TROUBLED LOANS AND LENDER LIABILITY

By Robert W. Cannon, Esq.

I. Introduction

During these and other difficult economic times, legal disputes involving allegations of "lender liability" are more prevalent and borrowers seeking relief from troubled financings are more likely to consult with their advisers about any lender conduct that might be argued to form the basis for an affirmative defense to the enforcement of loan obligations or the full or partial discharge of the borrower in connection with any of such obligations.  This article will review a series of important court decisions involving various claims of lender liability and explain the reasoning and decision of the court in each of such cases.  In a series of sections entitled "Lender's Guide", the author will also offer advice and suggestions regarding the importance of each such case as guidance for the future conduct of lenders encountering similar financings or circumstances. 

II. Lender Liability Claims

A.Breach of Duty of Confidentiality

One claim a borrower may advance is a breach of confidentiality if the lender improperly discloses information provided in confidence.  Any release of information by the lender where it has no obligation to provide the information can result in liability to the lender, particularly where the information provided is false, misleading or inaccurate.  Waivers of confidentiality may be ineffective.

Lenders Guide – OBSERVE CONFIDENTIALITY 

B. Improper/Excessive Control

If the lender effectively controls the borrower, it could be liable for the borrower's actions.

1. Lender Replaced Board and Controlled Operations

State Bank of El Paso v. Farah Manufacturing Company, Inc., 678 S.W.2d 661 (Tex. Ct. App. 1984) was a case involving interference with corporate governance resulting in a jury verdict against the lenders in excess of $18 million.  This verdict was upheld on appeal.  In this instance, the lenders placed their own people on the board of the borrower company and they were alleged to have mismanaged the company and sold off valuable assets to make loan prepayments which were not required under the terms of the loan.  The court determined that the company was injured by "the election of directors and officers whose particular business judgment and experience and whose divided loyalty" was in conflict with the ability of directors and officers to manage.  The court concluded that legitimate self interest could and did become illegitimate control.  As a consequence, lenders should not be involved in making decisions concerning the operation of a business and should focus on the financial criteria needed for making loans.  In this case, the dispositive item was control.

2. Right to Control Operations Is Not Control

In Messer Greisheim Industries, Inc. v. Cryotech of Kingsport, Inc., 45 S.W.3d 588, 602 (Tenn. Ct. App. 2001) the construction lender had a financing agreement with the operator of a facility that produced liquid carbon dioxide.  A purchaser of products from the borrower attempted to imposed negligence theories of liability on the lender arguing that the lender controlled the facility.  The lender had hired an independent engineering firm to inspect the facility, continually monitor the operator, and required the operator to comply with laws and regulations, and had the contractual right to take over in the event of a default.  The court here ruled that the mere right to control operations under these conditions did not mean that it actually exercised control and that it was merely demanding that the operator live up to its contractual obligations.

3. Lender Consent Right and First Refusal Rights Do Not Equal Control

In Vornado PS, L.L.C. v. Primestone Investment Partners, L.P., 821 A.2d 296, 322 (Del. Ch. 2002), the Court held that the provisions of the loan agreement requiring the lender's consent prior to any attempt to refinance and also giving the lender the right of first refusal on refinancing did not evidence the degree of control necessary to impose fiduciary duties.  These provisions protected the lender's economic interest.

4.Becoming Debtor's agent, partner or alter ego.

Coppola, et al. v. Bear Stearns & Co., Inc., et al. – U.S. Court of Appeals for the Second Circuit – 499 F.3d 144 (2007).  In this New York case, which primarily involved a question of violation of the Worker Adjustment and Retraining Notification Act ("WARN"), the Court set forth the traditional principles of lender liability which say that "a creditor that has not assumed the formal indicia of ownership may become liable for the debts of its borrower if the lender's conduct is such as to cause it to become the debtor's agent, partner, or alter-ego."

