Effect on Guarantees of Amending the Loan Agreement

At common law, a guarantor will be released from his or her liability under a guarantee if the creditor and the principal debtor agree to materially alter the loan agreement without the consent of the guarantor. An alteration will be considered as material if a reasonable person would take the alteration into account in assessing the risk of providing the guarantee pursuant to the loan agreement.
Modern guarantee contracts essentially exclude the material alteration principle so that a guarantor will not be released from liability if the debtor and creditor alter the loan agreement. However, a recent decision of the Ontario Court of Appeal in June of 1998 in Royal Bank of Canada v. Bruce Industrial Sales Ltd. indicates that the wording of the guarantee contract must be carefully worded to avoid the material alteration principal.

THE FACTS

Barry Fowler and Brenda Biasuzzi were employees of Bruce Industrial Sales Ltd. In 1989, they signed limited guarantees for the principal sum of $128,000.00 with interest at the bank's prime rate plus 1.5 percent. The Guarantees secured the following loan liabilities of Bruce Industrial Sales Ltd.:

1. a $100,000.00 term loan with interest at the Royal Bank's prime rate plus 2.25%; and

2. a revolving demand loan for general operating purposes.

The revolving loan was not to exceed the principal sum of $125,000.00 and lending was subject to an accounts receivable margin requirement. Interest under the revolving loan was at Royal Bank prime rate plus 1.5 percent. The revolving loan contained a special provision which provided that the bank was to apply credit balances in the Company's current account, rounded to the nearest $10,000.00, in repayment of the operating loan.

On March 6, 1991, the employment of Mr. Fowler and Ms. Biasuzzi was terminated and on March 21, 1991 the guarantors notified the bank in writing that in accordance with paragraph 4 of the Guarantee they were terminating their liability. At the time of the notice of the guarantors, their liability under the revolving loan was $95,000.00

After receiving the notice, the Royal Bank converted the revolving loan into a fixed loan without the knowledge or consent of the guarantors. In the first terms letter issued after the termination of the Guarantees, the loans of Bruce Industrial Sales Ltd. were recorded to be:

(a) a $100,000.00 term loan with interest at Royal Bank prime rate plus 2.5%; and

(b) a fixed operating loan with interest at Royal Bank prime rate plus 2.0% with more flexible margin requirements;

On March 28, 1983, the Royal Bank demanded payment. As Bruce Industrial Sales Ltd. was insolvent at that time, the bank sued to enforce the Guarantees. At trial, the bank's action was successful and the guarantors were found liable to pay some $194,997.42. The guarantors appealed to the Ontario Court of Appeal which allowed the appeal and relieved the guarantors of any and all liability for both the term loan and the operating line of credit.

The Ontario Court of Appeal held that contrary to the bank's submission, the first and fourth clauses of the Guarantee did not authorize the conversion of the revolving loan to a fixed loan.

Clause 1 of the Guarantee reads as follows:

"The bank may grant time, renewals, extensions, indulgences, releases and discharges to, take securities (which word as used herein includes other guarantees) from and give the same and any or all existing securities up to, abstain from taking securities from or from perfecting securities of, cease or refrain from giving credit or making loans or advances to, accept compositions from and otherwise deal with, the customer and others and with all securities as the Bank may see fit and may apply all moneys at any time received from the customer or others or from securities upon such part of the liabilities as the Bank deems best and change any such application in whole or in part from time to time as the Bank may see fit, the whole without in any way limiting or lessening the liability of the undersigned under the guarantee, and no loss of or in respect of any securities received by the Bank from the customer or others, whether occasioned by the fault of the Bank or otherwise, shall in any way limit or lessen the liability of the undersigned under this guarantee." [emphasis added]

Although paragraph 1 of the Guarantee contained a "blanket provision" that authorized the Bank "to otherwise deal with the customer as the Bank saw fit", the Court of Appeal found that this provision could not be interpreted to authorize the change because firstly, its language was vague, imprecise and general, and secondly, placed in the overall context of paragraph 1, it ought not be interpreted as authorizing radical changes to the principal contract. Thirdly, the Ontario Court of Appeal also reasoned that taking into account the circumstances of the loan transmission as a whole, there was nothing to suggest that in providing their Guarantees, the guarantors intended to confer upon the Bank the unqualified right to materially alter the loan agreement. In particular, the Court found that the loan transaction between the Bank and the Company was straightforward and common place. There was nothing unique about it. Therefore, according to the Ontario Court of Appeal, there was no conceivable reason why the Company or the guarantors would have felt obligated to give the Bank the extraordinarily power of being able to change the principal loan agreement in whatever fashion and to whatever extent deemed fit by the bank:

