Schmuckie v. Alvey

758 S.W.2d 31, 8 U.C.C. Rep. Serv. 2d (West) 1110, 1988 Ky. LEXIS 60, 1988 WL 102365

• Court: Kentucky Supreme Court
• Decided: October 6, 1988
• Docket: 87-SC-670-DG
• Status: Published

Opinions

LAMBERT, Justice.

Upon motion of appellant Gretchen Schmuckie, this Court granted discretionary review. The precise issue before us is whether a maker¹ of a promissory note may be discharged from liability as a result of the holder’s impairment of collateral which secures payment of the instrument.

Appellees, James N. Alvey and Mary E. Alvey, conveyed a parcel of improved real property to James M. Schmuckie and Gretchen Schmuckie, husband and wife, and Joseph Sostarich and Doris Sostarich, husband and wife, for the sum of $230,000. Contemporaneous with the conveyance and in partial payment of the purchase price, the Schmuckies and Sostariches executed a “First Lien” promissory note in favor of the Alveys for the sum of $165,000. In the deed, a vendor’s lien was retained to secure payment of the unpaid purchase money.

Thereafter, and contrary to a provision in the deed which prohibited sale of the real property, the Schmuckies and Sostariches conveyed the property, for valuable consideration, to Shively Lanes, Ltd., a Kentucky limited partnership. Gretchen Schmuckie and Doris Sostarich had no interest in the limited partnership, but James M. Schmuckie and Joseph Sostarich were the general partners. From the proceeds of this sale, none of the parties made any payment upon the Alvey debt. In the deed to Shively Lanes, reference was made to the vendor’s lien in favor of the Alveys, but Shively Lanes did not assume the indebtedness.

After acquiring the real property, Shively Lanes applied to Louisville Home Federal Savings and Loan Association for a loan of approximately $500,000 to make improvements on the property. As a condition to making the loan, the lender required a first lien position. In response to a request from Shively Lanes, and for valuable consideration, the Alveys executed an agreement whereby they subordinated their vendors lien to the mortgage in favor of Louisville Home Federal. The trial court found that “this (the subordination) was done without Mrs. Schmuckie’s consent or understanding.”

Upon default by the Schmuckies and Sos-tariches in payment of the note, the Alveys brought an action for recovery of the unpaid balance, about $80,000. During the pendency of the action, Joseph and Doris Sostarich instituted a proceeding under Chapter 7 of the Bankruptcy Act and their liability on the note was discharged. Judgment was entered against James M. Schmuckie, but as to Gretchen Schmuckie, the action was dismissed.

As grounds for dismissal of the claim against Gretchen Schmuckie, the trial court held that Alveys’ voluntary subordination of their lien in favor of the lien of Louisville Home Federal constituted an impairment of collateral bringing Mrs. Schmuckie within the protection afforded by KRS 355.-3-606(l)(b). The trial court said:

Her (Mrs. Schmuckie’s) position changed from one where the collateral securing her obligation more than equaled the amount of the note to one where the first mortgage to Louisville Home exceeded the value of the collateral.

Alveys appealed to the Court of Appeals and the decision of the trial court was reversed. Defining the issue as “whether a co-maker of a note is entitled to the defense of impairment of collateral under KRS 355.3-606(l)(b),” the Court below followed its decision in Ramsey v. First National Bank and Trust Company of Corbin, Ky.App., 683 S.W.2d 947 (1984), and denied relief to Mrs. Schmuckie. It held that the discharge provisions of the statute apply only to accommodation parties or guarantors and that the language “any party” is limited to sureties or accommodation parties even though they may appear on the instrument as makers.

Resolution of this case requires us to construe KRS 355.3-606(l)(b). The statute is as follows:

(1) The holder discharges any party to the instrument to the extent that without such party's consent the holder (b) unjustifiably impairs any collateral for the instrument given by or on behalf of the party or any person against whom he has a right of recourse.

At first blush, the language “any party to the instrument” would appear to include makers as well as accommodation parties whether they appear as makers or endorsers. However, on more thorough examination of the statutory language, the underlying purpose, and the relationship of this statute to other provisions of the Uniform Commercial Code, we are persuaded that a more narrow construction is required. Accordingly, we hold that KRS 355.3-606(l)(b) applies only to accommodation parties whether they appear as makers or endorsers, but does not apply to makers.

