Not So Fast: Texas Bankruptcy Court Finds Lender Liability Is Not a Thing of the Past

A bankruptcy court’s recent decision in Bailey Tool & Mfg. Co., et al. v. Republic Bus. Credit (In re Bailey Tool & Mfg. Co.), Adv. No. 16-03025-SGJ (Bankr. N.D. Tex. Dec. 23, 2021) serves as a reminder for lenders that they should avoid certain actions when dealing with distressed borrowers.  Specifically, in Bailey, a bankruptcy judge found a lender squarely at fault for its borrower’s bankruptcy and subsequent liquidation, and held the lender liable to the borrower’s bankruptcy estate for various breach of contract, tort, and bankruptcy claims.

Key Considerations

Bailey illustrates that lender liability, although infrequently applied, may arise where the lender exercises too much control over a borrower’s business affairs and, as a result, contributes directly to the borrower’s insolvency. The case is also a reminder that loan documents may not provide a complete defense to lender liability claims, even if they authorize the lender to take the actions in question.  The lender should think carefully before choosing to exercise any degree of control even if the loan documents contain protective covenants, expansive remedies, and other provisions that afford lenders some degree of control over the borrower’s actions.

Specifically, lenders should reflect on the following key considerations from Bailey in negotiating loan agreements and exercising remedies:

• Lenders should communicate clearly with the borrower and ensure that the lending agreements capture the express intent of parties, particularly with respect to economic terms and definitions (such as the definition of “over-advance” absent in Bailey).
• Lenders should consider the governing state law carefully. In Bailey, the application of Louisiana law may have led to a less favorable outcome for the lender.
• Regardless of any express rights or discretion a lender may have under the lending agreements, lenders should act in good faith in dealing with the borrower. In Bailey, the bankruptcy court determined that the lender acted in “bad faith” and even with “malice” toward the borrower and its owner.
• Before exercising remedies, lenders and their counsel should carefully review lending agreements to ensure that such remedies are permitted in reasonably clear terms.
• Lenders should not micromanage the borrower and should generally not direct the borrower’s business decisions.
• Lenders should keep clear records that are accessible to the borrower.
• Lenders should turn over excess funds to the borrower after the lending agreement is terminated and/or the loan is paid in full. If the borrower files for bankruptcy protection, the lenders should also comply with any requirement to turnover funds to the estate.
• Lenders should train employees to manage email correspondence properly and employees should assume that any email they send could be produced in litigation.

The following provides a brief recitation of the facts in Bailey and the court’s holding.

Factual Background

Baily Tool & Manufacturing Company and its affiliates (collectively, the “Company”) were long-standing metal fabrication, product engineering, and design companies.  In the years prior to the bankruptcy filing, the long-time owner expanded the Company’s business into new products and markets and was working on a new opportunity in ammunition manufacturing.

In February 2015, the Company entered into a financing arrangement with Republic Business Credit, LLC (the “Bank”), including a factoring agreement and an inventory loan agreement (together, the “Agreements”).  Pursuant to the Agreements, the Company expected that borrowings would be treated as “purchases” of the Company’s receivables and that it could expect an advance rate of up to 90 percent of the value of the related invoices, subject to certain eligibility requirements.  The Bank was also permitted to pay amounts owing under the inventory loan with amounts otherwise payable to the Company under the factoring agreement, even absent an event of default. 

The Bank also obtained a personal guarantee from the Company’s owner. 

Before it signed the Agreements, the Bank performed substantial diligence in late 2014 and early 2015 and purportedly identified several issues, including unpaid ad valorem taxes, overdue or late accounts payable, and a major customer that paid on unfavorable payment terms. Nevertheless, the Bank’s underwriter assured the Bank that the proposed transaction was a “strong deal.”

A few days before signing the Agreements, the Bank became concerned about the collectability of a large receivable that accounted for approximately 25 percent of the Company’s receivables.  The Bank internally decided that it would only make a 65 percent advance against this receivable, but did not notify the Company of its decision.  While this decision was technically permissible under the Agreements, it was contrary to the Company’s “reasonable expectation” of a 90 percent advance rate.

In late February 2015, the Bank sent final versions of the Agreements to the Company for signature, along with a borrowing base certificate showing only $17,000 in ineligible accounts.  After execution of the Agreements, in mid-March 2015, the Company made its first draw request.  In response, the Bank provided the Company a new borrowing base certificate showing $142,310.87 in ineligible accounts, a significant increase from the only $17,000 in ineligible accounts previously communicated. Although it ultimately honored the draw request, the Bank treated the funds as an “over-advance” (a term not defined in the Agreements) and imposed both a 2 percent service fee and higher interest rate on the funds advanced pursuant to the draw request.

The Bank defended its actions by noting that the Company had full access to information regarding the status of its accounts and loan balances on a “portal” available to the Company.  But the court found the testimony of the Company’s owner credible, determining that the portal was “incomprehensible” and did not provide the Company with any meaningful understanding of why it did not have availability to make draw requests or why the Bank was refusing to fund.

In April 2015, the Bank advanced 70 percent on receivables, lower than the 90 percent advance rate purportedly expected by the Company.  This 70 percent funding created a liquidity issue for the Company that resulted in the Company failing to make a $20,000 property tax payment in May 2015.  As a result, Comerica Bank (the Company’s term lender) declared an event of default.  The Bank, in turn, declared an event of default under the Agreements.