The Ontario Court of Appeal also considered paragraph 4 of the Agreement which provided:

"The undersigned or any of them may by notice in writing delivered to the Manager of the branch or agency of the bank receiving this instrument, determine their or his liability under this guarantee in respect of liabilities thereafter incurred or arising but not in respect of any liabilities theretofore incurred or arising event though not then matured, provided however, that notwithstanding receipt of any such notice the bank may fulfil any requirements of the customer based on agreements expressed or implied made prior to the receipt of such notice and any resulting liabilities shall be covered by this guarantee; and provided further that in the event of the determination of this guarantee as to one or more of the undersigned it shall remain a continuing guarantee as to the others or others of the undersigned." [emphasis added]

Paragraph 4 of the Guarantee provided that notwithstanding notice of determination, the Bank "may fulfil any requirements of the customer based on agreements expressed or implied made prior to the receipt of such notice". The Bank argued that there was an implied agreement to honour its commitment to the Company notwithstanding the determination of the guarantees. The Court found, however, that under the terms of the principal loan agreement, the Bank was entitled to treat the determination of the guarantee as an event of default, upon which the Bank could demand immediate and full repayment.

In the face of an expressed provision in the loan agreement which puts the Company on notice that the Bank could treat the determination of a guarantee as an event of default, the Court rejected the Bank's suggestion that as between the Bank and the Company, the Bank had implicitly agreed that it would continue to honour its commitment notwithstanding the determination of the guarantees.

In rejecting the Bank's argument with respect to paragraphs 1 and 4 of the Guarantee, the Court found that the Bank's unilateral conversion of the revolving loan was a material alteration to the principal loan agreement that was prejudicial to the guarantors thereby entitling the guarantors to be released from all liability with respect to the operating line. In point of fact, the prejudice to the guarantors resulting from the conversion of the revolving loan to a term loan was manifest. The conversion nullified the provision in the original loan agreement to apply credit balances to repay the loan.

If the Bank had continued to revolve the Company's operation loan after March 26, 1991, the operating loan of $95,000.00 would have been reduced to $5,000.00 by April 16, 1991 thereby reducing the guarantors' exposure on their Guarantees by some $90,000.00. This is to be contrasted with the Company's fixed operating loan liability on May 28, 1993 when the Bank ultimately decided to call the loan. On May 28, 1993 the Company's operating loan stood at its maximum limit of $125,000.00.

The Court also relieved the guarantors from all liability with respect to the original $100,000.00 term loan. Although paragraph 1 of the Guarantee permitted the Bank to renew the term loan obligation, the Court found that the Bank was not entitled to renew the term loan obligation at a higher rate of interest (2.5% above prime as opposed to 2.25% above prime) without consent of the guarantors. The Ontario Court of Appeal found that the increase in the interest rate constituted a material alteration to the principal loan agreement. Any alteration to the principal contract the Court found will be held to be "material" unless it is plainly unsubstantial or necessarily beneficial to the guarantor. In this particular case, although the increase in the interest rate was small, the Court found that it was not self-evident that the increase was unsubstantial bearing in mind that on July 11, 1992 $70,000.00 remained owing on the term loan. After finding that the increase in the interest rate was material, the Court had no difficulty in finding that based on its earlier description of clause 1 of the Guarantee, the Guarantee itself did not permit the change.

Given paragraph 1 of CIBC's Guarantee is very similar to that which was considered by the Ontario Court of Appeal in the Royal Bank v. Bruce Industrial Sales Ltd. the decision could have serious implications for CIBC should CIBC alter principal loan agreements without the guarantor's consent unless the alteration is "plainly unsubstantial or necessarily beneficial to the guarantor".

Therefore, consideration should be given to amending the principal loan agreement only with the consent of guarantors.

Prepared May 10, 1999 Michael J. Valente, Partner
Commentary is of a general nature and is not intended as legal advice. Specific advice should be sought with respect to each specific case.
© Scarfone Hawkins LLP, 1999
Effect on Guarantees of Amending the Loan Agreement