Federal Appeals Court Allows Reg. B Violation To Void Guaranty

May 1, 1995

FINANCIAL SERVICES NEWSLETTER

FEDERAL APPEALS COURT ALLOWS REG. B
VIOLATION TO VOID GUARANTY

The U. S. Court of Appeals for the Third Circuit recently held that a violation of Reg. B and the Equal Credit Opportunity Act can serve as a defense to a suit to collect on a guaranty agreement. Silverman v. Eastrich Multiple Investor Fund, L.P., No. 94-1783 (3d Cir., March 28, 1995). The case involved a lender that required not only a partner in the borrower to guaranty the debt, but also the wife of the partner. When the lender sued to collect from the guarantors, the partner's spouse who was not active in the business asserted a violation of Reg. B and the ECOA as a defense to the guaranty obligation.

The trial court held that the violation could not be asserted as a defense, but rather that the guarantor would be limited to statutory damages under Reg. B and the ECOA. The Third Circuit reversed and remanded the case to determine whether a violation in fact existed. If the violation did occur, the guarantor could assert the violation as a defense to her obligation on the guaranty.

I. A Common Scenario.

The prohibitions against discrimination in lending (including discrimination based upon marital status) contained in the ECOA apply to commercial loans as well as to consumer loans. An issue with respect to the ECOA commonly arises when a loan is made to a business owned by one spouse, in which the other spouse has no management or shareholder interest. Lenders often secure such a loan with a second mortgage on the principal's residence, which generally is owned by both spouses. Because the signature of each spouse is required on the mortgage or other security instrument, the lender (following the traditional "lend to the assets" rule) may obtain the signature of the inactive spouse on the note or guaranty in order to evidence the obligation secured by the mortgage. This final step of imposing personal liability on the inactive spouse often may result in a violation of Reg. B and the ECOA.

II. How to Avoid ECOA and Reg. B Violations.

Lenders should first analyze the credit of the business and the creditworthiness of the principals who would normally be expected to guaranty the loan. If the lender requires additional credit support for the loan, the lender may inform the borrower that a satisfactory third party guarantor is required. The lender certainly is not prohibited from accepting the guaranty of an inactive spouse, but simply is prohibited from requiring that the third party guarantor be the spouse.

The lender may require the signature of an inactive spouse on a mortgage or other security instrument if such signature is required to perfect the lender's security interest. The signature of an inactive spouse may not, however, be required on any instrument imposing personal liability on the inactive spouse unless the lender is reasonably certain that the signature is required to perfect the lender's security interest. In Alabama, an accommodation pledge of collateral or an accommodation mortgage signed by both spouses creates an enforceable lien even though only one spouse has personal liability for the secured obligations. There is no need in Alabama to obtain the signature of the inactive spouse on a guaranty agreement or note solely to perfect a second mortgage or other security interest in assets owned by the inactive spouse.

III. Remedies.

The ECOA allows an aggrieved party to maintain a suit for actual damages, including punitive damages. Punitive damages are limited to $10,000.00 in the case of an individual action, and $500,000.00 in a class action. In addition, should the Eleventh Circuit adopt the reasoning of the Third Circuit, violations of the ECOA and Reg. B may be asserted defensively when a lender attempts to collect on a guaranty agreement.

UPDATE: COLLECTION OF RACE AND GENDER DATA

OF LOAN APPLICANTS.

We reported in the December issue of this newsletter that the four banking regulatory agencies had issued a proposed regulation under the Community Reinvestment Act requiring the collection of race and gender data on applicants for business loans of one million dollars or less. Our concern was that the collection of such data under CRA would provide ammunition for discrimination cases under the ECOA and Reg. B, where the consideration of such data is illegal.

The regulators last month released final amendments to the proposed CRA regulations, and the proposal drops the requirement for the collection of race and gender data. In a related compromise, the Federal Reserve Board has proposed to revise Reg. B to permit the collection of race and gender data, but at the discretion of the lender.