Tough times bring all sorts of things out of the woodwork. Some of you will remember that back in the 80's and early 90's there was a flurry of "lender liability" lawsuits, with lenders being sued when they exercised remedies after a default on a loan. There were a lot of these cases filed across the country during that time. But by the mid 90's, these lawsuits appeared to have gone the way of the dinosaur. Times were good and defaults were few. Well, guess what . . . they're back. We shouldn't be surprised, given the increase in the number of loan defaults. In fact, we probably should expect to see more of these cases in the coming months.

How can you protect yourself against lender liability claims?

One common basis for a lender liability lawsuit is what the lender did after the borrower defaulted on the loan. If the lender behaves in a manner that later appears to have been unfair or inappropriate (perhaps "not in good faith", coercive, or in breach of a promise - more on this in future posts), a claim can result. So, what types of things should you do after a default or in a workout situation?

  • Engage in discussions. When a borrower goes into default on a loan, what is your typical response? With many lenders, the first thing that happens is a conversation with the borrower. Sometimes this turns into a long series of discussions, followed by forbearances or partial waivers, as the lender and borrower attempt to sort things out and avoid a negative outcome. And repeated defaults add pressure to subsequent discussions. Regardless of how things go, it is often a good idea to engage in at least some discussion with the borrower. For one thing, a discussion might actually result in the situation being "worked out" to a solution that's reasonably satisfactory to both parties. Of course, this is usually the goal! But even if the situation can't be worked out, engaging in negotiation and talking through the options can help you demonstrate later that your response to the default was reasonable and appropriate under the circumstances.
  • Consider a prenegotiation agreement. Not all defaults will require prenegotiation agreements, but in some cases you'll find it helpful to document what your understanding is before entering into workout discussions. As discussions proceed, sometimes misunderstandings can result -- the borrower might think that the lender has promised something when that isn't the case, or may think the lender has agreed to waive the default when the lender thinks it hasn't. Among other things, prenegotiation agreements help establish the scope of the discussions and what (if anything) can be agreed to orally vs. in a formal waiver document. A prenegotiation agreement can also clarify who is authorized to make promises on behalf of the lender.
  • Speak carefully. Sometimes lender liability cases arise from things the lender's representative said in the course of workout negotiations. It can come down to just being careful not to speak in broad terms, avoiding over-promising or over-stating what you are actually willing to do. In this regard, it is often helpful to establish (perhaps in a prenegotiation agreement) that nothing is considered agreed to or binding until it is in writing.
  • Write it down. If you decide to forbear from exercising remedies for a period of time while trying to work things out, it's a good idea to put the forbearance in writing and include an express reservation of your rights in connection with the default. Sometimes the argument is made that the lender gave tacit consent to ongoing defaults -- by ignoring them repeatedly, or by doing nothing about new defaults -- and that this action (or inaction) was effectively a waiver. You can help avoid this by recognizing in writing the ongoing existence of defaults and stating that you're reserving all your rights under the loan documents.

These are just a few suggestions -- hardly an exhaustive list. And, as we know, not every default can be worked out. Next up, we'll explain more about lender liability cases and get into how to mitigate the risk when you've decided to accelerate the loan, foreclose or seek other remedies.