Ninth Circuit Bankruptcy Appellate Panel Highlights Importance of Lender Due Diligence

The 9th Circuit Bankruptcy Appellate Panel (BAP) recently issued an opinion in which it emphasized the importance for lenders to complete the due diligence process on loan guarantors. In Kelly v. Merrill (In re Merrill), the BAP affirmed a bankruptcy court ruling that a creditor’s judgment against a guarantor was dischargeable in bankruptcy, because the creditors failed to demonstrate that they completed a due diligence process that showed they actually relied on statements made by the guarantor.

In the case, the creditor demanded a guarantor before making the loan, but proceeded to make the loan after receiving only an unsigned, undated loan application from the guarantor. When the original borrower defaulted, the creditors looked to the guarantor and got a state court judgment to enforce the debt. The guarantor then filed for bankruptcy, and the creditors sought to have the judgment excepted from discharge on the grounds the guarantor falsely represented his financial condition in the loan application. The bankruptcy court found, and the BAP affirmed, that the creditors failed to demonstrate they relied on the guarantor’s financial statements because a reasonable creditor would have demanded more information from a guarantor than an unsigned, undated application. Therefore, the debt was discharged in bankruptcy.

Before making a loan, creditors should make sure they complete due diligence on borrowers as well as any guarantors. The amount of due diligence will depend on the circumstances of the transaction, but in addition to a loan application creditors should consider requesting signed and sworn statements of financial condition, independently verifying information where appropriate, and requesting additional financial information such as tax returns, copies of bank and investment records, and asset statements.