Course Materials

LENDER LIABILITY

Nolan Zadra Managing Member

Commercial Credit Legal Advisors Cedarburg, Wisconsin

zade@wi.rr.com 414-333-5248

August 10 & 11, 2017

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LENDER LIABILILITY:The Bad, The Worse And The Potential

To Get Very Ugly

Nolan H. ZadraAssistant General Counsel

Senior Vice PresidentU.S. Bancorp

Milwaukee, WI

©July, 2013 by Nolan H. Zadra

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Denny

Ally

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The Ten Commandments For Avoiding Lender Liability

I. Thou Shalt Not Make A Sudden Move.

II. Thou Shalt Not Tell A Lie (Or Fudge The Truth).

III. Thou Shalt Honor Thy Commitments.

IV. Thou Shalt Not Run Thy Borrower’s Business.

V. Thou Shalt Not Bail Thyself Out on Thy Brother’s Money.

VI. Thou Shalt Keep Thine Own Files Clean.

VII. Thou Shalt Transfer A Troubled Loan To A Workout Officer.

VIII. Thou Shalt Confer With Workout Counsel.

IX. Thou Shalt Think Carefully Before suing On A Deficiency.

X. Though Shalt Not Be Arrogant.

Authored by and reprinted with the permission of Helen Davis Chaitman. Ms. Chaitman is a partner in the law firm of Ross & Hardies, Somerset, New Jersey.

I. Common Liability Concerns

II. Poor Structure of a Loan Transaction

III. Proposal Letters

IV. Commitment Letters

V. Course of Dealing

VI. E-Mail and Other Communication

TOPICS FOR DISCUSSION

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I. Common Liability Concerns

A. Good Faith and Fair Dealing

• Definition: Honesty in fact and the observance of reasonable commercial standards of fair dealing.

• Adequate notice before taking material action relative to Borrower?

B. Confidential Information

• Encrypted E-Mail

• Filing financing statements with account information

• Credit inquiries

– Handled via a standardized approach?

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C. “Control” of Borrower

• Making decisions on obligation to be paid – NO!

• Controlling or influencing management appointment –NO!

• Voting pledged common stock – No!

• Completing inventory when no payroll is paid – NO!

• Paying payroll when withholding tax is not paid – NO! [Liability on the Lender. IRC § 3505(b)]

D. Setoff

• Declared default?

• Do deposited funds belong to Borrower?

• Are deposited funds held in trust for benefit of third party?

• Violation of State One Action Rule?

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E. “Smoking Guns” – Whatever You Say Can and Will Be Held Against You

• Problematic Lender Statements

– To the borrower

– In internal files

• Written Statements

– “If this information comes out, we will not look good.”

– “It is our standard practice to get the wife to guaranty the loan.”

– “I told our borrower to focus on paying down our line and not to pay trade vendors.”

• Oral Statements

– “You don’t have to focus on that provision; it’s not important.”

– “That’s only boilerplate – you don’t have to read it.”

– “This deal is in the bag; I will get it will get approved.”

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• BUT – If Litigation is Brought or Reasonably Foreseeable, You Cannot Make Evidence Disappear or

Result could be - - -

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• Be Honest

• Avoid Legal Conclusions

– “We are not perfected in the collateral.”

– “There is no consideration for this pledge.”

• Stick With The Facts

• Less You Say, The Better

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F. Environmental Liability

G. Construction Lending Liability

• Exclusive Control of Disbursements

• Lending Beyond Scheduled Costs

• Lending Without Verifying Work Was Completed

H. Willful Misconduct

I. Damages

• Reputational Risk

• Publicity Negative

• Loss of Loan

• Time value of Money

• Actual Damages

• Punitive Damages

• Attorneys Fees15

II. Poor Structure of a Loan Transaction

A. Involving Spouses as Co-Signers or Guarantors• Regulation B a/k/a “Equal Credit Opportunity Act” 15

U.S.C. 1691– Bank cannot discriminate regarding extending credit

because of marital status

– General Rule: Banks cannot require a spouse to be co-applicant or guarantor on a loan

– Exceptions: Both spouses are co-applicants on the loan

The other spouse is a principal officer, shareholder or director of the borrower

One spouse does not qualify for credit and offers the other spouse as an obligor or guarantor without the Bank requesting such guaranty

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B. Issues in Lending to Multiple Individuals in Business Together• Co-Individuals Seeking Credit

– Importance of designating correct borrower (individuals vs. partnership) Proper loan documents

Proper debtor’s name for financing statement – absolutely crucial information under Revised Article 9

Ability to impose joint and several liability on each individual

Who’s your named borrower – the individual partner or the partnership?

