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?
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. 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
Substantial control has been
fount to exist when:
lender was involved in day-to-day operations or management of the borrower’s
lender has the ability to compel the borrower to engage in unusual
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.
the case Busy Bee, Inc. v. Wachovia Bank,
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.
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
(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
(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.
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.”
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.
court found lender control in Security
Pacific National Bank v. Williams. 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.
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”.
The bank persuaded the borrower to purchase this second dealership.
When the second dealership failed, so did the borrowers first successful
dealership. Here, again
the court found enough control to establish a fiduciary relationship.
In re N&D Properties, Inc,. 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. Lender agreed and lent the company, N &
D Properties, Inc., $40,000. Several months later, the lender pledged
$100,000 worth of bonds so that N & D could borrow money from a local bank. In return, the lender received 450 shares of
N &D stock.
years later the business was not doing well and the bank decided to call its
loan to N & D. 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.” 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.
One Ohio court,
however, found that the giving of advice without additional acts is not enough
control to give rise to a fiduciary relationship.
WHAT ACTS ARE ALLOWED
In re W.T. Grant. Co. 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. 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.”
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.” Lending advice to the borrower, even “advice
gloved with an implicit threat” was not enough to demonstrate control. 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
One Ohio court,
however, found that the giving of advice without additional acts is not enough
control to give rise to a fiduciary relationship.
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
What are the Consequences When a Lender Over-Reaches?
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.
court has the ability to subordinate claims. 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. If lender control is found, in order for the
lender’s interests to be subordinated there also must be some inequitable
conduct, 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.
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. 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
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
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.
the court subordinated a portion of the creditors’ interest.
re T.E. Mercer Trucking Co. The court denied the lender’s motion for
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.
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.
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. The lenders were the largest group of
secured debtors and had control of several board of directors seats. 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.” After the deal was approved, other creditors
challenged the deal and demanded the loans be converted to equity.
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.” Further, the fact that the lenders had some
control of the board of directors was not enough to characterize the debt as
equity. 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.
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. The District Court upheld a jury verdict
finding that the lender was a “control person.” 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.” The District Court recognized that the facts
presented in court evidenced enough “control.” 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.
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.
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. 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.”
As a result, the court upheld the jury’s verdict.
In Sanders Confectionery Products v. Heller
Financial, Inc., the Sixth Circuit adopted a test from the Eighth Circuit
for liability under securities laws. 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.” 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.”
The middle-ground standard is, “allegations that the controlling person both
had a capacity to control the primary violator and actually exercised that
control.” The most lenient standard requires the controlling
person to be “alleged to have had the capacity to control the primary
In re Falstaff Brewing Antitrust Litigation, the plaintiff alleged
that the lender gained control over the company under the day-to-day
involvement test. 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.
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
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