a set of three loans applied for by the borrower should
be considered a single loan transaction or three independent transactions.
Account Control Agreement Protects Lender from Loss
Joel S. Aronson
Email
A lender was entitled to a judgment against a brokerage firm for its losses when it showed that the
brokerage firm made false representations in the account control agreement about the securities’
current value.
301-347-1276
Tip of the Month: Confession of Judgments and Arbitration
Stated Per Annum Interest Rate Trumps Terms Providing for Calculation on
365/360 Basis
Cindi E. Cohen
Email
Many promissory notes provide that interest will be calculated on a 365/360 basis – that is, by
applying the ratio of the annual interest rate over a year of 360 days, multiplied by the outstanding
principal balance, multiplied by the actual number of days the principal balance is outstanding. This
can result in an effective annual interest rate that is higher than the stated annual rate in the note. In
a split decision, an Ohio Appellate Court found that the terms of a note relating to the method of
interest calculation did not permit the lender to charge interest in excess of the stated per annum
rate.
301-657-0169
In this case, Ely Enterprises, Inc. obtained a loan from FirstMerit Bank, N.A. in the principal amount of
$373,593.10. The promissory note contained both a heading and a section entitled “Promise to Pay”
that set forth the principal amount of the loan and an interest rate of “11% per annum.” However, the
section of the note entitled “Payment” stated that the annual interest rate would be computed on a
365/360 basis and also that the loan was to be repaid in 84 monthly payments of $6,428.30, with a
final payment of all principal and accrued interest not yet paid. Ely Enterprises filed suit in the Cuyahoga
County Court of Pleas, alleging that FirstMerit breached the contract by assessing the interest using the
365/360 basis because it created an effective annual interest rate of 11.153%.
FirstMerit filed a motion to dismiss the case for failure to state a claim, arguing that application of the
365/360 method of interest calculation is permitted by law and unequivocally required by the terms of
the note. Ely Enterprises argued that, under the note, it was impermissible for FirstMerit to charge more
Arthur F.
Lafionatis
Email
301-657-0731
than the stated per annum interest rate of 11%. The trial court granted FirstMerit’s motion to dismiss.
Reversing, the Court of Appeals of Ohio first focused on the meaning of the term “per annum, ” which
was undefined in the note. The court noted that the failure to specifically define a term does not
necessarily make that term ambiguous. Rather, undefined words in a written document are to be given
their ordinary meaning unless manifest absurdity results, or some other meaning is clearly evidenced
from the face or overall contents of the instrument. “Per annum,” the court said, is ordinarily defined as
“by the year,” which is generally understood to mean 365 days. First Merit argued that the parties
intended to modify the meaning of “per annum” in the note by agreeing to use the 365/360 method.
However, the Court was not persuaded, finding that the provision regarding the 365/360 method did not
clearly evidence an intent to alter the meaning of “per annum” or to create an annual interest rate other
than the stated rate of “11% per annum.”
Alison W. Rind
Email
301-657-0750
FirstMerit also argued that the note showed the parties agreement to compute the interest using the
365/360 method because it stated that Ely Enterprises would make 84 monthly payments of $6,428, a
provision that can be given effect only by applying the 365/360 method. Citing Hamilton v. Ohio Savings
Bank, Ely Enterprises argued that ambiguities in a contract, such as the internal inconsistency in the
note as to the interest rate term, should be resolved by the court. The court agreed and found the
promissory note to be ambiguous in that the calculation and the monthly payment amount were
inconsistent with the more specific terms of principal and stated interest rate. The Court concluded that,
on these facts, FirstMerit was not entitled to dismissal for failure to state a claim and sent the case back
to the trial court.
Justice Colleen Conway Cooney wrote a dissenting opinion, finding that the note clearly set forth the
method for calculating the annual interest and that use of the 365/360 basis was both legal and agreed
to by the parties. Justice Cooney also found the Hamilton case to be “easily distinguishable” because it
involved contradictory documents and genuine issues of fact as to what information was disclosed to
consumers of mortgage loans. In contrast, this case involved a substantial loan to a corporate borrower
and the only document at issue unambiguously stated how interest would be calculated.
Arnold D.
Spevack
This case is cited as Ely Enterprises, Inc. v. FirstMerit Bank, N.A., (2010-Ohio-80).
