Last-Out Loan Participation Construed as a Guarantee That Was Subject to Revocation
February 15, 2007
Michael Weissman - Chicago
Catherine, Patrick, Anthony and Merrill Kirsch owned shares of Capatony, Inc. which, in turn, owned 45 percent of the membership interests in Dart Distributing, LLC. CCP Limited Partnership owned the remaining 55 percent. Anthony and Merrill served on Dart’s board of directors.
In November 1997 First Source Financial made a loan to Dart. In 1998 Dart needed additional funding and agreed to give First Source a lien on most of its property. The First Source loans were revolving loans premised upon a borrowing base that determined the maximum amount that could be borrowed from time to time.
Dart needed even more funding in 2000 and a deal was struck under which First Source would provide it. In September 2000 the loan agreement was amended so as to permit Dart to increase the amount it could borrow. But First Source wanted to reduce its exposure in case of a loss. Therefore, it was agreed that the increase was contingent upon the execution of a last-out Participation Agreement between First Source, the Kirsches and CCP Limited Partnership.
The last-out Participation Agreement stipulated that the interests of the Kirsches and CCP were subordinated and that the purchase price of those interests was payable 10 days after they received notice from First Source that Dart was in default and that First Source had invoked an acceleration clause. It also stated that the participants would recover nothing until First Source had been paid in full and that the participants would bear all losses that First Source sustained up to the amount of their respective participations before First Source bore any loss.
The Kirsches secured their participation interests with pledge agreements covering securities they had in accounts they maintained with Lowry Hill.
In January 2003 the Kirsches and CCP sent First Source a letter indicating that, at that time, there was no amount due from Dart to First Source and that each of them was revoking their respective participation agreements and their respective debts, obligations and liabilities thereunder. The Kirsches also notified Lowry Hill of the revocation of their respective stock pledge agreements.
In December 2003, after Merrill Kirsch passed away, two other members of his family and Robert Cook, the managing director of CCP’s general partner, asked First Source to lend Dart additional funds. In April 2004 the surviving Kirsches reminded First Source by letter of the revocation of the participation agreements. In June 2004 some of the Kirsches and Cook once again sought additional funding for Dart.
Dart’s business apparently did not hit the target because in January 2005 First Source advised the participants that Dart was in default and that they owed First Source, in the aggregate, $1 million. When the participants refused to pay, First Source recovered $450,000 from Lowry Hill under the stock pledge agreements.
In April 2005 the Kirsches and CCP sued First Source for a declaration that the loan participation agreements had been revoked in 2003, and that it had no right to recover the money it received from Lowry Hill. First Source responded with a claim that the participants owed $1 million under the participation agreements and that it had the right to the $450,000 it received from Lowry Hill. CCP Limited Partnership v. First Source Financial, 856 N.E. 2d 492 (Ill. App. 1st Dist. 2006).
The parties agreed that when the revocation letter was sent the outstanding loans did not exceed the borrowing base and that under the formula in the participation agreements the Kirsches and CCP owed nothing.
In the litigation, First Source’s position was that the agreements were simply participation agreements and that the participants could not revoke them prior to the date on which First Source notified the participants that Dart was in default and that First Source had accelerated the entire indebtedness which was immediately due and payable. The Kirsches and CCP argued, on the other hand, the last-out participation agreements were continuing guaranties subject to revocation.
The court held for the Kirsches and CCP on the grounds that each participation agreement had the effect of a guaranty. As long as Dart was not in default the participants received no interest and paid nothing for their participation. But if Dart defaulted, the participants lost the amount of the respective participations before First Source suffered a loss.
Finding that the participation agreements did not impose any restrictions on the participants’ right of revocation, the court held the notice of revocation had been properly served in 2003, when there were no loans to Dart in excess of Dart’s borrowing base.
The court also noted that although First Source had made loans to Dart in excess of the borrowing base after receipt of the notice of revocation, the guaranty did not cover monies advanced after revocation even if it was some of the participants who requested the additional funding.
What’s the Point?
The court looked to the economic effect of the loan participations agreements in characterizing them correctly as guaranties. And having done so, applied the jurisprudential rules applicable to the revocation of guaranties.
For more information, e-mail Michael L. Weissman at michael.weissman@hklaw.com or call toll free, 1-888-688-8500.