Avoiding Lender Liability Claims: When Words and Actions Matter

Co-authored with Hilary Jordan and Michael Parisi.   Reprinted from The Secured Lender, December 2015.

“Lender liability” is a catch-all term for the many and often overlapping legal theories under which a lender can be held liable to a borrower, guarantor or third party. As some lenders have learned through experience, the stakes involved in lender liability cases can be very high.  In 2009, Credit Suisse and Deutsche Bank agreed to pay $632 million and provide $1.1 billion in favorable financing to Huntsman Chemical in order to settle fraud, tortious interference, and other claims relating to these lenders’ involvement in Hexion Specialty Chemical’s aborted acquisition of Huntsman.  In 2012, the U.S Court of Appeals for the Eleventh Circuit reinstated the infamous In re TOUSA bankruptcy court decision that ordered the so-called “Transeastern Lenders” to disgorge the proceeds of a $480 million fraudulent transfer.  Fortunately, a lender can take steps to minimize its potential exposure for an adverse judgment.  Developing and implementing sound documentation and relationship management techniques can go a long way to reducing the risk of lender liability claims under a variety of potential legal theories.          

LEGAL THEORIES

Breach of Contract:  The most common lender liability theory is a breach of contract claim, which may be based on a lender’s alleged failure to honor its commitment to lend under a commitment letter or a credit agreement.  A breach of contract claim also could be made for a wrongful foreclosure of collateral if it is alleged by the borrower that it was not in default because, for example, the lender had accepted repeated late payments and through its prior conduct, the lender had impliedly waived any such defaults.

A breach of contract claim also could be based on a lender’s failure to honor an oral commitment to extend credit. Many states have amended their Statutes of Frauds to require that a commitment to extend credit be in writing in order to be enforceable.  However, a borrower may be able to circumvent a lender’s Statute of Frauds defense by arguing that the lender, through its conduct, gave the borrower the reasonable impression that a loan would be made and, under the doctrine of promissory estoppel, the lender should be estopped from withdrawing an oral commitment.

Breach of Duty of Good Faith:  It is generally accepted in the United States that a party to any contract has an implied duty to exercise its rights or remedies under that contract in “good faith.”  This standard has been interpreted by some courts to mean that a lender cannot terminate a credit facility, accelerate the maturity of a loan or exercise collateral remedies based on an immaterial default or without reasonable prior notice to, and a reasonable opportunity to cure by, the borrower and any guarantors. 

Tort Claims/Wrongful Acts:  Even where a borrower cannot make a breach of contract claim, it may be able to allege that the lender committed a wrongful act in its handling of a loan transaction.  If successful, the tort claim (unlike a breach of contract claim) can give rise to both compensatory damages and punitive damage liability for a lender. 

Theories a borrower might assert include that the lender (a) used economic duress to cause a borrower to sign an unfavorable loan document that includes a release in favor of the lender, (b) made negligent misrepresentations to a borrower in the course of a loan restructuring that a borrower allegedly relied on to its detriment, (c) made intentional misrepresentations or fraudulent statements to a guarantor to induce it to guaranty a new or existing loan to a borrower or to a trade creditor to induce it to continue to extend trade credit to a distressed borrower, (d) tortiously interfered with a seller’s contractual relations with the borrower by refusing to finance an acquisition transaction, (e) tortiously interfered with a borrower’s corporate governance by requiring that the borrower replace its management or hire an allegedly incompetent financial advisor, (f) breached its alleged fiduciary duties to a borrower or its owners or trade creditors, or (g) defamed a borrower by giving an allegedly inaccurate credit report on a borrower to one of its trade creditors or customers.

Claims in Bankruptcy:  Should a borrower become the subject of a bankruptcy proceeding, a borrower (or its bankruptcy trustee) might seek to assert claims against the lender to reduce the lender’s recovery.  Most common are claims that the lender received a preferential or fraudulent transfer from the borrower.  The lender may also be accused of aiding and abetting the borrower’s management in concealing the borrower’s insolvency from its trade creditors or deepening the borrower’s insolvency by allowing it to incur too much debt.  These claims can have serious consequences, ranging from the return of amounts received by the lender to the subordination of the lender’s claim against a bankrupt borrower under the doctrine of equitable subordination.  Under the latter result, the lender would not get paid until all other allowed claims against the borrower are paid even if the lender held a perfected senior lien on the borrower’s pre-petition assets. 

Statutory Liability:  A lender also can be subject to claims under a number of federal and state statutes that run the gamut of legal theories.  These may include alleged violations of federal and state payroll and sales tax legislation (depending how a lender handles a distressed borrower’s loans and deposit accounts); federal securities law violations (if the lender “aided and abetted” the borrower’s violations); federal and state environmental laws (if the lender becomes too involved in the borrower’s compliance with environmental laws); the Fair Labor Standards Act (if the lender forecloses on and sells inventory that was produced in violation of federal minimum wage, overtime pay, or child labor laws (commonly known as “hot goods”)); federal intellectual property statutes (if the lender forecloses on collateral that infringes on a third party’s patents, trademarks or copyrights); or state usury laws (if the lender’s interest and fees exceed the applicable state’s usury laws).  The consequences for these violations can also be severe, and can include monetary liability, forfeiture and destruction of collateral, and forfeiture of amounts paid on the loans.

