Lender Liability Is Not Dead: A Recent Case Presents a Warning for Lenders (and a Roadmap for Borrowers)

A recent decision from the U.S. Bankruptcy Court for the Northern District of Texas illustrates that aggressive lender action can lead to “lender liability” in a loan workout. Bailey Tool & Mfg. Co., et al. v. Republic Bus. Credit (In re Bailey Tool & Mfg. Co.), 2021 WL 610847 (Bankr. N.D. Tex. Dec. 23, 2021). While an extreme example, the case is one that should be read by every lender and lender’s lawyer, as it contains a laundry list of things lenders should avoid doing in connection with their loan agreements (and, correspondingly, things borrowers should look for in their relationships with lenders). In Bailey, the Bankruptcy Court found a commercial factor, Republic Business Credit, LLC (“Republic”), liable to a Chapter 7 bankruptcy estate for almost $17 million in damages for breach of contract, fraud, breach of the duty of good faith and fair dealing, willful violation of the automatic stay, and other transgressions, and also awarded $1.2 million to the debtor’s owner. The Bankruptcy Court also subordinated Republic’s claim to the claims of unsecured creditors and even to the equity interest of the owner.

As explained by the Bankruptcy Court, “lender liability” is a broad umbrella term often used to describe various theories through which a borrower (or its trustee in bankruptcy) seeks to impose liability (or a remedy of some sort) against a former lender in a lending relationship that has gone bad. Sometimes, too much control exercised by a lender over a borrower can generate causes of action in tort. Normally, a lender-borrower relationship is not that of a fiduciary. If a lender exercises excessive control over a borrower, however, a lender can become a fiduciary rather than a mere creditor. When such a degree of control is reached, the lender must refrain from misleading or concealing information from the borrower, and the lender is required to make decisions in the best interests of the borrower, even if doing so is contrary to the best interest of the lender. Alternatively, even if a fiduciary duty is not established, if a lender takes a particularly active role in the business decisions of the borrower and, in an attempt to secure the course of the borrower’s business, the lender intentionally interferes with such things as management selection and the borrower’s business contracts, a lender may become liable for tortious interference. Additionally, in the context of bankruptcy, a lender may have its claim equitably subordinated pursuant to Section 510 of the Bankruptcy Code if it is determined that the lender engaged in inequitable conduct.

While the debtor in the case, Bailey Tool, had made progress in developing new markets after the world economic recession of 2008-2009, it was still in transition, revenues had not yet returned to pre-recession levels, and its new markets continued to demand additional capital for research and development. It was in this context that Bailey Tool’s existing revolving credit and term loan lender decided it wanted to exit its relationship with Bailey Tool and refrain from providing it with additional working capital. It asked the company to move its business to a new lender in 2014. The new potential lender suggested that Bailey Tool utilize a factoring company for a few months as a “bridge” from the existing lender to the new lender. While this factoring “cleanup” period occurred, the rest of the Bailey Tool 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 package with Republic to meet its working capital needs. As noted, the arrangements were only intended to serve as a short-term bridge. Republic performed due diligence for several months and assessed the proposed transaction with Bailey Tool as a “strong deal” for Republic. Republic was aware, before deciding to lend or factor, that Bailey Tool was past due on both ad valorem taxes and trade payables and its accounts receivable from the U.S. Defense Department were slow-paying or irregular in payment. However, despite its financial distress at that time, Bailey Tool still had significant enterprise value when Republic began negotiations and at the inception of the factoring arrangement between Republic and the company.

Ultimately, Bailey Tool’s business failed. It filed Chapter 11 and later converted its case to a liquidation under Chapter 7. The bankruptcy trustee (now standing in the shoes of the failed business enterprise) and the former owner of the business alleged more than a dozen torts against the factoring company, in addition to breach of contract. In its opinion, which was highly critical of the factor/lender, the Bankruptcy Court articulated several straightforward points for lenders to consider when governing their conduct with borrowers (which are also important for borrowers to understand, so that they know their rights).

First, it is critical for lenders and for borrowers to understand that there is an implied duty of good faith and fair dealing implicit in all agreements, even if 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 dealing also requires that a party not abuse its power when determining a contract’s explicit terms and not interfere with or fail to cooperate in the other party’s performance. A party who breaches its duty of good faith and fair dealing breaches the contract and risks liability for any purportedly tortious behavior.

