A New York trial court recently held that, absent an express contractual requirement, lenders are under no obligation to negotiate new terms with borrowers and guarantors in default due to the current economic crisis. KBS Preferred Holding I LLC v. Petra Fund REIT Corp., 601384/09 (N.Y. Co. May 3, 2010). Specifically, the court found that the lender had no obligation to negotiate the restructuring of a debt despite the fact that the borrower and guarantor were alleged to be deeply affected by the economic downturn. Evidencing the court’s unwillingness to read implied obligations into financial contracts, borrowers and lenders should read this decision as keeping the status quo of financial contracts despite an ever-changing economic backdrop.

Background

In 2007, plaintiff KBS Preferred Holding I (“KBS”) made a $50 million loan to defendant Petra Fund REIT Corp (“Petra REIT”) that was secured by two promissory notes and guaranteed by defendant Petra Offshore Fund, L.P. (“Petra Offshore,” collectively with Petra REIT, the “Funds”). The Funds, which invest, structure and trade debt in the real estate market, allegedly failed to make any payments under the loan agreement, notes or guaranty (collectively the “Loan Documents”), allegedly due to the economic crisis. Two separate lawsuits ensued.

In the first action (the “KBS Action”), KBS filed a motion for summary judgment in lieu of complaint pursuant to Section 3213 of the New York Civil Practice Law and Rules, seeking recovery of the loan balance. The Funds brought a separate action (the “Funds Action”) in which they sought declaratory judgments that KBS breached the loan agreement by acting unreasonably, that KBS breached the covenant of good faith and fair dealing implied in the loan agreement, and that performance under the loan agreement was rendered impossible due to the economic crisis. As these claims coincided with the Funds’ defenses to the KBS Action, the Funds responded to KBS’ motion for summary judgment in lieu of complaint by filing a cross-motion to consolidate the KBS Action with the Funds Action.

The Motion to Consolidate

The Funds moved for consolidation on the grounds that the Funds Action had the same parties, agreements and questions of law as the KBS Action, that consolidation would serve judicial economy and would best preserve the parties’ resources, and that the Funds would have asserted the claims in the Funds Action as defenses or counterclaims in the KBS Action had they been permitted to do so under the Loan Documents, which prohibited the assertion of non-compulsory counterclaims. KBS’ main argument in opposition was that consolidation would delay the accelerated procedure contemplated by Section 3213 for recovery on instruments for the payment of money only.

The Funds’ Claims and Defenses

The Funds’ defenses to the KBS Action were reflected in the declaratory judgments sought in the Funds Action. With regards to the first declaration sought, the Petra Funds relied on Section 30 of the loan agreement to support their claim that KBS acted unreasonably. Section 30 provided:

In the event that a claim or adjudication is made that Lender or its agents have acted unreasonably or unreasonably delayed acting in any case pursuant to the provisions of Section 21 or 22 hereunder where by law or under this Agreement or the other Loan Documents, Lender or such agents, as the case may be, has an obligation to act reasonably or promptly. Borrower agrees that neither Lender nor its agents shall be liable for any monetary damages, and Borrower’s sole remedies shall be limited to commencing an action seeking injunctive relief or declaratory judgment. The parties hereto agree that any action or proceeding to determine whether Lender has acted reasonably shall be determined by an action seeking declaratory judgment. Borrowers hereby waive their right to assert a counterclaim, other than a compulsory counterclaim, in any action or proceeding brought against [sic] Lender or its agents.

Section 21 of the Loan Agreement referenced in Section 30 above gave the lender the right to include information about the loan and the borrower in its public filings to the extent “in its reasonable judgment” such disclosures were necessary to comply with securities laws. Section 22 referenced therein, obligated the borrower to perform further actions and execute such documents “as the lender may reasonably request.” It was from these narrow obligations on the lender to act reasonably that the Funds alleged that, in light of the financial crisis, KBS acted unreasonably by not negotiating to restructure the debt and by allegedly not considering a proposal to transfer certain assets of the Funds to KBS.

As to the second declaratory judgment sought, the Funds claimed KBS breached the implied covenant of good faith and fair dealing by (1) intentionally preventing performance by the Funds; (2) declaring the Funds in default despite the economic crisis; (3) declaring the Funds in default despite the fact that the Funds were attempting to reorganize their debts with KBS and with their other lenders; and (4) unreasonably rejecting the Funds proposal that KBS purchase certain assets. The Funds sought a third declaratory judgment, that their performance under the Loan Documents was rendered impossible due to the economic crisis.

In response to these arguments, KBS argued that the loan agreement did not contain any pre-conditions and did not compel KBS to negotiate with the Funds in the instance of KBS declaring that the Funds were in default. Specifically, KBS asserted that Section 30 was for KBS’ protection and limited the remedies available to the borrower, rather than imposing obligations on KBS in the event of the borrower’s default. KBS also argued that the Funds’ defense of a breach of the implied covenant of good faith and fair dealing was not supported by law, as the Funds had already received the benefits of the contract, and KBS did in fact negotiate a possible restructuring with the Funds, albeit unsuccessfully. Lastly, regarding the Funds’ impossibility defense, KBS contended that, not only was the argument without legal merit, but flawed as the Funds’ inability to pay the debt was fueled by their own poor financial decisions, rather than just adverse market conditions.

