Avoiding Lender Liability in Commercial Loan Workouts:
Ten Rules Offered in Good Faith
Steven Bender
James and Ilene Hershner Professor of Law and Director of Portland Programs, University of Oregon School of Law
Particularly in the context of a defaulted loan and workout negotiations, the risk of “lender liability” still commands attention from lenders and their counsel. Most remember the late 1980s/early 1990s meltdown in commercial markets in which many borrowers and guarantors facing financial ruin fired off shotgun suits at lenders alleging nebulous claims of bad faith, tortious interference with contractual or business relations, duress, fraud, breach of fiduciary duty, and negligence, among other claims. Lenders were alarmed because of the potential for enormous punitive damages in tort, and because many of these grounds for liability eluded clear-cut standards. Moreover, juries were sometimes hostile to lenders.
Initially, lender liability litigation resulted in some publicized successes at the trial level. But during the 1990s and early 2000s, many appellate courts chipped away at these doctrines, stopping their expansion and providing lenders with more definite standards. For example, courts rejected the award of damages in tort, specifically punitive damages, for breach of the contractual good faith covenant. Many courts now refuse to find bad faith if the express terms of the loan documents even remotely authorize the lender’s conduct. See, e.g., Kham & Nate’s Shoes No. 2 v. First Bank, 908 F.2d 1351 (7th Cir. 1990). Lenders found success at the state legislative level, as some states enacted tort reform to constrain punitive damage awards. Many state legislatures passed statutes of fraud to bar otherwise straightforward claims of breach of contract based on alleged oral agreements such as commitments to lend additional monies or to forbear on collection remedies or to agree to restructure the loan. Lenders also dampened the risk of lender liability litigation while at the bargaining table. Most lenders removed claims from hostile juries by means of jury trial waivers or by arbitration provisions. Lenders also added carveouts to nonrecourse loans, and required that principals of single-asset borrowers execute exploding or springing full recourse guarantees, intended to discourage the assertion of defenses to loan enforcement remedies (including lender liability claims or counterclaims) along with other “bad acts.”
Lender liability therefore might be viewed today as a legal trend that ran its course. Many of the cases in the materials below are aging and may not represent the views of courts today. Most recent decisions suggest that lender liability doctrines are in retrenchment rather than expansion. Courts seem to have realized that the culpable party in a defaulted loan just might be the borrower that failed to pay rather than the lender that had the audacity in the borrower’s mind to exercise its contractual rights to compel repayment.
For purposes of commercial workouts in current markets, lenders need not conduct their lending and enforcement activities in constant fear of lender liability claims. Customary lender practices to enforce lender rights that are grounded in the loan documents generally are not wrongful and should not expose the lender to liability. Prudent lenders’ counsel and lenders, however, should keep the following suggestions in mind to ensure that if the sleeping dog of lender liability ever awakens in the courts, they will stay clear of harm’s way. The suggestions below, although in some cases applicable beyond workouts, are directed at defaulted commercial loans subject to workout negotiations. Defaulted loans are a traditional catalyst for lender liability claims, so attention at this stage is not a useless exercise.
Although the lender typically has no duty to undertake workout negotiations with the borrower, the lender should consider and offer a reasoned response to any borrower proposals concerning the loan or the collateral.
Commercial borrowers generally cannot challenge the mortgagee’s initiation of foreclosure remedies on the ground that the lender had a good faith duty to negotiate or to conclude a workout agreement. Courts agree that absent an express contractual or a statutory obligation, the mortgagee has no duty under the good faith covenant to negotiate a workout agreement with the mortgagor. See, e.g.:Carter’s Court Associates v. Metropolitan Federal Sav. and Loan Assn., 844 F. Supp. 1205, 1210 (M.D. Tenn. 1994) (“In the absence of an express contract term, there is no duty on the part of a lender to negotiate a workout or provide increased credit.”); Centerbank v. Purcell, 1996 WL 694614 at 3 (Conn. Super. Ct. 1996) (“Failure to restructure the terms of the loan after default does not constitute a breach of the covenant of good faith and fair dealing because the loan documents do not contain any agreement to restructure in the event of a default.”); Montana Bank of Circle, N.A. v. Ralph Meyers & Son, Inc., 769 P.2d 1208 (Mont. 1989) (affirming summary judgment to lender on guarantor's claim that lender acted in bad faith by failing to renegotiate the defaulted loan); Gaul v. Olympia Fitness Center, Inc., 623 N.E.2d 1281 (Ohio Ct. App. 1993) (lender’s decision to foreclose is exercise of contractual rights and not bad faith); Farm Credit Services of America v. Dougan, 704 N.W.2d 24 (S.D. 2005) (rejecting farmer’s claim that because collateral value of ranch exceeded the debt, the lender refused in bad faith a requested 7-month extension of a late installment payment during the post-9/11 plunge in livestock and commodity prices); Foseid v. State Bank of Cross Plains, 541 N.W.2d 203 (Wis. Ct. App. 1995) (rejecting borrower’s tortious interference claim arising from the mortgagee’s refusal to delay its collection remedies, allegedly resulting in a less favorable pre-foreclosure sale contract).
