United States: Ninth Circuit Allows Oral Agreement To Supercede Loan Documents

Last Updated: September 28 2005
Article by Peter S. Munoz

Despite several contractual phrases prohibiting loan documentation from being altered by subsequent agreements, an oral agreement struck between farmers and their loan officer following a crop failure was allowed to supercede their original loan agreement.

In Fanucchi & Limi Farms v. United Agri Products, No. 02-17525 (9th Cir., July 14, 2005) the U.S. Court of Appeals for the Ninth Circuit held that in instances in which a written contract prohibits oral modifications, an oral agreement cannot amend the express written terms. However, the court also held that if the oral agreement amounts to a replacement of the original contract, the oral agreement may supercede the written contract through "novation."

The decision revives the issue of whether an oral agreement can modify a written loan agreement notwithstanding a "no amendment provision."

In addition to infusing uncertainty into contract law, the holding also likely will have unfortunate procedural impacts for lenders. Because claims of oral novation involve questions of intent that are not appropriately determined at the summary judgment stage, borrowers may be able to buy themselves additional leverage in negotiations with lenders.

The Fanucchi case involved a 1994 loan from United Agri Products to Fanucchi & Limi Farms that was secured by the borrower’s 1995 crops. The loan agreements provided that no amendment would be effective unless in writing. Another statement prohibited the loan documents from being contradicted by any subsequent oral agreement.

The 1995 crop failed and Fanucchi proposed to file for bankruptcy. Fanucchi claimed an agreement was reached with the lending representative that in exchange for foregoing bankruptcy and continuing to farm, the lender would subordinate its crop lien to new financing.

After the new crop lenders were paid from the proceeds of each new crop, the balance was to be paid 60 percent to the lender and 40 percent to the borrower’s other creditors. If the 1994 loan was paid down to between $300,000 and $400,000, the balance would be written off. The testimony of the lender’s representative supported most of the borrower’s allegations.

The parties worked under this arrangement for two years, but a new credit manager refused to subordinate the lien to a family lender for the 1998 crop year, leading to the shutdown of the farm, and the borrower sued.

Under California’s Civil Code, novation of an obligation may occur either through the substitution of a new debtor for an old debtor or the substitution of a new obligation for an old obligation. To prove novation, a borrower must demonstrate the existence of a new oral agreement and the parties’ intent to extinguish the old agreement.

In determining the parties’ intent, the court looked at whether the differences between the old contract and the new agreement were substantial enough to show an extinguishment of the old contract, and whether the parties acted as if the old contract had been terminated.

The court concluded that if the borrower’s evidence was to be believed, the 1994 loan had been novated. In so holding, the court applied a broad reading of novation that, as the concurring opinion points out, "looks quite similar to modification."

Note: To reduce the likelihood of a claim of oral novation, lenders should clearly state their intent in dealing with defaulted borrowers. If a novation is not intended, the lender should state that the old agreement remains in effect. If an accord is intended, the lender should make it clear that the borrower is not to have the benefit of the agreement until the borrower has fully performed.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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