The opinion of the court was delivered by: HAIGHT
In this action, before this court on the basis of diversity of citizenship,
plaintiff Chemical Bank ("Chemical") sues to enforce a guaranty executed on July 10, 1970 by defendant H. B. Layne ("Layne") in respect of the liabilities of one Eugene J. Cohen ("Cohen") to Chemical arising out of a demand promissory noted dated July 1, 1966.
The case was tried to the court without a jury on September 2 and 3, 1976. Extensive and able post-trial memoranda have been filed by counsel.
Chemical's theory of liability is straightforward. Layne executed a guaranty of Chemical's demand loan to Cohen; Cohen's indebtedness under that loan amounted to $101,919.34 with interest of $10,768.75 to May 12, 1972 and interest thereafter plus reasonable attorneys' fees of $15,000 as provided for in Cohen's note; Layne is liable for these amounts as guarantor. At the trial Chemical's prima facie case required two minutes flat and consumed three pages of the 385-page transcript. Plaintiff offered in evidence, without objection, the note executed by Cohen on July 1, 1966 in favor of Chemical; Layne's guaranty of July 10, 1970; and a statement of agreed facts reflecting, inter alia, the amounts for which Chemical sued. Chemical thereupon rested, subject only to further proof on the reasonable amount of the attorneys' fees, that question being deferred until decision on Layne's liability under the guaranty.
Layne's denial of liability presented, in the pleading stages, a bristling arsenal of alternative defenses. His second amended answer reinforced a general denial by six affirmative defenses, and added three counterclaims. Layne prays for rescission of the two guaranties he executed;
punitive and exemplary damages in an amount of $250,000; and reasonable attorneys' fees in an amount to be determined.
Layne pleaded several defenses based upon fraudulent concealment by Chemical, and also alleged violation by Chemical of the Securities Act of 1933 and S.E.C. regulations. It is unnecessary to discuss all the defensive theories in detail. It is apparent from the post-trial briefs that Layne bases his defense upon Chemical's failure to disclose certain facts to Layne prior to the time Layne executed the guaranties.
Specifically, Layne charges that prior to his execution of the first guaranty on April 28, 1970, Chemical failed to disclose to Layne:
(1) that there were restrictions on the transfer of shares of Brilund Mines Company which Chemical was holding as collateral on the Cohen loan;
(2) that Cohen had guaranteed other loans made by Chemical to other individuals or companies; and
(3) that the bank officer in charge of the Cohen account had determined to release other individual guarantors of the Cohen loan.
Layne charges further that, prior to execution of his second guaranty on July 10, 1970, Chemical again failed to disclose the restrictions on the Brilund shares; the existence of Cohen's other guarantees; the actual release of other guarantors of the Cohen loan (the bank's intentions of April having been implemented by July); and the release, in May, of other collateral securing the Cohen loan.
In essence, Chemical does not dispute the facts of these non-disclosures. It contends that they are without legal significance; that Chemical was under no duty to disclose them; and that Layne is bound by the terms of his July 10, 1970 guaranty.
The Applicable Legal Standards
The guaranty in suit provides that New York law governs the contract and the rights and obligations of the parties.
Accordingly this court looks to New York law for resolution of the issues. Mohasco Industries, Inc. v. Giffen Industries, Inc., 335 F. Supp. 493, 496 (S.D.N.Y.1971).
It is well settled under New York law that, in certain circumstances, an obligee's failure to disclose material facts to a guarantor or surety will void the obligation. The burden of sustaining the defense is on the guarantor. A recent statement summarizing New York law appears in State Bank of Albany v. McDonnell, 40 A.D.2d 905, 337 N.Y.S.2d 697 (3rd Dept. 1972):
"Absent a clear showing that the bank was guilty of fraudulent concealment or misrepresentation or circumstances inconsistent with a bona fide transaction, the surety undertaking may not be avoided. Bostwick v. Van Voorhis, 91 N.Y. 353; Howe Machine Co. v. Farrington, 82 N.Y. 121; Security Nat. Bank of Long Is. v. Compania Anonima De Seguros, 21 Misc.2d 158, 190 N.Y.S.2d 820, affd. 10 A.D.2d 872, 199 N.Y.S.2d 532. The bank's duty was to disclose only those facts within its knowledge which were of such vital importance to the risk as to make it obvious that non-disclosure would, in effect, amount to a contrary representation to the surety. The defense of fraud fails unless there was concealment of material facts which were so important that if the surety had known them they would not have undertaken the risk. (Howe Machine Co. v. Farrington, supra.)." 337 N.Y.S.2d at 699.
