A complicated set of facts recently led the Tennessee Court of Appeals to a decision that sends a simple message to banks: When documenting a renewal loan, be careful when dealing with the collateral that secured the earlier loan. If a bank learns that a borrower has engaged in fraud to secure a renewal loan after it has released the borrower's guaranty from the earlier loan, a Tennessee court will not rescind the release agreement if the original guarantor was not involved in the fraud. In Healthcare Management Resources, LLC v. Carter, the Court refused to rescind a release agreement between a bank and Party B based on alleged fraud by Party C.
In 2003, a bank entered into a loan agreement with a business that was controlled by three individuals (the sellers). A fourth individual (the guarantor) pledged collateral to secure the loan. In 2004, the sellers transferred ownership of the business to new investors. As part of the change in control transaction, the bank entered into a new loan agreement with the new investors and released the guarantor from his 2003 pledge of collateral.
The new investors later sued the sellers alleging, among other things, that the sellers fraudulently induced them to invest in the business. The bank intervened in the lawsuit and sought to rescind its release agreement with the guarantor. The bank based its rescission claim against the guarantor on the alleged fraudulent conduct of the sellers. The trial court dismissed the bank's lawsuit against the guarantor since the bank did not allege that the guarantor was engaged in the fraud.
The Court of Appeals upheld the trial court's decision, observing that Tennessee law dictates that the remedy of rescission should be "exercised sparingly." It concluded that the alleged fraud committed by the sellers could not be the basis for the bank to rescind a separate agreement with the guarantor, who the Court described as "an innocent third party."
The Court's decision in Healthcare Management Resources explicitly closes the door to the rescission of a release agreement based on fraud when the party to the release agreement was not engaged in the fraud. This decision has the potential to dramatically limit a bank's recovery in fraud cases, just as it did in Healthcare Management Resources. There, the bank was denied an opportunity to revive its rights under a collateral pledge agreement valued at approximately $815,000.
Fraud is among the few grounds that will justify rescission of an agreement. Nevertheless, banks should be mindful that changes in control and ownership of entities, common in the business world today, may affect relationships between the signatories to various agreements associated with a credit facility. Specifically, the relationships may change between borrowing entities and parties, such as guarantors providing credit enhancement. Banks should take care to protect its collateral position in change-of- control circumstances and seek to negotiate into the loan agreement the right to revive any rights under a release agreement in the event of fraud.
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