Email
301-657-0749
Ambiguous Loan Application Language Stalls Collection of Fees
A recent case from Washington State illustrates the need for specificity when entering into
commitments for related loan transactions. At issue is whether a set of three loans applied for by the
borrower should be considered a single loan transaction or three independent transactions after both
parties refused to close. The court found implicit ambiguity in the respective applications for the
subject loans and remanded the case back to the lower court for further findings of fact.
David E. Kay
Email
301-657-0724
The borrower, The Senator, LLC, owned three commercial properties, the Cascade, the Senator and the
Savoy. All three properties were cross-collateralized to secure two outstanding loans: a $900,000 loan
from Fairway Commercial Mortgage and a $1.62 million loan from Aspen Yak LLC. Both loans were
maturing in December 2007.
Senator applied for three interest-only loans from Hoss Mortgage Investors, Inc. (HMI) in July 2007 with
three separate loan applications: a $1.6 million loan secured by the Cascade, a $1.2 million loan secured
by the Senator, and a $850,000 loan secured by the Savoy. Each loan application provided that “[HMI]
has not committed to make a loan and is under no obligation to grant borrower a loan . . . until all
exhibits are delivered to HMI’s satisfaction and the senior loan committee has given its written
approval.” Further, paragraph E of each application provided that “in the event that borrower should fail
or refuse to complete the transaction or to clear title to the real property to enable HMI to close the loan
within 30 days from the date hereof, borrower shall be liable [for HMI’s expenses].”
The day following its execution of the loan applications, Senator also executed deeds of trust on the
three properties in HMI’s favor and a HUD Settlement Statement reflecting the Aspen and Fairway loan
Patricia A.
Lankenau
Email
301-657-0748
payoffs, the proceeds of the three HMI loans, and a surplus to Senator in the approximate amount of
$690,000. In August, Senator also wrote a letter to HMI explaining that its planned use of the proceeds
from the three loans would include payoffs of the Aspen and Fairway loans, with the balance going
towards closing costs and capital reserves.
Following Senator’s loan application submissions, HMI sought investors to buy securities backed by
Senator’s commercial loans. Due to the disrepair of the Cascade property, it could find an investor only
for the loans secured by the Senator and Savoy properties. Centurion Financial Group, LLC agreed to
invest $1.7 million to fund the HMI loans secured by the Senator and the Savoy, on the condition that
its lien be secured by a first priority deed of trust.
In late October 2007, Senator demanded that HMI promptly close and fund the three loans or release
the deeds of trust on its three properties. HMI then agreed to fund the $1.2 million Senator loan and the
$850,000 Savoy loan, but declined to fund the $1.6 million Cascade loan for lack of an investor.
Michael D. Smith
Email
301-657-0166
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HMI never funded any of the loans and never released the deeds of trust. Senator likewise refused to
finalize any of the loan transactions and withheld escrow monies. Thereafter, HMI sued Senator for
breach of contract and breach of warranty and sought to recover its expenses under paragraph E of the
respective loan applications. Senator filed two motions for partial summary judgment. The trial court
granted one of Senator’s motions for partial summary judgment based on its finding that, as a matter of
law, HMI and Senator bargained for three loans to fund a single loan transaction. Accordingly, Senator
did not breach its agreement with HMI as HMI did not carry out its end of the bargain. HMI appealed.
HMI contended that an issue of material fact existed as to whether it agreed to fund the three loans as a
single transaction. HMI’s position was that it contemplated three separate loans. It pointed out that the
loan applications contained no language indicating that the three loans were co-dependent. Rather,
there were three separate loan applications, for loans in three separate amounts, secured by three
separate properties. Further, the express terms of the loan applications provided that HMI was under no
obligation to grant a loan unless and until Senator satisfied all requirements and the loan was approved
by HMI’s loan committee.
Senator countered that extrinsic evidence proved that HMI knew of Senator’s intentions to pay off the
maturing loans with the collective HMI loan proceeds, and that it would be absurd to find that Senator
would proceed with less than all of the requisite HMI funds to remove prior financing. Similarly,
requiring Senator to clear title before receiving money for a refinance would be inherently unreasonable.
