WHEN IS A LENDER CROSSING THE LINE AND ENTERING LENDER LIABILITY WONDERLAND?
A recent decision out of a bankruptcy court in Texas reminds lenders that an overly aggressive approach to a borrower can result in lender liability and substantial damages. In this case, brought by a chapter 7 trustee, the bankruptcy court concluded that the lender destroyed the debtor’s enterprise value and future as a going concern and ultimately drove the debtor out of business.
The Court found that for the lender’s actions, the debtor would not have failed as a going concern and would not have had to file bankruptcy. As a result, the Court awarded $16,966,928 in damages for breach of contract and breach of the duty of good faith and fair dealing; fraudulent misrepresentation; contractual and business interference; and willful violation of the automatic stay. The lender unsuccessfully tried to argue that the debtor was dead-on-arrival.
 As the bankruptcy court put it, “[l]ender liability” is a broad umbrella term often used to describe various theories through which a borrower (or its trustee in bankruptcy) seeks to impose liability (or a remedy of some sort) against a former lender in a lending relationship that has soured.”
THE STORY BEHIND THE AWARD
Bailey Tool & Manufacturing Company and its subsidiaries and affiliates (“Bailey”) was the debtor/borrower in this tragic story. Republic Business Credit, LLC (“Republic”) was the lender. Before filing bankruptcy, Bailey and Republic entered into a factoring arrangement and an asset-based loan facility in February 2015. Republic performed substantial diligence in late 2014 and early 2015 before entering into the agreements. During the due diligence process, Republic had identified several issues, including 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. Despite these issues, the underwriter viewed the proposed transaction as a “strong deal” and approved it.
Four months after entering into the agreements, Republic refused to advance funds as expected, declared default and made payments to itself from Bailey’s lockbox under the factoring agreement to pay down the ABL (Asset Based Lending) facility.
The Court found that Republic took complete and total control of Bailey’s cash. It controlled not only the collections through the lockbox and all disbursements too. All funds advanced from July 2015 forward were sent directly to vendors selected by Republic vendors and a payroll company for the payroll of employees selected by Republic. The Court held that the lender’s handling of disbursement was inconsistent with the parties’ agreements—specifically, the Factoring Agreements contemplated that Republic would “pay to Seller [Bailey] an Advance.” In September 2015, Republic stopped funding altogether.
Republic also became involved in replacing management and otherwise micromanaging the Debtor. It forced the Debtor’s Chief Executive Officer to give Republic a lien on his exempt homestead.
In a meticulous 145-page decision, the Court analyzed Republic’s conduct, including and highlighting numerous internal lender email communications produced in discovery and presented during the trial.
The Court adopted the bankruptcy trustee’s theory of the case, i.e. that the lender: (i) refused to advance funds in good faith and in the manner promised almost immediately after the agreements were signed taking a stance that the businesses were in an “over-advanced” position, which was not a defined concept in the agreements and was problematic in light of several weeks of due diligence and awareness regarding certain slow-paying accounts and inventory status; (ii) charged fees, expenses, penalties and other items against “reserves” (contributing to the alleged “over-advanced” position), without any transparency; (iii) exercised excessive control over the businesses by controlling what vendors, employees, and expenses got paid and insisting on direct payments to them by the factoring company rather than funding to the businesses as contemplated by the underlying agreements (i.e., the argument being that this was an improper exertion of control; there were no amendments of documents or forbearance agreements to justify deviating from the underlying agreements).
WHAT ACTION TO AVOID AS A LENDER
This decision can now serve as a roadmap for borrowers to establish lender liability. In summary, the factors considered by the Court include:
Taking over the business function and exercising business judgment – Without the requisite knowledge and experience, Republic approved payments to certain vendors and materials suppliers, reordered the sequence in which different products at Bailey were manufactured, and changed the manufacturing priorities from keeping long-term customers, to doing “quick-turn” projects;
- Controlling the workforce at Bailey through controlling the payroll and ordering who got paid and who did not and what types or classifications of employees could get paid;
- Directing vendors of Bailey to pay Republic instead of Bailey under the threat of litigation, destroying the goodwill that Bailey had built up with these vendors;
- Lack of transparency and misrepresentations as to why: (i) why it considered Bailey to be in default, (ii) the status of funds availability or lack thereof, (iii) application of funds collected and charging numerous fees and expenses.
