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Flashcards in Debtor-Creditor Relationships Deck (27):
1

Camp orally guaranteed payment of a loan Camp’s cousin Wilcox had obtained from Camp’s friend Main. The loan was to be repaid in 10 monthly payments. After making six payments, Wilcox defaulted on the loan and Main demanded that Camp honor the guaranty. Regarding Camp’s liability to Main, Camp is

  • Liable under the oral guaranty because the loan would be paid within one year.
  • Liable under the oral guaranty because Camp benefitted by maintaining a personal relationship with Main.
  • Not liable under the oral guaranty because Camp’s guaranty must be in writing to be enforceable.
  • Not liable under the oral guaranty because of failure of consideration.

Not liable under the oral guaranty because Camp’s guaranty must be in writing to be enforceable. The guaranty must be in writing to be enforceable under the Statute of Frauds. This is a promise to pay the debt of another.

2

Surety may take advantage of own contractual defenses for Fraud or Duress.

  1. If creditor obtains surety’s promise by fraud or duress, contract is voidable at surety’s option
  2. If creditor gets principal debtor’s promise using fraud or duress, then surety not liable
  3. Fraud by principal debtor on surety to induce a suretyship agreement will not release surety if creditor has extended credit in good faith
    1. But if creditor had knowledge of debtor’s fraudulent representations, then surety may avoid liability

3

Lux Financial Corp. loaned Boe $100,000. At Lux’s request, Boe entered into an agreement with Frey and Harp for them to act as cosureties on the loan in the amount of $100,000 each. If Lux releases Harp without the consent of Frey or Boe, and Boe subsequently defaults, which of the following statements is correct?

  • Frey will be liable for 50% of the loan balance.
  • Lux's release of Harp will have no effect on Boe's and Frey's liability to Lux.
  • Boe will be released for 50% of the loan balance.
  • Frey will be liable for the entire loan balance.

Frey will be liable for 50% of the loan balance. A discharge or release of one cosurety by a creditor results in a reduction of liability of the remaining cosurety. The remaining cosurety is released to the extent of the released cosurety’s pro rata share of debt liability, unless there is a reservation of rights by the creditor against the remaining cosurety. Frey and Harp each had maximum liability of $100,000. Thus, Lux’s release of Harp will result in Frey’s liability being reduced by Harp’s pro rata share of the total debt liability which was one half. Therefore, Frey’s liability has been reduced to $50,000 (i.e., 50% of the loan balance) due to the release of Harp as a cosurety.

4

Nash, Owen, and Polk are co-sureties with maximum liabilities of $40,000, $60,000, and $80,000, respectively. The amount of the loan on which they have agreed to act as co-sureties is $180,000. 
The debtor defaulted at a time when the loan balance was $180,000. Nash paid the lender $36,000 in full settlement of all claims against Nash, Owen, and Polk.

The total amount that Nash may recover from Owen and Polk is"

  • $0
  • $24,000
  • $28,000
  • $140,000

$28,000. When there are co-sureties, each has a right to a proportionate contribution from the others if a co-surety pays an unfair share of the debt. In this case, Nash's liability is 2/9 of the total liability among all co-sureties ($40,000 out of a total $180,000). She therefore should not pay more than 2/9 of any total settlement. She has a right to recover 7/9 * $36,000 from the others, or $28,000. More specifically, she will get $12,000 from Owen and $16,000 from Polk.

5

Lane promised to lend Turner $240,000 if Turner obtained sureties to secure the loan.

Turner agreed with Rivers, Clark, and Zane for them to act as co-sureties on the loan from Lane. The agreement between Turner and the co-sureties provided that compensation be paid to each of the co-sureties. It further indicated that the maximum liability of each co-surety would be as follows: Rivers $240,000, Clark $80,000, and Zane $160,000. 
Lane accepted the commitments of the sureties and made the loan to Turner. After paying ten installments totaling $100,000, Turner defaulted. Clark's debts, including the surety obligation to Lane on the Turner loan, were discharged in bankruptcy. Later, Rivers properly paid the entire outstanding debt of $140,000.

What amount may Rivers recover from Zane?