– If no partnership name or no partnership agreement, then no partnership? No – probably is a partnership Two people in business together for a profit are presumed

to be a partnership (unless a passive investment)

Recomment partnership agreement

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C. Issues in Lending to an Entity with a Co-Signing Individual vs. Guaranty by the Individual• Loans and Benefits Are to the Borrowing Company

• Covenants Apply to the Borrowing Company

• The Courts Treat the Individual as a Guarantor

• Best Structure: Individual Should be a Guarantor, not a Co-Borrower– Take advantage of the waiver of defenses by the

guarantor

– Ability to sue guarantor immediately

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D. Issues in Lending to Multiple Companies• Easiest to Make One Loan to Multiple Companies or to

Make Loan to Parent Holding Company with Upstream Guaranties from Subsidiaries. Yes – BUT . . .

Company A Company B

Bank

$5MM Loan

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Potential Problem

Company A Company B

Bank

$5MM Loan

Pledge ofReliance Collateral

Unsecured Creditors

$

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ASSETS LIABILITIES

$3MM

$5MM Loan from Bank

$1MM

$5MM Note to Bank

$2MM Equity

ASSETS LIABILITIES

$3MM $1MM

$2MM Equity

ASSETS LIABILITIES

$3MM

$5MM

$1MM

$5MM

$2MM Equity

<$3MM Negative Net Worth>

Pre-Transaction Balance Sheet of Company A

$5MM Loan From Bank to Co-Borrowers Companies A & B

All Loan Proceeds Go to Company B - Resulting Balance Sheet of Company A

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Best Structure

“Lend Where the Assets Are”

Company A Company B

Bank

Pledge ofReliance Collateral

Pledge ofReliance Collateral

Bank

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$Loan

$Loan

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Extra Step

Company A Company B

Bank

Guaranty

Bank

Guaranty

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Upstream or Cross Guaranties

Holding Company

Subsidiary

Bank

$ Loan

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Potential Problem

Holding Company

Subsidiary

Bank

$ Loan

Unsecured Creditors

Pledge ofReliance Collateral

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Best Structure

“Lend Where the Assets Are”

Holding Company

Subsidiary

Bank

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• If other creditors are harmed as a result of the loans by the bank, a trustee in bankruptcy will assert that a fraud has been perpetuated on the unsecured creditors (“Fraudulent Conveyance” or “Fraudulent Transfer”).

• Result? Trustee in Bankruptcy or Judge might:– Set aside the transaction – eliminate the lien of the Bank; or

– Subordinate the lien of the Bank; or

– Force the bank to share collateral pro rata with other creditors

AND

– Always Attorneys Fees!!

What Problems Can Arise If A Poor Structure

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• Pledging Parties Are Very Strong Financially– Even after assuming all of the debt obligation, they are solvent

AND sufficiently capitalized AND able to pay their debts as they come due.

• There Exists a Community of Interests” Between the Borrowing Entities Such That the Money Advanced Benefits All the Companies as Integrated Ongoing Operations.– e.g., Entity A is a widget manufacturer

Entity B is the sole, exclusive sales company for Entity A

Exceptions Permitting Co-Borrowing or Cross Guaranty Reliance

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III. Proposal Letters / Letter of Interest

A. Issued Before Credit Approval

B. Not Intended to be a Contract

C. Be Careful What You Write (And What You Say)

D. Form of Proposal Letter/Letter of Interest

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[Bank stationery]

[SAMPLE PROPOSAL LETTER / LETTER OF INTEREST]

[Date]

[Name and Address of Borrower]

Dear__________:

We are pleased to consider your request for financing of the loan transaction described in this letter. Set forth below is a summary of some of the terms [Name of Bank} is interested in considering at this time.

[Describe general terms of the proposal loan transaction]

This letter does not constitute a commitment to lend by [Name of Bank]. We expect to engage in further discussions with you and to obtain additional information before deciding whether a loan closing can occur, and what the terms and conditions of that closing will be. While this letter may form the basis for a discussion with you of various loan terms, you understand that no oral discussions provide the basis of any commitment, and [Name of Bank] will not be committed to make a loan available to you unless the loan commitment is evidenced by a writing executed by the Bank, expressly stating that it is intended to be a loan commitment.

Should you wish us to continue to pursue this proposal, please furnish to us a check in the amount of $_______ as a deposit towards our out-of-pocket and due diligence costs.

