Lender liability lawsuits have generally been few and far between. However, recently, a Chapter 7 trustee obtained a judgment against a lender premised on the lender’s bad acts against the debtor prior to the filing of a bankruptcy Chapter 11 reorganization, which was subsequently converted to a Chapter 7 liquidation. Though it’s premature to say lender liability lawsuits are coming back, the opinion 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), is instructive regarding the actions a lender needs to avoid.
In Bailey Tool & Mfg. Co., the Chapter 7 trustee sued the lender for breach of contract, fraud-related claims, and breach of fiduciary duty. Though the bankruptcy court found the lender substantially liable as discussed below, there was insufficient evidence to show a fiduciary relationship existed.
The Chapter 7 trustee, having assumed ownership of the claim, alleged that the lender (a factoring company): (a) failed to advance funds in good faith under the factoring agreement based on being “over advanced” which not only was not defined in the agreement, but the lender had just completed its due diligence; (b) charged unauthorized fees and other costs against reserves based on the alleged over-advanced funds; and (c) exercised excessive control over the debtor including deciding who got paid (including ensuring that it was paid, rather than funding the business as contemplated in the agreement between the parties).
To make matters worse, after the bankruptcy was filed, the lender, among other things demanded that the customers pay it — as opposed to the debtor — and then refused to turn over those payments to the debtor. Such actions constituted a violation of the automatic stay.
To be frank, one can’t make up these facts.
The Lender’s Liability
The court found: but for the lender’s breach of its agreement to lend, the debtor would not have failed as a going concern and there would have been no need to file bankruptcy leading to its ultimate liquidation. Further, the control exercised by the lender was found to be excessive giving rise to a tortious interference with the debtor’s relationship with its customers, including making it almost impossible for the debtor to complete customer orders. The lender was also found to have committed fraud by misrepresenting that the debtor was in an “over advanced” position, that then led to the lender taking funds from the debtor’s reserve account and refusing to fund the debtor per the agreement.
Based on the lender’s improper conduct, the bankruptcy court found the lender liable for damages, 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 pre-judgment interest. Of note, the bankruptcy court ignored the provision in the contract limiting the lender’s liability for “incidental, special, or consequential damages.”
Total damages were $16,966,928 before attorneys’ fees and pre-judgment interest of which (a) $12,962,084 was for breach of contract and breach of duty of good faith and fair dealing; (b) $12,274,000 was for fraudulent misrepresentations, (c) $2,044,844 was for tortious interference of contractual and business relationships; (d) $1,9600,000 was for willful violations of the automatic stay; and (e) $1,470,000 in punitive damages.
The lender’s claim was also equitably subordinated. The elements for equitable subordination are: (a) the claimant must have engaged in inequitable conduct; (b) the misconduct resulted in injury to creditors or conferred an unfair advantage to the claimant; and (c) equitable subordination of the claim is not inconsistent with the provisions of the Bankruptcy Code.
In addition to being found liable to the debtor, the lender was found liable to the owner/guarantor for additional amounts, including exemplary damages related to the lender seizing the owner’s equity in his homestead. In this regard, the lender convinced the owner to grant a lien on his Texas Homestead, which violated Texas Homestead laws and in so doing committed fraud in a real estate transaction. The lender was further found to have committed negligent misrepresentations by representing to the owner that it would continue to fund the debtor, which included funding the owner’s salary. Unlike fraud, negligent misrepresentation does not require knowledge of the falsity or reckless disregard of the truth or falsity of the representation at the time it was made.1
In conclusion, it is important to recognize that the facts in this case were rather unique and thus were viewed negatively. But, notwithstanding these bad facts, this opinion stands for the proposition that lender beware. Be wary of pre-loan representations; be wary of declaring a default or over-reach soon after closing on the loan, and be wary of becoming involved in the debtor’s management and operations. A lender needs to do what it says it will do and stay out of the debtor’s business.
- The elements of negligent misrepresentation are (a) a representation made by the defendant in the course of its business or in a transaction in which it has a pecuniary interest; (b) the representation conveyed “false information” for the guidance of others in their business; (c) the defendant did not exercise reasonable care or competence in obtaining or communicating the information; and the plaintiff suffers pecuniary loss by justifiably relying on the representation.