On Aug. 26, 2011, the U.S. Court of Appeals for the Second Circuit held that a release of the lender given by the borrower in a forbearance agreement was not induced by economic duress and was therefore enforceable. Interpharm, Inc. v. Wells Fargo Bank, National Association, _____ F.3d ____, 2011, WL ______ (2d Cir. August 26, 2011). Upon paying its obligations to the lender after all its assets were sold, the borrower sued the lender alleging breach of contract, breach of duty of good faith and fair dealing, tortious interference with business expectations, unjust enrichment and breach of fiduciary duty. The lender moved to dismiss the complaint based on a release given in a forbearance agreement with the borrower. The borrower sought to avoid the effect of the release by claiming it was given under economic duress. The Second Circuit upheld the lower court’s determination that the plaintiff had failed in its complaint to plead facts establishing “wrongful threat,” an essential element of economic duress.

The court considered a number of issues relevant to financing distressed borrowers during a forbearance period — the time during which the lender has the option to enforce remedies based on existing defaults but agrees to forbear for a limited time and assuming no new defaults in exchange for certain additional terms agreed to by the borrower. The court also examined the merger clauses contained in the forbearance agreements and decided whether a series of the plaintiff-borrower’s arguments that were based on the oral negotiations surrounding the forbearance agreements were precluded by the merger clauses. Further, the court considered what constitutes an exercise of “reasonable discretion” by a lender during the forbearance period and whether the borrower established that the lender exceeded the “scope of such discretion.” Id. at *3.


In 2006, Interpharm (the “borrower”), a manufacturer of generic drugs, entered into a secured revolving credit agreement ($22.5 million maximum facility) with Wells Fargo Bank, National Association (the “lender”) maturing on Feb. 10, 2010. The agreement contained a typical current asset borrowing base with advance rates of 50 percent against eligible inventory and 85 percent against eligible receivables. By 2007 the borrower was in default of the credit agreement. The lender granted a forbearance and amended the credit agreement, increasing the line by $2 million at a greater interest rate, imposing additional fees, as well as requiring a capital raise and tighter financial covenants. The borrower acknowledged its ongoing defaults in the forbearance agreement but asserted in the ensuing litigation that, after objecting to certain of the new terms, it had no choice but to agree to financial covenants imposed by the lender which it considered unreasonable. This forbearance agreement contained a release by the borrower of the lender, as well as a merger clause stating that “[t]his Agreement represents the entire agreement between the parties.” Id. at *5.

In January 2008 there were additional borrower defaults and the lender imposed the default rate of interest. A superseding forbearance agreement was executed, requiring, among other things, the payment of fees, the imposition of an increased interest rate, and the exclusion of certain wholesale receivables from the borrowing base based on “charge-back” issues (which had the effect of limiting the amount the borrower could borrow from the lender). On Feb. 8, 2008, the parties entered into another amendment and forbearance in which the lender agreed not to exercise default remedies until June 30, 2008 and to continue to extend credit. This agreement also contained a lender release and a merger clause. The borrower alleged in the ensuing litigation that, although unwritten, it was understood as a condition to signing this agreement that the lender would continue to advance 50 percent against eligible inventory.

On March 6, 2008, the lender reduced the inventory advance rate to 39.6 percent from 50 percent. The borrower argued this was a material breach of lender’s agreement. On March 25, 2008, in response to the borrower’s objections as to the reduced credit availability, the parties entered into another amendment and forbearance agreement. Pursuant to this agreement, the advance on inventory was raised temporarily to 49 percent and the lender promised to forbear until June 30, 2008.

Asserting it had insufficient credit and liquidity to continue operating, the borrower signed an agreement to sell its assets in April 2008, with a scheduled closing date in June. The borrower advised the lender that it could not survive until the closing unless the lender abided by relaxed credit agreement terms related to availability. Certain terms were revised and another forbearance agreement was signed in May. This final forbearance agreement contained the following release (the fifth one agreed to by the borrower) that was later challenged by the borrower on the grounds that it was procured under economic duress:

By executing this Agreement, the Borrower and Guarantor [a holding company] hereby waive, release and discharge any and all claims or causes of action, if any, of every kind and nature whatsoever, whether at law or in equity, arising at or prior to the date hereof, which it or they may have against Wells Fargo and/or its officers and employees in connection with the [Credit] Agreement, this Agreement and all documents executed in connection therewith. Borrower also agrees that all waivers, releases and agreements made herein are made in consideration of, and in order to induce Wells Fargo to temporarily forbear the exercise or further exercise of its rights and remedies against the Borrower under the [Credit] Agreement and to induce Wells Fargo to enter into this Agreement.

Id. at *8-9.

