LLC v. Michael Johnson et al. (2010)

MEMORANDUM OF DECISION

In this matter, the plaintiff, Scott Porter, seeks to enforce written guaranty agreements against the defendants Michael Johnson (first count) and Peter Pratley (second count).¹  The guaranties were given by the defendants in connection with a plan to purchase and redevelop real property known as 1 Country Road, Westport.

The evidence shows that in late 2004, the plaintiff and his wife Jennifer Porter resided at 3 Country Road in Westport.   At that time they learned that the owners of the adjacent residence at 1 Country Road intended to place their property on the market.   The Porters believed that a significant profit might be made by buying their neighbor's property, enlarging and restoring the residence and selling the renovated home.   Apparently, the Porters had little or no experience in the construction of residential properties or in real estate investing.   In order to take advantage of the opportunity presented by the availability of the 1 Country Road property, Jennifer Porter discussed the matter with an acquaintance, Michael Johnson, who was involved in the redevelopment of another residential property located on Beachside Avenue in Westport.   Michael Johnson in turn introduced the Porters to Peter Pratley, the owner of The Pratley Company, LLC, which was the general contractor for, and an investor in, the Beachside Avenue project.

Eventually, the Porters, Johnson and Pratley agreed to form a limited liability company (One Country, LLC) in order to pursue the perceived opportunity.   Under the operating agreement for One Country, LLC (Ex. 13), the Porters invested $200,000 in the project through their jointly owned limited liability company, Iboport, LLC. Johnson and Pratley invested $50,000 each.   The parties understood that in order to purchase the property and complete the planned renovations, they would need mortgage financing and at least an additional $200,000 in equity investments.   Mortgage financing was arranged through Greenwich Bank and Trust Company (the Bank), which agreed to provide financing for acquisition of the property and construction financing to complete the renovations.

The Bank required that its loan to One Country, LLC be guaranteed.   Both Johnson and Pratley had issued guaranties to the Bank in connection with the Beachside Avenue project and the Bank was unwilling to rely upon their guaranties of the loans to One Country, LLC. The Bank found the plaintiff to be credit-worthy and required that he be the sole guarantor of the mortgage loans.   In an E-mail message to Johnson and Pratley dated February 5, 2005, the plaintiff acknowledged that he would be the only guarantor.  (Ex. 11.)

The parties negotiated the terms of the operating agreement in early 2005.   The final draft of the operating agreement, “dated as of January 1, 2005” was signed immediately prior to the closing on the purchase of the property on March 7, 2005.   Article 7.7 of the operating agreement, entitled “Loans by Members” provides:

Any Member or Manager may make a loan to the Company in such amounts, at such times and on such terms and conditions as may be approved by the Co-General Managers.   Loans by any Member or Manager to the Company shall not be considered as contributions to the capital of the Company.   All loans to or guarantees for the Company by a Member or its affiliate shall be non-recourse as to the other Members, except for the Members' interests in the Company of its property.

On February 17, 2005, the plaintiff and Pratley signed a contract to purchase the property for $1.35 million.  (Ex. 25.)   The purchase was closed on March 7, 2005.   One million eighty thousand dollars of the purchase price was provided by a mortgage to the Bank that was guaranteed by the plaintiff.  (Ex. 32.)   The balance of the purchase price was paid from the capital invested in One Country, LLC by its members.   Over the next nine months, Pratley had prepared plans for the renovation of the residence on the property and a proposed construction contract between The Pratley Company and One Country, LLC. During the same period, Pratley removed interior and exterior wall coverings in anticipation of the reconstruction work that would commence once the construction mortgage was finalized.   The construction contract was executed on December 15, 2005.  (Ex. 5.)

In the meanwhile, the Porters' marriage had fallen apart.   The plaintiff informed Jennifer Porter, Michael Johnson and Peter Pratley that he would not sign a personal guaranty of the construction mortgage unless each of them signed “backstop” guaranties in his favor to provide protection in the event that he was required to honor either of his guaranties issued to the Bank. There is conflicting evidence as to whether the plaintiff had informed the others of his demand for “backstop” guaranties prior to the fall of 2005.   The plaintiff testified that he told the others the requirement prior to the March 7, 2005 closing, while Pratley and Johnson claim that the matter first arose in late 2005.   An E-mail dated November 30, 2005 from the plaintiff to Johnson, Pratley and Jennifer Porter discusses the construction loan and states:  “I'll draft back stop guarantees from all to me.”  (Ex.14.)