The Legal Structure

Under Section 3213, which allows for commencement of an action by summary judgment rather than through a complaint where the plaintiff is suing on a instrument for the payment of money only, such as a promissory note, a plaintiff can establish a prima facie entitlement to judgment as a matter of law by demonstrating that (1) the borrower defaulted and (2) the guarantor failed to meet its obligations. Since these facts were not disputed by the Funds, KBS had established a prima facie case, and the burden shifted to the Funds to establish “a triable issue of fact relative to a bona fide defense.”

For the Funds to establish the defense that KBS breached the contract by acting unreasonably, they were first required to establish that the loan agreement included an obligation on KBS to act reasonably. Regarding the Funds’ allegation of a breach of the implied covenant of good faith and fair dealing, the Funds could establish a triable issue of fact for this defense only by showing that KBS acted in a manner so as to deprive the Funds the right to receive benefits under the agreement. Because the contract also involved an exercise of discretion in certain instances, the court stated that the implied covenant of good faith and fair dealing could also be breached if the Funds could show KBS acted “arbitrarily or irrationally exercising that discretion.” No implied obligation will be found, however, unless it is consistent with the other terms of the contract. Lastly, regarding the defense of impossibility, the court stated this defense would excuse the Funds’ performance only if they could demonstrate “the destruction of the subject matter of the contract or [that] the means of performance makes performance objectively impossible.”

The Court’s Ruling

Before deciding the merits of the two actions, the court first denied the Funds’ cross-motion to consolidate, while consolidating the actions in the opinion for disposition. In ruling so, the court emphasized the fact that the parties to the contract were “sophisticated commercial parties,” and that Petra REIT freely agreed to the waiver in the Loan Documents of its right to assert non-compulsory counterclaims in any action by KBS to recover under the loan agreement. The court also noted that consolidation would cause delay, was unnecessary and would prejudice KBS as it would be deprived of the acceleration afforded by Section 3213.

Turning to the KBS Action, the court then considered the defense of breach of contract. Looking at Section 30 of the loan agreement, the Court found that the clear and unambiguous language imposed no additional obligations on KBS. The court stated that, even if the contract did require KBS to negotiate for the restructuring of the Funds’ debt, there was no basis in the Loan Documents to conclude that negotiations between the parties had to be successful for such contractual obligation to be satisfied. Based on these facts, the court concluded that there was no triable issue of fact regarding the Petra Funds’ breach of contract defense based on unreasonableness.

Regarding the claim that KBS breached the implied covenant of good faith and fair dealing, the court held that the Funds failed to show a breach, explaining that “[t]he court does not accept the argument that sophisticated business entities would be justified in presuming that, in the event of default, the Lender would be obligated to restructure the Borrower’s and Guarantor’s obligations on those terms deemed acceptable by the Borrower and Guarantor.”

The court similarly struck the Funds’ impossibility defense, citing the case Pettinelli Elec. Co., Inc. v. Board of Educ. of City of New York, 56 A.D.2d 520 (1st Dep’t 1977), where the Appellate Division held that “financial difficulty or economic hardship, even to the extent of insolvency or bankruptcy, is not such impossibility as to excuse a defendant from liability in damages for failure to perform the contract.” Additionally, the court noted that the Funds were trying to excuse themselves not from performance of a contract but rather payment of a debt, and pointed to the case University of Minnesota v. Agbo, 176 Misc. 2d 95 (2d Dep’t 1998), where the court held that “the defense of impossibility of performance only excuses the performance of an executory contract,” and “has never been held available for the purpose of unjustly enriching one party at the expense of the other.” Based on the Funds’ inability to set forth a triable issue of fact for any of its defenses, the court granted KBS’ motion for summary judgment in lieu of complaint.

Lastly, the court granted KBS’ motion to dismiss the Funds Action. The court held that no actual controversy existed with regards to the Loan Documents because, as stated previously, KBS had no obligation to restructure the Petra Funds’ loans. Additionally, the court restated that the Funds had not pleaded a defense of a breach of the contract, that it had not pleaded a defense of a breach of the implied covenant of good faith and fair dealing, and it had not pleaded a proper declaratory judgment claim regarding the issue of impossibility.

Conclusion

While the economic crisis may have affected the borrower’s and guarantor’s ability to repay the loan documents, it did not change their responsibilities as borrower and guarantor, nor did it add defenses available for their breach. As such, where a prospective borrower or guarantor would like to require the lender to negotiate in good faith for the restructuring of their debt in the event of adverse economic developments, these parties should specifically contract for such an obligation, as a court is unlikely to read them into a contract. Additionally, while it is improbable that a court will read this obligation into a contract, lenders may be able to prevent litigation on the subject by making the contractual language clear about the lender’s obligations or lack of obligations under the contract.