Creditor Control and Lender Liability
| Publication year | 1987 |
| Pages | 1931 |
| Citation | Vol. 16 No. 10 Pg. 1931 |
1987, November, Pg. 1931. Creditor Control and Lender Liability
In lender-borrower relations, the rules of the game have changed. No longer can lenders write adhesive loan agreements or treat borrowers with anything less than the utmost care and consideration. Lenders are being sued with increasing frequency, and verdicts awarded in favor of borrowers are growing at a dramatic rate.
This article focuses on lender liability which results from lenders exerting undue control over borrowers. Such claims may be asserted not only by the borrower, but also by third parties, other creditors of the borrower and governmental authorities. The claims asserted may be based on the law of agency, contracts, torts, corporations and securities, as well as the Bankruptcy, Tax and Uniform Commercial Codes.
Lenders' control over borrowers can be both direct and indirect. Lending agreements often provide the lender with the specific ability to control the borrower and limit the borrower's freedom of operation. Examples of direct control include the lend-er's right to vote stock that is held as collateral or the ability to prohibit changes in the management of the borrower without the prior consent of the lender.
Indirect control may derive from the lender's financial domination of the borrower. Lenders in this position may make "suggestions" to the borrower regarding the operation of its business. Implicit in such suggestions is the possibility that the lender may call the loan or restrict further lending should the advice not be followed. However, for such financial leverage to give rise to a cause of action, the creditor generally must exercise its ability to affect the management or the continued viability of the borrower.(fn1)
Recent case law amply illustrates that the exercise of control by the lender over the borrower is fraught with peril and should be done with care. This article discusses significant cases and developments in order to highlight the types of conduct that can lead to lender liability.
A lender which exercises undue control over a borrower may have certain fiduciary duties which would not otherwise exist. Absent special circumstances, a debtor-creditor relationship is not a fiduciary relationship.(fn2) As the Tenth Circuit has stated, the creditor's duties to its borrower generally rise "no higher than the morals of the market place."(fn3)
However, when a lender exercises such control over the debtor that it "amounts to a domination of [the borrower's] will," the creditor's conduct may be measured by a fiduciary standard.(fn4) Proving sufficient control by the creditor to impose fiduciary duties is not easy. The lender's "... ability to command the debtor's obedience to his policy directives . . . [must be] so overwhelming that there has been, to some extent, a merger of identity. Unless the creditor has become, in effect, the alter ego of the debtor . . .", no fiduciary obligations will result from the control exercised by the lender.(fn5)
A creditor which exerts excessive control over its borrower may be liable to third parties for the borrower's obligations under a principal-agent theory. A leading case in this area is A. Gay Jenson Farms Co. v. Cargill, Inc.(fn6) A group of farmers brought an action against both the lender and the borrower for losses sustained when the borrower defaulted on contracts with the farmers for the sale of grain. The borrower operated a grain elevator, storing, purchasing and reselling grain. In exchange for an extension on its credit line with the lender, the borrower agreed to provide the lender with annual financial statements, to allow the lender to inspect its bookkeeping records, and to first obtain the lender's consent before making capital improvements or repairs in excess of $5,000, declaring dividends, selling or purchasing stock, becoming liable as a guarantor on another's indebtedness, or encumbering its assets. This degree of control was thought to be necessary because of the lender's view that the borrower needed "very strong paternal guidance."(fn7)
When the borrower experienced serious financial problems, the lender began to monitor the situation more closely, and made a number of suggestions about the operation of the borrower's business. The lender began to contact the borrower daily
The farmers brought suit and included the lender as a defendant on the basis that it was jointly liable for the indebtedness because it had acted as the borrower's principal. On appeal, the Minnesota Supreme Court affirmed the trial court in concluding that the lender, by its control and influence over the borrower, became a principal with liability for the transactions entered into by its agent, the borrower. The court held that the lender's interference in the affairs of the borrower constituted de facto control of the borrower's operations, thereby creating a principal-agent relationship.(fn8)
The court appeared to rely heavily on § 14 O of the Restatement (Second) of Agency, which provides for principal-agent liability for a creditor which assumes control of its borrower's business for the mutual benefit of it and its borrower. The court also noted Comment a to § 14 O, which states:
A security holder who merely exercises a veto power over the business acts of his debtor by preventing purchases or sales above specified amounts does not thereby become a principal. However, if he takes over management of the debtor's business either in person or through an agent, and directs what contracts may or may not be made, he becomes a principal, liable as a principal for the obligations incurred thereafter in the normal course of business by the debtor who has now become his general agent. The point at which the creditor becomes a principal is that at which he assumes de facto control over the conduct of his debtor, whatever the terms of the formal contract with his debtor may be.
Thus, putting an upper limit on the borrower's activities may be allowable, but actively engaging in those activities may expose the lender to unexpected vicarious liability for the borrower's debt.
Similar to the principal-agent theory is the instrumentality or alter ego theory. This theory was addressed in Harris Trust and Savings Bank v. Keig (In re Prima Co.).(fn9) When the borrower, Prima Company, began to operate unprofitably, one of its lenders suggested that it engage the services of an outside manager. Reluctantly, the Prima Co. agreed, and granted the outside manager complete control over its business. The manager was expected to answer only to two of the Prima Co.'s lenders. The Prima Co. ultimately filed a petition in bankruptcy. The bankruptcy trustee then sued for recovery of losses allegedly sustained as a result of mismanagement of the Prima Co.'s business and for repayment of claims which allegedly were wrongfully and unlawfully paid by the Prima Co.
The trial court concluded that the lender's conduct in suggesting that the borrower engage the services of an outside manager constituted undue influence over the borrower. Because the borrower had reasonable grounds to believe that disregarding the lender's suggestion would result in calling their loans in default, the court concluded that the borrower was forced to employ the manager and to give him such broad authority. The trial court held that such excessive control of the borrower by its lenders made the borrower the instrumentality of the lenders. Therefore, the lenders were liable to the bankruptcy trustee for the losses sustained while their manager operated the borrower's business.
The Seventh Circuit reversed, deciding that the...
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