Bankruptcy Court Ruling Imposes Lender Liability
January 26, 2022
You’re a lender and you’re owed millions of dollars. Your borrower is in default and you have concerns that it’s a poor business operator, jeopardizing the likelihood of repayment. When you made the loan, you bargained for contractual rights, including the right to exercise certain remedies in exactly these circumstances. How aggressive can you be in pursuit of repayment? What are the risks associated with crossing the line? And what is the line anyway?
On September 23, 2021, a bankruptcy court in Dallas handed down a 145-page ruling in Bailey Tool & Mfg. Co. v. Republic Bus. Credit, LLC (In re Bailey Tool & Mfg. Co.), 2021 Bankr. LEXIS 3502 (Bankr. N.D. Tex. 2021), provided its answers to some of these questions, offering a cautionary tale of the potential consequences of a court viewing lender loan recovery conduct as overly aggressive behavior in a distressed situation. In light of Bailey, distressed borrowers will likely try to portray lenders’ conduct in administering a loan facility in one or more of the following pejorative ways:
- Overreaching or taking an active role in micromanaging business decisions of the borrower.
- Withholding advances in an inconsistent or arbitrary manner.
- Not keeping clear records that are accessible to the borrower.
- Not documenting and charging fees and expenses in a clear and accurate manner.
- Communicating in a confusing or misleading manner.
- Not addressing any material issues discovered during diligence before consummating the loan transaction.
Facts of the Bailey Case
This case involved a loan gone bad between a Texas manufacturing company, Bailey Tool & Manufacturing Company and its subsidiaries and affiliates (“Bailey”) as borrower, and Republic business Credit, LLC (“Republic”) as lender. Bailey and Republic entered into both a factoring arrangement and an asset-based loan facility (collectively, the “Loan Agreements”).
Within months of entering into the Loan Agreements, Republic determined that the funds advanced to Bailey through the Loan Agreements put Bailey in an “over-advanced” position (more on that below) and declined or limited additional requests for funds from Bailey. As a result, Bailey was unable to make payments to vendors, could not continue its manufacturing business to fulfill customer orders, and failed to meet payroll. Bailey eventually filed a voluntary petition in the Northern District of Texas under Chapter 11 of the Bankruptcy Code, which was subsequently converted to a Chapter 7.
In an adversary proceeding against Republic, the bankruptcy trustee on behalf of Bailey claimed that Republic: (1) refused to advance funds under the Loan Agreements in bad faith, (2) charged without transparency a multitude of fees, expenses, penalties, and other items, and (3) exercised excessive control over the businesses by controlling payments to vendors and employees and attempting to make changes to Bailey’s management. US Bankruptcy Judge Stacey Jernigan agreed in large part, and determined by a preponderance of the evidence that Republic was liable as a lender for two torts: fraud through fraudulent misrepresentations and interference with business and contractual relations.
“Lender liability” is a generic umbrella term covering various legal theories by which a lender may be liable to a borrower with respect to a loan arrangement between the two parties. Typically, there is no fiduciary relationship created by virtue of a lender and borrower entering into a loan arrangement.1 But even absent a fiduciary duty, lender liability can arise if a lender were to take an unduly active role in directing the borrower’s business decisions and interfering with the borrower’s contracts, its client or supplier relationships, or its selection of management. According to the Bankruptcy Court in Bailey, such liability arises when “there is sharp dealing or overreaching or other conduct [by a lender] below the behavior of fair men similarly situated.”2
Below is a summary of the key findings in Bailey of lender wrongdoing.
Overreaching or taking an active role in micromanaging the borrower’s business decisions
The Bankruptcy Court found that following Republic’s declaration of Bailey’s default under the Loan Agreements, Republic “grossly interfered” with Bailey’s business by “injecting itself into corporate governance… and through its micromanaging what expenses [Bailey] paid beginning in July 2015 and insisting on paying vendors and employees itself directly.” The Court noted the following Republic conduct:
- Not allowing Bailey to pay certain vendors, which in turn deprived Bailey of key supplies needed for its manufacturing process.
- Communicating directly with certain of Bailey’s customers and demanding that certain customers not pay Bailey and instead direct payments to Republic, threatening litigation in the process
- Employing armed guards at Bailey’s locations, which the Court considered an effort to intimidate.
- Attempting to oust Bailey’s president (and owner) and install its chosen officer in his place, and doing so by “secretly communicat[ing] with one of Bailey’s consultants/managers (Bob McGovern), encouraging him to work with Republic toward replacing Mr. Buttles as president of Bailey and making McGovern the president with sole authority to make business decisions or execute business plans on behalf of Bailey.”
The Court held that “Republic’s acts of interference were patent, continuing, and without justification. They caused significant financial injury to the [Bailey]. Their acts were overreaching.”
Note that any one of these actions may not have been sufficient in itself to find overreaching conduct. For example, a lender under a factoring arrangement may want to communicate directly with a borrower’s customers as the lender has “purchased” the borrower’s receivables and is therefore entitled to the proceeds from those receivables. But even in the factoring context, interacting with third party customers, vendors, or suppliers can provide borrowers with ammunition to allege overreaching conduct, especially when the lender is also involved in replacing or removing the borrower’s directors or officers or other borrower business decisions.
