January 14, 2022
A recent decision from the U.S. Bankruptcy Court for the Northern District of Texas illustrates that aggressive lender action can lead to “lender liability” in a loan workout. 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). While an extreme example, the case is a reminder of what lenders should not do when entering into and when performing obligations under various agreements.
Bailey Tools & Manufacturing Co. and its affiliates appeared to be on the path to a successful business transition until entering into a factoring arrangement with Republic Business Credit. Republic’s improper conduct throughout the arrangement led the debtors to seek chapter 11 protection and later contributed to the conversion of the cases. The chapter 7 trustee prosecuted a lawsuit as co-plaintiff with the debtors’ prior owner. In a fact-intensive opinion, the court found Republic liable for, inter alia, breach of contract, breach of its duty of good faith and fair dealing, fraud and willful violations of the automatic stay.
In its opinion, the court articulates several straightforward points for lenders.
First, it is vital for lenders to understand their obligations—both express and implied. In this case, the lender’s most significant failures arose from its disregard of the implied duty of good faith and fair dealing implicit in all agreements. “Good faith” generally requires honesty during the fulfillment of the agreement. “Fair dealing” requires that a party not overlook, evade or act contrary to the “spirit” of the contract. Good faith obligations apply even though a party openly acts contrary to the spirit of the contract and, in doing so, provides its counterparty with notice of its intent. Fair dealing also requires that a party not abuse its power when determining a contract’s explicit terms and that a party not interfere with or fail to cooperate in the other party’s performance. Again, these restrictions need not be specifically set forth in the contract. A party that breaches its duty of good faith and fair dealing breaches the contract and invites liability for any purported tortious behavior.
Here, the debtors sought a short-term factoring relationship with Republic to meet their working capital needs. Throughout Republic’s due diligence, the debtors provided Republic with all requested documents and information regarding their financial history and financial position. From the beginning of the relationship, Republic was not as transparent; rather, Republic acted as if oblivious to the existence of its duty of good faith and fair dealing. Indeed, Republic, through certain of its employees, made several intentional misrepresentations to the debtors. Thus, the court concluded its repeated acts in breach of this implied duty were intentional and egregious.
The evidence at trial illustrated that Republic consistently intended to “overlook, evade, or act contrary to the ‘spirit’” of its agreements with the debtors. Op. at 54 (¶ 107) (“It appears ... that Republic was,  conducting an ‘unannounced liquidation’ of” the debtors); Op. at 138 (¶ 327) (explaining Republic sought only to “enhance its collateral position” while awaiting debtors’ liquidation). After several months of due diligence and shortly after closing, Republic declared a default while having also created the conditions for it. Although Republic did not actually breach certain onerous terms of the agreements, the court determined that Republic was liable for repeated breaches of its duty of good faith and fair dealing.
Second, lenders are still required to comply with the agreed terms, regardless of the discretion a lender has under an agreement or any alleged breach of the agreement by its counterparty. Here, the court described the agreements as “amazingly one-sided” in favor of Republic. Even with this disparity of power, Republic repeatedly took actions neither authorized nor contemplated under the agreements. For example, Republic took the extraordinary step of assuming control over deciding which operating expenses were paid, if any. This decision serves as a reminder that where a lender supplants core management functions, it opens itself to liability for a wide range of claims.
Third, lenders must comply with core statutory obligations, regardless of the breadth of their contractual discretion. Here, after the debtors sought bankruptcy protection, Republic willfully chose to ignore the automatic stay and refused to turn over money belonging to the debtors and, moreover, continued to collect on the debtors’ revenues. In turn, Republic argued that, notwithstanding the pre-bankruptcy termination of its agreements with the debtors, the agreements remained effective until the debtors provided a release in favor of Republic. On account of these actions, Republic subjected itself to liability for violating the automatic stay.
In yet another example, Republic turned its aggressive tactics against the debtors’ prior owner. In seeking to improve it position, regardless of the terms of the agreements, Republic sought a lien on the prior owner’s homestead, even though the Texas constitution prohibited the pursuit of such a lien. Under false promises it would resume payments to the debtors, Republic forced the sale of the homestead and, using what it knew to be an invalid lien as leverage, took approximately $225,000 in equity from the prior owner. While a lender is typically free to seek additional collateral or a pledge from a guarantor in a distressed transaction, Republic’s knowing misrepresentations led the court to conclude Republic was liable to the prior owner for well over $1 million. In fact, the court concluded Republic was liable for exemplary fees because “Republic was ‘actually aware’ of its false statements, failed to disclose the falsity, and benefited from the act.”
While Republic ostensibly sought to protect its position and maximize its recovery, it did so without considering the consequences. In reality, Republic chose to ignore some of the most basic rules of appropriate commercial conduct and, as a result, subjected itself to contractual and tort liability, incurring damages far exceeding the amounts it ultimately collected.