  • $0
  • $56,000
  • $70,000
  • $84,000

$56,000. Since Clark's debts have been discharged in bankruptcy, Clark has no liability. Also discharged in bankruptcy is his maximum liability of $80,000. The remaining co-sureties are liable for up to $400,000 between them: $240,000 for Rivers and $160,000 for Zane. Rivers paid more than her proportionate share of the liability. Her right of contribution from Zane is based on the percentage of the total maximum liability of $400,000. 
Zane will pay 40%, because his maximum liability is $160,000/$400,000 = 40%. 40% of $140,000 is $56,000 (not $70,000), the amount Zane owes Rivers.

6

Which of the following rights does one cosurety generally have against another cosurety?

  • Exoneration.
  • Subrogation.
  • Reimbursement.
  • Contribution.

Contribution. When two people act as a cosurety, neither can generally be held liable for an entire debt. Thus, when one cosurety, upon debtor's default, pays more than his or her proportional share, the cosurety can recover from the other cosurety the amount paid in excess of his or her share.

7

Sorus and Ace have agreed, in writing, to act as guarantors of collection on a debt owed by Pepper to Towns, Inc. The debt is evidenced by a promissory note.

If Pepper defaults, Towns will be entitled to recover from Sorus and Ace unless:

  • Sorus and Ace are in the process of exercising their rights against Pepper.
  • Sorus and Ace prove that Pepper was insolvent at the time the note was signed.
  • Pepper dies before the note is due.
  • Towns has not attempted to enforce the promissory note against Pepper.

Towns has not attempted to enforce the promissory note against Pepper. A guarantor on a guaranty of collection is conditionally responsible for a debt only if collection against the primary debtor fails.

8

Edwards Corp. lent Lark $200,000. At Edwards' request, Lark entered into an agreement with Owen and Ward for them to act as compensated co-sureties on the loan in the amount of $200,000 each.

If Edwards releases Ward without Owen's or Lark's consent, and Lark later defaults, which of the following statements is correct?

  • Lark will be released for 50% of the loan balance.
  • Owen will be liable for the entire loan balance.
  • Owen will be liable for 50% of the loan balance.
  • Edwards' release of Ward will have no effect on Lark's and Owen's liability to Edwards.

Owen will be liable for 50% of the loan balance. Since Edwards released one of the two sureties, the remaining surety is liable for only half of the entire debt. Until the release, Edwards could have collected the entire debt from either surety, and then that surety could have sued the other surety for half of that amount under the right of contribution. However, now Edwards can only collect 50% of the debt from Owen, because it has eliminated Owen's ability to collect anything from Ward.

9

Which of the following rights does a surety have?

  1. Right to compel the creditor to collect from the principal debtor 
  2. Right to compel the creditor to proceed against the principal debtor's collateral  

NO and NO...

A surety is primarily liable on a debt upon debtor's default. If the creditor wishes to collect from the surety, the creditor may do so. The surety may not compel the creditor to take either of these actions.

10

A distinction between a surety and a co-surety is that only a co-surety is entitled to

  • Reimbursement (Indemnification).
  • Subrogation.
  • Contribution.
  • Exoneration.

Contribution is a right one co-surety has against another. There cannot be rights between sureties if there is only a single surety.

11

Which of the following acts will always result in the total release of a compensated surety?

  • The creditor changes the manner of the principal debtor's payment.
  • The creditor extends the principal debtor's time to pay.
  • The principal debtor's obligation is partially released.
  • The principal debtor's performance is tendered.

The principal debtor's performance is tendered. Tender of full performance will totally release the surety, as in such a case there is no longer a debt to be repaid by anyone.

12

Green was unable to repay a loan from State Bank when due.

State refused to renew the loan unless Green provided an acceptable surety. Green asked Royal, a friend, to act as surety on the loan. To induce Royal to agree to become a surety, Green fraudulently represented Green's financial condition and promised Royal discounts on merchandise sold at Green's store. Royal agreed to act as surety and the loan was renewed. Later, Green's obligation to State was discharged in Green's bankruptcy. State wants to hold Royal liable.

Royal may avoid liability:

  • If Royal can show that State was aware of the fraudulent representations.
  • If Royal was an uncompensated surety.
  • Because the discharge in bankruptcy will prevent Royal from having a right of reimbursement.
  • Because the arrangement was void at the inception.

If Royal can show that State was aware of the fraudulent representations. A creditor is required to disclose any known material facts to a surety before the surety signs a loan agreement, if such facts will substantially increase the surety's risks. When a creditor does not make such disclosures, the creditor has committed presumed fraud, and the surety may use this as a defense to repayment.

