Phelps Dodge Corp. v. Schumacher Elec. Corp., 04-2621

• Decision Date: 15 July 2005
• Docket Number: 04-2834.,No. 04-2621,04-2621
• Citation: 415 F.3d 665
• Parties: PHELPS DODGE CORPORATION, Plaintiff-Appellee/Cross-Appellant, v. SCHUMACHER ELECTRIC CORPORATION, Defendant-Appellant/Cross-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

415 F.3d 665

PHELPS DODGE CORPORATION, Plaintiff-Appellee/Cross-Appellant, v. SCHUMACHER ELECTRIC CORPORATION, Defendant-Appellant/Cross-Appellee.

Nos. 04-2621, 04-2834.

United States Court of Appeals, Seventh Circuit.

Argued April 11, 2005.

Decided July 15, 2005.

COPYRIGHT MATERIAL OMITTED

Stephen T. Bobo (argued), Sachnoff & Weaver, Chicago, IL, for Plaintiff-Appellee/Cross-Appellant.

Steven R. Smith, Brian A. Sher, William F. Zieske (argued), Bryan Cave, Chicago, IL, for Defendant-Appellant/Cross-Appellee.

Before POSNER, RIPPLE, and SYKES, Circuit Judges.

POSNER, Circuit Judge.

Phelps Dodge brought this diversity suit (governed by Illinois law) against Schumacher Electric Corporation to enforce a guaranty. The district judge awarded summary judgment to the plaintiff and $372,000 in damages. The facts were stipulated. Schumacher Electric, a family-owned corporation, manufactures battery-charging equipment and electrical transformers. A major input in the manufacture of these products is copper wire. In 1968, Albert Schumacher, the company's principal, created Horning Wire Corporation to manufacture copper wire for his company — and also to provide a business for his daughter and her husband, John Horning, who became the co-owners of Horning Wire. Phelps Dodge sold the copper rod required for the manufacture of the wire to Schumacher Electric, but at the latter's request delivered the copper rod to Horning Wire. Beginning in 1971, again at Schumacher Electric's request, Phelps Dodge began selling the copper to Horning Wire directly. To induce Phelps Dodge to thus become a trade creditor of a fledgling company, Schumacher Electric wrote Phelps Dodge that "in connection with our request to Phelps Dodge to sell to, and therefore bill, Horning Wire rather than Schumacher Electric, this letter will serve as a guaranty by Schumacher Electric of the payment of any purchases of copper by Horning Wire from Phelps Dodge." The letter was signed by a vice-president of Schumacher Electric; his actual and apparent authority to issue the guaranty is not questioned.

Thirty years later, Horning Wire went broke and could not pay Phelps Dodge, which it owed $372,000. Phelps Dodge demanded that Schumacher Electric make good on its guaranty. The latter refused, explaining that it had failed to keep a copy of the guaranty and had forgotten about it. This lawsuit ensued.

Of course Schumacher Electric's carelessness is no defense, as it well knows. It defends instead on the grounds, first, that guaranties that specify no duration expire after a reasonable time, and, second, that in any event Phelps Dodge breached a legal duty to notify Schumacher Electric of any developments, during the time the guaranty was in force, that increased the risk to Schumacher Electric of having to make good on the guaranty or that increased the amount that it might have to make good.

