Doctrine of Lender Liability

by Jonathan Barreto, J.D. Class of 2017 Touro Law Review Senior Staff Member

Let’s say that you run a business, it is a well-run business and you have put many sweat hours into it and built it from the ground up. However, internal financing sources are limited, so you need capital to expand and capture more market. What do you do? You could ask for investors to put up equity, but that means sharing profits with partners that may not have the same goals as you and may cause internal strife (agency cost), or, in the alternative take out a loan. However, the loan is a debt and requires interest payments and repayment of the loan amount. As a business owner, you must also consider the possibility that the business gets into a cash flow crunch and you require more credit from the lender to keep operations going. But at that precise moment, without notice, the creditor denies extension of more credit and accelerates the loan amount. Without that cash your business goes under. The business owner worked diligently and now has nothing to show for it! But the key is that the business owner relied on the creditor to finance his business and without notice and knowing the delicate financial situation, the creditor shuts down the lifeline of the business, which causes the business to fail. The reality is that many businesses suffer from this dilemma, and the only option is to renegotiate with the bank from a position of weakness or bankruptcy and loss of profits and employment to society.[1] However, all lenders have an implied obligation of good faith[2], and a fiduciary duty to the borrower if the creditor engages in an egregious breach[3] so another remedy exist to the borrower: Lender Liability Claim.

The Doctrine of Lender liability is an umbrella terminology used to describe a vast array of commercial lawsuits, based on contract and tort law, alleged against a creditor. These claims include contract theories, fraud, misrepresentation, economic duress, negligence, tortious interference, breach of fiduciary duty, instrumentality theory, equitable subordination, re-characterization of debt to equity, and lending in the zone of insolvency. However, defenses exist for the lender, including representations, In pari delicto, business judgment rule and statutory defenses.[4]

In K.M.C. Co. v. Irving Trust Co.,[5] the landmark case which established the doctrine of lender liability, a creditor and borrower, in the business of wholesale and retail grocery, entered into a $3.5 million line of credit secured by all of the borrower’s current assets.[6] The promissory note was payable on demand and borrower sought to draw an additional $800,000 on the line of credit, which would have increased the loan balance to just under $3.5 million.[7] However, creditor, without prior notice to borrower, refused to make the advance.[8] Borrower needed the loan to facilitate the sale of its business, but because of the refusal, the sale fell through and the borrower’s business collapsed.[9] Borrower sued creditor for breach of contract and creditor’s bad faith in the transaction and the court found creditor liable for damages of the entire enterprise value of borrower.[10] The Sixth Circuit held that an implied obligation of good faith exists, and if the breach of that good faith occurs and causes damages to borrower then the creditor is liable for the borrower’s entire business value.[11] What made this case so influential was the liability laid on the creditor. The Sixth Circuit in K.M.C. Co., found the creditor liable for the entire enterprise value of the borrower due to the breach causing the sale to fall through.[12]

Currently, the doctrine of lender liability is applied in New York State jurisprudence.[13] In Gillman, the New York Court of Appeals upheld the doctrine of lender liability established in K.M.C. Co.[14] New York State is home of the financial capital of the world, New York City and Wall Street, and this common law doctrine is not good for business. However, the doctrine is not applied as vigorously as first seen and is very fact specific.[15] In Gillman, the New York Court of Appeals did not find lender liability (or damages for the business concern value, impliedly) and held that a lender has the ability to take proactive steps to limit its credit risks to the borrower by restricting its exposure to the fallout of the borrower’s financial distress.[16] New York puts a heavy burden on borrowers to find lender liability (bad faith). By simply alleging a cutting off of financing when the borrower is in financial distress, the lender has the ability to mitigate its losses and cut financing when it feels insecure under the loan agreement, and that, by itself, will not rise to the level of bad faith!

Furthermore, there is a split in the circuit in regards to the current state of the doctrine’s applicability. Only the First[17], Second[18], Sixth[19] and Eighth[20] Federal Circuit Courts have adopted the doctrine, while the Seventh[21] has declined to recognize it, and the rest of the circuit courts have not expressly adopted the doctrine or rejected it and look at it as a novel issue.[22]

As such, should a doctrine of liability exist that makes a creditor liable for the value of its borrower’s business when other factors, besides financing, impact the value of the borrower’s financial affairs? The Doctrine of Lender Liability is an implied obligation of good faith imposed on a lender to give notice to a borrower before refusing an advancement under an agreement to extend credit unless the refusal without notice was made in good faith on the basis that the borrower’s financial condition would not support such a loan.[23]

