In my last post, I gave some suggestions for reducing the risk of lender liability in a workout situation. This time, let's talk some more about what to do when you're working through a workout, and focus on what happens when you're getting ready to seek remedies.
As a general rule, it is a good idea to act "reasonably" in a default situation.
There is usually an implied requirement of "good faith and fair dealing" in a contract-based relationship, whether under general state contract law or under the UCC. Good faith and fair dealing essentially requires that you follow commercially reasonable standards of behavior and be fair to the borrower. In some states it means that you have to act "honestly" (the definition varies). This concept is applied to your agreement regardless of what the contract otherwise appears to say. And this is true all the time, of course, not just after a default.
Here's an example of how this plays out in a loan agreement. Secured loan agreements usually say that any kind of default gives the lender the right to terminate the loan and foreclose on all the assets. In practice, however, even though the agreement would appear to permit a lender to foreclose on assets if (for example) the borrower is just five days late in delivering its financial statements, it would be unusual for a lender to do so. Indeed, many courts would find that type of action to violate the implied covenant of good faith and fair dealing, as the remedy would appear to the court to be out of proportion to the harm suffered by the lender. That said, the law does respect your right to negotiate your own terms, and a judge won't normally rewrite the terms you agreed to. You shouldn't be asked to do more than what you agreed to, but you will be required to do what you agreed to do fairly and in good faith.
What else can you do to reduce the risk of lender liability when seeking remedies after a default?
- Give notice. Even though notice may not be required under your loan agreement, in some situations it may be wise to give the borrower some notice before taking any action. This is especially true if you are contemplating actions like foreclosure, that have harsh results. Depending on the situation (and this does differ from case to case), giving notice may be fairly easy and may not do any harm to the lender's position -- and it may help demonstrate to a court later that the lender acted reasonably, giving the borrower a chance to explore alternatives.
- Follow a consistent procedure. It helps if you have established policies and procedures for seeking remedies and for the decision process to get there. This seems like a good business practice generally, as it not only establishes consistency in dealing with borrowers, but it also helps to ensure that the options you want to have considered are actually considered -- and that a measured and appropriate response is given. Also, be aware that if your normal practice is to ignore defaults of the type at issue and then you suddenly deviate from that practice and terminate the loan, some courts have found this behavior objectionable.
- Figure out what the assets are worth, and what you're likely to be paid. If you have sufficient security and you are unlikely to lose anything if you forbear or take lesser steps against he borrower, you might want to consider these other options. Some courts may find your exercise of remedies inappropriate if it can be shown that you would've had full recovery by forbearing on the default; similarly, your exercise of remedies can be called into question if you recover more than the loan agreement would've given you otherewise. In these situations, you might do some clever thinking to see if you can get an appropriate result with less harm to the borrower. For example, maybe forbearance makes sense, or maybe you can do things over a longer period of time, foreclose on only certain types of assets, or seek other types of remedies, while otherwise allowing the business (or portions of it) to continue. Lots of options here.
There's no way to completely eliminate the risk of liability, but taking careful action can help mitigate this risk. Applying principles of "good faith and fair dealing" will help.