There is a common misconception that lender liability is a thing of the past. However, a recent decision provides a warning to lenders that they can be held liable and face substantial damages if they exercise excessive control over a debtor’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 Dallas bankruptcy court found a lender squarely at fault for its borrower’s bankruptcy and subsequent liquidation and liable to the borrower’s estate under various breach of contract, tort, and bankruptcy theories. The lender’s damages were substantial, including 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 lender was also liable to the owner/guarantor for additional amounts, including exemplary damages.
Bailey illustrates that lender liability, although rare, may arise when a lender exceeds the bounds of permissible control and contributes to a borrower’s demise. The case is a reminder that although loan documents may contain protective covenants, expansive remedies, and other provisions that afford lenders some degree of control over a borrower’s actions and purport to limit their liability, these contractual rights must be exercised precisely, reasonably, and in good faith to avoid liability. Our “takeaways” section provides specific tips to lenders to avoid the fate suffered by the bank in Bailey.
Bailey Tool & Mfg. Co. (along with its affiliates, the “Company”) was a decades-old 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 on a promising and potentially lucrative opportunity in ammunition manufacturing.
The Company’s misfortune began with the 2008-2009 global recession. By 2014, the Company had rebounded somewhat, but was not fully back to pre-recession levels. Still, the evidence demonstrated that the Company was cash flow positive and had “significant enterprise value,” and it “could have reorganized, if not for improper actions” of its bank, Republic Business Credit, LLC (the “Bank”).
The Bank’s Improper Actions
The Court’s decision provides a detailed description of the facts from a lengthy trial, including multiple actions the Bank took that harmed the Company, both before and after the Agreements were signed. It also includes copies of numerous internal emails among Bank officers and employees that paint the Bank and its representatives in a negative light. Overall, it appears that the Bank identified the transaction as risky prior to its consummation, yet it signed the Agreements anyway, perhaps regretted doing so almost immediately, and then took aggressive steps to protect its interests, which negatively impacted the Company’s liquidity and business operations. In turn, the Bank’s actions fostered a poor and continually deteriorating working relationship with the Company’s principals, especially the Owner. The highlights of the Court’s findings are summarized below, but a curious reader may wish to read the opinion to learn more.
In 2014, Bailey’s primary lender (the “Old Bank”) asked the Company to find a new lender. To obtain short-term bridge funding between the Old Bank and a new lender, the Company entered into a factoring agreement (the “Factoring Agreement”) and an inventory loan agreement (together, the “Agreements”) with the Bank on February 27, 2015. The Bank also obtained a personal guarantee from the Owner.
Before it signed the Agreements, the Bank performed substantial diligence in late 2014 and early 2015 and identified several issues. These included unpaid ad valorem taxes, stretched accounts payable, and a major customer (the Department of Defense) that paid on a milestone rather than progressive billing basis, which is typically unattractive to a factor. Nevertheless, the Bank’s underwriter assured his colleagues that the proposed transaction was a “strong deal.”
A few days before signing, the Bank became concerned about the collectability of a large receivable (the “Army Receivable”) that accounted for approximately 25% of the Company’s receivables. The Bank decided it would only make a 65% advance on the Army Receivable. While this decision was technically permissible under the Factoring Agreement, it was contrary to the Company’s “reasonable expectation” of a 90% advance rate. Indeed, a 90% advance rate had been a focal point of the negotiations, albeit not explicitly required under the Factoring Agreement. The Bank did not tell the Company about this decision prior to signing the Factoring Agreement. Further, discovery revealed internal emails where the Bank’s COO stated that the Bank may later make the Army Receivable “ineligible,” which also was not communicated 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, 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.”
The Bank defended its actions by noting that the Company had full access to information regarding the status of its accounts and loan balances on a “portal” available to the Company. But the Court believed the Owner’s testimony that the portal was “incomprehensible” and did not provide the Company an understanding of why it did not have availability.
There were also facts in the record that supported some of the Bank’s actions. For example, 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 Factoring Agreement, the Bank directly paid select payroll, vendors, and other parties of its choosing and refused some of the Company’s seemingly reasonable request 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.”
Things got worse from there. 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.