On the residential lending side, however, several states have adopted or are considering proposals that mandate mediation or some good faith negotiation of a defaulted loan or at least consideration of the borrower’s modification request. Even before the current economic crisis, some states imposed similar duties on farm lenders. See Michael T. Madison, Jeffry R. Dwyer, and Steven W. Bender, The Law of Real Estate Financing § 12:104 (Thomson/West 2009) [hereinafter Law of Real Estate Financing].
Despite the absence of a duty to negotiate or even to consider the commercial borrower’s proposals concerning the property, it is usually worthwhile for the lender to approach any such proposals with an open mind and without hostility rather than ignoring or rejecting them outright. Ideally, the lender’s response will be timely, yet carefully considered, as well as reasonable and defensible in light of the lender’s contractually expressed expectations. A timely response is important particularly for proposals made while some clock is ticking, such as an advertised foreclosure sale date. Moreover, a prompt response will prevent the borrower from building false hopes and in some manner relying on the delay as signaling forthcoming approval.
In the event that formal workout negotiations ensue, a preworkout agreement is essential to bolster the conclusion that the lender is under no obligation to reach any agreement to modify the loan terms. Travelers Ins. Co. v. Corporex Properties, Inc., 798 F. Supp. 423 (E.D. Ky. 1992) (rejecting borrower’s argument that lender was obligated to reach agreement on workout, and relying on terms in preworkout agreement such as its nonwaiver clause that specified “No negotiation or other actions undertaken pursuant to this agreement shall constitute a waiver of any party’s rights under the Loan Documents, except to the extent specifically stated in a written agreement . . . ;” note the savvy drafting symmetry of this clause despite its one-sided benefits to the lender); Metropolitan Life Ins. Co. v. Triskett Illinois, Inc., 646 N.E.2d 528 (Ohio Ct. App. 1994) (borrower’s claim that lender breached duty of good faith by engaging in protracted negotiations that led borrower to anticipate a workout is obviated by correspondence reflecting lender’s constant insistence that borrower cure or face legal action).
If the lender has developed some internal procedures to govern proposals for modification, workout negotiations, and any post-default enforcement, that protocol should be followed scrupulously. Otherwise, if the procedures are unearthed in discovery, the lender may face challenges based on the deviation ranging from negligence to bad faith and other claims in which malice and discrimination play a role.
Throughout the loan relationship, and particularly in the throes of workout negotiations or foreclosure, the lender should ensure that all internal communications and records are justifiable and reasonable and would not embarrass the lender in court.
Despite labeling internal emails, memos, and other communications as confidential, most internal communications are discoverable in litigation. Obvious harm to the lender’s image could result from epithets hurled at the borrower, suggesting that internal business records should remain free of emotion and instead contain statements of fact and reason. As I explain to my law students, lenders should assume anything they write about (or say to) the borrower will be blown up as an exhibit for a jury that will hang on every word. Lenders also should avoid a written or electronic record of their motivations and judgments, as these might support borrower theories of liability. Illustrating the potential damaging impact of such internal communications is litigation stemming from the acquisition of a 6,400 acre ranch in Wyoming with mortgage financing that also encumbered other property. Following foreclosure of the ranch, the borrower sued on theories of negligence, bad faith, and other claims, contending the lender knew or should have known the venture would fail. A jury awarded the borrower $3.2 million and the case was later settled for an undisclosed amount. Discovery revealed a memo from the lender’s local representative to his superiors urging a workout of the Wyoming loan. In part, it read:
These boys are losing all they accumulated. In a way we are not entirely blameless. We made them a 17% loan [about 1981] in Colorado to put a down-payment on a deal that was too big for them. They were in danger of losing that down-payment unless we revamped the loan on the Wyoming place. We did this, at a rate higher than they had bargained for. Then, when they needed a loan assumption agreement to sell the Colorado piece, we delayed it until they were maneuvered into a much less attractive sale. It was a bad deal all around and we helped make it so.
The Economist, Nov. 7, 1987, at 38. No doubt the memo stemmed from a loan officer who had developed a personal relationship with the borrower and who was either trying to help out, or to put a better face on a loan for which he was responsible. Sometimes these employees can be defensive and forget their employer is the lender, not the developer. When the person who perhaps created the mess is responsible to deal with the problem loan, sometimes the problem is swept under the rug until it becomes worse and prompts, in panic, precipitous and inconsistent action that is the fodder for lender liability claims. Alternatively, the loan officer might be angry with the borrower for making the officer look bad, resulting in outbursts and ammunition for the borrower to use before a jury. For these reasons, most lenders will shed such emotional baggage or conflicts of interest by transferring a troubled loan to workout specialists in another department.
During workout negotiations, the lender should avoid taking inconsistent positions and avoid communications the borrower may misconstrue as assurances of forbearance or the like.
