The current economic downturn places additional burdens upon lenders to want to take affirmative action or institute control upon borrowers in an effort to not only preserve collateral but mitigate further exposure to collateral depletion or devaluation; as borrowers grow weaker, the desire to intercede grows. Lenders often want to, and in fact do,  give substantive advice to borrowers including  who to hire or fire, mandate turn-around specialists, mandate acts or select representatives to be placed on the board of directors.  One or more of these acts, may result in adverse consequences to lenders beyond losses associated with the failure of the credit. Control can create fiduciary duties with liability running to the borrower, other shareholders or claimants. The lender may be subject to tort claims, equitable subordination or federal securities claims. 

When Does A Lender Become A Fiduciary? 

            Most lender-borrower transactions are considered as arms-length between parties with equal bargaining power acting in their own interests.  Because of the arms-length relationship, generally, no duties arise between the lender and its borrower.[1]  Notwithstanding what the written loan documentation may say to the contrary, Courts may recognize and impose duties as an operation of law when the lender takes substantial control over the borrower’s business.[2]

Substantial control has been fount to exist when:

1.      the lender was involved in day-to-day operations or management of the borrower’s business; or

2.      the lender has the ability to compel the borrower to engage in unusual transactions.

Control is not established merely by the fact that the lender has superior bargaining leverage as a result of the lender-borrower relationship.  The amount of control necessary to give rise to a duty is not absolute and courts will look at each claim on a case-by- basis.[3] 

            In the case Busy Bee, Inc. v. Wachovia Bank, N.A.,[4] the court found that the borrower’s tort claims, including breach of fiduciary duty, were not barred by the contractual relations because the lender exercised substantial control over the borrower.  The court applied both prongs of the control test and found several examples of control both through lender involvement in day-to-day operations and compelling the borrower to engage in unusual transactions.[5] The court listed multiple facts that, in its opinion, gave rise to a duty and a breach thereof.  Some of the enumerated  facts include:

(1) Refusing to release credit information to other banks so that [plaintiff] could attempt to obtain alternate financing with another bank.

(2) Denying [plaintiff’s] repeated requests for letters of credit to finance $2 million in pre-ordered sales and ignoring the recommendation of its consultant, Penn Hudson, that letters of credit be issued to B. Levy.

(3) Demanding that B. Levy submit borrowing base certificates as a condition to the issuance of letters of credit, while simultaneously failing to provide B. Levy with inventory and accounts receivable information that B. Levy needed in order to prepare those borrowing base certificates.

(4) Approving [plaintiff’s] issuance of checks and later dishonoring those checks when they were presented for payment.

(5)Seizing funds to which the Bank was not entitled, thereby causing [plaintiff’s] checks to be dishonored.

(6)  Hindering [plaintiff’s] ability to secure letters of credit from other banks by arbitrarily insisting upon a first lien security interest on any new accounts receivable and inventory that would be generated from any such letters of credit.

(7) Engaging in conduct that was designed to force [plaintiff’s] profitable wholesale business into bankruptcy, rather than genuinely attempting to provide financing for the continued survival of that business, so that the Bank could seize and liquidate the wholesale business' assets to pay the remaining loan balance.[6]

The court found that the lender had substantial control over the borrower when the lender “refused to further credit unless the borrower abandoned and liquidated a successful discount retail line of business.”[7] Clearly, from a business prospective, liquidating a profitable retail line is unusual, and therefore, evidence of lender control.  Further, the court also found involvement with day-to-day activities when the lender directed the borrower to retain a liquidation consultant. Based the Bank’s expert testimony, the court found instructing the borrower to hire a liquidation consultant was a violation of banking standards, and thus, the Bank owed a fiduciary duty to the borrower.  Therefore, the court found for the borrower and affirmed $17 million dollar judgment.[8]

            Another court found lender control in Security Pacific National Bank v. Williams.[9]  Here, the court found a fiduciary relationship existed between the lender, a bank, and the borrower, a car dealership owner, because the borrower was dependent on the lender. The lender gave the borrower advice almost daily, to the point that the borrower did not feel the need to examine his financial statements because the lender interpreted them for it[10]. The lender would suggest which employees should be terminated or whether the borrower should lower or raise inventory. Finally, the bank had pre-existing inside knowledge of the poor financial stability of a second dealership purchased by the borrower.  The court found that the second dealership before being purchased by the borrower was in “serious trouble and the bank knew it”. [11] The bank persuaded the borrower to purchase this second dealership.[12] When the second dealership failed, so did the borrowers first successful dealership.[13] Here, again the court found enough control to establish a fiduciary relationship.[14]

In re N&D Properties, Inc,.[15]   The Eleventh Circuit explored issues that arise when the lender is also a shareholder.  The lender was approached by her accountant to enter into a business venture with him.[16]  Lender agreed and lent the company, N & D Properties, Inc., $40,000.[17]  Several months later, the lender pledged $100,000 worth of bonds so that N & D could borrow money from a local bank.[18]  In return, the lender received 450 shares of N &D stock.[19] 

