The Bank of New Jersey, a Corporation of the State of New Jersey v. Brokers Financial Corporation (defendant in D.c.) Andnorthwestern National Insurance Company (defendantand Third-party Plaintiff in D.c.), v. Brokers Financial Corporation and Rocco J. Molinari Andmichael Grasso (third-party Defendants in D.c.).appeal of Northwestern National Insurance Company, 557 F.2d 365 (3d Cir. 1977)

Northwestern National Insurance Company appeals from a grant of summary judgment against it in the District of New Jersey, holding Northwestern liable on a surety bond to the Bank of New Jersey. The appeal presents the question whether a creditor who has accepted a one-year surety bond as collateral for a five-year loan can use the impending expiration of the bond as grounds for accelerating the entire debt, in an attempt to force the surety to renew its bond. The court below held that the creditor had such power. For the reasons that follow, we reverse.

In February, 1971, the Bank of New Jersey agreed to lend $250,000 to Brokers Financial Corporation over five years, so that Brokers could complete construction of an apartment building in Ventnor, New Jersey. The indebtedness was evidenced by a one-year note at an interest rate of eight percent per annum. The note was renewable solely at borrower's option, so long as interest payments were made as agreed during the first year. There was to be no reduction of principal until the second year of the loan.

As collateral, the Bank required the assignment of a $550,000.00 second mortgage on the apartment building and a surety bond covering the first year of the loan in the full amount of $250,000.00. Brokers obtained the proposed form of a bond from Northwestern and forwarded it to the Bank on March 31, 1971. A covering letter requested the Bank to have the Bank's attorneys "complete this (bond) in a form acceptable to them . . . ."¹ 

On April 7, 1971, Brokers executed and delivered to the Bank a note payable to the order of the Bank one year after date. The note reflected the agreement that only monthly interest was to be paid during the term of the note and included the borrower's option to renew if the interest was paid as agreed.²  Also, the note contained an acceleration clause³  of the sort permitted by N.J.Stat.Ann. § 12A:1-208.⁴ 

On April 16, 1971, Northwestern executed and delivered to the Bank the Financial Guarantee Bond in suit,⁵  which originally had been transmitted to the bank with instructions to obtain approval of the bank's attorneys. Among its provisions were the following two, upon which this case turns:⁶ 

7. The term of this instrument is and shall be one year. If Principal exercises its right to renew the note, Surety's obligation hereunder shall not thereby automatically be renewed, but may be renewed at the option of Surety.

8. If, during the term of the note, Principal defaults in the payment of any monthly installments of interest, Obligee shall notify Surety forthwith, and Surety shall have ten days after receipt of such notice in which to cure the default and thereby preserve all of the Principal's rights which, in that event, shall remain in full force and effect.

Brokers faithfully made all interest payments through November, 1971. At that time, difficulties arose at the apartment complex, and interest payments ceased. Although Northwestern had not been notified of Brokers' failure to pay, the Bank, by letter of March 3, 1972,⁷  notified Brokers of its intention to turn to the bond for payment:

Since there is now a default in the Note due to the nonpayment of interest from November 7, 1971, to March 7, 1972, in the amount of $6,622.09, we must under the terms of Paragraph 8 notify the "Surety" immediately and call for payment under the Bond. . . .

On March 8, 1972, the Bank apparently concerned about the value of the mortgage securing its five-year loan asked Brokers to obtain by March 14, 1972, an extension of Northwestern's surety bond.⁸  This letter produced no results, and on March 15, 1972, counsel for the Bank notified Northwestern for the first time that "there has been a default in the payment of interest," recited verbatim the language of paragraph 8 of the bond, set forth above, and requested payment of the interest arrearages. On March 24, 1972, Northwestern paid the outstanding interest on the note, to and including that due for March, 1972, in fulfillment of its obligation under the bond and in preservation of all of Brokers' rights under the note.⁹  At oral argument before this court, counsel agreed that this payment had cured any default.

Nevertheless, by letter dated April 5, 1972,¹⁰  the Bank notified Brokers that "due to the default in the note . . ., we do not wish to extend the loan and are hereby demanding payment be made prior to 3:00 P.M. on Friday, April 7, 1972." Believing that all its rights under the note including the right to renew had been preserved by Northwestern's payment of the interest arrearages, Brokers tendered the April interest on April 6, 1972, and informed the Bank that it was renewing the note.¹¹  The Bank returned the tendered interest payment and repeated its refusal to extend the loan "due to the default in the note."¹² 

Brokers refused to pay the full balance of the note, and the Bank on April 11, 1972, made demand upon Northwestern for payment of the principal sum plus interest from March 7, because the "principal sum had not been paid . . . ."¹³  Northwestern also refused to pay, contending that there had been no uncured default that could have obligated it to pay on its bond.