Lenders should strive for consistency in their communications with borrowers, avoiding inconsistent positions, as well as vague or ambiguous statements or proposals. Oral communications may be misconstrued or inaccurately remembered by the borrower. For example, in South Dakota litigation, the borrower contended the lender in workout negotiations agreed to save the property from foreclosure by the senior mortgagee and allow the borrower to continue to operate the 5,400 acre ranch. In contrast, the lender claimed this arrangement was only discussed as an option provided the property could be acquired for an amount enabling the lender to protect its interests. Garrett v. BankWest, Inc., 459 N.W.2d 833 (S.D. 1990) (affirming the trial court’s rejection of the borrower’s breach of contract claim on the ground that the terms of the acquisition agreement were incomplete and did not amount to a contract); seealsoLambert v. Fleet Nat. Bank, 865 N.E.2d 1091 (Mass. 2007) (commercial borrower seeking to establish oral agreement to renew loan managed to describe only vague and general discussions common to preliminary stages of business dealings that do not constitute an enforceable agreement).
Lenders can take several steps to bolster their position in litigation stemming from such misunderstandings. For all meetings or phone calls with the borrower, the lender should have at least two representatives present, allowing the lender to better counter the borrower’s flawed recollection of conversations. At the same time, to ensure consistency in communications, the lender should channel all borrower communications to a single contact point, preferably someone who would make an excellent impression as a witness in any later claim. The parties’ preworkout agreement can specify the contact person and also that in the course of workout negotiations, various proposals may be floated or considered without binding effect, and that all agreements must be formalized in writing signed by both parties to be effective. Moreover, although an agreement may actually be reached on individual issues, the agreement is not binding unless all issues are resolved and the agreement put in writing and executed by all parties.Moreover, the agreement should state that any discussions are settlement discussions and that none of the proposals are admissible in any proceeding for any reason. As a last resort, statutes of fraud in many jurisdictions require a writing for agreements binding the lender that may encompass loan modifications and post-default promises to forbear on collection. Law of Real Estate Financing § 14:37.
In negotiating the workout agreement, the lender should not threaten to take actions, such as an enforcement strategy, that the lender doesn’t intend to undertake.
Lenders that still remember the late 80s/early 90s experience of gratuitous lender liability threats launched during workout discussions may wish that borrowers too adhere to this principle. As with many commandments of lender liability, this advice for lenders stems from rogue case law outside the mainstream that became the standard for conduct given the amorphous doctrines construed, in this case predominantly that of duress. Here, the leading case of State National Bank of El Paso v. Farah Manufacturing Co., 678 S.W.2d 661 (Tex. App. El Paso 1984) (judgment later vacated pursuant to “joint motion to dismiss the entire case as settled”), treated the lender’s dealings with a borrower under a management change clause in their loan agreement as actionable fraud, duress, and tortious interference with business relations. The clause authorized the lender to declare a default upon any change in corporate management that, in its opinion, was adverse to its interests. The clause was part of a loan workout following years of severe financial difficulties that the lender believed had been caused by the borrower’s former president and CEO. When that president later signaled an intention to regain his position, the lender allegedly threatened to respond by declaring the loan in default. In fact, the lender had no actual intention to declare a default. Its false threats aiming to influence the board to reject the CEO’s reinstatement were held to constitute fraudulent misrepresentations. Also, these threats, together with the lender’s preventing the election of certain board members, established a cause of action for duress. As additional interference with management, the lender allegedly caused the successive appointments of two individuals it favored as CEO, caused the resignation and replacement of the former president as board chairman, and packed the board with its nominees, who allegedly were inexperienced in overseeing the borrower’s business and in conflict of interest with the borrower. The lender was held liable to the borrower for more than $18.5 million in damages suffered as a result of the lender’s control. In sum, the court limited the lender’s permissible alternatives either to declaring outright a default if the former president was reappointed or acquiescing in his reappointment. The threats and machinations by which it exerted extensive behind-the-scenes control of the borrower were found wrongful and beyond its contractual and legal authority.
In workout cases not involving similar circumstances of excessive, wrongful control, claims against lenders alleging duress are seldom successful. For example, the Texas Court of Appeals upheld summary judgment for a lender against the borrower’s contention that its release of claims executed in connection with a refinancing resulted from the lender’s unlawful duress. Deer Creek Ltd. v. North American Mortg. Co., 792 S.W.2d 198, 203 (Tex. Ct. App. 1990). In a similar case, guarantors of a line of credit alleged that the lender used economic duress to procure their release of claims executed in connection with an extension agreement. Specifically, they contended the lender disrupted them with post-default phone calls and forced them to sign the extension under the threat of filing an action to collect the accelerated debt. However, this threat failed to constitute economic duress because the lender had a legal right to threaten to enforce its collection remedies. Transamerica Consumer Receivable Funding, Inc. v. Warhawk Investments, Inc., 842 F. Supp. 536 (M.D. Ga. 1994). In Glenfed Finance Corp. v. Penick Corp., 647 A.2d 852 (N.J. App. Div. 1994), a New Jersey appellate court held the trial court erred in awarding the borrower $3 million in damages based on economic duress. Following the borrower’s default on financial covenants, the parties agreed to a date for acceleration of the note, in effect reaching an extension agreement. Because the accelerated date caused the borrower to fail to raise financing through an initial public offering, the borrower viewed the agreement less charitably, claiming it resulted from economic duress. Rejecting this claim, the court observed: