O’Melveny Worldwide

Steps and Measures for Lenders During COVID-19 Part I: Lender Liability

April 1, 2020

Given the unprecedented depth and duration of the COVID-19 crisis on economic activity, it is now clear that not some, but most industries will be impacted by the crisis. In this environment, lenders will be faced with sometimes difficult choices in exercising their rights and remedies, honoring their existing obligations, and protecting their interests in connection with extending new credit. As part of a series of alerts on steps and measures for lenders during the COVID-19 crisis, this alert focuses on lender liability and steps lenders can take to minimize lender liability risk.

Basic Principles of Lender Liability

A finding of lender liability can have disastrous consequences for lenders, including having its claims equitably subordinated or avoided entirely. It is important, however, to understand that protecting or preserving rights in a prudent manner or engaging in good faith dialogue with a borrower regarding difficult choices does not result in lender liability, even if choices available to a borrower are, from its perspective, highly unattractive.

  • “Lender liability” can arise where a lender exercises excessive control over a borrower’s affairs or engages in inequitable or fraudulent conduct with respect to the borrower or the borrower’s creditors.
  • In connection with mitigating lender liability, lenders should take a holistic approach that also considers actions to obviate any reputational damage once markets improve post-COVID-19.

Control and Domination

Excessive control and domination can arise not merely as a result of the severity of remedies taken, but from the manner in which such remedies are taken. At all times, lenders should remain engaged with the borrower in an open dialogue while taking care to avoid communications that are coercive, threatening, or controlling. Actions and remedies should be couched as necessary or prudent in protecting the rights and interests of the lenders rather than being adversarial in nature.

  • A lender’s direct or indirect ownership of an equity interest in a borrower, or otherwise having “insider” status, may provide the lender with power to control or influence the borrower’s management through the exercise of voting rights. In those circumstances, lenders should be careful to separate the roles of equityholder and creditor, and ensure that creditor actions are separate and arm’s length.
  • The actual exercise of control by a lender over a borrower’s affairs may expose the lender to liability. In triggering or taking remedies such as the exercise of voting rights over pledged equity and other “step-in” type rights, lenders should tread carefully and, if triggered, take actions in a manner intended to maximize value for all constituents.
  • Threatening a borrower to accelerate a loan and forcing a company into bankruptcy if the borrower did not appoint a management team or take other actions acceptable to the lenders could give rise to lender liability. Again, while acceleration in and of itself may be a valid remedy, establishing a record that justifies the remedy and communicating with the borrower in a non-coercive manner are important steps to minimize the risk of lender liability.

Good Faith Dealing

Some courts have placed upon the lender the duty to conduct its business with a borrower in “good faith.” As a practical manner, the steps outlined above with respect to avoiding a finding of excessive control and domination should protect against a finding of bad faith as well.

Specific Decisions that May Implicate Lender Liability

During the COVID-19 crisis, lenders will be faced with decisions of great consequence to all parties when exercising rights and remedies under the applicable loan documentation. Many of those decisions will be made in situations where the default was caused by events beyond the borrower’s control and where, if given time, a borrower could return to financial health when the exigent circumstances causing the issues are over. Given the financial distress imposed by the crisis and the unique circumstances arising from the pandemic, the severity of such consequences may lend themselves to borrowers asserting claims of lender liability.

  • Do I have to continue to honor existing lines of credit? A separate alert will follow regarding this topic.
  • Is it reasonable to exercise remedies against my borrower for any defaults caused by exigent circumstances if my borrower would not otherwise be in financial distress?
  • Under what circumstances should I act to accelerate?
  • Do I need to be more willing than under normal circumstances to consider forbearances and waivers during this crisis?
  • When do financial covenant defaults mature?
  • What do I do if my borrower is delaying paying or defaulting on contracts or other debt?
  • What additional information (e.g. COVID-19 questionnaires) is advisable to request from borrowers?
  • What do I do if my borrower refuses to provide reasonably requested information?
  • Is it OK to act in a manner contrary to the reasonable expectations of borrowers based upon borrower’s prior conduct and dealings with the lender?

Lenders facing difficult decisions like these should understand that a holistic approach of taking actions consistent with those that would be taken by any reasonable, prudent lender, without any element of insider status, control, coercion, or inequitable conduct, will both minimize lender liability risk and protect the reputation of the lender during and after the crisis.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Nancy Mitchell, an O’Melveny partner licensed to practice law in Illinois and New York, Sung Pak, an O’Melveny partner licensed to practice law in New York, John Rapisardi, an O’Melveny partner licensed to practice law in New York, and Maiah H. Parks, an O’Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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