First Interstate Bank of Idaho v. Small Business Admin.

• Decision Date: 22 February 1989
• Docket Number: No. 87-4254,87-4254
• Citation: 868 F.2d 340
• Parties: The FIRST INTERSTATE BANK OF IDAHO, Plaintiff-Appellant, v. The SMALL BUSINESS ADMINISTRATION and James C. Sanders, Administrator, Small Business Administration, Defendants-Appellees.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 340

868 F.2d 340

57 USLW 2550

The FIRST INTERSTATE BANK OF IDAHO, Plaintiff-Appellant, v. The SMALL BUSINESS ADMINISTRATION and James C. Sanders Administrator, Small Business Administration Defendants-Appellees.

No. 87-4254.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Oct. 7, 1988.

Decided Feb. 22, 1989.

William J. Russell and Jeffery J. Ventrella, Elam, Burke & Boyd, Boise, Idaho, for plaintiff-appellant.

Jeffrey G. Howe, Asst. U.S. Atty., Boise, Idaho, and John L. Loesch, Small Business Admin., Seattle, Wash., for defendants-appellees.

Appeal from the United States District Court for the District of Idaho.

Before NELSON and BEEZER, Circuit Judges, and REA, ^* District Judge.

BEEZER, Circuit Judge:

This is a contract dispute between a bank and the Small Business Administration ("SBA") over the SBA's failure to honor a guarantee agreement insuring one of the bank's loans. The district court entered an order of summary judgment for the SBA, on the grounds that the bank had substantially failed to comply with the agreement and that the SBA was not required to rescind its guarantee promptly upon learning of the failure of compliance. We affirm.

I

On October 3, 1978, the SBA and the Bank of Idaho ¹ ("the bank") entered into a Loan Guaranty Agreement establishing the conditions under which the SBA would guarantee the bank's loans to certain businesses. The agreement stated that it covered future loans "subject to SBA's Rules and Regulations." Any change in the terms and conditions of a loan following its approval required written agreement between the SBA and the bank.

In October 1980, the bank applied to the Spokane District Office of the SBA for the SBA's guarantee, pursuant to the master loan agreement, of 90 percent of a $450,000 loan to Cedar Products, Inc. ("CPI"). The bank requested that $206,900 of the loan proceeds be approved for repayment of CPI's prior debts to the bank. In November 1980, the SBA approved the loan in the lesser amount of $320,000, and specified that only $39,219 could be used to repay prior debt. The bank responded by cancelling the application for the SBA guarantee, and reapplying for a guarantee of a $395,000 loan, of which $75,000 would repay CPI's prior debts to the bank.

On January 6, 1981, the SBA and the bank executed an Authorization and Loan Agreement in which the SBA agreed to purchase 90 percent of the $395,000 loan to CPI in case of default. The loan agreement specifically listed the purposes for which the money could be used, including purchase of land, construction, working capital, inventory, and debt reduction. Only $39,219 was approved for repayment of CPI's debts to the bank.

The bank admits that the loan funds were not disbursed as the agreement provided. Rather than $39,219, nearly $154,000 of the loan proceeds were retained by the bank to repay its prior loans to CPI. Furthermore, the bank's loan officer in charge of the CPI account, Clark Lusk, sent the SBA a settlement sheet, dated January 16, 1981, falsely indicating that money had been disbursed as per the agreement.

At approximately the time Lusk filed the false settlement sheet, he asked SBA official Joe Finkel orally for approval to apply certain of the required disbursements to the bank's line of credit loan to CPI. Whether Finkel orally approved anything is disputed; however, on this de novo review of summary judgment, we take the facts as presented by the bank and assume that he did.

The bank sought written approval pursuant to the loan agreement for the changes in the disbursement schedule allegedly approved by Finkel. The SBA did not respond in writing before May, 1981, at which time the bank informed the SBA of the unauthorized disbursements and the false settlement sheet. The Spokane office of the SBA referred the matter to the Inspector General of the SBA. An FBI investigation led to Lusk's 1982 conviction under 18 U.S.C. Sec. 1001 (1982) for making false statements on the settlement sheet. Throughout the investigation, the bank continued to request that its disbursements be approved. It recognized that the SBA guarantee was in danger of denial. The SBA did not make any commitment on the matter, however.

CPI defaulted on the loan in April 1982, and the bank asked the SBA to honor the guarantee. The SBA's local office notified the bank that it intended to recommend denial of the request and, in April 1983, the SBA informed the bank that the SBA Administrator had approved denial.