On May 31, 1972, the Bank filed in the District of New Jersey a complaint, based on diversity of citizenship, against both Brokers and Northwestern. On July 17, 1972, default judgments were entered as to both defendants, but on July 20, 1972, the default was vacated as to Northwestern. The parties filed cross-motions for summary judgment, and on December 5, 1975, the district court granted the Bank's motion and denied Northwestern's.

The court found that the "default" in interest payments had been cured in accordance with the terms of the bond,¹⁴  but it discovered another "default" that, it concluded, had triggered Northwestern's obligation to pay on its bond. The court observed that the note in question contained a typical acceleration clause: if the holder of the note deemed the total value of the collateral insufficient to secure the entire indebtedness, the holder could demand a reduction of indebtedness or the deposit of "additional collateral"; in default of those demands, the note would immediately become due. As the district court viewed the case,¹⁵  the default in interest payments gave the Bank a substantial basis for believing its prospects for payment were impaired. The Bank then justifiably requested "additional collateral" in the form of an extension of Northwestern's bond, which was due to expire. When Brokers failed to produce this "additional collateral," said the district court, the note fell due in full under the acceleration clause; Brokers' subsequent refusal to pay amounted to a default for which the surety, Northwestern, was liable on its bond.

Northwestern appealed from the denial of its motion for summary judgment and the grant of summary judgment against it. Because we believe that the court below improperly interpreted the note's acceleration clause, we reverse.

Under the terms of the bond it executed and delivered to the Bank, Northwestern agreed to perform two duties: (1) to cure defaults in interest payments within ten days of notice from the Bank during the term of the bond (one year), and (2) to assume the risk of Brokers' default on the note occurring during the term of the bond (one year). It is undisputed that the default in interest payments was timely cured and forms no basis for holding Northwestern liable on its bond. The only question before us is whether the Bank's demand for an extension of Northwestern's bond was a demand for "additional collateral" within the meaning of the note's acceleration clause. Counsel have been unable to cite any cases on point. Unable to find a precedent, we must contrary to Dean Griswold's admonition make one.¹⁶ 

Undeniably, the Bank at no time prior to the institution of these proceedings acted as though its refusal to extend the term of the note was founded upon the acceleration clause. Indeed, every reference to "the default" in the correspondence cited above seems clearly to refer to the interest arrearages from November to March.¹⁷ 

Even apart from inquiries into what the parties "really" did, these facts simply cannot be stretched to fit the theory of the court below. There never came a time during the one-year term of the note when the collateral was insufficient to cover all the indebtedness; in fact, Northwestern's bond alone covered the full face amount of the note. The Bank's request for a new bond also in the amount of $250,000.00 to cover the second year of the note, demonstrates that the first-year collateral was sufficient. The Bank, then, was not requesting additional collateral to secure the indebtedness evidenced by the one-year note to which the bond referred.¹⁸ 

The Bank argues instead that, with the impending expiration of the one-year bond, the collateral was about to become insufficient. That was true, but not because the commercial value of the item constituting the collateral had diminished.¹⁹  The risk of that diminution, in light of the acceleration clause, quite properly would have fallen upon the borrower. Instead, it was true because the item serving as collateral was, as the Bank had previously agreed, about to cease existing. In light of the Bank's initial contractual acquiescence in that impending quietus, it appears unfair to shift the burden of it entirely onto Brokers (and thus the surety) while the note was still fully secured (by virtue of surety's guarantee bond itself).

To allow the Bank to declare a default during the term of the bond, while the bond itself completely covered the full indebtedness, would be to convert the very act of executing a bond for a term shorter than that of the principal debt into a sufficient condition for the declaration of a default which triggers liability on the bond. For example, the Bank in this case bargained for and obtained what it thought was sufficient collateral in the form of a one-year bond. If the impending lapse of that bond after one year was itself the condition creating present insecurity (and hence default), then the express language limiting the bond to a term of one year and vesting the renewal option exclusively in the surety was meaningless; unless Northwestern extended the bond at the Bank's option, a default would occur. Thus, following the logic of the court below, sureties effectively would be precluded from executing guarantee bonds for a term shorter than that of the principal debt; refusal to extend for the future would simply lead to immediate insecurity and default, triggering liability on the bond.²⁰ 

That seems an absurd result. If a bank considers a one-year bond too short for its own security, it can bargain with the borrower to pay the additional sum required to obtain a longer-term bond. But if the bank declares itself satisfied with a shorter-term bond, the surety is lured blindly into the snare: if the bank decides that expiration of the bond in the future will render the loan partially unsecured, the surety must provide regular extensions amounting to a longer-term bond, without gaining the additional consideration ordinarily asked for the longer-term bond. Otherwise, an immediate default will occur.²¹ 

Of course, the surety could protect itself by refusing to issue bonds for less than the full term of the principal debt and requiring the appropriate consideration. We cannot see the value, however, of creating such rigidity in the money market. The Bank here decided, as a matter of business judgment, that a one-year bond would be sufficient; it bargained for only a one-year bond, presumably making it less expensive for the borrower to obtain the loan. That flexibility would disappear if sureties were forced to execute, and charge for, only bonds covering the full term of the principal debt. Certainly there is no reason for the federal diversity courts to create that situation in an effort to protect lending institutions from the overreaching of surety companies.

