A recent September 2021, Texas bankruptcy court ruling is a cause for concern for lenders who deal with borrowers that have defaulted on their loan agreements.
In an advisory proceeding originated by the Chapter 7 trustee, the Dallas bankruptcy court handed down a ruling in Bailey Tool & Mfg. Co. v. Republic Bus. Credit, LLC, that offers a cautionary view of how the court viewed the lender’s actions.
It deemed the lender’s loan recovery conduct as overly aggressive behavior in a distressed situation.
LENDER CAUSED BANKRUPTCY …
The bankruptcy court held that the lender caused the debtor-borrower’s bankruptcy and its subsequent liquidation.
It awarded the debtor judgment for the full enterprise value of the debtor’s business, lost profits, the debtor’s administrative expenses, damages, legal fees and prejudgment interest, amounting to more than $17 million.
The court described Republic’s conduct as “outrageous” and “grossly overreaching,” and concluded that (i) the lender caused the company, which had shown positive cashflow and significant enterprise value, to fail as a going concern and (ii) if not for the lender’s interference, the company would not have had to file for bankruptcy protection.
In awarding damages, the court concluded that …
… governing Louisiana law (which restricts contracting parties’ ability to limit damages for “intentional or gross fault”) allowed the court to disregard a provision in the factoring agreement that limited the lender’s liability for “incidental, special or consequential damages.”
AVOID LENDER LIABILITY ACTIONS …
It’s important to understand that the majority of lenders act responsibly and bend over backwards to allow time for a borrower to remedy the operating issues that lead to a default under a loan agreement.
In fact, in our experience, we have seen many lenders provide multiple forbearance agreements that span prolonged periods of time, and which gives the borrower leeway to cure defaults.
We have seen in some circumstances, where the loan agreements have been modified to accommodate the borrower, to prevent a default from occurring. There is a limit, however, to the amount of flexibility a lender is willing to provide to a borrower.
They eventually must take action to protect the value of their collateral and to avoid taking a write-down on the loan. When those circumstances occur, however, it’s important to act prudently, and not open the door to possible “Lender Liability” actions.
TOO MUCH CONTROL …
Bailey illustrates that lender liability, although infrequently applied, may arise where the lender exercises too much control over a borrower’s business affairs, and as a result, contributes directly to the borrower’s insolvency.
The case is also a reminder that loan documents may not provide a complete defense to lender liability claims, even if they authorize the lender to take the actions in question.
The lender should think carefully before choosing to exercise any degree of control even if the loan documents contain protective covenants, expansive remedies, and other provisions that afford lenders some degree of control over the borrower’s actions.
KEY CONSIDERATIONS …
Specifically, lenders should reflect on the following key considerations in negotiating loan agreements and exercising remedies:
- Lenders should communicate clearly with the borrower and ensure that the lending agreements capture the express intent of the parties, particularly with respect to economic terms and definitions.
- Lenders should consider the governing state law carefully. In Bailey, the application of Louisiana law may have led to a less favorable outcome for the lender.
- Regardless of any express rights or discretion a lender may have under the lending agreements, lenders should act in good faith in dealing with the borrower.
- Before exercising remedies, lenders and their counsel should carefully review lending agreements to ensure that such remedies are permitted in reasonably clear terms.
- Lenders should not micromanage the borrower and should generally not direct the borrower’s business decisions.
- Lenders should train employees to manage email correspondence properly and employees should assume that any email they send could be produced in litigation.
ROADMAP FOR DISTRESSED BORROWERS …
Although Bailey is an extreme case, the decision will likely provide a roadmap to distressed borrowers looking to gain leverage against their lenders in future negotiations or adversary litigation.
Lenders should understand the impact of the court’s decision on the particular lending activities by consulting with their legal counsel and plan to mitigate any issues before they result in potential exposure to lender liability actions.
Revitalization Partners specializes in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations. Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering, a State Receivership or Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.
