A secured lender that is a party to a written loan agreement�even one that expressly provides that it may not be amended or altered except in writing�may nonetheless be surprised to find itself bound by a loan officer’s oral promises if the difference between the written loan agreement and the verbal promises is “drastic” and if the parties’ conduct indicates that they considered the promises to have extinguished and replaced the lender’s written loan agreement. See Fanucchi & Limi Farms v. United Agri Products, 2005 WL 1645694 (9th Cir. 2005).

Fanucchi & Limi Farms was a farming operation in Kern County, California. As is common in the agricultural business, it financed its operations by borrowing against future crop proceeds. In 1994, Fanucchi and United Agri Products Financial Services, Inc. entered into an Agricultural Loan Agreement, a Promissory Note, an Agricultural Security Agreement, and related documents under which United ultimately loaned Fannuchi roughly $1.4 million to finance its 1995 operations. The loan was secured by a security interest in Fanucchi’s crops. The loan documents contained typical integration clauses providing that “[n]o alteration or amendment to this Agreement shall be effective unless given in writing” and that “the written loan agreement may not be contradicted by evidence of any prior, contemporaneous, or subsequent oral agreements or understandings.”

When Fanucchi’s 1995 crops failed, it owed over $1 million to United. Fanucchi consulted with a United representative and with bankruptcy counsel. According to Fanucchi, the United representative persuaded it to continue farming rather than filing for bankruptcy by orally promising: (1) to subordinate United’s debt to new crop financing loans from other lenders for up to five years; (2) to split the proceeds of new crops on a 60/40 basis after new crop loans were satisfied, with 60% going to United and 40% going to Fanucchi’s other creditors; and (3) to potentially forgive $300,000 to $400,000 of Fanucchi’s debt at the end of the five-year period. While there was conflicting testimony with respect to the existence of a five-year term or an agreement regarding loan forgiveness, the testimony of the United representative, written correspondence, and the conduct of the parties was all consistent with the existence of an agreement to subordinate United’s debts to new financing and to split new crop proceeds on a 60/40 basis. After the United representative was terminated in 1998, however, United was unwilling to perform in accordance with the oral agreement.

Fanucchi then brought suit against United for breach of contract, asserting that, by promising substantially to change the terms of the original loan agreement, United had induced Fanucchi not to declare bankruptcy after the failure of the 1995 crops. (The court did not consider whether this promise not to declare bankruptcy might constitute an unenforceable ipso facto provision and whether it could not, on that account, constitute consideration for the new agreement.) In exchange, Fanucchi asserted that United agreed to new loan terms, which it then breached in 1998. Fanucchi’s theory was one of novation under California Civil Code § 1698(d). Novation is the substitution of a new obligation for an existing one, and Fanucchi argued that United’s oral promises had terminated and replaced the earlier written loan agreement.

The district court granted summary judgment to United, but the Ninth Circuit Court of Appeals overturned summary judgment on the novation claim and remanded for further proceedings. The Ninth Circuit noted that in determining whether a new agreement is meant to extinguish an old one, the court must determine the parties’ intent. In making this inquiry, the court must determine “whether the changes between the old and new obligations were sufficiently substantial to show an ‘extinguishment’ of the old obligation and a replacement by the new one.” Where the changes between the two agreements are “drastic,” the court may find that there has been a novation. For example, where the only changes between two loan agreements are changes to the payment schedule, additional interest payments, or the inclusion of an acceleration clause, courts have found that there is not a novation. See, e.g., Alexander v. Angel, 37 Cal. 2d 856 (1951).

In the Fanucchi case, however, the Ninth Circuit found additional “drastic” changes that supported novation. For example, United had relinquished a substantial portion of its security interest by subordinating its lien to new crop lenders, and United had allegedly agreed to a potential 30-40% reduction of its principal. Furthermore, the court found that the parties’ conduct in 1996 and 1997 indicated that the oral agreement had extinguished and replaced the written contract, because United performed during those years under the terms of the oral agreement by subordinating its lien to new crop lenders and taking only 60 percent of the proceeds remaining after the new crop lenders were paid. The Ninth Circuit therefore held that, if Fanucchi’s evidence were believed, the original, written loan agreement was novated by United’s new, oral promises.

Written by: Michael Lauter