13

Which of the following defenses would a surety be able to assert successfully to limit the surety's liability to a creditor?

  • A discharge in bankruptcy of the principal debtor.
  • A personal defense the principal debtor has against the creditor.
  • The incapacity of the surety.
  • The incapacity of the principal debtor.

The incapacity of the surety. When a surety loses capacity, the surety can usually avoid liability. Many legal obligations are therefore extinguished, including obligations taken on as a surety.

14

Florie is a compensated surety for a loan by Brenner to McDonald. In which of the following cases would Florie be released entirely from liability as a surety?

  • Brenner reduces the interest rate on the loan.
  • When the loan is due, Brenner refuses McDonald’s tender of payment and then attempts to collect from Florie.
  • Florie agrees to a material change in the debtor’s contract that substantially increases Florie’s risk.
  • Brenner, without Florie’s consent, agrees to a modification in McDonald’s loan that increases Florie’s risk in a nonmaterial way.

When the loan is due, Brenner refuses McDonald’s tender of payment and then attempts to collect from Florie. When the creditor refuses to accept the principal debtor’s tender of payment, the surety is released. However, the debtor remains liable as the accrual of additional interest stops.

15

The right of subrogation

  1. May permit the surety to assert rights he otherwise could not assert.
  2. Is denied in bankruptcy.
  3. Arises only to the extent that it is provided in the surety agreement.
  4. Cannot be asserted by a cosurety unless he includes all other cosureties.

May permit the surety to assert rights he otherwise could not assert.

The right of subrogation arises when the surety, pursuant to his contractual undertaking, fully satisfies the obligation of the principal debtor to the creditor and succeeds to the creditor’s rights against the debtor (i.e., "steps into the creditor’s shoes"). The surety acquires the identical claims or rights the creditor possessed against the principal debtor, permitting the surety to assert rights he otherwise could not assert.

16

Cornwith agreed to serve as a surety on a loan by Super Credit Corporation to Fairfax, one of Cornwith’s major customers. The relationship between Fairfax and Super deteriorated to a point of hatred as a result of several late payments on the loan. On the due date of the final payment, Fairfax appeared 15 minutes before closing and tendered payment of the entire amount owing to Super. The office manager of Super told Fairfax that he was too late and would have to pay the next day with additional interest and penalties. Fairfax again tendered the payment, which was again refused. It is now several months later and Super is seeking to collect from either Cornwith or Fairfax or both. What are Super’s rights under the circumstances?

  1. It cannot collect anything from either party.
  2. The tender of performance released Cornwith from his obligation.
  3. The tender of performance was too late and rightfully refused.
  4. Cornwith is released only to the extent that the refusal to accept the tender harmed him.

The tender of performance released Cornwith from his obligation.

The tender of performance by the principal debtor completely releases the surety from his obligation. However, such tender does not release the principal debtor if the contractual duty consists of the obligation to pay money. If the contractual duty consisted of anything but the obligation to pay money, then the tender of such performance would have also released Fairfax.

17

Which of the following defenses will release a surety from liability?

  1. Insanity of the principal debtor at the time the contract was entered into.
  2. Failure by the creditor to promptly notify the surety of the principal debtor’s default.
  3. Refusal by the creditor, with knowledge of the surety relationship, to accept the principal debtor’s unconditional tender of payment in full.
  4. Release by the creditor of the principal debtor’s obligation without the surety’s consent but with the creditor’s reservation of his rights against the surety.

Refusal by the creditor, with knowledge of the surety relationship, to accept the principal debtor’s unconditional tender of payment in full.

The surety will be discharged by the creditor’s refusal to accept the principal debtor’s tender of full payment on a mature debt. However, the tender of full payment will not discharge the principal debtor but will merely stop the running of interest on the monetary obligation.

18

Ford was unable to repay a loan from City Bank when due. City refused to renew the loan to Ford unless an acceptable surety could be provided. Ford asked Owens, a friend, to act as surety on the loan. To induce Owens to agree to become a surety, Ford made fraudulent representations about Ford’s financial condition and promised Owens discounts on merchandise sold at Ford’s store. Owens agreed to act as surety and the loan was made to Ford. Subsequently, Ford’s obligation to City was discharged in Ford’s bankruptcy and City wishes to hold Owens liable. Owens may avoid liability

  1. Because the arrangement was void at the inception.
  2. If Owens was an uncompensated surety.
  3. If Owens can show that City Bank was aware of the fraudulent representations.
  4. Because the discharge in bankruptcy will prevent Owens from having a right of reimbursement.