A negotiable instrument is an unconditional order or promise to pay a sum certain in money.² KRS 355.3-104. If the instrument is “subject to or governed by another agreement,” its negotiability is destroyed, and the determination of whether an instrument is unconditional must be made from the content of the instrument itself. KRS 355.3-105(2)(a). Upon execution of a negotiable instrument, the maker engages that he will “pay the instrument according to its tenor.” KRS 355.3-413. “Thus, the maker’s (contractual) liability is unconditional and absolute; ...” J. White and R. Summers, Uniform Commercial Code, (2d ed. 1980) pp. 498-499.

It is not uncommon, of course, for a promissory note to be signed by two or more persons as co-makers. In the absence of an express agreement to the contrary, such persons are jointly and severally liable to the holder even though the instrument contains no such express provision. KRS 855.3-118. As between or among themselves, however, in the absence of evidence of a contrary agreement, comakers are presumed to be liable in equal amounts and a right of contribution, based upon an implied contract of reimbursement and not the instrument, exists between or among them. 11 Am.Jnr.2d, “Bills & Notes” § 588 (1963).

On the other hand, the status of accommodation makers differs significantly from that of makers. Under KRS 355.3-415, an accommodation party does not lose his status as such even though he executes the instrument as a maker. In such a case, the holder may proceed directly against the maker, the accommodation maker, or both. Upon payment of the instrument, however, the accommodation maker has recourse against the maker and may prove his status as an accommodation maker by oral evidence. KRS 355.3-415(3) and (5).

From the foregoing, it is apparent that an important distinction exists between makers and accommodation makers. While either has primary liability to the holder, upon payment the accommodation maker has recourse upon the instrument against the maker. Co-makers, however, are limited to asserting claims for contribution upon an express or implied contract.

In the statute before us, KRS 355.-3-606(l)(b), the right of recourse is an essential element. To illustrate this and for better understanding generally, the statute may be read as follows:

The holder discharges any party to the instrument to the extent that ... the holder unjustifiably impairs any collateral for the instrument given by ... the party or any person against whom he has a right of recourse.

The initial phrase “any party” is limited by the remainder of the sentence to another party “against whom he has a right of recourse.” Said otherwise, a party seeking discharge must have a right of recourse against another party which has been impaired by the holder’s action. This view is consistent with the protection given accommodation makers by granting them a right of recourse on the instrument, but denied makers when proceeding against one another for contribution. The rationale for this disparate treatment appears to be the consideration received by the maker, but not by accommodation makers.

Our position on this issue is clearly in line with prior decisions of the Court of Appeals of Kentucky³, the “Kentucky Commentary” which accompanies KRS 355.3-606(l)(b)⁴, the statute in effect prior to the adoption of the Uniform Commercial Code⁵, and a clear majority of state jurisdictions⁶. This view has been critized, however, by text writers and a minority of state courts as being contrary to the language of the statute⁷. Other texts have indicated that the language of the statute is ambiguous⁸. Of the state court decisions consulted, EL-CE Storms Trust, Etc. v. Svetahor, 724 P.2d 704 (Mont.1986), is particularly persuasive. In addressing a claim for discharge under MCA 30-3-606, a statute which, like its counterpart in Kentucky, is a verbatim adoption of the Uniform Commercial Code, the Court at length discussed the statutory language, its interpretation, and its relationship to other sections of the Code. The Court in EL-CE Storms Trust explained its decision as follows:

We find that the majority rule is the better approach. The comments to § 30-3-606 make it clear that the statute discharges “any party who is in the position of a surety, having a right of recourse ...” Makers and co-makers are not sureties and do not have a right of recourse on the instrument. A maker is primarily liable on the instrument and cannot look to anyone else for payment. Similarly, co-makers are primarily liable on an instrument. As between co-makers, each is ultimately liable for the obligation. Although one co-maker may have a right of contribution from the other co-maker if the former pays more than his share, he does not have a right of recourse for the entire payment made. However, a party who occupies the position of a surety does have a right of recourse on the instrument for the full amount owing if he is made to pay.

We could not conclude this opinion without revisiting the facts of this case. As found by the trial court, the Alveys’ execution of the subordination agreement impaired the collateral for the note executed by Mrs. Schmuekie. On the other hand, Mrs. Schmuekie conveyed the property to the limited partnership contrary to an express provision of the vendor’s lien. She did not apply any part of the proceeds to the Alvey indebtedness nor did she seek discharge upon the note. Moreover, by alienation of the property she divested herself of any right to prevent modification of lien priority then in existence. It cannot be disputed that Mrs. Schmuckie’s conveyance made it possible for Shively Lanes to seek an additional loan which necessitated subordination of the Alvey loan.