We look forward to receiving your comments on this proposal. If you have any questions, please call us.

Sincerely,[Name of Bank]

By: _____________________________30

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D. What is Missing in the Proposal Letter / Letter of Interest?

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• Acceptance by Prospective Customer

• No Expiration Date

A. Commitment Letter is a Contract

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IV. Commitment Letters

B. Never Issued Before Credit Approval

C. Has to Include All Material Terms of the Deal• California Bank v. Prudential Insurance Co.

The owner and developer of a hotel in Phoenix won a verdict against a lender that refused to close on a $25.5 million permanent loan to replace construction financing. The lender’s refusal to close was based on the borrower’s inability to convey to the lender, at the time of closing, a valid first mortgage on the real estate. The written loan commitment contained numerous pre-closing conditions but did not state that the borrower had to be able to convey a valid first lien on the property. The lender argued that this condition was so standard that it was implicit in the commitment agreement. The court rejected this argument and held the lender liable for anticipatory repudiation of the loan commitment and nailed them for $10.5MM!!!

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[Name and Address of Borrower]

Re: Loan to: __________________

Dear: ______________________________________ (the “Bank”) is pleased to extend this Commitment at your request to make a secured loan (the “Loan”) to _________________________ (the “Borrower”) for the purpose of _________________________, upon the terms and conditions set forth in this Commitment.

1. Borrower. This Commitment is issued to _________________________, a _________________________.

2. Amount. The maximum amount of the Loan is $______________________.

3. Closing Date. This Loan shall be closed and funded on or before _________________________.

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7. Loan Documentation. The Loan is conditioned upon the preparation, execution and delivery of loan documentation in form and substance satisfactory to the Bank and its counsel, which loan documentation will include such representations and warranties, covenants, duties and other terms and conditions as are customary with the Bank for transactions of this type and amount and consistent with the terms of this Commitment (the “Loan Documents”). The Loan Documents will include, without limitation:

a. Loan Agreement

b. Note

c. Mortgage

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9. Pre-Closing Documents. At least __________ (_____) days prior to the Closing Date, the Borrower, at its expense, will deliver the following to the Bank:

a. Title Insurance. A commitment for an ALTA mortgagee’s extended coverage policy of title insurance, along with a pro forma policy, in an amount equal to the maximum Loan Amount, in form and substance satisfactory to the Bank, insuring that the mortgage will be a valid first lien against the Property subject to utility easements and other matters acceptable to the Bank in its sole discretion. The commitment and the . . .

10. Conditions to Funding. The Loan Agreement will set forth certain conditions to funding satisfactory in form and substance to the Bank, including, but not limited to, the following:

a. Requirement that a title company approved by the Bank execute a closing instructions letter under which all disbursements to or for the benefit of the Borrower will be made by the title company subject to conditions and requirements enumerated in the closing instructions letter as approved by the Bank.

b. Requirement that the Borrower not be in default under this Commitment and that the Borrower has satisfied all of the conditions and requirements set forth in this Commitment.

c. The Bank shall have received evidence that satisfactions, terminations and releases of all existing mortgages, liens, security interests and pledges from any other lender or creditor prior in time or right to the collateral interests of the Bank.

d. _______________________________________________________

e. _______________________________________________________

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13. The Loan Closing.

a. The final execution of the Loan Documents by the Borrower and the Bank and funding of this loan transaction shall occur on or before the Closing Date, or this Commitment shall be null and void unless extended in writing by the Bank.

b. The Closing will be conducted by the title insurance company selected by the Borrower and reasonably acceptable to the Bank. An authorized representative of the title insurance company shall attend the Closing, prepare the settlement sheet and be responsible for recording the appropriate Loan Documents and disbursing the proceeds of the Loan pursuant to the written instructions to be delivered to the title insurance company by the Bank’s counsel.

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16. Termination. In addition to paragraphs 10 and 12, the Bank may terminate this Commitment upon the occurrence of any of the following events:

a. If the Borrower fails to deliver to the Bank any of the items required to be delivered pursuant to this Commitment within the time and in the form required by this Commitment, or if the Borrower fails to satisfy a condition provided in this Commitment by the Closing Date.

b. If any representation made to the Bank by or on behalf of the Borrower or any Guarantor is untrue or misleading in any material respect, or if the Borrower defaults under any of the terms of this Commitment.

c. If the Borrower or any Guarantor dies, makes a general assignment for the benefit of creditors, or files or is subjected to a petition in bankruptcy.

d. If there is a material, adverse change in the financial condition, business or prospects of the Borrower or the Guarantors.

e. If there is any destruction or damage to the Property deemed substantial by the Bank in its sole but reasonable discretion.