Recently, in Bondi v. Citigroup, Inc., the 2011 Parmalat lawsuit between Citigroup and giant Italian dairy company, the company claimed that Citigroup caused its insolvency, and it brought lender liability based on contract and tortious theories.[24] The court dismissed the claims against the bank and held that Parmalat was a deciding factor (parti in delicto) in causing its own insolvency, and that the financial structure engineered by the bank was not the main contributing factor of Parmalat’s insolvency.[25] The case involved a food company (dairy producer) whose operating leverage was higher than other industries and required extensive and rapid liquidity to maintain its operations and value. However, the insolvency was caused by the mismanagement of the company’s directors, and the bank was simply hired to structure financing operations of the borrower’s current assets to facilitate financing.[26] In conclusion, the court recognized that the doctrine of lender liability does have merit, but only if the creditor acts in bad faith and causes damages to the enterprise value of the borrower.

In K.M.C. Co., the borrower was a wholesale and retail grocery business that required liquidity due to the rapid turnover of the business. Any credit crunch would impact the margins of the business exponentially, due to its high operating leverage (high fixed costs relative to variable costs, therefore a small drop in revenues can mean an exponential decline in profits).[27] The potential of financial risk was implicit, and not caused by the creditor. However, the Sixth Circuit did not mention that analysis, and simply focused on the refusal to advance the credit to borrower when creditor had strong convictions that the business was in financial distress.[28] Furthermore, nowhere in the contract, did the creditor agree to insure borrower against the loss of business, the creditor is just that, a financier to facilitate business (invest in current assets and fixed assets), not to insure against losses and act as a backstop in the event the business collapses.[29] A legal system and jurisprudence already exist to deal with failed businesses and failed markets that protect investors’ and creditors’ rights and enforces obligations: bankruptcy restructuring.

This extra layer of liability upon creditors is a doctrine that does not add real economic value to society. It simply shifts money from one pocket to another, and instead rewards failure. This doctrine should be revisited by the courts and legal community. However, the reality is that this common law doctrine exists and learned lawyers should take note to apply it when possible.

[1] Judge Lang & Katers and Mahany Law Partners in Lender Liability, http://www.lenderliabilitylawyer.com/news.php#mediabar (last visited Sept. 2, 2016).

[2] U.C.C. § 1-201(b)(20) (2001) (in the context of UCC Article 9 secured transactions).

[3] Ginsberg v. Bistricer, 2007 WL 987162, at *19-20 (N.J. Super. Ct. App. Div. 2007).

[4]Judith Elkin, Lender Liability in the US-An Exercise in Finger Pointing, Insolvency and Restructuring International Vol. 9 No. 1 (Apr. 2015), http://www.haynesboone.com/~/media/files/attorney%20publications/iri_9_1_april_2015_lender_liability.ashx.

[5] K.M.C. Co., Inc. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985).

[6] Id. at 754-55.

[7] Id. at 755.

[8] Id.

[9] Id.

[10] K.M.C. C., Inc., 757 F.2d at 755.

[11] Id. at 756.

[12] Id.

[13] Gillman v. Chase Manhattan Bank, N.A., 537 N.Y.S.2d 787, 15-16 (1988).

[14] Id.

[15] Id.

[16] Id. at 9-10 The crucial fact laid in the lender’s ability to mitigate any credit risks by transferring funds deposited by borrower to an account to pay another party, and instead used to pay the lender’s obligation, as the lender anticipated financial insecurity and unsecured, as stipulated in the loan contract. Id. 

[17] Reid v. Key Bank of Southern Maine, Inc., 821 F.2d 9, 12-15 (1987).

[18] Fasolino Foods Co., Inc. v. Banca Nazionale del Lavoro, 961 F.2d 1052, 1056-1058 (2d Cir. 1992) (reaffirmed by Manufacturers Hanover Trust Co. v. Yanakas, 7 F.3d 310, 318 (2d Cir. 1993)).

[19] K.M.C. Co., Inc., 757 F.2d at 759-760.

[20] Terry A. Lambert Plumbing, Inc. v. Western Sec. Bank, 934 F.2d 976, 982-983 (1991).

[21] Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356-1359 (1990).

[22] Reid, 821 F.2d at 13-14. The First Circuit referenced the statute’s applicability in the Eleventh Circuit, under Alabama state law.  Id. 

[23] Gilbert Central Corp. v. Overland National Bank, 442 N.W.2d 372, 377 (1989).

[24] Bondi v. Citigroup, Inc., 32 A.3d 1158 (N.J. Super. Ct. App. Div. 2011).

[25] Bondi, 32 A.3d at 1180-81.

[26] Id. at 1167-68.

[27] K.M.C. Co., Inc., 757 F.2d at 755.

[28] Id.

[29] Id.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s