Lenders frequently get to call a lot of the shots. They have the money, can decide the terms on which to lend it out, and get to decide which borrowers are going to receive the loans. That power, however, comes with various obligations and risks. One legal risk is “lender liability,” a broad term referring to various types of legal theories that borrowers use in court to sue banks, or defend themselves against suits by banks.
Lender liability claims became more common in the 1990s. Though successful lender liability claims have declined in many jurisdictions, some courts in recent years have expanded the scope of lender liability, particularly after the financial meltdown. Given that borrowers still assert these types of claims and sometimes succeed, lender liability should remain an area of concern for banks during all stages of a lending relationship, including origination, administration, default, forbearance, and enforcement.
Perhaps the most common type of lender liability claim is a breach of contract claim where a borrower alleges that a bank failed to comply with contractual obligations in the loan agreement or other documents. Examples include a bank issuing a commitment letter, but then failing to fund a loan or failing to honor a side deal or oral agreement that is not explicitly set forth in a loan agreement. Other examples include a bank’s failure to provide adequate notices required under a loan agreement, or improper acceleration and demand under a loan.
More ambiguous theories of lender liability can be even more troublesome for lenders who attempt in good faith to help a borrower, but subsequently are attacked for getting too cozy with the borrower. If a borrower provides confidential information to a lender, the lender’s receipt of such information can unwittingly create a fiduciary relationship with the borrower, which imposes a high degree of loyalty between the parties. Such information should be used judiciously. Moreover, loan officers should not give business advice to borrowers such as advising on operational or strategic decisions. Such advice can be construed as exercise of control over a borrower, exposing a lender to claims of overreaching, particularly when a lending relationship goes south.
Another more subtle trap arises with the implied covenant of good faith and fair dealing, which is implied by law to exist in every contract. The duty of good faith and fair dealing, though not found anywhere in a loan agreement, creates rights that exist nonetheless, and which require a lender to act reasonably in asserting its rights under the loan documents. This could include threatening to enforce documents or liquidate collateral when the lender has no intent to do so.
It should be noted that most courts have held that lenders cannot be liable for breaching the implied covenant of good faith and fair dealing when they are simply exercising their rights under the loan documents. In other words, the implied covenant of good faith and fair dealing attaches only to promises made within a contract, but does not override express obligations of a written contract. Thus, the words of loan documents still matter and must be carefully drafted. However, courts sympathetic to borrowers will be inclined to construe loan agreements liberally to remedy perceived inequities.
There are special lender liability considerations and pitfalls for lenders taking over loans of failed or distressed banks, whether through an acquisition from the FDIC or otherwise. In one case, a court concluded that where there was a lengthy dispute regarding whether the failed entity properly disbursed loans, the acquiring bank had a duty to investigate the loan history and negotiations that were initiated by a predecessor entity in conjunction with negotiating with the borrower and making its own credit decisions. In that decision, the court moved away from the prevailing law that lenders do not owe a duty of care to borrowers. Rather, that determination was held to be a fact-intensive issue requiring consideration of amorphous issues such as the “moral blame” attached to the bank’s conduct and the foreseeability of harm to the plaintiff.
Remedies for lender liability can be varied and may depend on the extent of the conduct and the circumstances at issue. A common remedy pursued by borrowers in lender liability cases is the recovery of monetary damages such as the difference between the loan amount and the cost of obtaining a replacement loan. Borrowers may also seek damages for lost profits resulting from the damage to their business. Another possibility is that a lender’s claim could be “equitably subordinated” to the claims of other creditors in a subsequent bankruptcy, or a state law liquidation proceeding. Although equitable subordination is a more extreme remedy usually reserved for a lender engaged in grossly inequitable conduct or fraud that impacts others creditors, it is a risk nonetheless.
Regardless of the fallout, lender liability claims remain alive, and banks must prepare for them through by documenting loans carefully, maintaining internal policies and controls on workouts, and seeking effective legal counsel.