Lender Liability is Not a Thing of the Past: Texas Bankruptcy Court Slams Lender with $17 Million in Damages for Exercising Improper Control Over Borrower
In recent years it seems that a common misconception among lenders and their counsel has been taking shape. Namely, that lender liability is no longer a viable cause of action in today’s financial services and judicial landscapes. Those who subscribe to this view, however, should pay careful attention to a recent decision demonstrating that lenders still can be held liable and face substantial damages if they exercise excessive control over a borrower’s business affairs.
In Bailey Tool & Mfg. Co. v. Republic Bus. Credit (In re Bailey Tool & Mfg. Co.), 2021 WL 6101847 (Bankr. N.D. Tex. Dec. 23, 2021) (“Bailey”), the United States Bankruptcy Court for the Northern District of Texas found a lender at fault for its borrower’s bankruptcy and subsequent liquidation and held the lender liable for $17 million in damages to the bankruptcy estate under various legal theories. The $17 million in damages included the full enterprise value of the debtor’s legacy business and anticipated new business, lost profits, all of the debtor’s administrative expenses, punitive damages, attorneys’ fees, and more. The bankruptcy court also hit the lender with an award of nearly $1.2 million in favor of the debtor’s owner. And if that wasn’t enough, the court subordinated the lender’s claim to the claims of unsecured creditors and even to the equity interest of the owner.
Although rare, the Bailey decision illustrates that lender liability causes of action can arise when a lender exceeds the bounds of permissible control and contributes to a borrower’s demise. And while a lender’s loan documents may contain protective covenants, expansive remedies, and other provisions that afford them some degree of control over a borrower’s actions and purport to limit their liability, these contractual rights must be exercised according to the precise terms of the loan documents and in a reasonable and good faith manner in order to avoid liability to the borrower.
The Bailey court’s decision was thoroughly set forth in a 145-page opinion. This post will attempt to summarize the salient points of the opinion, but the entire opinion is definitely worth a read—especially if you are a lender or lender’s counsel.
Bailey Tool & Mfg. Co. (the “Company”) was a metal fabricating business whose primary customers were automotive suppliers. In the years prior to the Company’s bankruptcy, its long-time owner (the “Owner”) expanded the Company’s business into new products and markets and was working to expand the business to include ammunition manufacturing.
Although the Company began to struggle during the 2008-2009 global recession, it managed to (somewhat) right the ship by 2014, although it was not yet back to its pre-recession performance.
The Bank’s Actions Giving Rise to Lender Liability
The first 100 pages of the Bailey opinion contain the court’s findings of fact. The findings had citations to the record of the trial, which took place over almost eight days. The record included more than 1,000 exhibits and testimony from 11 witnesses. Below are some highlights from those factual findings.
In 2014, the Company’s primary lender (the “Old Bank”) asked the Company to find a new lender because it was concerned that the Company was behind on tax payments. To obtain short-term bridge funding between the Old Bank and a new lender, the Company entered into a factoring agreement and an inventory loan agreement (the “Agreements”) with a new lender (the “Bank”). The Bank also obtained a personal guarantee from the Owner.
Notably, prior to executing the Agreements, the Bank performed substantial diligence and identified several problems with extending credit to the Company, including: (i) unpaid taxes, (ii) aged accounts payable, and (iii) the Department of Defense (“DOD”), a major customer, paid on a milestone rather than progressive billing basis (i.e., this major customer was slower than other customers in making payments). Nevertheless, the Bank approved the financing arrangement.
A focal point of the negotiations between the Bank and the Company prior to executing the Agreements was the need for the Company to receive a 90% advance rate on receivables under the terms of the Agreements to meet its anticipated operating expenses.
Just days prior to executing the Agreements, however, the Bank became concerned about the collectability of a large receivable from the DOD (the “DOD Receivable”) that accounted for approximately 25% of the Company’s receivables. As a result, the Bank decided it would only make a 65% advance on the DOD Receivable. While this decision was technically permissible under the Agreements, it was contrary to the Company’s “reasonable expectation” of a 90% advance rate. The Bank failed to notify the Company of this decision prior to signing the Agreements. What’s more, discovery revealed internal emails where the Bank’s COO stated that the Bank may later make the DOD Receivable “ineligible,” which the Bank also failed to communicate to the Company.