Broad questions of the lender's right to accelerate because of prospective impairment are not before us. We hold only that the Bank's right to demand "additional collateral" cannot be understood to mean that the Bank could demand a "temporal extension of the same collateral," where the parties explicitly bargained for the expiration of the collateral the bond at a precise date within the term of the principal debt, and where that agreed-upon collateral currently covered the full indebtedness. The judgment of the district court will be reversed.

SEITZ, Chief Judge, dissenting.

The issue here is whether the debtor, Brokers Financial Corporation, defaulted on any obligations under its note to the Bank within the term of the Financial Guarantee Bond. The district court concluded that Brokers had failed to comply with a good faith timely demand for additional collateral, and that the Bank was therefore justified in calling the principal when Brokers defaulted on its obligation to so comply. The court found that Brokers' failure to pay interest from November 7, 1971 to March 7, 1972 was sufficient to "make a reasonable and honest creditor doubt the security of (the) loan beyond the first year." I see no basis for overturning this finding of fact. But while the finding is relevant, it is not a sufficient basis on which to conclude that Northwestern may be held liable on the Bond. The Bond and a $500,000 Second Mortgage on certain real estate, which the Bank also held, were clearly sufficient to secure all obligations which could be due during the first year of the note. Unless the note was to be renewed beyond the first year, the Bank had no reason to worry about the security of its obligations. Thus, the mere fact that the note might be renewed is not, in my view, sufficient to allow the Bank to make a good faith demand for additional collateral.

This, however, does not end the problem. The note was payable April 7, 1972, unless validly renewed. The Financial Guarantee Bond expired April 15, 1972. Thus, unless all obligations under the note were paid on April 7, 1972, or the note was validly renewed, the Bank could demand that Northwestern make good its obligations under the Bond.

The principal due under the note was never paid. Nor was the note validly renewed, though Brokers' attorney attempted to renew it. It is true that the note states that: "(a)lthough written for a period of 1 year, if interest is paid as agreed, this Note may be renewed." Moreover, the Bond states that: "(i)f, during the term of the note, Principal defaults in the payment of any monthly installment of interest, Obligee shall notify Surety forthwith, and Surety shall have ten days after receipt of such notice in which to cure the default and thereby preserve all of the Principal's rights which, in that event, shall remain in full force and effect." Thus, since Northwestern made good its obligation to tender the interest payments on which Brokers had defaulted, Brokers' default in paying interest did not preclude it altogether from renewing the note. Nonetheless, I conclude that Brokers was not entitled to renew the note, because it had failed to comply with the Bank's demand that it provide additional collateral¹  a demand which, as the district court found, was based on good faith uncertainty as to the Bank's security beyond the first year.

The note does not expressly give the Bank the right to condition renewal upon satisfaction of any good faith demands for additional collateral. But I believe that this right is inherent in the right to demand additional collateral: even if one should give Brokers the unqualified right to renew, the Bank would still have the option of immediately demanding additional collateral on the renewed note, and then calling all obligations due if this demand were not satisfied. Moreover, the course of dealings between the parties to the transaction shows that the Bank did demand additional collateral in connection with the renewal of the note. The Bank's letter dated March 8, 1972 to Rocco J. Molinari, President of Brokers, said that "at or prior to (March 14, 1972) you will present to us an extension of the Financial Guarantee Bond, Promissory Note of the Northwestern National Insurance Company . . ." The extension of the Bond must contemplate renewal of the note.

I do not understand the majority to question the proposition that the Bank could, in the proper circumstances, demand more collateral to secure obligations which had not yet matured. Rather, the majority stress that "(t)o allow the Bank to declare a default during the term of the bond, while the bond itself completely covered the full indebtedness, would be to convert the very act of executing a bond for a term shorter than that of the principal debt into a sufficient condition for the declaration of a default which triggers liability on the bond." I believe this conclusion to be in error. The Bank would have no right to demand additional collateral of Brokers unless it could do so in good faith. In my view, this requirement of good faith would not be satisfied if the sole basis for the demand were the impending expiration of the Financial Guarantee Bond. The present case, however, is different, since Brokers had failed to pay interest from November 7, 1971 to March 7, 1972.

While the result reached by the district court may seem harsh, I believe that it is correct because the Bond extends Northwestern's obligations as surety until April 15, 1972, and thus to any default in the payment of principal at the end of the first year of the note.

I would affirm the grant of summary judgment for the plaintiff.