The court determined that it was necessary to ascertain HMI’s knowledge of the level of Senator’s
existing debt from the outset as paramount in deciding whether their agreement was to fund three loans
as a single transaction. The reasonableness of Senator contracting to clear title for a refinance and to
pay substantial fees in the event of a breach was in issue. Therefore, a question of material fact existed
that made the trial court’s grant of summary judgment erroneous. The court found an additional issue of
material fact in that paragraph E was ambiguous as to whether the 30-day period was intended to run
from the date of the loan application or the date of final loan approval. The trial court was directed to
make further findings as to what the parties intended as to the beginning point of the thirty-day closing
period. The court reversed the trial court’s decision and remanded the case back for trial of the material
issues of fact, namely, the parties’ intentions regarding the structure and timing of the loan transaction(s).
Providing counsel
What does the Senator case mean for other commercial lenders? The case demonstrates the wisdom of
to bank and non-
clarity and specificity in the negotiation and drafting of loan applications and commitments. Particularly
in instances in which consummation of companion loans is contemplated in order to satisfy the
bank lenders in
closing
government
guaranteed loans
under the 7(a),
504, B&I and
borrower’s financial objectives, the loan application or applications should clearly specify the “package”
nature of the deal (if that is in fact the parties’ agreement).
This case is cited as Hoss Mortgage Investors, Inc. v. The Senator, LLC, (Wash. Ct. App. 02-20-10).
“piggyback” loan
programs.
Account Control Agreement Protects Lender from Loss
Providing our
clients with the
necessary
resources to deal
constructively with
problem loans and
the
Lenders often will allow borrowers to pledge their securities accounts as collateral for loans. Under
the Uniform Commercial Code, a lender may perfect its security interest only by entering into an
“Account Control Agreement” with the brokerage firm handling the securities. In this case, a lender
was entitled to a judgment against a brokerage firm for its losses when it showed that the brokerage
firm made negligently false representations about the securities’ current value in the account control
agreement.
implementation of
creative loan work-
The U.S. District Court for the Western District of Kentucky found a securities broker liable for breach of
out arrangements.
contract amounting to nearly $3 million because the broker failed to verify funds in an account pledged
as collateral for a loan prior to entering into the Account Control Agreement with the lender.
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Transactions
On December 21, 2005, Schneider Consulting, LLC borrowed $3 million from Fifth Third Bank. Shaun
Schneider and Chandra Schneider pledged as collateral securities held in a brokerage account managed
by Lincoln Financial Securities Corporation, which Schneider had fraudulently represented as containing
a balance in excess of $3.2 million. On December 29, 2005, Schneider delivered a check to Lincoln’s
representative for $2.8 milion, which was used by Lincoln’s clearing firm to purchase securities
deposited into the account at issue. In order to perfect Fifth Third’s security interest in the account, Fifth
Third required Lincoln to sign an Account Control Agreement. After some post-closing negotiations,
Lincoln signed an Account Control Agreement on January 10, 2006 stating that i) the account had been
established; ii) the total market value in the account was at least $3.211 million; iii) no distributions had
been made between January 3 and January 10, 2006; and iv) it was unaware of any claims against the
account. Lincoln further released its rights to the account and agreed that any trades made in the
account would be subject to the waiver. The agreement effectively restricted transfers out of the
account but permitted normal trading within the account.
After Lincoln recorded the $2.8 million deposit and purchased securities using those funds, the $2.8
million check was returned for insufficient funds. On January 16, 2006, Schneider deposited another
check that also was returned. At this point Lincoln ordered the cancellation of the trades and adjusted
the account balance down to $450,000 pursuant to its rights under the brokerage agreement between it
and the Schneiders. Schneider Consulting then defaulted on its loan from Fifth Third, which, on February
3, 2006, directed Lincoln to liquidate the balance of the brokerage account as per the Account Control
Agreement. Unable to pay the full amount of the expected funds because of the bounced checks, Lincoln
paid Fifth Third a total of $466,308.01 sometime in 2007. Fifth Third filed suit claiming that Lincoln had
breached the Account Control Agreement by misrepresenting the account balance and cancelling trades
without Fifth Third’s permission. Fifth Third requested a judgment for the difference between the
amount it would have received had the trades not been cancelled and the amount it actually received,
plus interest.