Lenders Guide – DON'T STEP OVER THE LINE AND RUN THE RISK OF BEING ADJUDICATED AS THE BORROWER'S PARTNER.

C. Breach of Contract

Breach of contract is another theory creative plaintiffs and their lawyers have advanced.  Alleged breaches may stem from any one of a series of documents including loan commitments, loan applications, loan extensions, promises to provide financing, promises to modify loan terms, etc.

D.Fraud

Potential lender liability for fraud is grounded on many different theories.  Some of these relate to a conspiracy by the lender with someone else, threatening action where no intention to act is present, silence when there is some obligation on the part of the lender to say something, etc.

1. False Threat

In Stirling v. Chemical Bank, 382 F. Supp. 1146 (E.D.N.Y. 1974), the court held a lender liable for common law fraud where it told the borrower that it would not call loans if certain officers and directors resigned.  Where the lender could have taken actions in the event of default, making the statement to cause the borrower to take such actions can be wrongful where there is in fact no intent to call the loans.

2.  Lender's "No Comment" Was Not Fraud

Heritage Surveyors & Engineers, Inc. v. National Penn Bank, 801 A.2d. 1248, 1251-1253 (Pa. Super. Ct. 2002).  The financial institution provided a line of credit to a firm and the institution was also the lender to a developer.  When foreclosure commenced against the developer, the engineering firm sued the lender for intentional misrepresentation in connection with the extension of credit to it.  The court held that the lender's response of no comment to an inquiry about the financial status of the developer was appropriate and that the lender had no duty to disclose the financial status of the developer.

3. False Promise Was Fraud

In United Companies Financial Corp v. Brown, 584 So.2d. 470 (Ala. 1991) the lender acted inappropriately by advising a borrower at the time the borrower was signing papers, that a check would not be released until some work was actually complete and the bank would see to it that the work was actually completed.  In fact the work was not completed.  The court awarded the borrower $500,000 for compensatory and punitive damages by noting that the check was in fact delivered and the sequence of events are "so clearly one transaction as to establish an intent not to honor the promise at the time it was made."

4.Opinion Statements Found Not Fraudulent

Continental Bank, N.A. v. Meyer, 10 F.3d. 1293 (7th Cir. 1993) was a case in which a borrower alleged fraud on the part of the lender in connection with the borrower being told by the lender that the principals of a business venture were competent, that the assets being purchased were of the "highest quality" and that the investment was going to be profitable.  The Court said that those statements were not fraudulent but were matters of opinion and not fact.  Fraud can only be based upon a misstatement of factual matters.

All of the above cases tell us that honesty about the lender's intention is critical even when it may be necessary to deliver unpleasant news to a borrower.

Lenders Guide – HONESTY ABOUT THE LENDER'S INTENTION IS CRITICAL EVEN WHEN IT MAY BE NECESSARY TO DELIVER UNPLEASANT NEWS TO A BORROWER

E.Duress Cases

Borrowers claiming duress must establish that they were illegally compelled or coerced to act by fear of serious injury to their person, reputations or fortunes.  See Palmer Barge Line Co., Inc. v. Southern Petroleum Trading Co., Ltd., 776 F.2d 502 (5th Cir. 1985).

F.Aiding and Abetting Fraud

A lender could incur liability if it knowingly assists a party to commit a fraud.  This is aiding and abetting.  In Aetna Casualty & Surety Co. v. Leahey Construction Co., 219 F.3d 519, 533-537 (6th Cir. 2000), a construction company needed to improve its capitalization to satisfy its surety.  It induced the bank to issue a 4-day loan that straddled the end of a month so that an additional $275,000 appeared on the month-end bank statement that would be supplied to the surety.  In this case, the Court said that the bank's officer knew enough to realize that he was adding significant funds to a company's account for only 4 days that would not serve to meet bonding company's capitalization requirements and that therefore, they carried out a tortuous scheme of aiding and abetting.