The plaintiff, an attorney then employed in the role of an in-house counsel, drafted proposed guaranties for Jennifer Porter, Pratley and Johnson to sign.   Although Porter testified that he used the Bank's form of guaranty as a template, there are significant differences in the wording of the documents.   Both Pratley and Johnson signed their respective guarantees on the last page on the signature lines intended for witnesses signatures.   Thereafter, the plaintiff requested that the guaranties be signed on the proper lines.   Pratley's guaranties were admitted into evidence as exhibits 1 and 2. Johnson's guaranty, with both signature pages appended, was admitted as exhibit 3. Jennifer Porter's guaranty was admitted as exhibit 4.

Each of the backstop guaranties contains the following recitations:

WHEREAS, GUARANTOR desires to induce SDP 2 to enter into contracts for the guaranty of loans from The Greenwich Bank & Trust Company and to loan the amount of Two Million, One Hundred Eighty Thousand Dollars ($2,180,000.00) (collectively, the “Underlying Transactions”) to One Country, LLC, a Connecticut limited liability corporation with his principal office at 3 Country Road, Westport, CT 06880 (“DEBTOR”), pursuant to two Loan Agreements with DEBTOR, dated March 7, 2005 & Feb. 9, 2006, and other Underlying Transaction documents referred to therein, as amended from time to time (collectively, the “Underlying Transaction Documents” or “UTD”);  unless otherwise defined herein, capitalized terms herein shall have the same meaning set forth in the UTD;  and

WHEREAS, DEBTOR and GUARANTOR have acknowledged that DEBTOR is indebted to SDP for SDP's guaranties (attached hereto and incorporated herein) in the full amount of the Underlying Transaction Documents;  and

WHEREAS, GUARANTOR acknowledges the benefit to it from the aforementioned transactions and, in the furtherance of the business purposes of GUARANTOR, desires to guaranty the obligation of DEBTOR under the Underlying Transaction as provided herein.

In relevant part:  each of the guaranties contains the following provisions:

1.  GUARANTOR, as primary obligor and not merely as surety, hereby absolutely, unconditionally and irrevocably guarantees to SDP the complete and punctual (I) payment in full when due, whether at scheduled payment, prepayment, stated maturity, acceleration, demand or otherwise, of any and all present and future obligations of DEBTOR to SDP arising from the Underlying Transactions, whether of principal, interest, overdue interest, fees, expenses, indemnities and other amounts and (ii) performance by DEBTOR of all obligations and covenants under the Underlying Transactions (collectively, the Guaranteed Obligations).   This Guaranty is a continuing guaranty of payment and performance and not only of collection and shall be valid and enforceable until all Guaranteed Obligations and other obligations have been indefeasibly paid in full and completely performed.

After Johnson, Pratley and Jennifer Porter signed their respective backstop guaranties, the plaintiff signed a guaranty of a one million dollar construction loan in favor of the Bank. (Ex. 33.)   Pratley signed the construction mortgage note and deed on behalf of One Country, LLC. (Exs. 9 & 10.)   Thereafter, the Bank advanced funds to One Country, LLC to pay the costs of construction and to pay the interest on both mortgages.   One Country, LLC raised an additional $200,000 in equity capital by admitting four new members.   Pratley also arranged for his girlfriend's stepfather to lend One Country, LLC $200,000.   Despite funds from the construction mortgage and the capital infusions, One Country was unable to complete the renovations to the property before running out of cash in 2007.   At that point, Pratley ceased working as general contractor, which left the property in an uncompleted condition.

In early 2008, after One Country, LLC ceased making payments on the mortgage, the Bank commenced foreclosure proceedings against One Country, LLC and the plaintiff as guarantor.   After a judgment of strict foreclosure entered in favor of the bank, a deficiency was found.   Thereafter, the plaintiff reached an agreement with the Bank to settle his obligations under his two guarantees in return for a payment of $300,000.  (Ex. 6.) After being served with process in the Bank's foreclosure action, the plaintiff brought this action against Pratley, Johnson and Jennifer Porter seeking damages based on their failure to honor their obligations to him under the backstop guarantees.

