Aggressive Extra-Contractual Conduct Leads to a “Lender Liability” Judgment: A Cautionary Tale | McGuireWoods LLP
A recent decision from the United States Bankruptcy Court for the Northern District of Texas illustrates that aggressive lender action can result in “lender liability” in a lending transaction. Bailey Tool & Mfg. Co., et al. vs. Republic bus. Credit (In re Bailey Tool & Mfg. Co.), Adv. No. 16-03025-SGJ (Bankr. ND Tex. Dec. 23, 2021). Although an extreme example, this case serves as a reminder of what lenders should not do when entering into and performing obligations under various agreements.
Bailey Tools & Manufacturing Co. and its subsidiaries appeared to be on the path to a successful business transition until a factoring agreement was reached with Republic Business Credit. Republic’s improper conduct throughout the arrangement led debtors to seek Chapter 11 protection and later contributed to the conversion of the cases. The Chapter 7 trustee filed the lawsuit as a co-plaintiff with the former owner of the debtors. In a factual opinion, the court found the Republic liable for, among others, breach of contract, breach of duty of good faith and loyalty, fraud and willful violations of the automatic stay.
In his view, the court is making several simple points for lenders.
First, it is essential that lenders understand their obligations– both express and implied. In this case, the lender’s most significant breaches stemmed from its disregard for the implicit duty of good faith and fair dealing implicit in all agreements. “Good faith” generally requires honesty when performing the agreement. “Fair use” requires that a party not neglect, evade, or act contrary to the “spirit” of the contract. The obligations of good faith apply even if a party acts openly against the spirit of the contract and, in doing so, informs its counterpart of its intention. Fair use also requires that a party does not abuse its power in determining the express terms of a contract and that one party does not interfere or cooperate with the performance of the other party. . Again, these restrictions do not need to be specifically stated in the contract. A party that fails in its duty of good faith and fair dealing violates the contract and incurs liability for any alleged tortious conduct.
Here, debtors sought a short-term factoring relationship with Republic to meet their working capital needs. Throughout Republic’s due diligence, Debtors have provided Republic with all requested documents and information regarding their financial history and financial condition. From the start of the relationship, Republic was not as transparent; rather, the Republic acted as if it was unaware of its duty of good faith and fair dealing. Indeed, Republic, through some of its employees, made several intentional misrepresentations to debtors. Thus, the court concluded that his repeated actions in breach of this implied duty were intentional and flagrant.
The evidence presented at trial showed that Republic always intended to “ignore, evade or act contrary to the ‘spirit'” of its agreements with debtors. Op. at 54 (¶ 107) (“It seems…that the Republic was,  carry out a “winding-up without notice” of debtors); op. at 138 (¶ 327) (explaining that the Republic only sought to “strengthen its collateral position” pending liquidation of the debtors). After several months of due diligence and shortly after closing, Republic declared default while also creating the conditions for it. Although Republic did not in fact breach certain onerous terms of the agreements, the court determined that Republic was liable for the repeated breaches of its duty of good faith and fair dealing.
Second, lenders are still bound by the agreed terms, regardless of the discretion a lender has under an agreement or any alleged breach of the agreement by its counterparty. Here, the court described the deals as “surprisingly one-sided” in favor of the Republic. Even with this power disparity, the Republic has repeatedly taken actions that were neither authorized nor contemplated under the agreements. For example, Republic has taken the extraordinary step of assuming control over which operating expenses to pay, if any. This decision is a reminder that when a lender supplants basic management functions, it exposes itself to liability for a wide range of claims.
Third, lenders must comply with key legal obligations, regardless of the extent of their contractual discretion. Here, after the debtors filed for bankruptcy protection, Republic deliberately chose to ignore the automatic stay and refused to return the money belonging to the debtors and, moreover, continued to collect the income from the debtors. Republic, in turn, argued that notwithstanding the pre-bankruptcy termination of its agreements with the debtors, the agreements remained in effect until the debtors granted a release in favor of Republic. As a result of these actions, Republic is liable for violation of the automatic suspension.
In yet another example, Republic turned its aggressive tactics against the former owner of Debtors. Seeking to improve its position regardless of the terms of the agreements, Republic sought a lien on the former owner’s property, even though the Texas constitution prohibited the pursuit of such a lien. Under false promises he would resume payments to debtors, the Republic forced the sale of the property and, using what it knew was an invalid lien as leverage, took approximately $225,000 in equity from the former owner. While a lender is generally free to seek additional security or a pledge from a guarantor in a distressed transaction, Republic’s knowing misrepresentations led the court to conclude that Republic was liable to the previous owner for far more than that. ‘one million dollars. In fact, the court found that Republic was liable for exemplary fees because “Republic was ‘actually aware’ of its false statements, failed to disclose the falsity, and benefited from the act.”
While the Republic ostensibly sought to protect its position and maximize its recovery, it did so without regard to the consequences. In reality, Republic chose to ignore some of the most basic rules of proper business conduct and, as a result, subjected itself to liability in contract and tort, incurring damages far exceeding the amounts it ultimately claimed. perceived.