 Lenders Guide – TO HAVE RISK FOR AIDING AND ABETTING, THE LENDER MUST HAVE KNOWINGLY PARTICIPATED IN THE BORROWER'S BREACH OF ITS FIDUCIARY OBLIGATIONS TO A THIRD PARTY AND HAVE ACTUAL KNOWLEDGE OF THE WRONGDOING, NOT UNCONFIRMED SUSPICIONS.

G.Good Faith and Fair Dealing

Issues presented here are questions relating to any obligation to deal with parties either fairly or in good faith or in accordance with both.  An interesting question arises as to whether or not a subjective or objective test is to be applied.  Materials and cases present conflicts in response to this question.  For example, the code provisions of the UCC are as follows:

(i) Section 1-203.  Every contract or duty within Titles 1 through 10 of the Act imposes an obligation of good faith in its performance or enforcement.

(ii) Section 1-201(19).  "Good faith" means honesty in fact in the conduct or transaction concerned.  (THIS SEEMS TO BE AN OBJECTIVE STANDARD.)

(iii) Section 1-208.  Option to accelerate at will.  A term providing that one party or his successors in interest may accelerate payment or performance or require collateral or additional collateral "at will" or "when he deems himself insecure" or in words of similar import shall be construed to mean that he shall have power to do so only if he in good faith believes that the prospect of payment or performance is impaired.  The burden of establishing lack of good faith is on the party against whom the power has been exercised.  (THIS SEEMS TO BE A SUBJECTIVE STANDARD.)

Another section of the UCC, Section 2‑103(1)B, requires a standard of "honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade."  This is an objective standard and also applies to other sections of the Code.  Having said all of that, there is still debate over what good faith means and combining "honesty in fact" with "reasonable standards of fair dealing" is troublesome.  The majority rule seems to be whether the good faith is a method of construing contract terms.  The minority rule is that it is an independent obligation that imposes additional terms to those in an express agreement.  Many jurisdictions imply a covenant of good faith and fair dealing in all acts between the parties contracting.  Having said that, a covenant of good faith is not intended to alter the clear terms of an agreement and may not be invoked to preclude a party from exercising its contractual rights.  When two lawyers or two parties sit down to interpret an agreement each thinks the terms are clear although they disagree on what the terms mean.  It is fair to say that no lender has an obligation to negotiate a restructuring of a loan if the documents do not require a restructuring and if the lender chooses to enforce the express provisions upon the default of the borrower.

Good faith cases include the following:

1. KMC Co., Inc. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985).  In this case the bank stopped extending credit under a line of credit agreement where it had discretion to approve or disapprove advances.  The borrower suggested that the bank was obligated to act reasonably.  The court held the lender liable in this case despite its protestations and indicated that the nature of the relationship and the degree of control by the lender over the borrower's financial survival required more than an arbitrary yes or no to the request.

2. Sahadi v. Continental Illinois National Bank and Trust Company, 706 F.2d 193 (7th Cir. 1983).  This case defines the general good faith standard as subjective and the Court found that there was sufficient evidence that the bank was motivated by a desire to cause damage to the borrower as a result of vindictiveness.

3.First National Bank of Cicero v. Sylvester, 196 Ill. App.3d 902, 559 N.E.2d 1063 (Ill. App. 1990).  Here a line of credit of long standing was terminated.  The Court held that there was a good faith implication in every contract and there had to be a good faith justification to refuse the requested loan.  The Court indicated that the fact that the bank had stopped making construction loans did not justify its actions in this matter and suggested that the exercise of the termination rights would require reasonable notice to afford the borrower an opportunity to seek other sources of financing.

Lenders Guide –THERE ARE MANY LENDER LIABILITY CASES WHICH ARE REPLETE WITH FACT SITUATIONS WHERE LENDER'S BAD BEHAVIOR RESULTED IN DECISIONS BY THE COURTS TO ACCOMMODATE THE FACTS.