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19. Acceptance of this Commitment. The Borrower may accept this Commitment by executing the acceptance at the end of this Commitment and returning the accepted Commitment and payment of the commitment fee to the Bank on or before the close of business for the Bank on _____________, time being of the essence. This Commitment shall be null and void if not accepted in accordance with the terms of this paragraph.

This Commitment is delivered to the Borrower in duplicate originals. Please date and sign where indicated below and return one of the original signed copies of this Commitment, together with a commitment fee of $_________ to the Bank on or before the close of business on ___________________.

Very truly yours,[Name of Bank]

By _________________________________________________, __________

Borrower acknowledges and agrees to the terms and conditions of this Commitment,and encloses the commitment fee of $________________.Dated __________________________.

[Name of Borrower]

By _________________________________________________, __________

D. Withdrawing From a Commitment to Lend• Reliance by Customer on Commitment

• Not Arbitrary

• Materiality

• General Electric Capital Corp. Case.

GE cannot excuse its non-performance under the commitment letter by invoking the non-occurrence of aspects of the transaction it was charged with furthering.

There is “. . . an implied duty to use ‘reasonable efforts’ to advance primary goals of a contract,” which includes an obligation “not to act arbitrarily or irrationally in exercising that discretion.”

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V. Course of Dealing (“Course of Conduct”)

A. Ignoring A Problem – Establishing A Course of Conduct

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B. How Many of You Have (or Seen Others Have)

• Accepted Late Financial Statements?

• Ignored a Violation of a Financial Covenant?

• Accepted Late Payments?

• Funded in Excess of a Borrowing Base?

• Allowed Repeated Overdrafts by a Customer?

• Funded After Maturity of a Loan?

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C. Expectations of the Borrower

• “Based upon the Bank’s Actions, I thought my miss on the covenant was no big deal.”

• “You are doing what to me now? I relied on that borrowing availability.”

• “What do you mean you are not going to renew the loan? I had no idea that there was going to be a change. After all, you have renewed it year after year. What am I supposed to do at this last minute?”

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D. Modification of a Written Contract May be Effected Either Through Subsequent Actions or Oral Agreements

• John Deere Case

– Borrower was two months late (December) in first installment of $11,960.48

– Deere (Lender) waived the default and extended time for payment.

– Customer only makes partial payment three months later, and Deere agrees remainder can be paid March 1.

– When payment was late, Deere followed up two months later and agreed orally that the balance could be due at the time of harvest.

– Deere repossessed (before harvest) July 30th.

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• The Court Found That the Contract was Modified by the “Course of Dealings”, and the Repossession was Improper.

• “We hold that the repeated acceptance of late payments by a creditor who has the contractual right to repossess the property imposes a duty on the creditor to notify the debtor that strict compliance with the contract terms will be required before the creditor can lawfully repossess the collateral.”

• Alaska Statebank v. Fairco

The Supreme Court of Alaska held that a borrower could recover actual and punitive damages from a lender who had taken possession of its collateral without notice, in spite of the fact that the loan agreement authorized such repossession. The court held that the lender had waived its right to strictly enforce the loan agreement by previously accepting late payments and by negotiating with the borrower for an extension of the loan.

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E. Can The Lender’s Course of Conduct Be Reversed?

• Yes, but only with prior notice to the Borrower AND

• Providing sufficient time for the Borrower to react to the changed circumstances

• What is realistic; how soon practically can the borrower comply with the “New” Expectations?

• Lender has to be serious and be prepared to act if another violation (No “ Crying Wolf”)

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A. Problem #1 - Danger, Danger, Danger

• Lawyer representing Eli Lilly in confidential negotiations with U.S. Government on a $1 Billion settlement sent an e-mail to her co-counsel, Austin Berenson. When she started typing in the name Berenson, her e-mail prefilled the name from her contact list but instead of “Austin” Berenson, the e-mail was sent to “Alex” Berenson.

– “Alex” Berenson was a reporter for the New York Times.

– Next day, article on those settlement discussions appeared on the front page of the New York Times.

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VI. E-Mail And Other Communications – Why Is It Such A Problem?

• UNITED STATES v. MICROSOFT

– Government’s contention was that Microsoft was conspiring against Sun Microsystems.

– Bill Gates’ e-mail surfaced in which he asks: “Do we have a clear plan on what we want Apple to do to undermine Sun?”