The conduct of the lender, in this case, appears egregious. Still, it is a reminder for lenders to closely review with counsel contractual remedies and exercise caution in implementing these remedies.
The Creditors’ Rights, Reorganization and Bankruptcy Editorial Board
ABOUT JEFFREY CARBINO
Jeffrey M. Carbino is a Principal attorney in Offit Kurman’s Creditors’ Rights, Reorganization and Bankruptcy practice. With almost 30 years of experience, his practice focuses on bankruptcy and corporate reorganization. He has represented debtors, chapter 7 trustees, buyers and sellers of assets throughout the United States, creditors’ committees and secured and unsecured creditors in bankruptcy proceedings and restructurings outside bankruptcy.
ABOUT JIM HOFFMAN
James Hoffman is a corporate, bankruptcy and litigation attorney. Mr. Hoffman focuses his practice in the areas of representing various business types, particularly closely held businesses and has a broad base of experience representing creditors, trustees and debtors in bankruptcy cases and litigation. In his business practice, Mr. Hoffman represents businesses through their life cycles from creation, to formulating employment and shareholders agreements, creating contracts, collecting debts and closing the business through sale or liquidation. Mr. Hoffman has represented nine different Chapter 7 trustees, and several Chapter 11 trustees and receivers. Thus, he is “a lawyer’s lawyer.” He has been involved in handling a broad range of litigation before state courts, including disputes involving complex commercial litigation, breach of contract actions, and collection actions.
ABOUT JOYCE KUHNS
With extensive experience at the national and regional levels, Joyce Kuhns brings her in-depth knowledge in delivering creative solutions to help transform financial challenges to successful outcomes. Whether representing businesses as debtors or creditors, creditors’ committees or equity committees, or as an advisor to trustees or regulators, Ms. Kuhns’ understanding of the complexities of financial and business structures and her experience with out-of-court resolutions as well as litigation at the trial through appellate levels enables her to provide critical strategic advice from the boardroom to the courtroom to a broad spectrum of clients at every stage of the business cycle including directors and officers of companies in crisis. A pragmatic problem-solver, Ms. Kuhns uses her cross-disciplinary legal skills to meet the daily business needs of her clients and to help reshape their future. Ms. Kuhns has significant transactional and litigation experience representing all constituents in distressed real estate settings including lenders, borrowers and investors covering every asset class from multi-family to office to shopping centers, in work-out and in bankruptcy.
ABOUT STEPHEN METZ
Stephen Metz is a Principal attorney at Offit Kurman. In more than 23 years of practicing law, he has garnered a reputation for being a tremendous advocate for his clients. While typically meeting clients and opposing counsel under less-than-favorable conditions, Stephen applies his signature techniques to each situation: he is fair-minded, a good listener and a straight shooter, providing his best advice and legal tactics in a calm but decisive manner. In addition to earning the respect and appreciation of those he represents, Stephen has been referred to by his legal colleagues as one of the best bankruptcy attorneys in Maryland.
ABOUT ALBENA PETRAKOV
Albena Petrakov is a Principal and the Chair of the Creditors Rights, Reorganization and Bankruptcy practice group. Ms. Petrakov advises on restructuring, bankruptcy, creditors’ rights, and real estate-related litigation. Ms. Petrakov has extensive experience representing clients in bankruptcy and commercial matters in both civil and common law jurisdictions. She has represented secured and unsecured creditors, trustees, debtors, and lenders in Chapter 11 and Chapter 7 bankruptcy cases in various industries including financial services, retail, hospitality, aircraft manufacturing, energy, and technology, to name only a few.
ABOUT PAUL J. WINTERHALTER
Since 1983, Paul J. Winterhalter has been representing businesses and individuals in bankruptcy matters, commercial litigation proceedings, and a variety of other engagements involving sophisticated legal representations. It is his mission to provide every client, regardless of size or stature, with the most exacting and attentive legal representation possible. With an emphasis on providing excellence in legal representation on a cost-effective basis, Mr. Winterhalter never loses sight of financial implications for his clients on any action he recommends and understands that clients’ interests and goals are the priority.
ABOUT OFFIT KURMAN
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