If Owens can show that City Bank was aware of the fraudulent representations. Fraud by the principal debtor on the surety to induce a suretyship agreement will not release the surety if the creditor extended credit in good faith. But if the creditor (City Bank) had knowledge of the debtor’s (Ford’s) fraudulent representations, then the surety (Owens) may avoid liability.

19

Which of the following bonds are an obligation of a surety?

  1. Convertible bonds.
  2. Debenture bonds.
  3. Municipal bonds.
  4. Official bonds.

Official bonds.

This is a secondary obligation: Basically a party is guaranteeing that a public official will discharge duties in compliance with laws and regulations.

Surety bonds are an acknowledgment of an obligation to make good the performance by another of some act or re­sponsibility.

  • Usually issued by companies which for a stated fee assume risk of performance by bonded party
  • Performance of act or responsibility by bonded party discharges surety’s obligation

Performance bonds are used to have surety guarantee completion of terms of contracts

  • Ex. Construction bond guarantees builder’s obligation to complete construction

Fidelity bonds are forms of insurance that protects an employer against losses sustained due to acts of dishonest employees.

Surety bonding company retains right of subrogation against bonded party.

20

In relation to the principal debtor, the creditor and a fellow cosurety, the cosurety is not entitled to

  1. Exoneration against the debtor under any circumstances.
  2. A pro rata contribution by his fellow surety or sureties if he pays the full amount.
  3. Be subrogated to the rights of the creditor upon satisfaction of the debt.
  4. Avoid performance because his cosurety refuses to perform.

Avoid performance because his cosurety refuses to perform.

A cosurety is not released from his obligation to perform merely because his cosurety refuses to perform. However, upon payment of full obligation, the cosurety can demand a pro rata contribution from his/her nonperforming cosurety.

  • However, upon payment of full obligation, cosurety can demand a pro rata contribution from his/her nonperforming cosurety
  • Cosurety is not released if other cosureties are unable to pay (i.e., dead, bankrupt)

Cosureties have rights of exoneration, reimbursement, and subrogation like any surety

21

Which of the following does not involve a suretyship relationship?

  1. A third-party beneficiary contract.
  2. A cosigner on a loan.
  3. An accommodation endorser on a note.
  4. An ordinary endorser on a negotiable note.

A third-party beneficiary contract. Involves an agreement between two parties in which the third-party beneficiary receives benefits under the contract without being one of the primary parties to it. No one is acting as a surety of another’s obligation in such case.

22

Dent Corporation received a loan from Jardine Finance Company. As part of the signed written agreement, Jardine required that one of the members of the board of directors of Dent Corporation act as a surety for the entire loan. The loan agreement also called for some of Dent’s real estate to be used as collateral for 50% of the loan. Which of the following is correct?

  1. When the loan is due, Jardine must first seek collection of the loan from Dent before resorting to the surety or the collateral.
  2. Jardine may choose to proceed against the surety for the entire loan when the loan is due.
  3. When the loan is due, Jardine needs to exhaust the collateral before resorting to the surety or the debtor.
  4. Jardine may only resort to the collateral if neither the surety nor the debtor can repay the loan in full.

Jardine may choose to proceed against the surety for the entire loan when the loan is due.

Jardine does have the right to proceed immediately against the surety for the full amount of the loan without needing to first seek remedies against the principal debtor, Dent, or the collateral.

23

Ott and Bane agreed to act as cosureties on an $80,000 loan that Cread Bank made to Dash. Ott and Bane are each liable for the entire $80,000 loan. Subsequently, Cread released Ott from liability without Bane’s consent and without reserving its rights against Bane. If Dash subsequently defaults, Cread will be entitled to collect a maximum of

  1. $0 from Bane.
  2. $0 from Dash.
  3. $40,000 from Bane.
  4. $40,000 from Dash.

$40,000 from Bane.

Cosureties exist when there is more than one surety guaranteeing the same obligation of the principal debtor. Unless the creditor specifically reserves his/her rights, a release of a cosurety by the creditor will release the other cosurety to the extent of the released cosurety’s pro rata share of debt liability. Both Ott and Bane agreed to act as cosureties for the full amount of the loan, $80,000. Their pro rata share of the debt was $40,000 ($80,000 / 2). Since Cread did not reserve its rights against Bane when it released Ott, Bane would only be liable for $40,000.

