Covenantors can be sued as principal debtors

This case considered whether a mortgage signed by a covenantor binds that covenantor as principal debtor, and whether a material change in the underlying transaction can release a guarantor from liability.

In this case,1 a creditor advanced a loan to a company. The loan was signed by the company and by its sole director as guarantor, but the document did not contain any guarantee provisions. The loan was secured by a mortgage over a building. The director signed the mortgage as covenantor. The arrangement also included an agreement to grant a deed of assignment of leases (including rental income) associated with the building.

The loan was advanced and, a few months later, 15 titles were issued. Three of the titles were sold, and the creditor released its mortgage without requiring the company to repay any of the loan.

The company defaulted on an interest payment and subsequently defaulted in repayment of the principal amount. The creditor served notices to sell under the Property Law Act (the PLA) on the company and on the director.

The company went into liquidation and the remaining 12 titles were sold by mortgagee sale. The creditor then applied for summary judgment against the director for the shortfall of over $1 million.

The court identified five main issues to consider:

1.    Did the creditor comply with the PLA?

The court found that it did.

2.    Is the director liable as a guarantor or as a principal debtor?

The court decided that the director was liable as a principal debtor and not solely as a guarantor for the following reasons:

• The definition of "Mortgagor" provided that:
  

  "the covenants in the mortgage shall bind all persons jointly and severally and any Covenantor as a principal debtor".

  There was some argument around the definition of "Mortgagor", but the court considered the context and determined that it wasn't unreasonable for the director to be binding himself as a principal debtor since he was the sole director and shareholder of the borrower.
  
  
• The fact that the director was sued by the creditor as a guarantor was irrelevant because the only basis on which he could be sued was under the mortgage.

3.    If the director is a guarantor only, has there been a material change that releases him from liability?

Since the director was liable as a principal debtor, the question about whether there had been a material change that would release him from his obligations as a guarantor was irrelevant. However, the court did say that, if he had been a guarantor and not a principal debtor, then he would have had an arguable case for a material change occurring, since there was no reduction in the principal sum owing to the creditor when the company sold the three units subject to its mortgage.

4.    Did the creditor breach its duty of care as mortgagee when it sold the remaining 12 titles? Is there any other reason for declining summary judgment?

The creditor did not breach its duty of care as a mortgagee when it sold the 12 units because the duty of care (as codified in section 103A of the PLA) provides that it is only owed to the mortgagor (and the definition of mortgagor in the PLA is not wide enough to capture principal debtors). The director would only get the benefit of section 103A if he had made payments under the guarantee and acquired an interest or rights in the security.

5.    Negligence

Despite answering each of these questions against the director, the court refused to award summary judgment in favour of the creditor. The court reasoned that the director may have a claim in negligence against the creditor for the manner in which the security was released. The three apartments sold by the company were the most profitable, were sold at a time when the company was in default under the mortgage, and the net proceeds from the sales were not applied in reduction of the principal sum.

If negligence was found, then this could give rise to set-off.

 

1 National Mortgagee Nominee Company v Clark (2006) 5 NZ ConvC 194, 242

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