Phelps Dodge Corp. v. Schumacher Electric Corp.

In the
United States Court of Appeals
For the Seventh Circuit
____________
Nos. 04-2621, 04-2834
PHELPS DODGE CORPORATION,
Plaintiff-Appellee/Cross-Appellant,
v.
SCHUMACHER ELECTRIC CORPORATION,
Defendant-Appellant/Cross-Appellee.
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Appeals from the United States District Court for
the Northern District of Illinois, Eastern Division.
No. 01 C 4035—Wayne R. Andersen, Judge.
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ARGUED APRIL 11, 2005—DECIDED JULY 15, 2005
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Before POSNER, RIPPLE, and SYKES, Circuit Judges.
POSNER, Circuit Judge. Phelps Dodge brought this diver-
sity 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,
2 Nos. 04-2621, 04-2834
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 connec-
tion 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 de-
fense, 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.
Nos. 04-2621, 04-2834 3
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., 69 N.E. 504, 507 (Ill. 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., 439 A.2d 362, 363 (Conn. 1981);
Continental Can Co. v. Lanesboro Canning Co., 230 N.W. 121,
122 (Minn. 1930); see Meyer v. Marilyn Miglin, Inc., 652
N.E.2d 1233, 1239 (Ill. App. 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, 63 N.W. 245, 246 (Minn. 1895). But the
principle has only limited application to continuing guaran-
ties. 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 guaran-
tor upon notice to the obligee, Mamerow v. National Lead Co.,
supra, 69 N.E. at 507; City National Bank v. Reiman, 601 N.E.2d
316, 322 (Ill. App. 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 appro-
priate 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.
4 Nos. 04-2621, 04-2834
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 opportu-
nity to cancel it or demand modifications. McLean County
Bank v. Brokaw, 519 N.E.2d 453, 458 (Ill. 1988); Barrett v.
Shanks, 47 N.E.2d 481, 484 (Ill. 1943); McHenry State Bank v.
Y & A Trucking, Inc., 454 N.E.2d 345, 349 (Ill. App. 1983);
Georgia-Pacific Corp., Williams Furniture Division v. Levitz, 716
P.2d 1057, 1059 (Ariz. App. 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 in-
crease in risk must be “material”; and what is material de-
pends on what is being insured or guaranteed. If an insur-
ance 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 materi-
ally increased the insurer’s risk, for in the absence of an
Nos. 04-2621, 04-2834 5
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 fluctua-
tions were normal in the sense of falling within the foresee-
able 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 were
that both should be unlimited.” Mamerow v. National Lead
Co., supra, 69 N.E. at 507.
The reason Schumacher Electric placed no conditions on its
guaranty of Horning Wire’s debts to Phelps Dodge was the
close family linkage between the Schumacher and Horning
firms. That linkage began to fray when the Hornings
divorced in 1985 and it frayed further when Albert
Schumacher, the family patriarch, died in 1988. At some
point his successor at the head of the Schumacher company
(his son) should have realized that because the firms had
grown apart he might not have good information about the
current dealings between Horning and Phelps Dodge. He
could have insisted, as a condition of continuing the guar-
6 Nos. 04-2621, 04-2834
anty (which, remember, his company could have revoked at
will), that Phelps Dodge send him copies of the annual
contracts. He did not do that.
Maybe he didn’t do that because he didn’t know about the
guaranty. That wasn’t Phelps Dodge’s fault. It wasn’t privy
to the relations between the Schumacher and Horning
companies. Had Phelps Dodge known that Schumacher
Electric had forgotten about the guaranty and that if it hadn’t
forgotten it would have insisted on a renegotiation, Phelps
Dodge would have had a duty to warn Schumacher. First
Midwest Bank, N.A. v. Sparks, 682 N.E.2d 373, 378-79 (Ill. App.
1997); Magna Bank v. Jameson, 604 N.E.2d 541, 545 (Ill. App.
1992); St. Paul Fire & Marine Ins. Co. v. Commodity Credit
Corp., 646 F.2d 1064, 1073 (5th Cir. 1981); Logan Bank & Trust
Co. v. Letter Shop, Inc., 437 S.E.2d 271, 274 (W. Va. 1993);
International Harvester Co. v. Fuoss, 758 P.2d 649, 652 (Ariz.
