In January 1998, Heritage Land [Company] and M.G. Financial [Services of Indiana, Inc.,] formed Heritage/M.G.[, LLC,] for the purpose of developing a residential neighborhood known as Ironwood Estates in Delaware County[, Indiana]. On May 25, 1999, Heritage/M.G. executed * * * [a] note to Peoples Bank and Trust Company, custodian for the James Henke, I.R.A. (“Henke I.R.A.”), in the amount of \($300\),000 to partially fi nance the development. The fi nal installment under the note was due June 1, 2001. [The note authorized an extension of the time for payment.]

The signatories [included Thomas McMullen, on behalf of Heritage/M.G., and Larry and Vivian Keesling.]

Heritage/M.G. did not complete the payments under the original note by the June 2001 deadline. On January 3, 2002, the balance due on the note was \($48\),228.69.

Then, on May 24, 2002, * * * without the knowledge or consent of the Keeslings * * * , Heritage/ M.G. executed [a] second note to the Henke I.R.A. in the amount of \($102\),000. * * * No payments were ever made on the second note.

Accordingly, on September 2, 2004, 1st National Bank and Trust Company, [which had succeeded Peoples Bank] as custodian for the Henke I.R.A., fi led * * * [a complaint in an Indiana state court] against the Keeslings [and others].

On October 25, 2004, the Henke I.R.A. assigned * * * both the original note and the second note to T.E.K. [Partners, LLC] * * * .

On November 19, 2004, the trial court entered an order substituting T.E.K. for 1st National Bank as plaintiff. Following a * * * trial, the trial court * * * concluded in relevant part that * * * T.E.K. is entitled to judgment * * * in the sum of \($365\),905.07 plus \($10\),000 in attorney fees, for a total judgment of \($375\),905.07. * * * The Keeslings

* * * bring this appeal [to a state intermediate appellate court]. * * * *

In sum, the Keeslings * * * contend that because they were accommodation parties on the original note, and the second note constitutes a material alteration of the original note, they are discharged from further personal liability under the original note, and they have no liability under the second note.

* * * A guaranty is * * * a promise to answer for the debt, default, or miscarriage of another person. It is an agreement collateral to the debt itself and represents a conditional promise whereby the guarantor promises to pay only if the principal debtor fails to pay. [Emphasis added.]

* * * *

Under Indiana common-law principles, when parties cause a material alteration of an underlying obligation without the consent of the guarantor, the guarantor is discharged from further liability * * * . A material alteration which will effect a discharge of the guarantor must be a change which alters the legal identity of the principal’s contract, substantially increases the risk of loss to the guarantor, or places the guarantor in a different position. The change must be binding. [Emphasis added.]

Here, Heritage/M.G. is the principal obligor. The Keeslings are guarantors on the original note payable to the Henke I.R.A., which was the original obligee. As guarantors, the Keeslings are accommodation parties.

* * * *

The original note was past due.

* * * T.E.K. maintains that the second note merely extended the time for payment of the original note, as authorized by that note, and did not constitute a material alteration of the original obligation. The trial court agreed, fi nding that the second note for \($102\),000 was merely given “to evidence the current amount of monies then due and owing” under the original note “and extend the due date for payment” of the original note. Those fi ndings are clearly erroneous.

* * * The evidence shows that * * * on May 24, 2002, * * *

McMullen, on behalf of Heritage/M.G., executed the second note for \($102\),000 payable to the Henke I.R.A. * * * . McMullen, who signed both notes, testifi ed that the “difference [between \($48\),228.69 and \($102\),000] was used to pay vendors,” as well as to pay “interest and stuff.”

The evidence clearly shows that the second note did not merely extend the time of payment on the “current amount of monies then due and owing” on the original note. Instead, the facts demonstrate that the second note included additional money to “pay the bills.”

The second note also capitalized interest due on the original note, that is, it converted interest due on the original note to principal in the second note. The capitalization of interest meant that the contract interest rate of 12% and the default interest rate of 24% would be charged against the interest added to the second note, thereby compounding the payment of interest and the effective interest rate. In itself, this capitalization of interest was a material alteration.

Thus, the second note not only added new debt but increased the total principal draws beyond the \($300\),000 face amount of the original note. [ James] Henke testifi ed that under the original note, his I.R.A. was committed to advance “up to \($300\),000” for the project.

The Henke I.R.A. advanced two \($130\),000 draws to Heritage/M.G. under the original note, for a total of \($260\),000. But the second note of \($102\),000 brought total draws to \($362\),000 * * * which was \($62\),000 more in draws than the original note authorized.

* * * *

* * * The original note was an unambiguous “promise to pay

* * * the sum of \($300\),000.” The note contains a promise to pay a sum certain and does not provide for total draws greater than that sum. The original note was not a revolving line of credit. The accommodation parties assumed the risk of a \($300\),000 loan, not some multiple of \($300\),000. * * * *

In sum, the second note constitutes a material alteration of the original obligation. As such, the Keeslings * * * are discharged from their personal liability on the original note, and they have no liability for the additional sums advanced under the second note, which they did not sign. We reverse the trial court’s judgment [against the Keeslings] * * * .

Questions:-

1. If the court had affirmed the judgment in favor of T.E.K., against whom might the Keeslings have had a right of recourse?

2. What might the parties who executed the second note have done at the time to avoid the outcome in this case?