“[A]lmost immediately” after signing the Agreements and “despite months of due diligence,” the Bank deemed itself “insecure” and did not reliably make advances on receivables, falling well short of the expected 90% advance rate. Instead, the Bank deemed accounts “ineligible” and deemed itself “over-advanced,” a term not defined in the Agreements or explained to the Company. In addition, the Bank “charged fees and expenses with abandon [and] without transparency.”
In June 2015, the Old Bank, which still had some amounts outstanding under its loan, declared a conditional default due to the Company’s unpaid taxes. This led the Bank to declare its own default and take certain of the actions described below.
After calling the default, the Bank ceased advancing any funds to the Company. Contrary to the Agreements, the Bank directly paid select payroll, vendors, and other parties of its choosing and refused some of the Company’s requests to make certain payments. The Bank “took complete and total control of [the Company’s] cash,” controlling not only collections of receivables (through its lockbox arrangement), but all of the Company’s disbursements as well. It eventually refused to fund payroll, “caus[ing] the shutdown of the Company in July 2015” “for no rational reason.” It then called a second default based on this shut down. “This was the beginning of the end for [the Company]—approximately four months into the [Bank] relationship.” In the Court’s view, “[i]t was clear that [the Bank] began to substantially improve its own position, to [the Company’s] detriment.”
But this was not the end of the Bank’s misbehavior. Thereafter, the Bank “surreptitious[ly]” sought to replace the Company’s management and “micromanag[ed]” the Company. Furthermore, for months after it stopped making advances, the Bank continued to collect all of the Company’s receivables advances even though the evidence showed that the Company at all times had availability and the Bank was fully protected. Even after the Bank terminated the Agreements, it continued to hold the Company’s cash unless the Company signed a release.
Without access to its money, the Company filed for chapter 11 bankruptcy protection on February 1, 2016. Once in bankruptcy, the Bank continued interfering in the Company’s operations, directing customers to pay the Bank instead of the Company and “refusing to turn over cash it held after the bankruptcy cases were commenced.”
After the Company converted its cases to chapter 7, the chapter 7 trustee (the “Trustee”) commenced an adversary proceeding against the Bank arguing, in short, that the Bank’s actions caused the Company’s failure, and the Bank should have to pay all resulting and consequential damages as well as punitive damages.
The Bankruptcy Court’s Decision
i. Breach of Contract
Although the court found that many of the Bank’s “bad acts” were permitted under the Agreements (for example, the Bank was “within its rights under the Agreements” when it declared an event of default almost immediately after executing the Agreements even though the Bank’s action “could easily be considered an over-reaction”), the court nevertheless found that certain of the Bank’s actions were material breaches of the Agreements under Louisiana law (the choice of law under the Agreements) because such actions were not permitted under the Agreements, including (i) paying vendors directly instead of funding the Company, (ii) charging a termination fee and then taking the position that the Agreements were not terminated until the Company provided the Bank a release, and (iii) after termination, refusing to turn over funds collected, demanding that the Company continue to send its receivables to the Bank, and even telling the Company’s customers to send payments to the Bank.
The court concluded that but for these breaches, the Company “would not have failed as a going concern and would not have had to go into bankruptcy.” As such, the court found that the Bank’s breaches “ultimately caused [the Company’s] bankruptcy, the associated destruction of [the Company’s] enterprise value, and future as a going concern.” According to the court, these consequences were “reasonably foreseeable.”