            Several years later the business was not doing well and the bank decided to call its loan to N & D.[20]  After the bank called its loan, the lender immediately took “control” of the company. The court stated that a shareholder takes control when “[it] determines corporate policy, whether by personally assuming management responsibility or by selecting management personnel.”[21]  The lender retained legal counsel and a business consultant with the goal of keeping the business on its feet by allowed the consultants to review the debtor’s operations.  The business consultant even attempted to negotiate a new lease on behalf of N &D.  Further, the Eleventh Circuit found that the lender  acted contrary to the interest of other creditors after she took control because she had knowledge that N & D suppliers had cut off shipments to N & D, however, she failed to take any action when she learned that the accountant/majority-shareholder was still advertising business.  The Court further found that the lender knew no customer trust account existed, customers were being misled as to the delivery date of their purchases and the reason for the delay.  The Court found these actions to be inequitable, and thus the lender breached her fiduciary duty.  [22]

One Ohio court, however, found that the giving of advice without additional acts is not enough control to give rise to a fiduciary relationship.[23]

WHAT ACTS ARE ALLOWED

In re W.T. Grant. Co.[24]  The Second Circuit helps to define when control does not exist.  In Grant, the borrower attempted to argue that the lender was “running” the company.[25]  The following arguments were made to show control:  (1) the lender knew or had reason to believe that the borrower to insolvent and that granting a security interest one year before the borrower filed bankruptcy would “discourage further extensions of trade credit to Grant,” substantially reducing its flow of merchandise, and thus, its “prospects for a successful reorganization;” (2) The lender increased the amount of Senior Indebtedness by forcing the borrower to enter into the security agreement;  (3) The lender directed the borrower to sell accounts receivable for 25 cents on the dollar;  (4) The lender “used their position of control over Grant’s management to prevent Grant from promptly seeking relief under the bankruptcy act.”[26]

            The court found that although the lender was keeping a “careful watch,” its acts did not demonstrate lender control.  The court went on to state that in order to prove lender control, “[t]hey must show at least that the banks acted solely for their own benefit, taking into account their reasonable belief that their claims constituted Senior Indebtedness vis-à-vis the debenture holders, and adversely to the interest of others.”[27]  Lending advice to the borrower, even “advice gloved with an implicit threat” was not enough to demonstrate control.[28]  Grant thus allows a lender to give advice to the borrower, and it is only when the lender starts forcing the borrower into business decisions, does adequate control attach. 

One Ohio court, however, found that the giving of advice without additional acts is not enough control to give rise to a fiduciary relationship.[29]

The Test

            Therefore, arguably several factors can be applied to the already established test of day-to-day control.  These factors include: (1) Did the lender threaten, force or in some other way manipulate the borrower into entering into transactions; (2) If the lender gave advice to the borrower, how long was the relationship between the borrower and the lender when the advice was exchanged; (3) Did the lender tell the borrower who to appoint to its board of directors; (4) Was the lender acting for its own best interest.    

What are the Consequences When a Lender Over-Reaches?

When sufficient control is found, the consequences are harsh. The lender may be subject to equitable subordination of its secured interest or could even be subject to federal securities claims. 

Equitable Subordination

In bankruptcy, court has the ability to subordinate claims.[30]  The rights of the lender may be subordinated - and thus priority may be lost or securitization  defeated - if a fiduciary duty found combined with some improper conduct or if fraud or misrepresentation is shown.[31]  If lender control is found, in order for the lender’s interests to be subordinated there also must be some inequitable conduct,[32] and either injury to other claimants or a gain of an unfair advantage. The claims will be subordinated only to the extent necessary to offset the unfair advantage or harm suffered by the creditors.[33]

Here, again control becomes central. If the lender is found to be in control of the debtor it owes duties to those within the company and other creditors, the court may subordinate the lender’s loan to the interests of others if inequitable conduct and injury and/or unfair advantage is found. 

In the case of Citicorp Venture Capital, Ltd. v. Committee of Creditors Holding Unsecured Claims, the court subordinated the lenders secured interest.  Here, control was found because the lender owed 1/3 of the outstanding equity in the company and held positions on the board of directors.  Inequitable conduct was found because the creditor purchased outstanding unsecured claims at a deep discount without disclosing its identity to note sellers nor disclosing the corporate opportunity to the borrower’s board of directors.[34]  Finally, the district court found and the Third Circuit agreed, that the claimants were injured because:

·        First, selling note holders were deprived of the ability to make a fully informed decision to sell their claims.

·        Second, CVC diluted the voting rights of members of the Committee. Though CVC ultimately did not vote its claims, its purchased claims secured a position of influence over the reorganization negotiations.