Then Pratley filed an answer denying the essential allegations of the complaint and claiming, by way of special defense, that pursuant to the provisions of the Operating Agreement (Ex. 13), Porter was required to submit his claims against Pratley to arbitration.   Johnson filed an answer denying the allegations of the complaint and claiming that Johnson's backstop guarantee was unenforceable because of lack of consideration.

The case was tried before the court over several days in late July 2010.   The plaintiff testified at length regarding:  (1) the circumstances that led to the formation of One Country, LLC;  (2) the financing of the acquisition of the property;(3) the development of plans for the renovation of the residence on the property;(4) the preparation and execution of the construction contract between One Country, LLC and The Pratley Company;  (5) the negotiation of the backstop guarantees signed by Pratley, Johnson and Jennifer Porter;  (6) his guarantees of both of the acquisition mortgage and the construction mortgage;  (7) the administration of the construction contract and the construction mortgage;  (8) the failure of the parties to complete the project;  (9) the ensuing mortgage foreclosure action and settlement of the Bank's claim for a deficiency and (10) the preparation and filing of tax returns for both One Country, LLC and Iboport, LLC. In his testimony, Porter acknowledged that, if the backstop guarantees were enforced against Pratley and Johnson, they would bear the entire loss on the Bank's deficiency judgment and Porter would only lose the funds that Iboport, LLC has invested in One Country, LLC.

Richard Muskus, Jr., who is the Bank's loan officer, testified as to the Bank's financing of the project, the Bank's requirement that the loans be guaranteed by the plaintiff, the advances made under the construction loan and the eventual foreclosure and settlement with the plaintiff.

Michael Johnson testified as to the circumstances surrounding the formation of One Country, LLC and the division of responsibilities among the managers.   He claimed that despite his being designated, under the Operating Agreement, as one of three co-managers, he considered himself to be a passive investor whose responsibilities for losses was limited by the Operating Agreement to 10 percent.   In his initial testimony, he denied having even signed a backstop guaranty.   He claimed that Pratley often gave him signature pages to sign that were not attached to any agreement.   When it was pointed out to him that the signature pages of his backstop guarantees recited that it was a signature page for a guarantee, he claimed that he had not read it before signing.

Peter Pratley testified as the negotiations leading up to the execution of the Operating Agreement, his ultimately successful efforts to secure an additional $200,000 in equity investment in One Country, LLC and his success in obtaining another $200,000 in additional funds from his girlfriend's stepfather as a loan to One Country, LLC. Pratley also related the circumstances leading to his signing of his backstop guarantee in favor of the plaintiff.

Steven Glaser, a certified public account who prepared tax returns for One Country, LLC, Iboport, LLC and the plaintiff for 2008 and 2009, testified as to his discussions with the plaintiff concerning the tax treatment of the $300,000 payment he made to the Bank to settle his obligations under his guarantees of One Country's mortgage obligations to the Bank. He testified that, under the tax code, losses incurred on investments in limited liability companies such as One Country, LLC are typically treated as capital losses with a limited right to deduct such losses on the investor's personal tax return.   However, because of Pratley's position as a person engaged in the construction industry as a member of One Country, LLC, the losses incurred by members of One Country, LLC were required to be treated as ordinary losses which can be deducted, without limit, against ordinary income.

On its 2008 tax return, One Country, LLC treated the $300,000 that the plaintiff was required to pay the Bank as a capital contribution by Iboport, LLC. In turn, Iboport, LLC treated the same $300,000 as a capital contribution by the plaintiff.   The net result was that the plaintiff was able to take an immediate tax deduction for the $300,000 he paid to the Bank. Glaser testified that the plaintiff had approved and agreed to this treatment of his $300,000 on the tax returns of both One Country and Iboport.

DISCUSSION

The operative language of the guarantees signed by Pratley and Johnson is somewhat awkward and difficult to comprehend.   Nevertheless, it is apparent that both Pratley and Johnson undertook to guarantee the obligations of One Country, LLC, described in the guarantees as “debtor,” to Scott Johnson and the performance by One Country, LLC of its obligations under “the Underlying Transaction.”   As the plaintiff correctly observes in his post-trial brief, despite the language employed, the intent of the guarantees is clear-if the plaintiff was obligated to make payments to the Bank under his personal guarantee and One Country, LLC thereby became indebted to the plaintiff, the defendants would be obligated to make payment to the plaintiff to discharge One Country, LLC's debt to the plaintiff.

