Lender Liability: Taking Stock in Uncertain Times

Although we have seen little change in the area of lender liability law over the past decade, todays unprecedented slowdown in the global economy is proving to be fertile ground for disputes among lenders, borrowers, guarantors, and other third parties. During the widespread defaults of the 1980s and early 1990s, lenders pursuing remedies were met by a massive upsurge in claims directed at them. During the mid-1980s, California courts expanded the theories under which lenders could be held liable and often awarded substantial damages to plaintiffs. The late 1980s and early 1990s saw a reversal in this trend, where courts limited some of the more far-reaching lender liability theories and reversed a number of high-profile judgments from previous years.

Today, the number of lenders taking enforcement actions is once again on the rise. This will likely result in a corresponding increase in borrowers challenging, and courts probing, lender practices. For example, in response to the exercise of remedies by construction lenders against developers of troubled real estate projects, numerous lender liability claims have been brought by developers – not only to maximize their ultimate recoveries but also to increase leverage in workout negotiations. These claims mostly allege breach of contract and recycle familiar issues such as course of conduct and breach of the covenant of good faith and fair dealing. As the credit crisis spreads in 2009 to various industries and continues to affect all types of lending arrangements, lenders should take care to be aware of the most common lender liability claims (as well as new claims that will begin to evolve), including the following. 
 
Typical Lender Liability Causes of Action

Breach of Contract. A lender-borrower relationship is a contractual relationship, which may result in a lender being held liable for breaching written, oral, and implied contracts or agreements. Some common breach of contract claims are that a lender failed to (a) lend after a loan commitment became legally binding, (b) extend a loan, honor loan modification terms or forbear from exercising remedies after promising to do so, or (c) take actions required under loan documents or interpret loan documents properly. In breach of contract claims, the courts have considered "course of conduct" between parties as a critical factor in interpreting the language of a contract.

Breach of the Implied Covenant of Good Faith and Fair Dealing. Borrowers have also used traditional breach of contract claims to piggyback claims based on the evolving theory of breach of the implied covenant of good faith and fair dealing. In jurisdictions recognizing this covenant, lenders have been found liable for (a) refusing to release a deed of trust in an effort to pressure the borrower into paying off another loan and (b) manipulating the appraisal of the borrowers property to trigger a default and deliberately delaying foreclosure to increase the debt through interest accrual, thereby enabling the lender to take the entire collateral. Nonetheless, in most cases the obligation of good faith does not compel a lender to refrain from enforcing express contract terms as written.

Fraud. Fraud is usually based upon an affirmative misrepresentation. Even where the law imposes no obligation upon a lender to answer an inquiry in the first place, a lenders voluntary response may trigger a duty to disclose additional, pertinent information in a truthful and complete manner. Even where a lender possesses no actual fraudulent intent, constructive fraud may arise if a relationship of confidence and trust exists between borrower and lender and the lender subsequently breaches its duty to the borrower. Additionally, silent fraud may be found if the lender has a duty to speak but chooses to remain silent.

Economic Duress. In addressing these claims, the courts have drawn a distinction between a lender (a) making inappropriate threats or demands and (b) threatening to do that which it has a legal right to do or refusing to do that which it is not legally required to do. Since it is difficult to assess if a lender has made improper use of legitimate rights or remedies, courts have tended to find liability in cases where the lenders conduct was tainted with some additional fraud or other wrongdoing.

Tortious Interference with a Contract. Tortious interference with a contract may arise when a lender intentionally induces breach of the borrowers contract with a third party. However, lenders who have interfered with contracts through the bona fide exercise of their rights and remedies have been deemed privileged to do so. Courts have taken varied approaches with regard to whether malice or a purposeful or improper motive are essential elements to this cause of action. Moreover, some courts have allowed lenders to interfere with contracts between borrowers and third parties if the lenders hold equal or superior interests in the subject matter.

Instrumentality Theory. Under this theory, a lender may expose itself to direct liability to the borrower and third parties where the lender exercises such control over the borrowers day-to-day operations that, in effect, the lender becomes the borrower. Direct liability can also be found where total control of a borrower does not exist, but the lender may be characterized as an agent or principal of the borrower, or the lenders relationship with the borrower is more akin to a partnership or joint venture.

Breach of Fiduciary Duty. In one recent decision, the court held that the elements to establish a fiduciary relationship between a bank and a debtor are (a) the borrower reposes faith, confidence, and trust in the bank, (b) the borrower is in a position of inequality, dependence, weakness or lack of knowledge, and (c) the bank exercises dominion, control, or influence over the borrowers affairs. Where a fiduciary duty is found, a lender will owe far greater duties to the borrower than those arising under a loan agreement.

Statutory Violations. With respect to federal tax laws, a lender with sufficient control over a borrower may be liable under the Internal Revenue Code (IRC) for withholding federal taxes. Courts have also held lenders liable under the Racketeer Influenced and Corrupt Organizations Act (RICO) if they engage in activities prohibited thereunder. Also, a significant amount of lender litigation has occurred under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) in relation to lenders exercising a certain degree of control over the day-to-day operational aspects of a borrowers mortgaged property.

The causes of action listed above represent a mere sampling of potential lender liability claims that may be asserted against lenders in todays environment. Additionally, in a syndicated context, lead lenders also have duties to other lenders, the violation of which may expose lead lenders to liability. The foregoing summary is clearly not all-encompassing and only serves as a brief discussion of this vast and growing area of law.

Authored By:

Eugene C. Kim

(213) 617-5404

ekim@sheppardmullin.com

and

Gina Giang

(213) 617-5484 

ggiang@sheppardmullin.com

 

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