Demand Promissory Notes and Commercial Loans: Balancing Freedom of Contract and Good Faith

Publication year2021
CitationVol. 94

94 Nebraska L. Rev. 151. Demand Promissory Notes and Commercial Loans: Balancing Freedom of Contract and Good Faith

Demand Promissory Notes and Commercial Loans: Balancing Freedom of Contract and Good Faith


George A. Nation III(fn)*


TABLE OF CONTENTS

I. Introduction .......................................... 151

II. Background ........................................... 153

A. The Reger Case ................................... 153

B. The Problems Associated with Using Demand Notes in Commercial Loans .............................. 158

III. Analysis .............................................. 161

A. Old and Continuing Problems ..................... 161

B. Recognition of Demandable Notes: A Step Toward a Solution ........................................... 167

C. Revised Article 3-More Ambiguities .............. 170

D. Achieving Balance ................................. 173

E. Freedom of Contract ............................... 175

F. Good Faith ........................................ 179

G. Negotiability ...................................... 181

IV. Seventh Circuit's Analysis ............................. 182

V. Conclusion ............................................ 190

I. INTRODUCTION

Promissory notes are ubiquitous in commercial lending.(fn1) The promissory note represents the borrower's promise to repay.(fn2) The Uniform Commercial Code's Article 3 (Article 3) governs promissory notes.(fn3) Under Article 3, promissory notes are either demand instru-

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ments or time instruments.(fn4) In general, the holder of a demand instrument may decide to demand payment at any time and for any reason,(fn5) while the holder of a time note must wait for payment until the arrival of the specific repayment date or dates included in the note.(fn6) For this reason, time notes usually contain an acceleration clause.(fn7) An acceleration clause allows the holder to accelerate-move forward in time-the maturity date of the note if certain events oc-cur.(fn8) These events, usually defined as "events of default," typically indicate a decline in the borrower's credit rating.(fn9) An acceleration clause allows the lender to require (demand) payment of the loan early, but only if an event of default occurs.(fn10) Given the fact that most commercial borrowers plan an illiquid use of the borrowed funds it may seem odd that demand notes are also often used in the commercial lending context.(fn11) However, many lenders see advantages in using demand notes.(fn12) These advantages usually relate to perceived

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enforcement flexibility;(fn13) that is, many lenders believe, sometimes incorrectly, that if they use a demand note to document the loan they not only have the right to demand payment at any time, but they also have the right to receive repayment of the loan as soon as they demand payment.(fn14) Borrowers, on the other hand, may interpret the "payable on demand" language as similar to an acceleration clause; that is, some borrowers may believe, sometimes incorrectly, that the lender will demand payment only if the borrower's credit worthiness declines.(fn15)

Article 3 was substantially revised in 1990,(fn16) and some minor revisions were made in 2002.(fn17) The 1990 revisions, inter alia, clarified in some respects the treatment of demand notes, however the revisions also created some confusion as to the difference between time and demand notes.(fn18) The purpose of this Article is to discuss the proper way to balance freedom of contract and good faith when demand notes are used in the commercial lending context. In other words, how should courts accommodate the different interpretations that lenders and borrowers often have of demand notes?

II. BACKGROUND

A. The Reger Case

A good illustration of the use of a demand note by a commercial lender and the potential problems associated with such use can be found in the case of Reger Development, LLC v. National City Bank, (fn19) which was decided by the Seventh Circuit Court of Appeals in 2010. Reger Development, an Illinois LLC, was involved in real estate development and Kevin Reger was Reger Development's principal and sole member.(fn20) In June 2007, Reger and National City Bank ("National City") entered into discussions concerning the possibility of a loan