App. 1988); Restatement of Security § 124(2) (1941). That is an
implication of the duty of performance in good faith that the
common law reads into contracts. But it cannot help
Schumacher Electric, because Phelps Dodge didn’t know
that its guarantor had forgotten about the guaranty. The law
would be complicated unnecessarily if the obligee were re-
quired to inform his guarantor of an increase in risk merely
on the off chance that the guarantor had forgotten the very
existence of the guaranty. That would be a duty not of good
faith but of paternalism. The law does not go that far. If the
obligee knows, he is the lower-cost avoider of the impending
train wreck and so has a duty to warn. But if he doesn’t
know, then the guarantor is an equal- or lower-cost avoider
and there is no reason to set in motion the cumbersome and
expensive machinery of the law to shift the cost of the mis-
take to the obligee.
At argument Schumacher Electric’s lawyer told us that if
we allow this guaranty to be enforced, businesspeople will
Nos. 04-2621, 04-2834 7
be reluctant to give guaranties and an important device for
encouraging commercial activity will be impaired. The op-
posite is true. Guaranties that exist at the whim of judges
have little value. A business wouldn’t know what it was
getting when it got a guaranty. The less protection Phelps
Dodge could expect to get from Schumacher Electric’s
guaranty, the tougher would be the terms that it imposed on
Horning Wire—which might therefore have gone broke
sooner. The analogy is to letters of credit, which are promises
to pay that are absolute and thus independent of the under-
lying contract and so protect commercial transactions from
both buyers’ trickery and judges’ and jurors’ foibles.
Quizzed at argument, Schumacher Electric’s lawyer was
notably vague on when he thought the guaranty had expired
or otherwise terminated—when the “reasonable time” was
up or a “material” change in risk had occurred. It would
have been easier for Schumacher Electric to have specified
limits in the guaranty than for a court to fill in the blanks
that the company had left in its eagerness to assist Horning
Wire and its confidence that, given the family ties between
the firms, it would always know how much risk it was
assuming. The indefiniteness of the guaranty was the fault
of the guarantor.
Judicial interpolation of missing contractual terms, which
is what Schumacher Electric is seeking from us, performs an
important economic function. Haslund v. Simon Property
Group, Inc., 378 F.3d 653, 655 (7th Cir. 2004) (Illinois law);
Central States, Southeast & Southwest Areas Pension Fund v.
Basic American Industries, Inc., 252 F.3d 911, 915-16 (7th Cir.
2001); Omron Healthcare, Inc. v. Maclaren Exports Ltd., 28 F.3d
600, 602 (7th Cir. 1994). Contracts would be thousands of
pages long if the parties had to anticipate and provide for
every contingency, however remote, that might occur in the
course of contractual performance. Better that courts should
8 Nos. 04-2621, 04-2834
stand ready to fill some gaps if and when the parties’
relationship breaks down and precipitates litigation. But the
sparser the contract (the material portion of the guaranty,
which we quoted, consists of one sentence, and not a very
long one at that), and the more difficult it is for the courts to
devise crisp terms to fill its gaps, the weaker the argument
for judicial intervention, and the more likely, therefore, the
court is to find that the contract is too indefinite to be
enforced. Academy Chicago Publishers v. Cheever, 578 N.E.2d
981, 984 (Ill. 1991); Haslund v. Simon Property Group, Inc.,
supra, 378 F.3d at 655 (Illinois law); Architectural Metal
Systems, Inc. v. Consolidated Systems, Inc., 58 F.3d 1227, 1229
(7th Cir. 1995) (same); Ryan v. Wersi Electronics GmbH & Co.,
3 F.3d 174, 180-81 (7th Cir. 1993) (same); Goldstick v. ICM
Realty, 788 F.2d 456, 461 (7th Cir. 1986) (same); Neeley v.
Bankers Trust Co., 757 F.2d 621, 628 n. 5 (5th Cir. 1985). This
precept is especially compelling in a case in which the party
seeking judicial assistance had a cheap, simple, and effica-
cious self-help remedy: namely, to terminate the contract,
without liability, at any time. Schumacher Electric had no
justification for seeking the aid of the courts, to the prejudice
of Phelps Dodge.
AFFIRMED.
A true Copy:
Teste:
_____________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—7-15-05