A recent decision from the United States Bankruptcy Court for the Northern District of Texas illustrates that aggressive lender action can result in “lender liability” in a lending transaction. Bailey Tool & Mfg. Co., et al. vs. Republic bus. Credit (In re Bailey Tool & Mfg. Co.), 2021 WL 610847 (Bankr. ND Tex. 23 Dec. 2021). Although an extreme example, the case should be read by every lender and their attorney, as it contains a long list of things lenders should avoid doing in relation to their loan agreements (and , therefore, the things that borrowers should look for in their relationship with lenders). In Bailey, the bankruptcy court found a business factor, Republic Business Credit, LLC (“Republic”), liable in a Chapter 7 bankruptcy for nearly $17 million in damages for breach of contract, fraud, breach of good faith duty and fair dealing, willful breach of automatic stay and other transgressions, and also awarded $1.2 million to debtor owner. The bankruptcy court also made Republic’s claim conditional on the claims of unsecured creditors and even the owner’s participation.
As the bankruptcy court explained, “lender’s liability” is a general term often used to describe various theories by which a borrower (or his trustee in bankruptcy) seeks to impose liability (or some remedy) against a former lender in a loan relationship gone bad. Sometimes too much control by a lender over a borrower can give rise to tort causes of action. Normally, a lender-borrower relationship is not that of a fiduciary. If a lender exercises excessive control over a borrower, however, a lender may become a fiduciary rather than just a creditor. Where such a degree of control is achieved, the lender must refrain from misleading or concealing information from the borrower, and the lender is required to make decisions in the best interest of the borrower, even if it is against the borrower’s best interests. lender. Alternatively, even if a fiduciary duty is not established, if a lender plays a particularly active role in the borrower’s business decisions and, in an effort to secure the borrower’s course of business, the lender intentionally interferes with matters such as management selection and borrower business contracts, a lender may become liable for tortious interference. Additionally, in the context of a bankruptcy, a lender may have its claim equitably subordinated under Section 510 of the Bankruptcy Code if it is determined that the lender has engaged in unfair conduct.
Although the debtor in the case, Bailey Tool, had made progress in developing new markets after the global economic recession of 2008-2009, it was still in transition, its revenues had not yet returned to pre-crisis levels. recession and its new markets continued to require additional capital for research and development. It is against this backdrop that Bailey Tool’s existing revolving credit and term loan lender has decided to terminate its relationship with Bailey Tool and refrain from providing additional working capital to Bailey Tool. He asked the company to transfer its business to a new lender in 2014. The potential new lender suggested that Bailey Tool use a factoring company for a few months as a “bridge” between the existing lender and the new lender. During this factoring “cleanup” period, the remainder of Bailey Tool’s bank debt with the existing lender would remain with that lender.
In late 2014 and early 2015, Bailey Tool discussed a factoring and inventory financing program with Republic to meet its working capital needs. As noted, the arrangements were only meant to serve as a short-term bridge. Republic conducted due diligence over several months and rated the proposed transaction with Bailey Tool as a “solid deal” for Republic. Republic knew, before deciding to lend or factor, that Bailey Tool was delinquent on both ad valorem taxes and trade debts and that its accounts receivable with the US Department of Defense were slow or spotty. However, despite its financial difficulties at the time, Bailey Tool still had significant enterprise value when Republic entered into negotiations and at the start of the factoring agreement between Republic and the company.
In the end, Bailey Tool’s business failed. He filed Chapter 11 and later converted his case to Chapter 7 liquidation. The trustee in bankruptcy (now in place of the bankrupt company) and the former owner of the company alleged more a dozen torts against the factoring company, in addition to breach of contract. In its highly critical opinion of the factor/lender, the bankruptcy court set out several simple points for lenders to consider when governing their conduct with borrowers (which are also important for borrowers, so that they know their rights).
First, it is essential that lenders and borrowers understand that there is an implied duty of good faith and fair dealing implicit in all agreements, even if they are not expressly written into a contract. Good faith generally requires honesty and fair dealing requires that a party not act contrary to the spirit of the contract. Fair use also requires that a party not abuse its power in determining the express terms of a contract and that it does not interfere with or cooperate with the other party’s performance. A party that fails in its duty of good faith and fair dealing violates the contract and risks being held liable for any allegedly tortious conduct.