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from the bank to Reger for the purpose of financing potential development opportunities.(fn21) National City had lent funds to Reger Development for similar purposes on a number of previous occasions.(fn22) That is, the parties had an established course of dealing.(fn23) Kevin Reger met with National City's representative to discuss the loan and asked about changing the terms of form documents that had been suggested by the bank to document the proposed line of credit.(fn24) The suggested form documents purported to create a demand obligation.(fn25) Kevin Reger was told that the form documents presented by National City were nonnegotiable.(fn26) Kevin Reger, on behalf of Reger Development, executed the form documents, which consisted of a promissory note and a commercial personal guarantee signed by Kevin Reger in his individual capacity, guaranteeing the debt of Reger Development.(fn27) Reger Development also paid a $5,000 closing fee for the line of credit.(fn28) The promissory note provided that Reger will pay "on demand" the principal amount of the loan. Interest payments were to be made monthly based on the outstanding principal amount.(fn29) In addition, the note provided the following: "Payment: Borrower will pay this loan in full immediately upon Lender's demand."(fn30) However, the note also provided:

Notwithstanding any other provisions set forth in this Note, if (a) any principal owing under this note remains unpaid after Lender shall have given Borrower notice of demand for payment thereof or after the commencement of any proceeding under any bankruptcy or insolvency laws by or against Borrower or (b) any accrued interest under this note remains unpaid after the due date of that Interest, then, and in each such case, all unpaid principal of this Note shall bear Interest at a rate equal to three percent (3%) per annum above the rate that would otherwise be applicable.(fn31)

Also, notwithstanding the $5,000 closing fee paid by Reger Development, the note stated in bold the following: "NO COMMITMENT . . . NOTWITHSTANDING ANY PROVISION OR INFERENCE TO THE CONTRARY, LENDER SHALL HAVE NO OBLIGATION TO EXTEND ANY CREDIT TO OR FOR THE ACCOUNT

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OF BORROWER BY REASON OF THIS NOTE."(fn32) The note also included an integration clause, stating that the documents were the complete agreement between the parties.(fn33)

In June 2008, a year after the documents were executed, the bank requested updated personal financial statements and tax returns, which the note gave the bank the right to request.(fn34) The borrower provided the requested documents.(fn35) On August 19, 2008, notwithstanding the fact that Reger Development was in full compliance with all of the terms of the loan documents, including being fully up-to-date in the payment of all interest charges due, National City asked the company to pay down $125,000 of the principle of the line of credit, which the borrower did the next business day.(fn36) On September 9, 2008, at which time Reger Development continued to be in full compliance with all of its obligations under the loan documents, National City requested that "Reger Development 'term out' $300,000 of the Note by having one of Kevin Reger's other businesses agree to take out a three-year loan in that amount secured by a second mortgage on some real estate."(fn37) The bank also notified the borrower that it would be reducing the amount of money available under the line of credit to between $400,000-$500,000, down from the original $750,000.(fn38) Kevin Reger was surprised by the bank's actions and requests and asked if National City would call the line of credit if Reger Development did not agree to the Bank's "requests."(fn39) The bank acknowledged that Reger Development was not in default but stated, "there is a possibility that we may demand payment of the line."(fn40) Reger Development then sued the bank, filing a complaint in Illinois state court accusing National City of breaching the terms of the note.(fn41) "The company also alleged that National City used the form promissory note contracts to perpetuate a fraudulent scheme in which the bank fooled people into taking out loans by concealing the fact that the principal could be called on demand."(fn42) The bank was headquartered in Cleveland, Ohio, and removed the case to the Northern District of Illinois under diversity jurisdiction.(fn43) The bank successfully moved to dismiss the complaint for failure to state a cause of action.(fn44) The district court

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rejected Reger Development's motion for reconsideration and Reger Development appealed to the Seventh Circuit Court of Appeals.(fn45)

With regard to the breach of contract claim, Reger Development alleged that National City breached the loan contract by arbitrarily and capriciously demanding payment under the line of credit even though Reger Development was in good standing and by unilaterally changing, and attempting to change the fundamental terms of the contract documents without Reger Development's consent.(fn46) In this connection Reger Development identified several provisions in the note that...

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