June 26, 2022

Volume XII, Number 177


June 24, 2022

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Preventing Lender Liability: A Cautionary Case Study

In lending, the importance of full, transparent and accurate communications with a borrower cannot be overstated. In times of trouble, a lender must closely monitor a borrower’s activities and ensure not only that the lender takes any actions necessary and permissible under its loan documents but also that its borrower is taking the steps necessary to preserve the lender’s collateral.

While a distressed borrower (and sometimes its other creditors) may feel the lender is “giving the borrower advice” or even “taking over,” a lender must remain focused on strictly adhering to the terms of its loan documents, preserving its collateral and ensuring the borrower remains completely independent and in full control of its operations. Rather than taking a “do-it-yourself” approach and risking a result similar to the lender in In re Bailey Tool & Mfg. Co. (discussed below), if a borrower’s control over a business is unacceptable due to mismanagement, fraud or any other reason, the lender should quickly evaluate legal options to protect its collateral, including a possible receivership or bankruptcy case.


Recent Case Study

The recent opinion issued on December 23, 2021 in In re Bailey Tool & Mfg. Co. (Bankruptcy Court, Northern District of Texas) serves as a textbook example of lender overreach and reminds us of the critical importance of maintaining transparency and independence in lending. In 2014, the borrower was asked to exit its existing lender, Comerica Bank. At that time, the borrower had several new business lines, valuable contracts and an enterprise value of approximately $6 million. To accomplish the exit from Comerica Bank, the borrower then entered into discussions with Regions Bank for a new lending arrangement. As part of the move, Regions Bank suggested the borrower utilize a factoring and inventory financing lender for a few months as a “bridge” to get from Comerica Bank over to Regions Bank. One of the companies Regions Bank recommended for factoring was Republic Business Credit, LLC (“Republic”). In March 2015, the borrower ultimately entered into factoring and inventory financing agreements with Republic pursuant to agreements that the Bankruptcy Court described as “not a model of clarity.”

After receiving its first draw request from the borrower, Republic sent over a Borrowing Base Certificate showing ineligible accounts had jumped from $17,000 shown on the pre-closing pro forma Borrowing Base Certificate to $142,310.87 and further showed negative availability of $342,978.27 for purposes of account receivable factoring! By July 2015, Republic caused the borrower to close by refusing to release funds for payroll, causing its employees to walk off the job. In the aftermath, Republic then “became involved in trying to get management of its choosing in the Company and otherwise micromanaging the Company” and began putting pressure on the borrower’s owner to give a lien on his exempt homestead. On one phone call, a Republic loan officer told the principal of the borrower and its financial advisor that he “shut down” the borrower because he was “tired of it” and attempted to convince the financial advisor to assume complete control. The borrower ultimately filed for Chapter 11 bankruptcy in February 2016 in the hopes of salvaging its business and effectuating a sale or reorganization.


The Cost of Lender Liability

Post-petition, Republic seems to have doubled down on its misbehavior by violating the automatic stay in bankruptcy, refusing to turn over approximately $584,250 of monies that it over-collected from the borrower after completely paying off its loan unless the borrower agreed to give them a release from potential lender liability claims. The delays caused by the refusal to turn over the funds sabotaged the borrower’s efforts to facilitate a sale or reorganization process and caused the bankruptcy cases to convert to Chapter 7. The Chapter 7 Trustee then commenced an investigation into the pre-petition activities and filed a lender liability lawsuit against Republic.  

The Bankruptcy Court ultimately ruled that Republic, among other things, (i) misrepresented the amount of funds available to the borrower, (ii) charged excessive, undisclosed fees and penalties, and (iii) refused to turn over funds and took complete control of the borrower’s finances, causing the Company to completely shut down. Republic was held liable for $17 million in damages as well as over $700,000 in Chapter 11 and Chapter 7 administrative expenses, i.e. it was forced to pay for the entire cost of the bankruptcy proceedings.


Lender Liability in Other Cases

While an extreme lender liability case like In re Bailey is rare, adverse lender liability rulings do happen with some frequency. Before In re Bailey, there were a number of other cases the resulted in lawsuits against lenders:

These cases serve as additional reminders to lenders to steer clear of the kind of behavior shown in the Bailey case. Or, in the words of one veteran workout counsel: “If it feels good… don’t do it!”  

© 2022 Varnum LLPNational Law Review, Volume XII, Number 139

About this Author

Kimberly A. Baber, Varnum Law Firm, Grand Rapids, Corporate Contracting Attorney, Securities Matters Lawyer

Kim is an attorney in the Corporate Practice Group where she represents both publicly-traded and private businesses at all stages of growth in a variety of transactional matters. Although Kim regularly counsels clients on general contract and business law matters, she focuses her practice on securities law matters, corporate governance issues, and mergers and acquisitions. She has particular expertise in the community banking and financial services industry. She also has substantial experience representing companies and investor groups seeking to raise capital through the sale of debt and...

Brendan G. Best, Varnum, Chapter 11 Bankruptcy Lawyer, Manufacturing Industry Attorney

Brendan focuses his practice on restructuring, workouts and bankruptcies, representing creditors, debtors and other parties in Chapter 11 bankruptcy cases, out-of-court workouts and restructurings, distressed transactions and general insolvencies. Brendan has a national insolvency practice, serving clients in diverse industries including manufacturing, automotive, building supply and service, energy, oil and gas, health care, food service, gaming, hospitality, construction and real estate.

Brendan serves as outside bankruptcy counsel for clients, advising them on commercial issues...

Michael J. Romaya, Varnum, Financial Services Attorney, Acquisition Funding Lawyer

Michael Romaya represents lenders and borrowers in a wide variety of commercial financial transactions. He has structured, negotiated, and documented numerous senior and subordinate debt financing arrangements of all types, including secured and unsecured single bank and syndicated credit agreements, multi-currency financing facilities, mezzanine facilities and acquisition financings. His practice also focuses  on workouts and restructuring of troubled credits.

Additionally, Michael advises significant companies on different areas of corporate...

Kristen M. Veresh, finance attorney, Varnum

Kristen is an associate in the finance and corporate practice groups, and focuses her practice on both financial matters, and business and corporate matters. She represents lenders and borrowers in a variety of financial transactions including real property, acquisition and commercial financing transactions. In addition, she advises startup to mid-size companies in general business, corporate governance and private equity matters.