– A Microsoft executive e-mailed Gates with a strategy to force Apple to do Microsoft’s bidding by threatening Apple that, otherwise, Microsoft “will do a great deal of harm to Apple immediately.”

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• FORTUNE 500 MAGAZINE (2007 ISSUE)

– $20 billion lawsuit against Citigroup

– Allegation that Citigroup financed Enron’s continued expansion while knowing that it was going to fail

– Reliance on internal e-mail from one Citigroup banker to another in April 2001:

“When Enron blows up, will it be worse thanLong-Term Capital?”

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• On an Individual’s Level

– Elementary school teacher is having an affair with the married father of one of her students. She writes a salicious e-mail to him, but when she proceeded to send it to him, her address book pre-populated all of the parents of her students and her e-mail went to all parents. She is not a teacher anymore.

• Texting

Even If You Are Not Anthony Weiner, Brett Favre Or Tiger Woods,You Don’t Have To Be Famous To Have A Texting Scandal

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B. Problem #2 – Costly, Costly, Costly

• To search for electronic data in order to comply with request to produce documentation in litigation, think computer experts; attorneys fees, staff time; management time, interruption of business

• UBS fined $29,000; Merck $253,000; and Phillip Morris $2,750,000 . . . for insufficient compliance to electronics discovery requests in litigation.

• Microsoft expends approximately $10-12 Million for electronic discovery for every lawsuit.

• US business is spending between $5 to 10 Billion per year on electronic discovery costs.

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C. Problem #3 – Volume, Volume, Volume

• Nearly 100% of written communication today is in electronic format.

• Approximately 730,000,000,000,000 (trillion) (and growing!) e-mails are sent each year (this does not even include texting, instant messaging, tweeting and other electronic communication)!

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• If you took one step (at an average stride of 2.3 feet per step) for every e-mail sent this year, it would take you 317,992,725,372 (billion) miles to get to the end: Or the equivalent of walking around the earth at the equator over 12 Million (12,769,997) times:

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– Or traveling over 70 times farther than the distance from the Earth to Pluto

• If you took one step per second for every e-mail sent in one year, it would take you over 23 Million years to complete the task (23,148,148 years, to be exact).

D. Problem #4 – Huh? Huh? Huh?

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Who's On First (Teacher)

Who’s On First (wimp)

• Attorney: She had three children, right?Witness: YesAttorney: How man were boys?Witness: NoneAttorney: Were there any girls?Witness: Your Honor, I think I need a different attorney. Can I get a new attorney?

• The most classic “failure to communicate”

• “What we’ve got here is failure to communicate.:

Struther Martin in “Cool Hand Luke

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E. Problem #5 – Quick, Quick, Quick; Mindless, Mindless, Mindless; Sloppy, Sloppy, Sloppy

• We author written electronic communications

– Too quickly

– Without review

– Carelessly

• E-Mails are

– A Permanent record

– Discoverable in litigation

– Are impersonal

– Often sent with emotion or when the sender is agitated, tired, stressed or in a hurry

– Sent without much thought

– Sent sometimes to the wrong person

– Misconstrued/misinterpreted by the recipient

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• How many times have you hit “Reply All” when you did not want someone to see your reply?

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• How many times have you sent an e-mail out to a boss, a colleague, a friend or even your significant other, and you then wish you hadn’t sent it?

• How many times have you sent an e-mail when upset with the party you are replying to?

• How many times have you sent a reply to an e-mail quickly, just to get it off of your computer because you are busy or have too many e-mails?

• How many times have you sent an e-mail with the words or concepts that could have been expressed better if you re-read what you wrote a day later?

How many times have you sent an e-mail that you seem like an idiot?

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F. Discussion (Off the Record)

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So Where Does This Leave Us?

As that once famous ex-governor of New York said before being brought down by some taped phone calls and unseemly text messages authored by him:

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“Never write when you can talk,

Never talk when you can nod.

And never put anything in an e-mail.”

~Eliot Spitzer

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“TOP TEN” Lender Liability Lessons10. Exposure to the Bank is not just limited to the amount of credit extended.

9. Be honest and act in good faith.

8. Do not make decisions for your customer.

7. Be careful what you write or say; it might come back to haunt you.

6. Structure your loan correctly (or expect a judge or trustee to snoop into your transaction).

5. Do not commit when all you want is to propose.

4. The less you say, the better.

3. Stick with the facts.

2. Require strict compliance with loan covenants and warranties.

1. DO NOT, DO NOT put anything important in an e-mail.

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