In final analysis, it appears that either Mrs. Schmuekie or the Alveys will lose a substantial sum of money. While the equities are in conflict, at the time of this transaction, the prevailing view in American law denied makers the protection afforded by KRS 355.3-606(l)(b). As such, Mrs. Schmuekie had no reason to believe that she would be entitled to the benefit of the statute. Moreover, due to the interstate nature of commercial transactions, we believe there is a substantial need for uniformity among the states. It would be unwise for this Court to depart from a rule of law which is clearly a majority rule in American jurisdictions, a rule heretofore adopted in Ramsey v. First National Bank and Trust Company of Corbin, supra, and Nunnelley v. Herndon, Ky.App., 685 S.W.2d 206 (1985), and join a minority of states which view the statute differently.

Upon execution of the promissory note, Mrs. Schmuekie unconditionally engaged to “pay the instrument according to its ten- or.” Her promise must be enforced.

We affirm the Court of Appeals.

STEPHENS, C.J., and LEIBSON and STEPHENSON, JJ., concur. GANT and VANCE, JJ., dissent. WINTERSHEIMER, J., dissents by separate opinion.

1 . As used in this opinion, the terms "maker” and "co-maker” do not include accommodation parties. The factor which determines a party's status is whether that party received a direct benefit from the execution of the instrument or whether he signed the instrument to lend his name to another party. See Cummins v. Lowry, 691 S.W.2d 582 (Tex.1985) (concurring opinion by Ray, J.), and KRS 355.3-415. Mrs. Schmuck-ie does not cdntend that she signed the instrument as an accommodation party and the trial court found that she was "a signatory on the note and owner of an undivided one-fourth interest in the property.”

2 . Mrs. Schmuckie contends that the phrase "First Lien Note” appearing at the top of the promissory note which she executed is substantive and that subordination of the lien constituted a breach of a material provision of the note resulting in a discharge of her liability. This argument is refuted by KRS 355.3-104, .3-105, and .3-112. If such a provision were enforced, the instrument would not be "unconditional” and thus, not a negotiable instrument.

3 . Ramsey v. First National Bank and Trust Company of Corbin, Ky.App., 683 S.W.2d 947 (1984); Nunnelley v. Herndon, Ky.App., 685 S.W.2d 206 (1985).

4 . Baldwin’s Kentucky Revised Statutes Annotated.

5 . See KRS 356.120 (repealed 1960).

6 . Commonwealth Insurance Systems, Inc. v. Kersten, 40 Cal.App.3d 1014, 115 Cal.Rptr. 653, 663 (1974); Farmers State Bank of Oakley v. Cooper, 227 Kan. 547, 608 P.2d 929, 933 (1980); Holcomb State Bank v. Adamson, 107 Ill.App.3d 908, 63 Ill.Dec. 704, 438 N.E.2d 635 (1982); ELCE Storms Trust v. Svetahor, Mont., 724 P.2d 704 (1986); Bank of New Jersey v. Pulini, 194 N.J.Super. 163, 476 A.2d 797 (1984); Citizens State Bank v. Richart, 16 Ohio App.3d 445, 476 N.E.2d 383 (1984); Oregon Bank v. Baardson, 256 Or. 454, 473 P.2d 1015 (1970); Commerce Union Bank v. Davis, Tenn.App., 581 S.W.2d 142 (1978); Peoples Bank of Point Pleasant v. Pied Piper Retreat Inc., 158 W.Va. 170, 209 S.E.2d 573 (1974); Wohlhuter v. St. Charles Lumber and Fuel Co., 62 Ill.2d 16, 338 N.E.2d 179 (1975); Smiley v. Wheeler, 602 P.2d 209 (Okla.1979); and United States v. UNUM Inc., 658 F.2d 300 (5th Cir.1981).

7 . D. Leibson and R. Nowka, The Uniform Commercial Code of Kentucky § 3.3(F)(1) (Supp. 1987) p. 29 endorsing the view set forth in Bishop v. United Missouri Bank of Carthage, 647 S.W.2d 625 (Mo.App.1983); Southwest Florida Production v. Schirow, Fla.App., 388 So.2d 338 (1980); Rushton v. U.M. & M. Credit Corporation, 245 Ark. 703, 434 S.W.2d 81 (1968).

8 . J. White and R. Summers, Uniform Commercial Code, (2d ed. 1980) pp. 524-525 (Footnote 125).