LOAN DOCUMENTATION TECHNIQUES

Given the many theories that can be asserted to impose liability, lenders should structure their loan documentation to minimize the risk that borrowers, guarantors, or third parties can assert a successful claim.  For example, a lender should:

1. Refer to definitive loan documentation. Proposal letters, letters of intent and expense reimbursement letters should disclaim any commitment to extend credit until a formal commitment letter or definitive loan agreement is executed and delivered. If a commitment letter is used, it should state that the lender’s initial funding obligation is subject to the execution and delivery of definitive loan documentation satisfactory to the lender and the satisfaction of other specified closing conditions.
2. Include protective provisions in loan documents. Commitment letters and credit agreements should include an integration or merger clause to avoid or minimize parole evidence issues arising from oral or “side” agreements. Pre-commitment letters, commitment letters and definitive loan documents should all contain favorable or neutral forum selection and jury trial waiver clauses. In states where jury trial waivers are not enforceable, a binding arbitration clause may be included as an alternative. Loan documents should also expressly disclaim any fiduciary, agency, partnership or joint venture relationship between the lender and the borrower.
3. Include “Xerox Provisions” in acquisition financing. The acquisition agreement should include so-called “Xerox Provisions” under which the borrower and the seller agree that (a) the lender is an express third party beneficiary of the exclusive remedy, exclusive venue and jury trial waiver provisions in the acquisition agreement, (b) the seller has no recourse against the lender if the sale transaction fails to close, and (c) the parties to the acquisition agreement will not amend the “Xerox Provisions” without the lender’s consent.
4. Limit control “trigger” in pledge agreements. If the borrower or guarantor pledges its stock (or equivalent), the pledge agreement should not provide that the lender automatically obtains the right to vote or sell the stock upon a default. This prevents the lender from inadvertently acquiring control of the borrower.
5. Obtain releases of claim from all obligors. All amendments and forbearance agreements should be consented to in writing by all borrowers and guarantors and should include a release of claims and covenant not to sue from each of them.
6. Include acknowledgments in forbearance agreements. Written forbearance agreements should include acknowledgements by all borrowers and guarantors of the existence of specified defaults, the absence of counterclaims or defenses, the outstanding amount of the loans, the validity and enforceability of the loan documents, and the perfection of the lender’s security interests and other liens.
7. Remedy legal defects promptly. Lender’s counsel should conduct a legal audit of a loan account and the loan documentation when a borrower is placed on the lender’s “watch list” and the lender and its counsel should promptly remedy any documentation issues (e.g., at least 90 days prior to bankruptcy in the case of a lapsed or belated lien perfection).

RELATIONSHIP MANAGEMENT TECHNIQUES

A lender’s actions during the course of its financing relationship with the borrower are as important as the words used to document the relationship. When dealing with borrowers, guarantors and third parties, a lender should:

1. Be professional. A lender should assume that all emails, memos and other writings from the lender’s personnel may be disclosed later to a judge or jury. Profane language and sarcasm do not reflect well in litigation.
2. Follow credit policy. Business personnel should adhere to internal credit manuals and policies when administering a loan. A lender that consistently applies its procedures is more likely to appear evenhanded.
3. Reduce all agreements to writing. Every promise, offer or understanding should be in writing, no matter how small it may appear. If matters are discussed verbally, they should be followed up in writing. Similarly, when a default arises, it should be addressed through a reservation of rights letter, waiver letter, amendment, or forbearance agreement.
4. Obtain a second set of “eyes.” A lender can benefit by the review of a problem loan by a work-out or restructuring specialist who can bring a fresh perspective.
5. Be cautious when considering exercising remedies. A lender should think twice before terminating a credit facility based on a non-payment default or an immaterial payment default, particularly if similar defaults have occurred in the past without any remedial action or a written reservation of rights letter. Unless a compelling reason exists for immediate action, the lender should also give its borrower reasonable prior notice and an opportunity to obtain alternative financing before terminating or accelerating a credit facility or foreclosing on collateral. A lender should be prepared to explore all realistic alternatives before terminating or accelerating a credit facility, such as a work-out or restructuring where the lender receives an acknowledgment of debt and a release of claims. A lender that exercises patience is more likely to appear reasonable and fair.
6. Avoid getting involved in the management of the borrower. A lender should avoid actions that give the appearance that it is involved in directing the borrower’s business. Potentially problematic behavior includes: (a) having an actual or contingent ownership interest in a borrower or serving on a borrower’s board of directors, either directly or indirectly through a nominee, (b) deciding which creditors get paid or who will manage the borrower or be on its governing board, (c) dictating who the borrower should hire as a management consultant, although the lender may require that a distressed borrower retain a financial consultant acceptable to the lender, (d) drafting or dictating a business plan, although the lender may require that the borrower develop and implement a business plan that is acceptable to the lender, or (e) setting forth how the borrower will use its cash, other than to verify that payroll, payroll taxes and sales taxes are paid.
7. Use third party liquidators. A lender should require the borrower to use a third party professional liquidator acceptable to the lender to handle a “going out of business” sale. This is preferred over the lender taking physical control or possession of a borrower’s premises or records.
8. Be cautious when suing guarantors. Even if a loan deficiency exists, a lender should think twice before suing a personal guarantor. Unless the assets are significant and recovery is likely, such actions may provoke a lender liability counterclaim from a guarantor who is “pushed to the wall.”

The foregoing techniques cannot guaranty that a disgruntled borrower, guarantor or third party might pursue a lender liability claim when a lending relationship sours and the lender may have the upper hand. However, following these suggestions can help minimize the risk and allow the lender to put forward the best argument against the viability and potential success of any claims, regardless of the theories employed.