The area of lender liability has been reasonably dormant for many years. An entire generation has grown up since this was a hot topic amongst lenders and, as a result, many of the lessons learned years ago have not been learned by at least some of the present generation of lenders. Generally, lender liability claims succeed when a lender has exercised management controls.
Christmas came a day early for a factor who woke up on Dec. 23 with a lump of coal (well, maybe a mountain of coal) in its stocking by a searing, 145-page decision issued by a Dallas Bankruptcy Court at the request of a Chapter 7 trustee that should be of concern to every lender.
This case involves: (a) a decades-old metal fabricating business; (b) its long-time owner; and (c) a factoring company. There was a short-lived financing arrangement among the parties that went terribly wrong. The bankruptcy trustee and former owner of the business alleged that:
(a) improper conduct of the factoring company ultimately destroyed the business enterprise which—although experiencing financial distress—had prestigious customers and a hopeful future; and (b) the factoring company unlawfully put a lien on and coerced the former owner to sell his exempt homestead and pay over the sale proceeds to the factoring company (based on a broken promise to resume factoring, if he did). The bankruptcy trustee and former owner allege[d] more than a dozen torts against the factoring company, in addition to breach of contract.
Specifically, the trustee alleged that the factor:
refused to advance funds under the applicable factoring and inventory loan agreements in good faith and in the manner promised—in fact, almost immediately taking a stance that the businesses were in an “over-advanced” position, which was not only not a defined concept in the agreements, but 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). This, collectively, is argued to have caused the businesses’ failure. (emphasis added)
In addition, the business owner alleged that the factoring company: (a) wrongfully coerced him to transfer to it his equity from his exempt homestead in violation of the Texas Constitution and Texas Property Code; (b) misrepresented in the process that the factoring company would resume making advances on accounts receivable if he did so; (c) but had no intention of doing so and, in fact, never did so; (d) took a termination fee of $75,000 immediately after receiving $225,000 of sale proceeds from the home, without disclosing the termination fee; and (e) thereafter continued to accept accounts receivable collections but extended no funding.
The Court stated:
This was an excruciatingly difficult case but, on balance, the court has determined that the factoring company breached its agreements in certain ways and committed various torts. While the factoring company has essentially argued that the businesses involved here were dead-on-arrival and it did not cause their demise, the court strongly believes this is an incorrect assessment.
The Debtor companies were engaged in metal fabrication, product engineering and design, and provided products to suppliers for automotive manufacturers in the U.S. and Mexico. They suffered downturns during the 2008-9 recession but later developed additional sophisticated components for rocket engines used by Elon Musk and SpaceX. They also developed new technology to manufacture bullets for the military, replacing machines built during World War II, which remain in use to this day.
In 2014, the Debtor companies’ bank lender asked them to find a new lender. Another bank was interested but suggested that the companies temporarily transition via an interim factoring arrangement. The factor conducted due diligence from October 2014 through February 2015. During this period, the factor described the company as a “strong deal” although the companies were in arrears in paying ad valorem taxes. In addition, their accounts payable were in arrears with some 50% aged over a year and certain future business opportunities to be paid on a “milestone” basis.
Notwithstanding the “issues” the factor and the company entered into a factoring agreement as well as a revolving inventory loan agreement. In reciting the facts, the Court appeared to be critical of a number of provisions in these agreements including common ABL and factoring loan provisions such as cross-default provisions, general insecurity clauses, using availability under one facility to satisfy the unpaid fees in the other facility, and 15 categories of fees and expenses to be charged under the factoring agreement.
Almost immediately after closing and funding the financing and factoring agreements, the companies fell into an over-advance situation.
The Court cited destructive acts by the factor as:
- refusing to make advances in good faith;
- making payments directly to third-party vendors and employees of factor’s choosing;
- exercising excessive control over the Debtor’s business;
- misleading the Debtor about availability;
- wrongfully placing a lien on the Guarantor’s exempt homestead;
- declaring a default without a reasonable basis; and
- taking a termination fee.
The Court concluded that the factor’s actions destroyed the business.
The court fully recognizes that the Agreements (the Factoring Agreements as well as the Inventory Loan Agreements) were quite replete with rights, fees, and other provisions that heavily favored [the factor] . . . ). In fact, the Agreements were shockingly one-sided in favor of [the factor]. And, generally, a contract is a contract. Be that as it may, the following are non-exclusive examples that the court finds demonstrated [the factor]’s bad faith and, at times, even malice toward [the Debtors], especially from July 1, 2015 forward.
. . . .
While this court believes that [the factor]’s conduct was in many ways tortious (and shocking), the breach of contract analysis here is actually quite vexing. As alluded to earlier, the Agreements are amazingly one-sided. In fact, they are so one-sided (i.e., providing a smorgasbord of rights, remedies, and discretion in favor of [the factor], with very few rights in favor of Debtors) that there seem to be very few breaches of contract. In other words, many of the alleged bad acts articulated by the Trustee were seemingly permitted by the terms of the Agreements.
The Court went on to find the factor liable for:
- breach of contract;
- breach of the duty of good faith and fair dealing;
- lender liability (which it described as a broad umbrella of tort liability);
- fraud;
- tortious interference with contractual and business relations;
- violations of the bankruptcy automatic stay; and
- attorneys’ fees.
The Court ultimately awarded the Trustee $17 million in damages ($13 million of which was for breach of contract, breach of duty of good faith and fair dealing, fraudulent misrepresentation); plus $2 million for separate tort of contractual and business interference; plus $2 million for willful automatic stay violations (including some $1.5 million in punitive damages); plus in excess of $1 million to the Guarantor. And this is before the attorneys’ fees have been assessed.
The key takeaway is to exercise care when involved in a workout. Most critical is to secure releases at every stage to better ensure that you will not be a victim of an ugly lawsuit such as this one. A valuable lesson may be learned from this case. In a case I defended years ago where the lenders’ conduct was not nearly as bad, but where we secured releases at every opportunity, the result was significantly different. Read that decision from the Second Circuit Court of Appeals.