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Note: Commercial Money Center, Inc. (Lessor/Obligee), leased vehicles and equipment to subprime lessees. To remarket the leases, Lessor/ Obligee bundled them into pools and sold the pools to banks and other investors (Investors). To make the lease pools a more attractive investment, Lessor/ Obligee obtained "Lease Bonds" from Royal Indemnity Company and SAFECO Insurance Company of America (Sureties). The Lease Bonds named the lessee as "principal" and the Lessor/ Obligee as "obligee." In addition to paying the Lessor/ Obligee in the event of a default by the lessee/ principal, a sample Lease Bond provided that:

The Surety is responsible to Obligee for the individual underwriting of each lessee and Lease, including, but not limited to, all related credit matters, issues of fraud, bankruptcy, and the accurate and timely performance by any sub-servicer designated by Surety, and Surety shall assert no defenses to any claim under this Bond as a result of any of the foregoing. This Lease Bond and the Surety's obligation constitute an unconditional and absolute guarantee of payment, not collection.

Sureties understood that Lessor/Obligee intended to assign its rights under the Lease Bonds to Investors.

Shortly before it went out of business and filed for bankruptcy, Lessor/Obligee stopped forwarding lease payments to Investors. Investors sought payment under the Lease Bonds but Sureties refused. Investors sued Sureties to recover under the Lease Bonds, and Sureties defended, claiming fraudulent inducement, alleging that Lessor/Obligee had misrepresented the financial condition of its lease pools, and that the Lease Bonds were therefore void. Although the Lease Bonds provided that Sureties could not assert a fraud defense against a lessee/ principal, the Lease Bonds did not contain a waiver of Sureties' right to assert a fraud defense against obligee or its assignees. Therefore, the question of whether the Lease Bonds intended the Lessor/ Obligee or the Investors to be the obligee became of crucial importance.

The U.S. District Court for the Northern District of Ohio, O'Malley, J., conducted a bench trial to address the questions of whether the Lease Bonds could be construed to designate the Investors as the obligee rather than the Lessor/Obligee, and whether the Lease Bonds were intended to function as "a letter of credit or similar financial guarantee instrument" rather than "standard surety bonds". The Judge ruled that the Lease Bonds "simply [were] not susceptible to a meaning whereby [Lessor/Obligee] would mean [Investors] ... [nor] that the parties intended [the Bonds] to mean 'financial guarantee'".

Investors attempted to show that because all of the parties understood that Lessor/Obligee would assign its rights under the Lease Bonds to Investors, Investors were the first real obligee, and Lessor/ Obligee was effectively a "co-principal." However, because the express language of the Lease Bonds designated the Lessor/Obligee as the obligee, the court rejected this argument.

Alternatively, Investors argued that, because the Lease Bonds guaranteed amounts equal to the amounts paid to Lessor/Obligee by the Investors, the Lease Bonds were intended to function as financial guarantee instruments, similar to letters of credit. To support this argument, Investors pointed to a description of surety bonds in a letter to the Lessor/ Obligee written by Michael Anthony (Broker), the surety broker responsible for "virtually all" of the lease pool transactions:

A surety bond is unlike an insurance policy and acts more as a financial guarantee, similar to a letter of credit issued by banks. In the case of the lease bond program, if the lessee fails to make their payments, the surety will. This type of obligation is pure and simple from the surety's language on the bonds. It is a strict financial guarantee.

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The bond is non-cancelable by the surety and runs for the entire term of the lease. The leases can be sold to financial institutions and investors and the surety bond remains valid for the entire term. The surety understands that this is the purpose of the bond in the first place and understands that their obligation must remain the same regardless.

The Judge did not believe that this evidence was sufficient to outweigh the express language of the Lease Bonds, nor did it consider that the statements made by Broker in a letter to Lessor/Obligee could be attributed to Sureties. Furthermore, in later communications between Broker and Investors, Broker stated that the Lease Bonds were "'not guaranteeing a loan, but rather the performance of the lessee ... .'"

When the case goes to trial, because the Judge determined that the Lease Bonds were not intended to function as letters of credit, Investors may only claim the rights under the Lease Bonds that were assigned to the Investors by Lessor/Obligee. Since the Lessor/Obligee was an obligee and not a principal, Sureties will be able to assert the defense of inducement by fraud.

The Judge said:

"Remarkably, all parties to these deals testified that, while they expected the transactions to be extraordinarily lucrative, they also anticipated that they would run no risk of loss. See, e.g., Tr. 95- 96 (Tanner expected a 13.5 percent return with zero risk); Tr. 218 (Safeco underwrote the bond transactions to a zero-loss ratio). Meanwhile, at the center of these transactions were individuals with little or no experience in the equipment leasing field, upon whom all parties were depending for the protection of their investments. While the Court observes that virtually all parties demonstrated an astonishing lack of foresight in entering into these transactions, and essentially eschewed any meaningful form of due diligence, the Court's determinations here are based solely upon the terms of the transaction documents and the evidence presented to the Court during the bench trial."

[JEB/pbl]

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