CONSIDERATION

Although only defendant Johnson filed a special defense claiming lack of consideration, both defendants filed briefs addressing that issue.   The defendants claim that after the plaintiff acted as guarantor to the Bank of the mortgage that provided One Country, LLC with the funds to acquire the property, the plaintiff was obligated to guarantee the construction mortgage.   The defendants do not point to any provision of the Operating Agreement requiring the plaintiff to act as guarantor of either mortgage, nor do they identify any binding agreement among the parties requiring the plaintiff to act as guarantor of the construction mortgage.   It was clear to all of the investors that the business purposes of One Country, LLC (the renovation of the residence on the property and subsequent sale at a profit) could not be achieved without bank financing.   It was also clear that the Bank would not provide such financing without the personal guarantee of the plaintiff.   Nevertheless, the agreement obligated the plaintiff to sign a guaranty of the construction mortgage.

In the fall of 2005, the plaintiff demanded that the defendants and his wife sign the “back stop” guarantees before he would agree to guarantee the construction loan.   At that time, none of them claimed that the plaintiff was already obligated to sign the guarantee to the Bank. Instead, each of them signed a “back stop” guarantee.   Thereafter, the plaintiff signed a guarantee of the construction mortgage.   The court finds that the execution of that guarantee was sufficient consideration to support each of the defendant's “back stop” guarantees.

ESTOPPEL

Although neither defendant pleaded any special defenses based on a theory of estoppel, both defendants claim that the plaintiff should be barred under the principles of both equitable estoppel and promissory estoppel from enforcing their “back stop” guarantees.   The defendants argue that they would not have invested in One Country, LLC if the plaintiff had not agreed to guarantee both the acquisition mortgage and the construction mortgage.   Accordingly, they claim that in light of this expectation, the plaintiff should be barred from claiming that his execution of the guarantee of construction mortgage is adequate consideration to support the “back stop” guarantees they signed.

The evidence does not support the defendants' claim.   The terms of the Operating Agreement were subject to extensive negotiations among the parties prior to the finalization of the terms and the delivery of investment funds to One Country, LLC. As noted above, the evidence does not support the defendants' claim that the plaintiff was either legally or equitably required to execute a guarantee of the construction mortgage.   The defendants may well have relied upon the fact that the plaintiff, as the largest investor in One Country, LLC, would have more to lose if funds could not be secured to enable the renovation to be completed.   Any such reliance would be nothing more than an assessment of the business risks involved in the investment and can not support a claim of either equitable or promissory estoppel.

ARBITRATION

Defendant Peter Pratley's answer sets forth a special defense claiming that “there is ․ an arbitration provision between all of the individually named defendants.”   No evidence was produced at trial of any agreement requiring the parties to arbitrate disputes arising with respect to the “back stop” guarantees.   Moreover, defendant Pratley did not brief any claims relating to arbitration.   Under these circumstances, the court finds that defendant Pratley abandoned this special defense.   Accordingly, the court finds the issues raised in defendant Pratley's special defense for the plaintiff.

EXISTENCE OF A DEBT

In their post-trial briefs, the defendants argue that even if, immediately after the plaintiff paid $300,000 to the Bank, One Country, LLC might have been indebted to the plaintiff, that debt was settled and extinguished when the plaintiff transferred the debt to Iboport, LLC which, in turn, elected to convert that debt into an additional equity investment in One Country, LLC. In his post-trial brief, the plaintiff asserts that, although the plaintiff treated his $300,000 payment as a capital loss deductible against ordinary income on his personal 2008 tax return and on the tax returns of lboport, LLC and One Country, LLC,³ that such “treatment for tax purposes is not relevant to the issue before the court.”   The plaintiff's brief also claims that “The tax accounting methods [by the plaintiff in his personal income tax returns] utilized do not in any way affect the enforceability of the Defendants' liability by way of their personal guarantees to Scott Porter.”   The plaintiff offers no authority whatsoever supporting these claims.

