North Carolina Court of Appeals Rules Lender Has a Duty to Disclose Information to Surety about Borrower's Financial Condition
By Matthew A. Cordell
(First published July 2010)
In May 2010, the North Carolina Court of Appeals ruled that a surety, including a co-borrower signing as a mere "accommodation party," can avoid liability on a promissory note if the lender knew, or should have known, that there was a material risk that the primary borrower would be unable to fulfill its obligations under the note and the lender did not inform the surety of that risk.
The case, Whisnant v. Carolina Farm Credit, ACA, involved loans by Carolina Farm Credit, ACA ("CFC") to the Wilsons to consolidate and renew outstanding debts of a commercial greenhouse business. Mrs. Wilson's brother and sister-in-law, the Whisnants, signed the notes as co-makers, but had no interest in the greenhouse business and received none of the loan proceeds. The notes were secured with a deed of trust on the Whisnants' farm, which also was their residence. The greenhouse business failed, the Wilsons could not pay the notes, and CFC commenced foreclosure proceedings on the Whisnants' farm.
The Whisnants sued CFC to invalidate their obligations on the notes. They based their arguments on four legal theories: (i) fraud in the inducement, (ii) actual fraud, (iii) negligence, and (iv) unfair and deceptive trade practices. They alleged that CFC knew, or should have known, that the greenhouse business would not generate the revenues necessary to repay the loans, but either (a) affirmatively represented that it would or (b) at least failed to disclose to them the known risks that it would not. The Whisnants specifically alleged that, as they were signing the notes, they questioned the loan officer about the greenhouse's viability and were told "everything looks to be running okay." The trial court granted summary judgment in favor of CFC.
On appeal, the Whisnants relied upon the law of suretyship, asserting that CFC's misrepresentations about the greenhouse business, or its failure to tell them of the risks, precluded CFC from enforcing their obligation to pay the notes. CFC responded that since the Whisnants signed the notes as co-makers and, therefore, were primary obligors, suretyship principles were irrelevant. The Court of Appeals sided with the Whisnants, ruling that summary judgment in favor of CFC was improper. The Court stated that, regardless of the titles assigned by the loan documents, the Whisnants were in fact "accommodation makers" and the law relevant to suretyships applied. The Court emphasized that the Whisnants had not received any loan proceeds and had no economic interest in the greenhouse business. Therefore, the Whisnant decision demonstrates that the role assigned to parties by the loan documents may not control. A party may be treated as a surety even where the party signs a note as a co-borrower, if the circumstances tend to indicate that the party is not receiving a direct benefit from the loan.
Treating the Whisnants as sureties, the Court held that when a lender "knows or has good grounds for believing that [a] surety is being deceived or misled, or that he was induced to enter into the contract in ignorance of the facts materially increasing the risk," the lender has an affirmative duty to so inform the surety and, if the lender fails to do so, the surety can avoid its obligation.
The Court further ruled that the Whisnants' allegations – that they "were induced to enter into the contract in ignorance of facts materially increasing the risk, of which [CFC] had knowledge…and opportunity…to inform [them]" – were sufficient to support claims under each of the four legal theories set out above, the last of which, unfair and deceptive trade practices, presents the possible liability of the lender for treble damages.
Whisnant raises at least three distinct concerns for banks and other lenders:
Lenders must exercise due diligence in underwriting loans in order to determine who is, and the possible risks to, an "accommodation party," including the collection and analysis of all material information regarding the intended use of loan proceeds and the primary borrower's ability to repay. The Whisnant Court indicated that ignorance of the material facts may not save the lender.
Lenders must not misrepresent or mischaracterize the primary borrower's ability to repay, or the adequacy of other security for the loan, to a surety, guarantor, or accommodation maker. As shown by the Whisnant decision, even relatively vague assurances such as "everything looks to be running okay" can amount to a material misrepresentation.
Unless it is clear that a surety or accommodation maker is aware of the repayment risks, lenders may be required to affirmatively disclose those risks. The Whisnant Court indicated that such a duty exists. Silence, according to the Court, may be fraudulent.
This third obligation may present complications for regulated lenders (such as banks) because of the numerous state and federal restrictions and internal policies forbidding or limiting the disclosure of customer information. The Court did not address the possible tension between the duty created by its decision and existing privacy laws and policies.
In response to the Whisnant decision, lenders should remind their loan officers to make no assurances regarding repayment to co-borrowers, sureties, or guarantors. Appropriate disclaimers and warnings should be included in loan documents. Lenders should review their policies and procedures and adjust them, where necessary, in response to Whisnant, which may include creating or revising policies to allow, to the extent permitted by law, the disclosure of financial information to relevant loan parties.