24

Which of the following actions between a debtor and its creditors will generally cause the debtor’s release from its debts?

  • Composition of creditors
  • Assignment for the benefit of creditors

Composition of creditors

A composition of creditors occurs when creditors make an agreement with each other to accept less than the full debts as full satisfaction of those debts. Once the debtor performs under the agreement, the debts are discharged, so this generally causes a release of the debtor from its debts.

However, an assignment for the benefit of creditors does not generally cause the release of the debtor from it debts. In this case the creditors do not have to agree to the assignment. The debtor assigns its assets to a trustee who sells the assets for cash. The cash is then paid out to creditors who agree to accept a stipulated amount to release their claims. The assignment itself, however, does not cause the claims to be released because at that point the creditors have not agreed to do so.

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25

Maxwell was the head cashier of the Amalgamated Merchants Bank. The Excelsior Surety Company bonded Maxwell for $200,000. An internal audit revealed a $1,000 embezzlement by Maxwell. Maxwell persuaded the bank not to report him, and he promised to pay the money back within 10 days. The bank acquiesced and neither the police nor Excelsior was informed of the theft. Maxwell shortly thereafter embezzled $75,000 and fled. Excelsior refuses to pay. Is Excelsior liable? Why?

  1. Excelsior is liable since the combined total of the embezzlements is less than the face amount of the surety bond.
  2. Excelsior is liable for $75,000, but not the $1,000 since a separate arrangement was agreed to by Amalgamated with Maxwell.
  3. Excelsior is liable since it is a compensated surety and as such assumed the risk.
  4. Excelsior is not liable since the failure to give notice of the first embezzlement is a valid defense.

Excelsior is not liable since the failure to give notice of the first embezzlement is a valid defense.

The general rule is that a surety is released from liability for acts of the creditor which materially increase the surety’s risk. In this case the failure of the creditor to give notice of the prior embezzlement materially increased the surety’s risk.

26

State Bank loaned Barr $80,000 and received securities valued at $20,000 from Barr as collateral.  At the request of State, Barr entered into an agreement with Rice and Noll to act as cosureties on the loan. The agreement provided that Rice and Noll’s maximum liability would be $80,000 each.

Which of the following defenses asserted by Rice will completely release Rice from liability to State?

  1. State and Barr entered into a binding agreement to extend the time for payment that increased the sureties’ risk and was agreed to without the sureties’ consent.
  2. Fraud by Barr which induced Rice to enter into the surety contract and which was unknown to State.
  3. Release of Barr’s obligation by State without Rice’s or Noll’s consent but with State’s reservation of its rights against Rice.
  4. Return of the collateral to Barr by State without Rice’s or Noll’s consent.

State and Barr entered into a binding agreement to extend the time for payment that increased the sureties’ risk and was agreed to without the sureties’ consent.

A material alteration by the principal debtor and creditor in the terms and conditions of their original contract without the surety’s consent will automatically release the surety if the surety’s risk of loss is thereby materially increased. The extension of time for payment is an alteration which has increased Rice’s risk and was made without Rice’s consent.

27

Allen was the surety for the payment of rent by Lear under a lease from Rosenthal Rentals. The lease was for 2 years. A clause in the lease stated that at the expiration of the lease, the lessee had the privilege to renew upon 30 days’ prior written notice or, if the lessee remained in possession after its expiration, it was agreed that the lease was to continue for 2 years more. There was a default in the payment of rent during the extended term of the lease and Rosenthal is suing Allen for the rent due based upon the guarantee. Allen contends that he is liable only for the initial term of the lease and not for the extended term. Allen is

  1. Not liable since it does not appear that a judgment against Lear has been returned unsatisfied.
  2. Not liable because there has been a material alteration of the surety undertaking.
  3. Not liable because there was a binding extension of time.
  4. Liable on the surety undertaking which would include the additional 2 years.

Liable on the surety undertaking which would include the additional 2 years.

The leasing arrangement, to which Allen is a surety, remained intact with no modifications. The lease, itself, expressed a holdover clause which went into existence when Lear remained in possession after the original leasing period. The essence of a surety arrangement is that the surety promises to perform upon default of the principal debtor. Therefore, Allen becomes liable when Lear defaults during the extended term of the lease.