H. Liability From Joint Ventures

A joint venture is essentially a partnership between the parties.  Where a lender is involved in a joint venture, it can find that its rights as lender have been lost but, that, it can also be held to be liable for the obligations of the joint venture.

Cases include:

1.  A. Gay Jenson Farms Co. v. Cargill, Inc., 309 N.W.2d 285 (Minn. 1981).  In this case the issue was whether Cargill had effectively become a joint venture partner of the borrower.  The Court held that the most important evidence included the following:  (a) an internal memo of the lender which indicated the borrower needed "strong paternal guidance"; (b) the fact that the lender financed all of the borrower's purchases and (c) the lender had the power to discontinue the financing of the borrower's operations.  The question once again is the question of whether the creditor assumed control of the business on an ongoing basis rather than being focused on a means to protect its security for repayment.

2. McFadden v. Baltimore Contractors, 609 F.Supp. 1102 (E.D. Pa. 1985).  In this case the lender took many steps which were claimed to have effectively assumed control over the borrower.  The Court rejected this and said they did not take absolute and total control but took steps to minimize their risk as a substantial creditor.  This was the determination even though the agreement could prevent any new contracts by the borrower until a new and acceptable CEO was appointed.  In this case, the Court was not persuaded by these facts.

3. Conner v. Great Western Savings & Loan Association, 69 Cal.2d 850, 447 P.2d 609 (1968).  This case involved the relationship of a construction lender with a home builder where the construction lender was very involved in the minutiae of the business.  Although no joint venture was found to exist, the Court indicated that the lender could be liable for misrepresentations by the builder which were beyond the scope of the relationship because the lender knew the builder could only be successful by cutting corners and creating risks of cost cutting in quality in the final product.  The Court implied that the lender knew or should have known that the builder was misrepresenting the quality of construction to its buyers.

Where loans have a participation or other equity feature, the lenders must be careful to avoid becoming involved in the day to day business operations and affairs and should avoid having their representatives and employees serving as officers or board members of the borrower.

Lender's Guide – WHERE LOANS HAVE A PARTICIPATION OR OTHER EQUITY FEATURE, THE LENDERS MUST BE CAREFUL TO AVOID BECOMING INVOLVED IN THE DAY TO DAY BUSINESS OPERATIONS AND AFFAIRS AND SHOULD AVOID HAVING THEIR REPRESENTATIVES AND EMPLOYEES SERVING AS OFFICERS OR BOARD MEMBERS OF THE BORROWER.

I.Fiduciary and Special Relationship Theories

Because of facts in particular cases, lenders have sometimes been held to owe duties of disclosure to customers with whom they maintain a relationship of trust and confidence.  This situation does not come into being until there are elements such as where the lender becomes the borrower's financial advisor, creates a partnership relationship or exercises excessive control and influence over a borrower's business activities.  Some of the cases are as follows:

1. Commercial Cotton Co., Inc. v. California Bank, 163 Cal.App.3d 511, 209 Cal. Rptr. 151 (Cal. Ct. App. 1985).  The Bank paid a customer's check which had no authorized signatures.  The check in fact had been stolen with others.  The Bank refused to credit the borrower on the advice of its counsel.  Because the law was so clear where there were checks executed by unauthorized parties, the Court stated that the borrower was "totally dependent to the banking institution to which it entrusts funds and depends on the Bank's honesty and expertise to protect [it],".  The Court awarded a $100,000.00 punitive judgment award in connection with this matter which involved a check for $4,000.00.

2. Barnett Bank of West Florida v. Hooper, 498 So. 2d 923 (Fla. 1986).  The borrower had a longstanding relationship with the Bank and was introduced to customer B of the Bank with respect to tax shelter investments.  A Bank officer indicated that these investments were sound and borrower then borrowed $50,000.00 to invest in customer B's investments.  The Bank then dishonored all of customer B's checks.  On the same day, they extended another loan to customer A who then deposited this second loan in an account belonging to customer B.  The Bank credited this to customer B and used these funds to cover checks which would have bounced.  The Court here held that the Bank had a duty to disclose information material to the transaction which is "peculiarly within the Bank's knowledge and not otherwise available to the customer".  Here the Bank knew of the fraud being perpetrated against customer A and this situation created the "special circumstances". 