As a result, the court found the Bank was liable to the Company for the full enterprise value of the Company’s business. This included not only the Company’s legacy business (valued at almost $5 million), but also its “anticipated future ammunitions-focused” business (valued at $7.3 million). The Bank was also held liable for almost $600,000 in funds wrongly over-collected and withheld.
ii. Breach of Duty of Good Faith and Fair Dealing
The court also found that the Bank intentionally violated the duty of good faith performance implied in every contract under Louisiana law. In so doing, the court relied on many of the same facts and conclusions supporting the breach of contract finding. It also focused on the Bank’s “outrageous” behavior in certain of its funding decisions and other “grossly overreaching conduct,” such as demanding that the Company sign a release to receive its own funds back, even after the Bank had terminated the Agreements.
iii. Lender Liability (Torts Claims)
The lender liability claims, sounding in tort rather than contract, were governed by Texas rather than Louisiana law given the parties’ relationship to Texas. Examining Texas lender liability law, the court noted that “[i]f a lender exercises excessive control over a borrower . . ., a lender can assume the role of fiduciary rather than creditor.” However, even absent a fiduciary duty, “if a lender takes a particularly active role in the business decisions of the borrower” it “may become liable for tortious interference.” Although the court failed to find a fiduciary duty, it did find that the Bank committed two torts against the Company: (i) fraud (as a result of fraudulent misrepresentations), including misrepresenting to the Company that it was in an “over-advanced” position, which was not true; and (ii) tortious interference with the Company’s business and contractual relations, including “overreaching” acts that drove away customers and made it impossible for the Company to fill customer orders.
For the finding of fraud, the court awarded damages equal to the Company’s enterprise value of $12.3 million as discussed above. On the finding of tortious interference, the court awarded damages for substantial lost profits of over $2 million.
iv. Violations of the Automatic Stay
The court also found that the Bank willfully violated the automatic stay by, among other things, demanding that customers pay the Bank and refusing to turn over cash it held. As damages for the Bank’s “willful conduct,” the court awarded actual damages equal to the debtor’s chapter 11 administrative expenses (almost $500,000) plus punitive damages of triple that amount (almost $1.5 million).
v. The Bank’s Claims: Equitable Subordination and Claim Objection
The court further found that the Bank’s claims in the bankruptcy case should be equitably subordinated under section 510(c) of the Bankruptcy Code, which provides for such relief where: (i) the claimant engaged in some sort of inequitable conduct, (ii) the conduct resulted in an unfair advantage or injury to creditors, and (iii) subordination is not inconsistent with the Bankruptcy Code. Based on the Bank’s actions giving rise to the court’s earlier findings, the court held that the Bank’s claims (if any) would be subordinated to all other classes of creditors (and classes of interests). Moreover, without much analysis, the court held that all of the Bank’s claims should be “disallowed entirely” in light of the Bank’s misconduct.
Lessons for Lenders
Bailey is a stark reminder of the substantial lender liability risks associated with exercising excessive control over a borrower. When a lender improperly controls a borrower’s affairs, fiduciary duties may be imputed on a lender and expose the lender to liability for acting in its own interest. The decision offers some practical lessons:
First, it is important that lenders negotiate clear agreements that capture the objective intent of the parties, especially with respect to critical economic terms like borrowing base availability, collateral eligibility, and the calculation of fees. It is also important to choose the governing state law carefully, as the application of Louisiana law in this case may have led to a worse outcome for the Bank.
Second, before exercising remedies, lenders and their counsel should carefully review loan documents to ensure that those remedies are permitted in reasonably clear terms.
Third, even technical compliance with an agreement might not absolve a lender of liability if the facts, taken as a whole, lead a court to view the lender as having acted in bad faith. In Bailey, the court held that the Bank not only acted in “bad faith,” but also with “malice” toward the Company and the Owner.
Fourth, internal emails can become public through discovery, so a lender’s employees should be trained in the proper use of email and avoid unnecessary comments that could cast the lender in a negative light.
In sum, lender liability claims remain viable causes of action in certain scenarios. As such, lenders should pay particular attention when taking actions that could be viewed as exercising control over a borrower. While defaulted borrowers are certainly a bane on a lender’s enterprise, over-zealous responses to a default could end up costing lenders even more.