A bank's duty of disclosure in cases such as this is described generally in First Citizens Bank & Trust Co. v. Sherman's Estate, 250 App.Div. 339, 294 N.Y.S. 131 (4th Dept. 1937):
"'A surety is "a favored debtor." His rights are zealously guarded both at law and in equity. The slightest fraud on the part of the creditor, touching the contract, annuls it.' Magee v. Manhattan Life Ins. Co., 92 U.S. 93, 98, 23 L. Ed. 699. A contract of guaranty is 'one in which the guarantor is entitled to a full disclosure of every point which would be likely to bear upon his disposition to enter into it.' Barns v. Barrow, 61 N.Y. 39, 42. The law imposes upon a creditor the duty of dealing with his surety with the utmost good faith at every step in the transaction. Honesty and fair dealing required the bank to speak out, and correct the false impression which was entertained by decedent, and for which the bank was largely, if not wholly, responsible. While in many instances mere silence cannot be made the basis of fraud, yet, where the circumstances are of such a nature as to impose a duty upon one to speak, and where he deliberately fails to do so, his neglect will be deemed a deliberate suppression of the truth, and will amount to constructive, if not actual, fraud. A concealment of facts which, if known to the surety, would have deterred him from entering into the contract of suretyship, or which increased the risk of his undertaking, constitutes fraud, and will prevent an enforcement of his obligation." 294 N.Y.S. at 139.
It is equally clear that duties of inquiry and awareness fall upon the guarantor. In Mohasco Industries, Inc. v. Giffen Industries, Inc., supra, this court said in applying New York law:
"In order to constitute fraud, however, silence on the part of the obligee must be tantamount to affirmation of a state of affairs which does not exist and which would have the effect of deceiving or defrauding the surety. The obligee is not under an obligation to disclose to a surety information of which the surety has knowledge readily to hand. A surety cannot 'rest supinely, close his eyes, and fail to seek important information' and then seek to avoid liability under the guaranty by claiming he was not supplied with such information. Magee v. Manhattan Life Insurance Co., 92 U.S. 93, 23 L. Ed. 699 (1875). Moreover, as stated in Bostwick v. Van Voorhis, supra:
'... [They] [sureties] must inquire and inform themselves of all the facts they desire to know, and if they omit to seek for or obtain the requisite information, they cannot easily avoid the bond upon inferential or unsatisfactory proof that they were drawn into signing it by bad faith on the part of the obligee. Before a bond in such a case can be avoided, the fraud and bad faith should be brought home to the obligee by quite clear and decisive evidence, otherwise bonds of this character will furnish a very precarious security to the parties who take them.' (91 N.Y. at 360-361)" 335 F. Supp. at 497.
These are the general principles to be applied to the case at bar. In their light, I turn to the evidence.
The Events Leading to Execution of the First Guaranty in April, 1970
Chemical's primary obligor was Cohen, who on July 1, 1966 executed a demand note for $250,000.
The Chemical loan officer in charge of the account was Charles W. Charles, until, in May of 1970, he was replaced by Richard L. Herrington.
Cohen used securities as collateral for his loan. Charles permitted Cohen considerable latitude in the substitution of securities standing as collateral; the loan cards
reflect numerous transactions. It is apparent that Cohen was an active trader in the market.
In 1968, Cohen had a "big position" in the stock of Brilund Mines Company; the shares Cohen held were freely traded, not investment shares. This testimony was given by John Maggio, a friend and sometime business partner of Cohen, who also owned Brilund stock. In 1969 Maggio, at Cohen's expense, went to Southwest Africa to examine the Brilund Mines operation. On his return Maggio purchased 10,000 shares of restricted Brilund stock. The purchase price was $30 per share, or a total of $300,000. Maggio put up about 800 shares' worth, or $24,000; a Dr. Saperstein put up about 1200 shares' worth, or $36,000; and Cohen put up the balance.
The 10,000 share certificate
contained this restriction on its reverse side:
"This stock is held for investment purposes and should not to be [sic] transferred, sold or otherwise disposed of until registered under the United States Securities Act of 1933, as amended, or until such transfer, sale or other disposition is exempt from registration under that Act."
Prior to 1969, Chemical had held unrestricted Brilund shares as a part of the collateral for the Cohen loan. In July, 1969 or thereabouts, the loan officer, Charles, accepted 7400 of the 10,000 restricted shares as collateral. The record is uncertain as to whether these restricted shares were accepted in substitution for other Brilund shares or other collateral; but it is clear that Chemical placed certain restrictions on the use of the restricted shares as collateral. Charles testified:
"Q When you, originally, accepted the restricted shares, did you have an agreement or understanding with Mr. Cohen concerning how much of his loan could be collateralized by that restricted stock?
"Q Would you tell the Court what that understanding or agreement was?
"A We agreed to permit 20 percent of Mr. Cohen's loan to be secured by these ...