Lender's Guide – EXTREME FACTS RESULT IN DECISIONS THAT ARE IN CONFLICT WITH THE GREAT MAJORITY OF COURT DECISIONS INVOLVING THIS ISSUE.

J. The Equal Credit Opportunity Act

This act was passed to assure equal treatment of men and women and their borrowing relationships with lenders.  You cannot require a spouse to join in unless there is a credit or collateral perfection reason for doing so.  This is not usually a defense to the enforcement of the claim but creates an affirmative claim of recoupment.

Lenders Guide – LENDERS CANNOT REQUIRE A SPOUSE TO SIGN UNLESS THERE IS A CREDIT OR COLLATERAL PERFECTION REASON FOR DOING SO.

K. Maryland Case With Multiple Claims of Lender Liability

ST Systems Corporation v. Maryland National Bank, 112 Md. App. 20, 684 A.2d 32 (1996).  In this Maryland case, in which our firm was involved on behalf of the lender, claims were made for:

(i) breach of an alleged (oral) alternative loan agreement;

(ii) breach of a loan modification proposal;

(iii) breach of duty of good faith and fair dealing;

(iv) fraud in the inducement;

(v) fraud in performance;

(vi) tortious interference with prospective advantage; and

(vii) breach of fiduciary duty.

The court upheld a lender liability statute enacted in 1989 to limit the increase in lender liability litigation.  Among other things, the statute requires that all credit agreements must be in writing and signed by the person against whom enforcement is sought.  This case also upheld the continuing effectiveness of a jury waiver in original documents where the parties subsequently had an alleged (oral) alternative loan agreement and a loan modification proposal that the lender never signed.

L. Statute to Limit Lender Liability Claims

Christopher A. Ramsey, et al. v. Bank of Oklahoma, et al. – United States District Court for the Northern District of Oklahoma – 2008 U.S. Dist. LEXIS 93318.  This Oklahoma case sets forth an Oklahoma statute which is similar to a Maryland statute saying that these statutes have been enacted to protect lenders from liability for actions or statements a lender might make in the context of counseling or negotiating with a borrower which a borrower construes as an agreement.  They are intended to discourage lender liability litigation and to promote certainty into credit agreements.  The statutes are intended as a reform measure to regulate the number and variety of cases arising as lender liability actions.

Lenders Guide – STATUTES TO LIMIT LENDER LIABILITY CLAIMS ARE HELPFUL TO LENDERS.

M. Instrumentality Theory

1. FAMM Steel, Inc., et al. v. Sovereign Bank, U.S Court of Appeals for the First Circuit, 571 F.3d 93 (2009).  In this case a company that went into default on loans with a lender brought suit against the Bank claiming the Bank caused its failure.  In this case the following theories were propounded:

Covenant of Good Faith and Fair Dealing

Fiduciary Duty

Instrumentality Theory of Lender Liability

Fraud

Duress

Interference with Advantageous Business Relations

Chapter 93A (unfair or deceptive acts or practices in the conduct of any trade or commerce.) 

  1. In this case the Court granted summary judgment to the Bank and it was affirmed on appeal but the case is the first occasion for the Massachusetts courts to deal with the "instrumentality" theory of lender liability.