The bank sued for damages for breach of contract and for a declaratory judgment that the guarantee remained in force. The district court granted the SBA's motion for summary judgment because of the bank's substantial failure to follow the terms of the agreement, thus permitting the SBA not to honor the guarantee under SBA regulations. The bank appeals on the grounds that its breach was not substantial, and that, even if the SBA had a right to rescind the contract, it lost that right by its failure to rescind promptly. We have jurisdiction over this timely appeal of a summary judgment. 28 U.S.C. Sec. 1291 (1982); Fed.R.App.P. 4(a)(1). We review a grant of summary judgment de novo. Darring v. Kincheloe, 783 F.2d 874, 876 (9th Cir.1986).

II

The bank does not question the applicability of SBA regulations as part of the contract. The regulations release the SBA from "any obligation to purchase its share of a guaranteed loan if the lender has not substantially complied with all of the provisions of these regulations and the guaranty agreement." 13 C.F.R. Sec. 122.10(b)(1)(iii) (1979). ²

The bank argues, however, that its deviations from the approved disbursements were not a substantial breach justifying the SBA's refusal to honor its guarantee. We apply general federal law. ³ United States v. Kimbell Foods, Inc., 440 U.S. 715, 726, 99 S.Ct. 1448, 1457, 59 L.Ed.2d 711 (1979); Eastern Ill. Trust & Savings Bank v. Sanders, 826 F.2d 615, 616 (7th Cir.1987). A party may rescind a contract in case of substantial breach by the other party. See Eastern Ill. Trust, 826 F.2d at 616-17; CBS, Inc. v. Merrick, 716 F.2d 1292, 1296 (9th Cir.1983) (applying New York law). The test of materiality for a federal contract is an all-the-circumstances test. United States v. Baus, 834 F.2d 1114, 1125 (1st Cir.1987); Eastern Ill. Trust, 826 F.2d at 617; cf. Restatement (Second) of Contracts Sec. 241 (1979) [hereinafter "Restatement "].

The facts of this case approach the level of a prima facie substantial breach of the loan agreements. We need not mince words about what happened here. The bank, specifically its officer Clark Lusk, attempted twice to persuade the SBA to guarantee a paydown of its large existing loans to CPI, replacing overdue nonguaranteed loans with SBA-guaranteed ones. Not succeeding in this effort, the bank tried to do covertly and illegally, in the amount of approximately $115,000, what it could not do legally; use a government loan program to insure its past bad loans. We analyze the case in terms of the tests of materiality of breach developed by the courts and commentators.

In applying federal contract law, we are guided by general principles of contract law and by the Restatement. Baus, 834 F.2d at 1125 (citing, e.g., Eastern Ill Trust, 826 F.2d at 616). Absent specific language indicating a condition precedent, see In re Bubble Up Delaware, Inc. v. United States, 684 F.2d 1259, 1264 (9th Cir.1982), we interpret the contractual language as the mutual exchange of promises supported by consideration. Restatement, supra at Sec. 232. The nature of this contract required that the bank perform first. See id. at Sec. 234(2). Pursuant to Restatement Sec. 237 and the SBA regulations, 13 C.F.R. Sec. 122.10(b)(1)(iii), a material failure of the bank to perform its side of the bargain operated as the nonoccurrence of a condition, which excused performance by the SBA. Restatement, supra, at Sec. 225(1).

The Restatement lists five circumstances as "significant" in determining whether a breach is material. Id. at Sec. 241. ⁴ We consider these factors as guides in applying the all-the-circumstances test, and hold the bank's breach to be material. The SBA was deprived of its specifically bargained-for disbursements by reason of the bank's misallocation of the funds. See id. at Sec. 241(a). This was a loan guarantee in furtherance of a governmental policy of helping small business. See 15 U.S.C. Sec. 636(a) (1982). The "benefit" the SBA reasonably expected was not financial profit, but assistance to CPI in acquiring specific capital improvements that the SBA felt would best help CPI survive, and thus benefit the public interest. The SBA specifically bargained for this allocation of the funds, and specifically rejected the bank's proposed use of the loan guarantee program primarily to benefit the bank.

Such nonmonetary losses are best compensated by allowing rescission under the material breach standard, rather than by holding the breach to be a nonmaterial one that might give rise to a damage claim, but not excuse the SBA's performance. See id. at Sec. 241(b), comment c. By reason of its breach, the bank admittedly suffers forfeiture of its bargained-for interest in receiving the guarantee payment. See id. at Sec. 241(c).

Restatement Sec. 241(d) is inapplicable, because the bank failed to cure its breach by correcting the misallocation of funds. We find Restatement Sec. 241(e) to be most compelling. The bank's covert evasion of its bargained-for performance failed completely to comport with "standards of good faith and fair dealing" as we understand them. Id.

The Seventh Circuit recently approved a district court's application of a somewhat different four-part test of materiality to determine whether the SBA was justified in refusing to honor a loan guarantee. Eastern Ill. Trust, 826 F.2d at 617. ⁵ The court held that the district court's judgment that a bank's unauthorized "side loans"...