The principle that contracts, including guaranties, that specify no expiration date are terminable without liability after a reasonable time is, like most principles of contract law, a guide to interpretation rather than a flat rule. Mamerow v. National Lead Co., 206 Ill. 626, 69 N.E. 504, 507 (1903); Insurance Co. of North America v. Hoyt, 419 F.2d 1148, 1151 (7th Cir.1969) (Illinois law); Monroe Ready Mix Concrete, Inc. v. Westcor Development Corp., 183 Conn. 348, 439 A.2d 362, 363 (1981); Continental Can Co. v. Lanesboro Canning Co., 180 Minn. 27, 230 N.W. 121, 122 (1930); see Meyer v. Marilyn Miglin, Inc., 273 Ill.App.3d 882, 210 Ill. Dec. 257, 652 N.E.2d 1233, 1239 (1995); cf. Employers Ins. of Wausau v. El Banco de Seguros del Estado, 357 F.3d 666, 670 (7th Cir.2004). It reflects the commonsense idea that a party is unlikely to place itself under an obligation that will perdure until the Day of Judgment. See, e.g., Lehigh Coal & Iron Co. v. Scallen, 61 Minn. 63, 63 N.W. 245, 246 (1895). But the principle has only limited application to continuing guaranties. A continuing guaranty — one tied to a course of dealing, such as the continuing purchase of copper by Horning Wire from Phelps Dodge — is revocable at any time by the guarantor upon notice to the obligee, Mamerow v. National Lead Co., supra, 69 N.E. at 507; City National Bank v. Reiman, 236 Ill.App.3d 1080, 175 Ill.Dec. 919, 601 N.E.2d 316, 322 (1992); John Nagle Co. v. Gokey, 799 A.2d 1225, 1227 (Me.2002), and a contract that a party can revoke at will protects him from being placed under an obligation of oppressive duration even more effectively than a contract that expires on a specified date.

The only circumstance in which it is necessary or appropriate to interpolate a time limit into a continuing guaranty is where, the course of dealing to which the guaranty was tied having ceased, the guarantor reasonably assumed that the guaranty had lapsed — only to discover that, perhaps many years later, the parties to the course of dealing (Phelps Dodge and Horning Wire) had resumed their dealings. Monroe Ready Mix Concrete, Inc. v. Westcor Development Corp., supra, 439 A.2d at 363-64; see William R. Hubbell Steel Corp. v. Epperson, 679 So.2d 1131, 1132-33 (Ala.Civ.App.1996). That did not happen here.

Schumacher Electric's alternative ground for rescinding the guaranty is that changes in the relationship between Horning Wire and Phelps Dodge between 1971 and 2001 increased the risk to Schumacher Electric to an extent that justifies regarding those changes as "material." A party who has a guaranty cannot be permitted to increase the risk that the guarantor will have to make good on the guaranty without notifying the guarantor so that he has an opportunity to cancel it or demand modifications. McLean County Bank v. Brokaw, 119 Ill.2d 405, 116 Ill. Dec. 561, 519 N.E.2d 453, 458 (1988); Barrett v. Shanks, 382 Ill. 434, 47 N.E.2d 481, 484 (1943); McHenry State Bank v. Y & A Trucking, Inc., 117 Ill.App.3d 629, 73 Ill. Dec. 485, 454 N.E.2d 345, 349 (1983); Georgia Pacific Corp., Williams Furniture Division v. Levitz, 149 Ariz. 120, 716 P.2d 1057, 1059 (1986). This rule is an application of the economic principle, fundamental to insurance, of "moral hazard." This is the idea that a person or firm that is insured against a risk has an incentive, unless blocked by contract or law, to increase that risk if it will increase his income or reduce his costs, since he will get to keep the benefit of the greater risk while the insurer will bear the cost. A guaranty is a form of insurance.

But what the cases say, sensibly enough, is that the increase in risk must be "material"; and what is material depends on what is being insured or guaranteed. If an insurance company agrees to insure the life of a person who it knows is a one-pack-a-day cigarette smoker, and sometime after buying the insurance the insured begins to smoke two packs a day, the insurance company cannot rescind the insurance policy on the ground that the insured has materially increased the insurer's risk, for in the absence of an explicit provision regulating the amount of the insured's smoking he would not think his rights under the policy were limited to a particular level of smoking. (So neither would he expect a discount if he stopped smoking.)

Likewise it was to be expected that volume, price, interest rate, credit limits, and other terms and conditions in the sales contracts between Phelps Dodge and Horning Wire would fluctuate over the years and that Schumacher Electric would not have to be notified of every fluctuation and its guaranty would not terminate automatically if the fluctuations were normal in the sense of falling within the foreseeable range. Had the company worried that these fluctuations might significantly increase the risk of its having to make good on its guaranty, it could have conditioned the guaranty on Phelps Dodge's sending it copies of the sales contracts with Horning Wire, which were renegotiated annually. It did not do that. It could have capped the guaranty at a specific dollar amount; it didn't do that either. "The guarantors could have limited their undertaking both as to time and amount, had they seen fit to do so, but, from a reading of the guaranty, it would seem that their desire and intention...