In Bailey, the bankruptcy court identified a plethora of ways Republic failed in its duty of good faith and fair dealing. Among other things, the lender exercised too much control over the bonds the borrower paid, effectively taking over the manufacturing function by approving or disapproving payments to certain vendors and material suppliers. For example, Republic made advances directly only to vendors and employees of its choosing, even though the parties’ loan agreement only provided for distributions to be made to the borrower. As the Court said, “the evidence showed the Republic’s behavior to be rather scandalous on various occasions – fussing with debtors over such things as Bailey’s request to buy oil for the machines to operate and Gatorade to be provided to employees on an unair-conditioned manufacturing site. Identifier. to *40. The bankruptcy court also found that the lender breached the duty of good faith and fair dealing by collecting and holding funds that belonged to the company. In addition, she concluded that the lender was proceeding with a “sneak liquidation” of the borrower, when it was in its best security position, at the expense of the other parties. Identifier. to *20. The bankruptcy court also determined that the lender repeatedly misrepresented material facts, such as whether the borrower was “over-advanced” or in default. Further, the bankruptcy court found that Republic “repeatedly created the impression in communications (up to and after the relationship ended) that Bailey [Tool] was in default due to an excessive advance,” a term the bankruptcy court noted was not even defined in the loan agreement and an assertion that “was simply not true.” Identifier. to *45.
Second, it is important that lenders recognize that they are still bound to comply with the express terms of their contracts, regardless of any discretion they have under the agreement or any alleged breach by a borrower. Here the bankruptcy court said:
“As mentioned earlier, the agreements are surprisingly one-sided. In fact, they are so one-sided (that is, they offer an assortment of rights, remedies, and discretion in favor of the Republic, with very little rights in favor of debtors) that there appear to be very few breaches of contract. In other words, many of the wrongdoings alleged by the trustee were apparently authorized by the terms of the agreements.” Identifier. to *37.
Nevertheless, the bankruptcy court still found that Republic breached the agreements in certain ways (one of which is discussed above – by not directly funding Bailey, but by setting up a procedure to only pay certain suppliers and employees that Republic saw as beneficial to improve its collections) and charging a termination fee while asserting that the agreements could only be terminated after receiving a release from the borrower. ID. to *38. In short, even if a loan agreement gives a lender great latitude, the latter must be careful not to violate some of its provisions by acting too aggressively.
Third, regardless of the terms of their loan agreements, lenders should be aware of the impact of their actions and their obligations under the Bankruptcy Code. In Bailey, the bankruptcy court found that after the debtors filed for bankruptcy, Republic deliberately ignored the automatic stay by refusing to return the money belonging to the debtors, continuing to collect debts from the debtors and demanding after the petition (and after his agreement had terminated) that customers pay Republic rather than Bailey (even though Bailey owned the claims), among other things. Notably, and instructively for attorneys, the bankruptcy court also found that Republic’s insolvency attorney specifically violated the Automatic Stay when he ordered a client to pay funds directly to Republic instead only to Bailey Tool, and had pressured Bailey Tool to grant a release. As a result, the bankruptcy court ordered Republic to pay punitive damages representing three times the amount of administrative costs in the failed Chapter 11 case.
Fourth, while lenders are generally free to seek whatever collateral arrangements they wish at the outset of a transaction or in a distressed situation, and to liquidate that collateral, they must do so in accordance with applicable laws and without making misrepresentation to a borrower or guarantor. In Bailey, seeking to improve its position, Republic demanded a lien on the owner’s property, even though the Texas constitution prohibited obtaining such a right. Additionally, Republic took the lien under false pretences, promising that the mortgage on the farm would allow Republic to resume the advances to Bailey. Republic then forced the sale of the farm and realized about $225,000 in equity from the previous owner, even though Texas law prevented it from doing so. As a result, the bankruptcy court awarded the owner/guarantor actual damages of $410,000 plus $750,000 in exemplary damages. Identifier. at *52-58.
In sum, the concept of lender liability is not dead. Although well-drafted loan agreements can make lender liability claims difficult to sustain, lenders must be careful in their interactions with borrowers and must act reasonably, honestly, and in a manner consistent with applicable laws.