After completing the sale in June, the borrower paid off the lender, but shortly thereafter notified the lender that it was repudiating all of the 2008 agreements and sued the lender for damages. Upon the district court’s finding that the release was effective to preclude plaintiff-borrower’s claims, the parties stipulated that only the court’s findings as to the May 2008 releases would be appealed.

Court’s Holding

The Second Circuit held that the lender was under no obligation to continue to extend credit given the borrower’s ongoing defaults and the lender’s rights to exercise its remedies under the credit agreement. Therefore, the lender did not make a “wrongful threat” by asserting an intention to exercise its legal rights unless the terms of the forbearance agreement were agreed to by the borrower, including providing a release of the lender. Further, in acknowledging that actions that were not consistent with its legal rights could constitute a “wrongful threat” by a lender, the court considered allegations that the lender did not comply with its contractual terms to use “reasonable discretion” in various instances related to the borrowing base and the amount of credit made available from time to time to the borrower. Noting that that there was an absence of definitive case law in New York interpreting “reasonable discretion,” the court considered the lender’s actions in light of a broad interpretation of what constitutes reasonable behavior by a lender in the context of ongoing defaults. Under these circumstances, the court found that the actions of the lender were reasonable and did not constitute a wrongful threat, an essential element to be proven in an economic duress claim.

Notable Elements of Court’s Reasoning

  1. Hard Bargaining vs. a Threat: Citing case law in support, the court found that there must be more than financial pressure and unequal bargaining power for a wrongful threat to occur. The court distinguished a threat to withhold contractually mandated performance from an intention to exercise a “legal right in pursuit of those same demands.” Id. at *13. Since the borrower’s defaults were ongoing and the lender had no obligation to provide credit availability, the lender was merely exercising its contractual right to alter terms of the credit agreement as an accommodation to the borrower.
  2. Executed Forbearance Agreement vs. History of Negotiations: Among the allegations of economic duress were borrower’s assertions that it had no choice in agreeing to increased fees, higher interest rates, more restrictive advance percentages, receivable eligibility requirements and revised (and allegedly more difficult to comply with) financial covenants. The court rejected the notion that these lender requirements constituted the misconduct essential to establishing economic distress both because the lender had no legal obligation to continue to fund, and the forbearance agreement’s merger clauses limited borrower claims to the language of executed written document — thereby precluding from consideration oral discussions in which the borrower objected to certain provisions.
  3. Violation of Credit Documentation vs. Exercise of Contractual Reasonableness: Although the court did not specify the outer boundaries of contractual discretion limits, the court stated that the exercise of such discretion cannot conflict with law or reason. Further, even in the face of borrower arguments that the lender acted outside the scope of customary lender behavior to the borrower’s industry, the court held that the lender behaved reasonably based on its contractual discretion.
  4. Valid Release vs. Economic Duress: The court considered the validity of the release in the context of both the merger clause, which barred the history of the negotiations leading to the forbearance, as well as whether the lender behaved in accordance with the provisions of the credit documentation. If the court had found that the lender had violated the terms of its credit documentation, including the forbearances, it is possible that the releases would have been held to be invalid based on misconduct and duress (assuming the additional elements of economic duress were satisfied). “The Court noted that to void a contract based on economic distress, the complaining party is required to establish ‘(1) a threat, (2) which was unlawfully made, and (3) caused involuntary acceptance of contract terms, (4) because circumstances permitted no alternative.’ ” Id. at *12 (quoting Kamerman v. Steinberg, 891 F.2d 424, 431 (2d Cir.1989)).

But the court found in reviewing the alleged actions of the lender, that, even if true, the borrower had not demonstrated that the lender acted inconsistently with its documentation.

Practical Considerations

Lenders to financially distressed companies must consider an array of legal issues in deciding whether to extend further credit to a borrower in default of its contractual obligations. This scenario typically plays out over a period of months or sometimes years, and is often based on unpredictable fact patterns and circumstances. During this time, many lenders carefully monitor the borrower’s current assets relative to their outstanding loans and assess ways to maximize their recovery in contexts that already may contemplate ultimately realizing less than payment in full of the borrower’s debt obligations. This case clarifies the validity of some lender protections during the forbearance period and relies heavily on the fact that contractual provisions do not obligate a lender to lend post-default and continue to support the borrower’s operations. Noting the presence of a merger clause that bars oral evidence and a common form of release, absent behavior outside the scope of its legal rights under governing contractual provisions, this case identifies, in a fairly typical fact pattern, permissible lender behavior and upholds the releases typically included to protect a lender from borrower litigation. The court used a broad interpretation of what constitutes contractually sanctioned “reasonable discretion” in determining that lender’s actions were consistent with the credit and forbearance agreements executed by the borrower.