Lincoln defended, claiming that the amount represented to be in the account was true as of, and only
for, the dates indicated. Lincoln further claimed that it had not breached the Account Control Agreement
by adjusting the value of the account to reflect its true value because the adjustment was not a
payment, withdrawal, claim or setoff, all of which were prohibited by the Account Control Agreement
and because the clearinghouse, not it or Schneider, owned the securities in question while awaiting the
deposit by Schneider. The court disagreed with Lincoln, stating that Lincoln had indeed breached the
Account Control Agreement either by misrepresenting the amount of funds in the account or, contrary to
its rights under the account control agreement, “asserting a claim against the account to compensate
itself” or the clearinghouse for the bad check. The court stated that, contrary to Lincoln’s assertion, its
ruling did not convert Lincoln into a guarantor for the Schneider loan, rather that it simply held Lincoln
accountable to Fifth Third for breach of contract arising out of its i) representation that the value of the
account was $3.2 million; ii) waiver of any claim or setoff against the brokerage account; iii)
cancellation of the trades; and iv) removal of the “$2.8 million worth of securities from the brokerage
account without the approval of Fifth Third in clear violation of the Account Control Agreement.”
Lincoln further claimed that the Account Control Agreement was unenforceable because it had not
received any consideration for the account control arrangement and because Lincoln and Fifth Third had
both labored under a mutual mistake regarding the sufficiency of the funds in the account. The court
again disagreed, stating that Lincoln received adequate consideration by continuing to maintain its
customers’ accounts during the control arrangements, pointing out that Lincoln earned income through
such maintenance and lost customers when it began refusing to sign such agreements. In addition, the
court stated that Lincoln had sole responsibility for determining the adequacy of the funds in the account
and “assumed the risk of loss by treating the check as sufficient, warranting the value of the account,
and releasing all claims and rights of setoff against the account.”
Last, Lincoln claimed that the contract should be rescinded based on Schneider’s fraud. However, the
court pointed out that Kentucky law will not give relief to a party complaining of fraud who had
“knowledge of the truth or falsity of representations at hand.” Here, Fifth Third did not participate in
Schneider’s fraud or have “notice of the alleged fraud when it executed the Agreement.” The court
determined that, because Lincoln knew the check had not cleared and the securities were still owned by
the clearing house, it was on notice that the securities were not owned by Schneider and that the value
of the account was in question to the extent of the un-cleared check. As such, the court refused to grant
relief to Lincoln for harm it suffered as a result of its own negligence.
The court ultimately granted Fifth Third a judgment against Lincoln for $2,727,081.07, plus interest.
This case is a reminder to lenders who allow third party liens against their clients’ accounts that they
must insure receipt and ownership of funds within the accounts prior to obligating themselves in any
way regarding those funds. This case is cited as Fifth Third Bank v. Lincoln Financial Securities Corp.,
2009 WL 2523444 (W.D.Ky.)
Tip of the Month: Confession of Judgments and Arbitration
Be aware of promissory notes or guarantees that contain both a confession of judgment and grant the
borrower or guarantor the ability to seek arbitration. Although the Sixth Circuit Court of Appeals recently
held that the right of a party to a loan document to request arbitration of a dispute does not prevent the
lender from exercising its right to confess judgment, the existence of both provisions creates a possible
ambiguity and not every court may rule as favorably as the Sixth Circuit.
A confession of judgment provision enables the lender to go to court and obtain an immediate judgment
against the borrower or guarantor, thereby extinguishing the ability of the borrower or guarantor to
arbitrate the claim. The Sixth Circuit held that the borrower or guarantor still had the right to demand
arbitration until the entry of a judgment. Therefore, the right of a party to demand arbitration was not
totally nullified by the existence of the right of the lender to confess judgment. We recommend that if a
loan document is to contain both the right to confess judgment and the right of the parties to demand
arbitration, the confession of judgment should provide that it may be exercised notwithstanding the
existence of the right of a party to demand arbitration. Presumably, once a demand for arbitration is
made, the lender could not confess judgment against the borrower or guarantor.
We publish the Bulletin as part of our ongoing efforts to provide our clients with responsive service and
practical advice when needed. As always, we would like to hear feedback from our readers regarding the
content of the newsletter. If there are items or topics you would like to see covered in future issues, or
you have a suggestion concerning the newsletter itself, please send them to Anne Core at
ascore@lerchearly.com, or via phone at 301-961-6096.
Additionally, a number of the Firm's other departments periodically issue highly informative newsletters
on a variety of other subjects, including Real Estate, Community Associations, and Employment and
Labor. If you would like to receive one or more of these newsletters, you may access them through our
website, www.LerchEarly.com.
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The information in this newsletter is not intended to constitute legal advice and should not be acted upon without consulting
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