In Bailey, the Bankruptcy Court identified a plethora of ways that Republic had breached its duty of good faith and fair dealing. Among other things, the lender exerted too much control over what obligations the borrower paid, effectively taking over the manufacturing function through approving or not approving payments to certain vendors and materials suppliers. For example, Republic directly made advances only to vendors and employees of its choosing notwithstanding that the parties’ loan agreement only provided for distributions to be made to the borrower. As the Court said, “The evidence reflected that Republic’s behavior was rather outrageous on various occasions—fussing with the Debtors over such things as Bailey’s request to buy oil for machines to run and Gatorade to provide to employees on an un-air-conditioned manufacturing floor.” Id. at *40. The Bankruptcy Court also found that the lender had breached the duty of good faith and fair dealing by over-collecting and holding monies that belonged to the company. Additionally, it found that the lender was conducting an “unannounced liquidation” of the borrower, at a time when it was in its best position as to the collateral, and doing so was at the expense of other parties. Id. at *20. The Bankruptcy Court also determined that the lender had repeatedly made misrepresentations concerning important 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 (until the termination of the relationship and even afterwards) that Bailey [Tool] was in default due to being over-advanced,” a term the Bankruptcy Court noted was not even defined in the loan agreement and an assertion it said “simply was not true.” Id. at *45.

Second, it is important for lenders to recognize that they are still required to comply with the express terms of their contracts, regardless of the discretion they have under the agreement or any alleged breach by a borrower. Here, the Bankruptcy Court stated:

“As alluded to earlier, the Agreements are amazingly one-sided. In fact, they are so one-sided (i.e., providing a smorgasbord of rights, remedies, and discretion in favor of Republic, with very few rights in favor of Debtors) that there seem to be very few breaches of contract. In other words, many of the alleged bad acts articulated by the Trustee were seemingly permitted by the terms of the Agreements.” Id. at *37.

Nonetheless, the Bankruptcy Court still found that Republic breached the agreements in certain ways (one of which is discussed above — by not funding Bailey directly, but instead putting in place a procedure to pay only certain vendors and employees that Republic deemed advantageous to enhance its collections) and by charging a termination fee while asserting that the agreements could not be terminated unless it received a release from the borrower. Id. at *38. In short, even if a loan agreement grants wide discretion to a lender, the lender must be careful to avoid breaching certain of its provisions by acting too aggressively.

Third, regardless of the terms of their loan agreements, lenders should be conscious of the impact of their actions and their obligations under the Bankruptcy Code. In Bailey, the Bankruptcy Court concluded that after the debtors filed for bankruptcy protection, Republic willfully ignored the automatic stay by refusing to turn over money belonging to the debtors, continuing to collect on the debtors’ receivables, and demanding post-petition (and after its agreement had terminated) that customers pay Republic rather than Bailey (even though Bailey owned the receivables), among other things. Notably, and as a cautionary tale for lawyers, the Bankruptcy Court also found Republic’s insolvency counsel specifically violated the automatic stay when he directed a customer to pay funds directly to Republic rather than to Bailey Tool, and pressured Bailey Tool into giving a release. As a result, the Bankruptcy Court ordered Republic to pay punitive damages of three times the amount of administrative costs in the failed Chapter 11 case.

Fourth, while lenders are generally free to pursue whatever collateral arrangements they desire 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 misrepresentations to a borrower or guarantor. In Bailey, in seeking to improve it position, Republic required a lien on the owner’s homestead, even though the Texas constitution prohibited obtaining that right. Moreover, Republic took the lien under false pretenses, promising that the mortgage on the homestead would allow Republic to resume advances to Bailey. Republic then forced the sale of the homestead and realized approximately $225,000 in equity from the prior owner even though it was precluded doing so under Texas law. As a result, the Bankruptcy Court awarded the owner/guarantor actual damages of $410,000 plus $750,000 in exemplary damages. Id. at *52-58.

In sum, the concept of lender liability is not dead. While well-drafted loan agreements can make claims of lender liability difficult to sustain, lenders need to be careful in their interactions with borrowers and must act reasonably, honestly, and in a manner that is consistent with applicable laws.