In order for the plaintiff to enforce the backstop guarantees against Pratley and Johnson, the debt that One Country, LLC owed to the plaintiff had to remain wholly or partially unsatisfied.   Once the plaintiff converted the debt into an equity investment, there was no debt remaining.   In the absence of such a debt the plaintiff is owed nothing under the guarantees signed by Pratley and Johnson.   The question of whether an interest in a corporate entity is debt or equity is determined by “whether there was a genuine intention to create debt instrument or an equity interest and whether the economic realities of the transaction comport with that intention.”   14A W. Fletcher, Cyclopedia of the Law of Private Corporations (2008) § 6989.70, p. 487.   When considering the proper characterization of entries made on corporate tax returns, courts have long held that “forms and labels must yield to reality.”  AWG Leasing Trust v. United States, 592 F.Sup.2d 953, 975 (N.D.Ohio 2008).  “[A]ccounting fiction [may not] obscure business and fiscal realties.”  Mooney Aircraft, Inc. v. United States, 420 F.2d 400, 410 (5th Cir.1969).   In this case, the evidence is clear that the plaintiff faced a choice.   He could, by way of his ownership interests in Iboport, LLC, capitalize the obligations owed to him by One Country, LLC and receive immediate tax write offs against ordinary income.   In the alternative, he could allow One Country, LLC's obligations to remain an unsatisfied debt and hope to enforce successfully the backstop guaranties against the defendants and collect the full amount of the debt from them.   The evidence shows that the plaintiff chose to capitalize the debt.   The court cannot accept the plaintiff's invitation to ignore this reality.

The obligations of a guarantor are found in the obligations of the principal and when that obligation is extinguished or released, the guarantor is, in most cases, released as well.   Restatement (Third), Suretyship and Guaranty § 39, p. 168 (1996).   In this case the principal was One Country, LLC. The obligation for which the defendants provided their back stop guarantees was the obligation of One Country, LLC to the plaintiff that arose when the plaintiff was required to pay $300,000 to the bank pursuant to his guaranty.   After that obligation arose, the plaintiff chose to contribute the obligation to Iboport, LLC. Thereafter, at the plaintiff's direction, Iboport, LLC elected to convert the obligation owed to it by One Country, LLC into an additional equity investment in One Country, LLC. In this process, the plaintiff first divested himself of title to the obligation, so that Iboport, LLC, rather than the plaintiff became the party entitled and empowered to enforce the defendants' backstop guarantees.   Thereafter, One Country, LLC's obligation became entirely extinguished when Iboport, LLC elected to convert the obligation into equity.

The court further finds that the plaintiff is not entitled to enforce the guarantees against Pratley and Johnson based on the claim that One Country failed to perform its obligations to the Bank under the “Underlying Transaction.”   While there is no doubt that One Country failed to perform its obligation to make the payments due under the mortgage notes, the plaintiff can no longer demonstrate that he suffered a loss as a consequence of that failure.   The plaintiff's election to contribute the obligations owed to him by One Country, LCC to Iboport, LLC and that entity's subsequent decision to convert that debt to equity precludes the court from finding that either the plaintiff or Ibport, LLC suffered a loss.

Judgment in favor of the defendant may enter on all counts of the complaint in accordance with this memorandum of decision.

David R. Tobin, J.

FOOTNOTES

FN1. Count three, in which Scott Porter sought to enforce a guaranty against the defendant Jennifer Porter, and count four in which One Country, LLC asserted a breach of contract claim against The Pratley Company, LLC, have been withdrawn, leaving Scott Porter as the sole remaining plaintiff and Michael Johnson and Peter Pratley as the only defendants.  FN1. Count three, in which Scott Porter sought to enforce a guaranty against the defendant Jennifer Porter, and count four in which One Country, LLC asserted a breach of contract claim against The Pratley Company, LLC, have been withdrawn, leaving Scott Porter as the sole remaining plaintiff and Michael Johnson and Peter Pratley as the only defendants

FN2. In the heading, “SDP” is defined as “Scott Porter” and “GUARANTOR” is defined as “Peter Pratley” or “Michael Johnson” respectively..  FN2. In the heading, “SDP” is defined as “Scott Porter” and “GUARANTOR” is defined as “Peter Pratley” or “Michael Johnson” respectively.

FN3. The evidence shows that the plaintiff controlled both Iboport, LLC and One Country, LLC and signed the tax returns reflecting the capitalization of the debt by both entities..  FN3. The evidence shows that the plaintiff controlled both Iboport, LLC and One Country, LLC and signed the tax returns reflecting the capitalization of the debt by both entities.

Tobin, David R., J.