The Rights of Lenders and Borrowers
Introduction
Sometimes a lender, such as a bank, intervenes in the affairs of its borrower's business to assure repayment of its loan. These situations are called "workouts," and the lender, perhaps mistakenly, believes that if it intervenes, it can correct what it perceives to be errors by its borrower's management. If the lender then mismanages the business, can the lender's actions lead to a discharge of the loan, or other remedies in favor of the borrower? This is a complicated issue that has no easy or simple resolution. If, however, you are faced with this issue, you should consult an experienced commercial lawyer.
Liability of a Lender That Intervenes in Its Borrower's Business
The term "lender liability" is often used by lawyers to describe different kinds of situations where a lender, because of its conduct vis-Ã -vis the borrower, has caused its loan to be discharged or compromised. The term, unfortunately, has no well-accepted and universally applied definition. The term often is applied to a multitude of sins that borrowers (and often the guarantors of their loans) seek to lay at the feet of their lenders, usually to escape liability on obligations that have gone into default or to find a source of liability for business failures. Rarely do these attempts by borrowers succeed, except in unusual circumstances where the lenders have departed from their traditional role and are held to have assumed obligations apart from those attending the normal kind of commercial lending arrangement. One illustration of this kind of situation arises where the lender has assumed control of the affairs of its debtor's business.
A lender normally is not responsible for the business decisions of its borrower, much less the success (or lack thereof) of its borrower. In a workout situation, where the lender has reason to believe that its loan might not be repaid, the lender may intervene in the debtor's business to some extent. The lender may require, for example, that additional collateral be provided to secure the loan, that other debts be converted to equity, that those who owe money to the debtor instead pay the lender directly, or other similar measures. These measures are lawful and are often explicitly authorized by the lending documents. The lender typically faces no likelihood that the repayment of its loan may be put at risk by these measures, or that it will be made liable to third parties as if it owned and operated the debtor's business itself. In other words, the courts treat these measures as normal incidents of the lender-borrower relationship where the loan has become troubled, non-performing, or delinquent. Otherwise, the lender would be forced to accelerate the loan by declaring a default on the first late payment, by demanding immediate repayment, and by foreclosing on any collateral securing the loan. In many cases, those measures would be unnecessarily harsh and would destroy the debtor's business, while reasonable forbearance would allow the debtor to get its feet back on the ground.
An exception to this rule may apply, however, where the lender, explicitly or implicitly, assumes the obligations of an owner or manager of the borrower's business by assuming control of the business affairs of its borrower. A lender that assumes control of its debtor's business for the mutual benefit of itself and its debtor, moreover, may become like a principal of the business, with liability for the acts and transactions of its debtor in connection with the business. In other words, a creditor who merely exercises a veto power over the business acts of its debtor by preventing purchases or sales above specified amounts does not thereby become responsible as if it were a manager of the business or a partner of the owner. If the lender takes over the management of the debtor's business, however, the lender then assumes a responsibility not unlike that of being an owner of the business. The lender may not only risk its own right to enforce the obligations of the debtor against the debtor itself and any guarantors of the debt, but may also be rendered liable for obligations incurred thereafter in the normal course of business by the debtor who has now become, in effect, an affiliate of the lender.
A classic illustration of a case where a lender takes control of its borrower and then later faces the consequences is provided by a Texas case. A lender decided that its borrower's business would be more successful if the borrower's current management were ousted and replaced by nominees of the lender. Eventually the lender succeeded in forcing out the borrower's existing management and replacing that management with the lender's nominees. The borrower's business promptly went into a precipitous decline, which placed the lender's loans even more in jeopardy. The former management (representing the firm's founding family) eventually regained control, and the business recovered some of its lost ground. The ousted management sued the lender, and the court allowed a recovery against the lender on several theories as a result of the injury to the profitability and value of the business, all of which theories depended on the control of the borrower's business by the lender.
There are a number of other cases that apply similar logic and principles. One court said that where a lender has taken control of the debtor the lender assumes the duties of good faith and trust inherent in management. In another case, the court concluded that the lender's control, domination, and subsequent destruction of its borrower's business, which deprived the borrower/corporation of working capital, justified an order subordinating the lender's claim in bankruptcy to those of the general creditors. In yet a third case, the court decided that a second mortgagee exercised sufficient control over commercial buildings owned by its mortgagor to warrant holding the second mortgagee liable for the costs of heating oil deliveries and repair calls made to the buildings.
Conversely, in the absence of control, actual or constructive, the chances of imposing affirmative obligations on a lender are much diminished. The law does recognize generally that there is an obligation of good faith imposed on the parties in the performance of any contract, regardless of whether the contract explicitly imposes that obligation. At least in the context of commercial parties, the obligations of good faith and fair dealing do not obligate a contracting party to do more (or less) than what its contractual undertakings obligate it to do. All parties to the contract, however, must deal with each other fairly and honestly, consistent with customary commercial relationships. Absent some showing of control by the lender over the debtor's affairs, however, it is difficult to persuade a court to obligate a lender to do more than it strictly has contracted to do, nor will the ability of the lender to enforce its loan rights be put in jeopardy by exercising the normal rights typically used by lenders to protect their ability to enforce the repayment of their loans.
Conclusion
From the point of view of a lender, the documents implementing a loan should be carefully drafted to give the lender optimum flexibility in engaging in a workout of a troubled loan with its borrower. From the point of view of a borrower faced with a lender that has overstepped its role as a lender and has intervened in the borrower's business, wreaking havoc with that business, the advice of, and representation by, an attorney well versed in commercial law with litigation experience is of vital importance.
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