In early July 2015, the Bank stopped advancing any funds to the Company due to the Company allegedly being “over-advanced” and lacking availability.  However, an internal email sent at the same time stated that “[w]e are in the best position we have been in right now with around $100k in availability on A/R.”  The court found that the Bank then “took complete and total control of [the Company’s] cash,” controlling not only collections of receivables but disbursements as well.  Allegedly without notice to the Company, the Bank also made payments to itself of approximately $250,000 to pay down the balance of the inventory loan.  Eventually the Bank refused to fund payroll, resulting in a walk-out by employees and “caus[ing] the shutdown of the Company.”  The Bank’s internal records showed that the Company had nearly $160,000 in availability at the time, although the Bank had apparently communicated to the Company that it had none.   

As a result of the shutdown, the Bank called a second default. Advances were no longer tied to any receivables purchased and, in fact, even after the Bank ceased making advances, it continued to collect and maintain all of the Company’s receivables. The Bank directly paid payroll, vendors, and other parties in its discretion and attempted to replace the Company’s management with management of its choosing.  In addition to exercising what the bankruptcy court found to be “excessive control,” the Bank “coerced” the Company’s owner into giving the Bank a lien on his Texas homestead (despite a law prohibiting it).  In the court’s view, “[i]t was clear that [the Bank] began to substantially improve its own position, to [the Company’s] detriment.”

The Company found itself in a liquidity crisis and filed for chapter 11 bankruptcy protection on February 1, 2016. There was evidence offered that the Bank continued to control aspects of the Company’s finances, directing customers to pay the Bank instead of the Company and “refusing to turn over cash it held after the bankruptcy cases were commenced.”  The Bank contended that the factoring agreement had not been terminated and gave it title to the Company’s receivables in perpetuity.  It even sued certain of the Company’s customers post-petition.  As a result, the Company could not continue efforts to reorganize and the case was converted to chapter 7.

The chapter 7 trustee (the “Trustee”) commenced an adversary proceeding against the Bank arguing, in part, that the Bank’s actions caused the Company’s failure and that the Bank should be responsible to the bankruptcy estate for the resulting actual and consequential damages.

The bankruptcy court agreed.

The Bankruptcy Court’s Decision

At the outset, the bankruptcy court noted that “[w]ithout a doubt, the Inventory Agreements were: (a) very expensive (as far as interest rate and fees); (b) very restrictive (as far as [the Bank’s] ability to decide not to loan based on its assessment of what was “Eligible Inventory” in the “Borrowing Base”); (c) in some ways a hindrance to the companion Factoring Agreement (since [the Bank] could pay down the Inventory Loans any time it chose to with what otherwise should have been funding available to the Company under the Factoring Agreements); and (d) not very reliable sources for working capital since [the Bank] could declare a default any time it “reasonably and in good faith deem[ed] itself to be insecure” because of a potential decline or anticipated decline in the value of the collateral.”  The court also concluded based on testimony that the Bank considered itself to be in an “over-advanced” position almost immediately after executing the Agreements, triggering various “over-advance” and “servicing” fees for advances made to the Company.

The bankruptcy court found that the Bank disregarded the duty of good faith and fair dealing. This implied covenant is meant to ensure that the reasonable expectations of the parties are preserved by preventing one party from violating the “spirit” of the contract, even if the contract does not expressly prohibit its actions.  Here, after several months of due diligence and shortly after closing, the Bank suddenly declared a default which it ostensibly created. Although the Bank did not actually breach the onerous terms of the Agreements in exercising its remedies, the court determined that it was liable for repeated breaches of its duty of good faith and fair dealing and awarded damages to the bankruptcy estate totaling more than $12.8 million.

The bankruptcy court also noted that “[i]f a lender exercises excessive control over a borrower . . ., a lender can assume the role of fiduciary rather than creditor.”  The court continued that, even absent a fiduciary duty, “if a lender takes a particularly active role in the business decisions of the borrower” it “may become liable for tortious interference.”  In Bailey, the bankruptcy court failed to find that the Bank’s actions rose to the level that would impute a fiduciary duty, but did find that the Bank committed two torts against the Company under Texas law, which the court determined was the controlling state law:

• First, the Bank committed fraud (fraudulent misrepresentations), including in misrepresenting to the Company that it was “over-advanced”, which was not true.
• Second, the Bank committed a tort (tortious interference) against the Company by directly interfering with the Company’s business and contractual relations, including “overreaching” acts that prevented the Company from continuing operations.

As damages, the court awarded the bankruptcy estate the lost enterprise value of the Company in addition to substantial lost profits totaling over $2 million.

The bankruptcy court also found the Bank liable to the bankruptcy estate for various breach of contract claims and violation of the automatic stay, and liable to the Company’s owner for violations of Texas law regarding fraud in a real estate transaction and negligent misrepresentation.

At bottom, the bankruptcy court’s decision in Bailey is a stark reminder to lenders, and borrowers, of the duties of good faith and fair dealing in all lending transactions and a cautionary tale to lenders regarding how much control is too much control when it comes to distressed borrowers.