  2. 2. Industrial Technology Ventures LP v. Pleasant T. Rowland Revocable Trust, et al. – U.S. District Court for the Western District of New York – 688 F.Supp.2d 229 (W.D.N.Y. 2010).  One count in this case had to do with lender liability against the Trust.  The Court quoted a bankruptcy court stating that lender liability is established by application of the instrumentality doctrine which requires:  (1) control meaning complete domination so that the corporate entity as to this transaction had at the time no separate mind, will, or existence of its own; and (2) such control must have been used by the defendant to commit fraud or worse; and (3) the control or breach of duty must proximately cause the injury or unjust loss complained of.  Another case cited in this opinion states that to establish lender liability through the use of the instrumentality doctrine, "Courts require a strong showing that the creditor assumed actual, participatory and total control of the debtor.  Merely taking an active part in the management of the debtor control does not automatically constitute control . . . ."  The Court went on to say that lender liability is predicated on an unmistakable showing that the subservient corporation in reality has no separate, independent existence of its own and is being used to further the purposes of the dominant corporation.

  3. 3. Fabrica De Muebles J.J. Alvarez, Inc. v. WesternBank de Puerto Rico, et al. – United States District Court for the District of Puerto Rico - No. 09-1558, 2009 WL 4730776.  In this case, the Court outlined the essential elements under the "instrumentality" doctrine saying a plaintiff must demonstration (1) that the dominant corporation controlled the subservient corporation and (2) that the dominant corporation proximately caused plaintiff's harm through its misuse of its control.

Lenders Guide – THE INSTRUMENTALITY THEORY IS A MORE ADVANCED COMPREHENSIVE THEORY THAN MERE CONTROL.  BAD BEHAVIOR IS CONTROL TO COMMIT FRAUD AND TO CAUSE INJURY OR DAMAGE.

N. 2010 Case – 16 Counterclaims

Sovereign Bank v. David Fowlkes, Jr., et al. – Superior Court of Rhode Island, Providence – 2010 R.I. Super. LEXIS 15.  This case is of interest because there were 16 counterclaims asserted by the defendants which were as follows:

Count I – Intentional Misrepresentation/Fraud:  Original Loan

Count II – Intentional Misrepresentation/Fraud:  Personal Guaranties

Count III – Fraudulent Inducement:  Original Loan

Count IV – Fraudulent Inducement:  Personal Guaranties

Count V – Negligent Misrepresentation:  Original Loan

Count VI – Negligent Misrepresentation:  Personal Guaranties

Count VII – Breach of the Covenant of Good Faith and Fair Dealing

Count VIII – Violation of R.E. Deceptive Trade Practices Act:  Original Loan

Count IX – Violation of R.E. Deceptive Trade Practices Act:  Personal Guaranties

Count X – Breach of Fiduciary Duty

Count XI – Duress

Count XII – Negligence

Count XIII – Intentional Interference with a Contract

Count XIV – Unjust Enrichment

Count XV – Negligent Infliction of Emotional Distress

Count XVI – Lender Liability

The reference to lender liability here was set aside by the Court as not a proper cause of action but as a term used to describe cases against lending institutions which seems to include many of the other counterclaims.

III. Conclusion

The foregoing materials are intended to be illustrative of various avenues which have been pursued by borrowers as they have  attempted to hold lenders liable for behavior and actions which the borrowers believed to constitute affirmative defenses to the enforcement of loan obligations.  This article has attempted to provide concrete examples of different ways in which courts have adjudicated the various theories of "lender liability" that have been suggested by borrowers and their legal counsel in efforts to provide relief to borrowers who are in default.  Some of these theories have been successful in some of the courts while it seems that the majority have been unsuccessful despite the creativity that has been shown to shift responsibilities.  As always, trying to interpret court decisions without having the benefit of all of the facts readily available or of people's behavior sometimes presents a judgment based on the manner in which the parties have dealt with each other.  In summary bad facts make bad law and ill-conceived  and ill-prepared theories do not usually generate the intended result. 

(c) 2010 Robert Canon

Robert Cannon is a member of Saul Ewing LLP's Project and Resource Development Department in its Baltimore, Maryland office and serves on the Firm's Government Involvement Committee.

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