Withholding advances in an inconsistent or arbitrary manner
A central point of contention in the Bailey case was the availability of funds under the factoring arrangement. Judge Jernigan relied on what she deemed “credible testimony” that Bailey’s understanding was that Republic would make advances under the factoring arrangement of up to 90% of eligible accounts receivable. While the Court noted that the Loan Agreements contained terms for determining which receivables would be “eligible” and which would be “ineligible”, and that “Republic was not required to factor at the rate of 90%,” the Court nevertheless found that Republic “was not making advances on accounts receivable with any reliability.” According to the Court, Republic “repeatedly created the impression in communications… that Bailey was in default due to being over-advanced…”—even though “over-advanced” was not a defined term in the Loan Agreements—and the Court went on to find that “it appears from the evidence that this ‘over-advanced’ status simply was not true.”; The Court concluded that Republic “misrepresented and concealed from Bailey its funds availability status.”
Republic’s position presumably was that Bailey’s eligible accounts receivable (and perhaps also its eligible inventory) were insufficient to meet the amount of funds it had been advanced or requested. Crucially, at trial, Republic admitted that there was no way to reconstruct what constituted eligible or ineligible receivables (or inventory) on any given day from Republic’s records. Thus, the Court determined that Republic did not make advances in a clear and consistent manner and pursuant to the loan documentation’s terms, and did not keep clear and accurate records of such advances
Not keeping clear records that are accessible to borrower
Relatedly, the Court repeatedly noted that Republic failed to communicate to Bailey clearly and accurately the amount of availability it had at any time under the Loan Agreements. The Court found “compelling” testimony that the “portal” Republic maintained for its customers to view their account information “was incomprehensible.”
Not documenting and charging fees and expenses in a clear and accurate manner
Combined with this poor record keeping were the poorly drafted loan documents. The Court, for example, described the lack of clarity in the loan documentation regarding how fees and expenses were determined, listing at least 15 categories of fees and expenses, as “sprinkled throughout” the Loan Agreements and “hard to track.” The Court found that these charges were made "without transparency.”
This ruling points to the importance of lenders documenting fees and expenses clearly and precisely.
Communicating in a confusing or misleading manner
Under the terms of the Loan Agreements, Republic had the right to apply any accounts receivable that might otherwise be factored to prepay the inventory loans, which of course would affect the amount of availability Bailey would have under the factoring arrangement. The Court found, however, that when Republic began applying Bailey’s receivables to prepay the inventory loans, Republic prepaid itself on these loans “without notice to Bailey.” It is unclear from the Court’s ruling if notice was required under the Loan Agreements. The Court considered the following to be part of Republic’s “misrepresentations”: “(i) why it considered Bailey to be in default, (ii) the status of its funds availability or lack thereof, (iii) what it was doing with the funds (i.e., paying down the Inventory Loans and charging fees and expenses)….” Even though the Court recognized that “Republic was simply exercising its contractual rights to use accounts receivable to pay down the Inventory Loan instead of making funds available to Bailey,” the Court found that what Republic characterized as “deficiencies” in availability of the receivables factoring was caused in part by Republic using such receivables to prepay the inventory loans ahead of what was scheduled in the Loan Agreements.
The Court’s findings regarding Republic’s lack of clear communication points to the importance of the lender clearly communicating its actions to the borrower throughout the life of the facility—in particular when it comes to what may be characterized as the “borrower’s” funds.
Not addressing any material issues discovered during diligence prior to consummating the loan transaction
Republic’s credit committee memorandum, prepared during due diligence for the loan, listed various “known issues,” including certain unpaid taxes. Based on that memorandum, the Court determined that Republic’s declaration of an event of default four months after closing the loan was in bad faith. Importantly, Republic’s declaration of a default was not expressly tied to these unpaid taxes; rather, it followed the declaration of an event of default by one of Bailey’s other lenders—Comerica Bank—one month earlier. Nevertheless, the Court found it “rather shocking” that Republic’s declaration of a default could be triggered by “one letter from Comerica regarding unpaid 2014 taxes.” Given Republic’s months of due diligence and its declaration of a default within four months of closing of the loan, the Court determined that Republic acted in bad faith and misrepresented why it considered Bailey to be in default.
There’s a good argument to be made that Republic’s declaration of a default was tied to Comerica’s declaration of a default—essentially a cross-default being triggered. But crucially, the Court chose to focus on the underlying reason for Comerica’s declaration of an event of default and that Republic had knowledge of the underlying condition. This suggests that lenders may be better off insisting that such issues be addressed and cleaned up prior to closing to avoid any implication of sand bagging.
Not discussed here are some of Republic’s additional actions that the Court viewed as going beyond the pale. For example, the Court found that Republic improperly placed a lien on the homestead of Bailey’s president and owner, John Buttles, and successfully pressured him to sell his homestead and use at least some of the proceeds to pay down Republic’s loans. In Texas, homesteads are exempt from such liens. And the Court pointed to email exchanges where Republic’s chief operating officer “abandoned all pretense of an arms-length negotiation, or for that matter, courtesy” and referred to Mr. Buttles as “dummy.” And the Court found that Republic was so focused on the homestead that it went so far as to ask Bob McGovern to drive by Mr. Buttles’ house to determine if it had a sale pending sign.
These examples show that Bailey is an extreme case under the facts found by the Court. But the decision will likely provide a roadmap to distressed borrowers looking to gain leverage against their borrowers in future adversary litigation or negotiations.
1The Bankruptcy Court noted that a lender that “exercises excessive control over a borrower… can assume the role of a fiduciary rather than a mere creditor. When such a change occurs, the lender must refrain from misleading or concealing information from the borrower and the lender is required to make decisions in the best interests of the borrower, even if contrary to the best interest of the lender.” The court in Bailey did not find that a fiduciary relationship was created in this case.
2The Bankruptcy Court cited the seminal Texas case, State Nat’l Bank v. Farah Mfg. Co., 678 S.W.2d 661 (Tex. Ct. App. 1984).
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