·        Finally, CVC's actions created a conflict of interest which jeopardized its ability to make decisions in the best interest of the company, free from its competing profit motive.[35]

Therefore, the court subordinated a portion of the creditors’ interest.[36] 

            In re T.E. Mercer Trucking Co. The court denied the lender’s motion for summary judgment.[37] The court found control may exist for the following reasons, amongst others; the lender entered into loan contracts that gave it “joint control of all bank accounts of the Corporate Debtors” that required co-signatures for substantial checks; gave the lender the right to designate a person for the board of directors; required all corporate by-laws, stock books and certificates to be sent to the lender’s counsel; allowed the lender’s representative to be at the creditor’s company and participate in day-to-day activities; gave the lender the right to set salaries of officers and directors; and required “corporate debtors to pledge all their stock.[38] The court stated that the loan agreements by themselves may be enough to rise to the level of inequitable conduct, and that the lender gained an unfair advantage or other creditors suffered harm as a result of the lenders conduct.[39]

            Finally, equitable subordination may arise in a “loan to own” situation.  In In re Submicron Systems Corp., the group of lenders, that were already subordinated lenders, loaned additional funds to company as the company came dangerously close to going insolvent.[40]  The lenders were the largest group of secured debtors and had control of several board of directors seats.[41]  The lenders negotiated a deal that “the Subordinated Group contributed their secured claims to an acquisition vehicle for a large equity stake in the acquiring entity, which entity then used to the claims to credit bid for the company’s assets in a section 363 sale that occurred in the context of a prepackaged bankruptcy.”[42]  After the deal was approved, other creditors challenged the deal and demanded the loans be converted to equity.[43] 

            The District Court and the Third Circuit disagreed, finding for the lenders.  The District Court found that because the “funding had fixed maturity dates and interest rates, and were disclosed as debt in the debtor’s SEC filings and UCC financing statements.”[44]  Further, the fact that the lenders had some control of the board of directors was not enough to characterize the debt as equity.[45]  Therefore, the lenders loans were not converted to equity. 

Federal Securities Laws

Section 10(b) and Rule 10b-5 of the Securities and Exchange Act of 1934; Section 15 of the Securities Act of 1933 and Section 20(A) of the Securities Exchange Act of 1934.[46]

            A lender may be exposed to liability under both Section 10(b) and Rule 10b-5 due to information the lender posses about the borrower.  Based on the discussion of control above, if the lender has enough control over the borrower to induce the borrower to engage in the purchase or sale of securities that later causes injury the company, it may give rise to a claim for fraud.   Mecca v. Gibraltar Corp. of America.  Here, the investors filed a securities fraud action against the lenders and borrower’s guarantor.[47]  The District Court upheld a jury verdict finding that the lender was a “control person.”[48]  The jury instructions the District Court looked to in order to define control was “control means possession of direct or indirect power over the primary violator, so that ‘[e]ven indirect means of discipline or influence short of actual direction fulfill the requirement’ of control.”[49]  The District Court recognized that the facts presented in court evidenced enough “control.”[50]  First, the lender had power over the borrower because the borrower needed financing to stay in business and lender retained discretion to determine the amount of financing.[51] The lender gained additional control when it learned of the borrower’s misconduct. Instead of going to the Attorney General, the lender promised to refrain from reporting the borrower as long as the borrower worked with them and told the truth.[52] 

            At this point the lender started to make decisions on behalf of the lender.  The control was evidence by, amongst other acts, requiring payment before shipment, even though this requirement would jeopardize the borrower’s relationship with its biggest client.[53]  The District Court found that a jury could find that the lenders “exercise of control over [the borrower] was much more threatening and pervasive that that of an ordinary lender.”[54] As a result, the court upheld the jury’s verdict.[55]

In Sanders Confectionery Products v. Heller Financial, Inc., the Sixth Circuit adopted a test from the Eighth Circuit for liability under securities laws.[56]  In order to establish liability, the plaintiff must demonstrate that (1) “the defendant lender actually participated in (i.e. exercised control over) the operations of the [borrower/violator] in general;” and (2) “that the defendant possessed the power to control the specific transaction or activity upon which the primary violation is predicated.”[57]  The level of control required to be plead changes from jurisdiction to jurisdiction.  The highest standard is “that the controlling person was in some meaningful sense a culpable participant in the primary violation.”[58] The middle-ground standard is, “allegations that the controlling person both had a capacity to control the primary violator and actually exercised that control.”[59]  The most lenient standard requires the controlling person to be “alleged to have had the capacity to control the primary violator.”[60]

In re Falstaff Brewing Antitrust Litigation, the plaintiff alleged that the lender gained control over the company under the day-to-day involvement test.[61]  The lenders involvement included replacing officers and directors, implementing certain policies, revising its debt structure, obtaining an equity investor, giving additional security to the lenders, and obtaining lender approval before buying or selling assets.[62] The court agreed, holding that the court “could apply 20(a) to a lender who assumed a controlling influence and held that the control exercised by the lender and the requisite “scienter” were sufficient to survive a motion to dismiss.[63]

Conclusion

            Clearly, lenders should be extremely careful when in dealings with borrowers..  Too much control and the court may find the lender liable in tort or find cause to subordinate or even invalidate its secured interest. Certainly, a prudent lender should seek counsel before acting.