When a lender underwrites a loan application it examines the borrower’s business and makes a decision about whether the business model is acceptable to it, whether cash flows are adequate and whether sufficient collateral exists to secure the loan. If the borrower is expanding its business operations the lender may decide whether the new operations make sense to it. Likewise, if a borrower is purchasing a major piece of equipment the lender might indicate that it does not finance certain items or it might say that it only finances such equipment on certain terms. The point is that the terms of what the lender finds acceptable will be contained in a commitment letter setting out all of the terms of the loan or in the actual loan documentation. As part of that process the lender may be a part of conversations the borrower has with various vendors such as ones selling major pieces of equipment or building major projects.
What happens if the lender decides that it wants to communicate directly with the vendor to ask questions about the product being sold? What if they have objections about the contract itself, can they express those directly to the vendor as opposed to dealing directly with the borrower? Can they request that changes be made to the contract without consulting with the borrower? Even if they can do it from a pure legal standpoint, is it a good idea? A recent case (Velocity Press v. Key Bank, N.A., 2014 WL 2959460 (CA10 2014)) would suggest that engaging in such behavior is problematic.
The lender agreed to provide a line of credit to a company in order to purchase a custom printing press from the manufacturer for $1,797,229. Under its arrangement with the manufacturer the borrower was scheduled to make several progress payments: 30% down, 30% halfway through manufacturing, 35% when the press was completed and operating on the manufacturer’s floor and the final 5% when installation of the press was finished at the borrower’s plant.
The borrower sought financing from a lender who agreed to provide a construction line of credit. The borrower granted a security interest to the lender in all of its assets and the owners executed personal guaranties. According to the testimony at trial, immediately prior to the loan closing the lender sought to make changes in the contract between the borrower and the manufacturer without the borrower’s knowledge. Among other things, the lender informed the manufacturer that it would need to obtain a letter of credit to secure the second progress payment before it would be advanced. The principal of the borrower testified that he would not have signed the loan documents if he had been aware of those changes.
A month after the loan closed the loan office contacted the manufacturer to see where they stood on obtaining a letter of credit. The manufacturer replied that they thought that the lender would actually be issuing the letter of credit. The lender reacted to the confusion on the part of the manufacturer by deciding that it would, in fact, issue the letter of credit in lieu of the second progress payment. As a result though the manufacturer would need to obtain independent funding using the letter of credit as collateral. This necessitated changes to the loan documents. The borrower testified that the lender explained that the loan documents needed to be amended based on requirements set forth by the manufacturer and the documents were silent about the substitution of the letter of credit.
The manufacturer later filed for bankruptcy and the equipment was never delivered. The borrower later sued the lender alleging a breach of fiduciary duty, breach of contract, breach of the obligation of good faith and fair dealing and unjust enrichment. The borrower also sought punitive damages and an award of attorneys’ fees and costs. After a bench trial, the district court determined that Key did not repudiate either the loans thus was not liable for breach of contract. However, the court concluded that the lender violated the implied covenant of good faith and breached a fiduciary duty it owed to the borrower. After allowing the borrower to add a fraud claim, the court also found that the lender fraudulently induced the borrower to enter into the loan. It awarded the borrower $904,576.41 in damages, as well as attorneys’ fees. The lender appealed.
With respect to the fraud claim the court noted that the evidence showed that the lender withheld from the borrower the fact that it did not intend to provide a second progress payment unless a letter of credit was in place and did so to induce the borrower to enter into the first loan agreement. The court also concluded that the lender’s actions with respect to the letter of credit and the second progress payment caused delays in construction of press, additional interest payments, and the manufacturer’s ultimate failure to manufacture the press prior to its bankruptcy.
Regarding the claim for breach of the obligation the good faith and fair dealing the court began its analysis by first acknowledging that under the state law which applied to the case, the covenant of good faith and fair dealing exists in every contract and creates an “implied duty that contracting parties refrain from actions that will intentionally destroy or injure the other party’s right to receive the fruits of the contract.” The obligation does not create any new rights or impose any obligation on the parties that is not found in the written loan documents. The court found that the lender breached the covenant of good faith and fair dealing by renegotiating the contract between the borrower and the manufacturer without the borrower’s knowledge and telling the manufacturer, after the loan documents were first executed, that a letter of credit needed to be in place before the lender would make the second progress payment. These actions, the court found, were inconsistent with the agreed purpose of the loan agreements, which was to provide periodic financing for the manufacturer’s construction of the borrower’s press.
The obligation of good faith and fair dealing is oftentimes referred to as a “gap filler” in that it is intended to fill in the gaps of written contracts. Some courts have attempted to define it by stating what types of conduct actually represent bad faith, i.e., as an “excluder.” Other courts have sought to define it by examining whether one of the parties was denied the “fruits of the contract.” Neither one is a perfect model. A party can be deprived of the fruits of the contract for very valid business reasons and likewise, attempting to catalog every action deemed to constitute acting in bad faith can become exhaustive. Whichever way you define it, lenders can seek to minimize legal risk in a number of ways. The first, and perhaps best method, is by making sure that all of the relevant terms of the loan are contained in the loan documents. When presented with a situation where a third party’s performance impacts a loan underwriting decision the lender should make it clear to the prospective borrower what the lender finds acceptable and what areas are problematic. If the lender feels that it needs information directly from the vendor or supplier then it would be a good idea to obtain the loan applicant’s consent in advance and to involve them in the discussion if at all possible. As seen in this case, if the lender has issues with the contract between the loan applicant and its supplier or vendor, any requested changes to the contractual relationship need to be communicated clearly and made a part of the overall loan documentation package.
In addition to legal claims based on fraud or breach of the obligation of good faith and fair dealing which might arise out of the making and funding of a loan, lenders also need to be sensitive to actions which might impact existing contractual relationships. Attempting to affect an existing contract may subject the lender to claims based on a cause of action for intentional interference with contractual relations.
Communicating directly with vendors or suppliers for a borrower or loan applicant can present considerable legal risks for lenders. Lenders should consult with counsel prior to doing so and then carefully consider the risks of initiating such a conversation. A more significant risk presents itself when the lender attempts to affect any current or prospective contractual relationship between the borrower and a supplier. Such conduct may result in the lender being subject to actual damages for breach of the obligation of good faith and fair dealing and punitive damages for fraud or intentional interference with contractual relations. This is not always an “obvious” area for loan officers and it underscores the need for training of credit and loan personnel to better understand where the acceptable limits may be.