In addition, based on the Bank’s promise to resume funding advances, the Bank convinced the Owner to grant the Bank a lien on his own home notwithstanding a Texas law prohibiting homestead liens. The Owner subsequently remitted to the Bank proceeds from the sale of his home, but the Bank did not provide any additional financing.
Without access to its cash, 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 and then some. The Court agreed.
The Court’s Decision
i. Breach of Contract
The Court recognized that many of the Bank’s “bad acts” were permitted under the Agreements and “generally, a contract is a contract.” For example, the Bank was “within its rights under the Agreements,” which “were shockingly one-sided in favor of [the Bank],” when it declared an event of default in July 2015 even though the Bank’s action “could easily be considered an over-reaction.” Nevertheless, the Court 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 they 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 those breaches, the Company “would not have failed as a going concern and would not have had to go into bankruptcy.” Thus, 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.” Moreover, these consequences were “reasonably foreseeable.”
Importantly, the Court refused to apply a provision in the Agreements that would have limited the Bank’s liability for “incidental, special or consequential damages.” The Court cited a Louisiana statute that nullifies any contractual provision that would limit, in advance, a party’s damages for “intentional or gross fault.” Case law has interpreted a refusal to fulfill contractual obligations as a bad faith breach of contract, which in turn constitutes gross fault that triggered the statute.
Thus, the Bank was liable to the Company for the full enterprise value of the Company’s business, as determined by expert testimony. 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 low-end expert valuation based on the Company hitting 50% of its projections). The Bank was also liable for almost $600,000 in funds wrongly over-collected and withheld.
ii. Breach of Duty of Good Faith and Fair Dealing
The also Court found that the Bank intentionally violated the duty of good faith performance implied in every contract under Louisiana law. In support, 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 (such as not permitting the Company to buy Gatorade for employees in an un-air-conditioned plant) 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 Agreement.
iii. Lender Liability (Torts Claims)
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.” Here the Court failed to find a fiduciary duty, but found the Bank committed two torts against the Company under Texas law, which governed tort claims given the parties’ relationship to Texas:
First, the Bank committed fraud (fraudulent misrepresentations), including in misrepresenting to the Company that it was in an “over-advanced” position, which was not true. The Court awarded damages equal to the Company’s enterprise value (discussed above).
Second, the Bank was liable for 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. As damages, the Court awarded substantial lost profits of over $2 million.
iv. Violations of the Automatic Stay
The Court held 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. Cf. City of Chicago v. Fulton, 141 S. Ct. 585 (2021) (holding retention of estate property after the filing of a bankruptcy petition does not violate §362(a)(3) of the Bankruptcy Code). 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 (another almost $1.5 million).
v. The Banks Claims: Equitable Subordination and Claim Objection
The Court noted the standards of equitable subordination under section 510(c) of the Bankruptcy Code: (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. As a result of the Bank’s numerous misdeeds, the Court held that the Bank’s claims (if any) would be subordinated to all other class of creditors (and classes of interests). In addition, without much discussion, the Court held that all of the Bank’s claims should be “disallowed entirely” in light of the Bank’s misconduct.
vi. Liability to the Owner
With respect to the Owner, the Court found the Bank (i) violated the Texas statute against homestead liens, (ii) violated a Texas statute relating to fraud in a real estate transaction, and (iii) committed negligent misrepresentation. For his part, the Owner was awarded damages equal to the lost value of his homestead plus exemplary damages and attorney’s fees.
Bailey is a reminder of the substantial lender liability risks that come with excessive borrower control. When a lender exercises improper control over a borrower’s affairs, fiduciary duties may be imputed on a lender and expose the lender to liability for acting in its own interest. Even where fiduciary obligations are not imputed on a lender, as in Bailey, a finding of excessive control can expose a lender to liability for various contract and tort claims. As such, Bailey offers some practical lessons:
First, it is important that lenders negotiate clear agreements that capture the objective intent of 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 a distasteful and misleading manner. Here the Court held that the Bank acted in “bad faith” and even “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. The old but true tip to assume all your non-privileged emails will be discovered and used against you in litigation is worth reiterating often.
Above all, Bailey is a reminder that market participants owe each other duties of good faith and fair dealing and that bankruptcy courts are well-equipped to see that those duties are upheld.