What is Lender Liability? – By A. Barry Cappello
Lender liability, which first gained prominence in the mid-1980s, has gained acceptance as a substantive body of law. Briefly, lender liability law says lenders must treat their borrowers fairly, and when they don’t, they can be subject to borrower litigation under a variety of legal claims. The decade-long evolution of lender liability has resulted in most cases now involving breach of contract and/or fraud claims.
Breach of Contract/Fraud
For years, lenders were the ones who typically sued borrowers for breach of loan agreements. With the arrival of lender liability, borrowers became just as likely to sue lenders for those breaches.
A loan agreement is like any other contract. If the agreement was fraudulently induced or there was an absence of mutual consent, the agreement cannot be enforced. If the loan contract was breached, the lender can be sued if it was the breaching party.
The most common remedy pursued by borrowers when a breach of a loan agreement has occurred is the recovery of damages. This can include both the difference between the loan amount and the costs for obtaining a replacement loan, and any lost opportunity or lost profit damages.
Lenders often assert the “parol evidence rule” to prevent borrowers from recovering against them based on oral promises the lender may have made to the borrower. The rule prevents admission of evidence in court of certain oral agreements that would contradict a later signed agreement. The theory behind this rule is that written evidence is more accurate than human memory, and the rule would prevent fraudulent later-asserted claims. Unfortunately, this can open the door to lender misconduct (i.e., a lender making an oral promise that the lender then refuses to fulfill). Luckily for borrowers, there are several exceptions to this “apparent” open and shut rule.
In Siegner v. Interstate Production Credit Association of Spokane, PCA convinced the plaintiffs, two couples who operated a cattle ranch, to do business with it by making a series of promises about funding. The PCA loan officer assured the plaintiffs that PCA understood the cattle industry and knew it was cyclical and that plaintiffs could take 10 to 20 years to pay off a capital loan. PCA also induced the plaintiffs to purchase a second cattle ranch.
When the time came to sign the loan papers, the plaintiffs noticed that the documents contained new provisions to which they had not agreed and that the document structured the real estate loan for only one year. The PCA loan officer assured them that these provisions were mere formalities and they had nothing to worry about. Based on the officer’s assurances, the plaintiffs signed the documents.
When PCA failed to honor its oral promises and made unreasonable demands regarding the real estate loan, the plaintiffs sued. PCA defended itself based on the parol evidence rule. The plaintiffs prevailed at trial and PCA appealed. The appellate court applied the parol evidence rule and found that the oral agreements were not inconsistent with the written agreement and were the type of agreements that might have been made separately. The court found that it would have been highly unlikely for the plaintiffs to have agreed to repay the loan in a year as reflected in the loan documents; if so, the plaintiffs would have purchased the ranch knowing with virtual certainty that they would lose it, as well as other assets, at the end of one year. A one-year loan would also mean that PCA had made the loan knowing it would be required to foreclose on it in one year. As a result, there was nothing inconsistent with loan documents prepared on a yearly basis, with a separate oral agreement to renew over a long period.
A fiduciary relationship is one in which one person–the fiduciary–owes special duties to another person, and must look out for that other person’s interests with special care. Early lender liability cases attempted to establish that lenders had such fiduciary duties to their borrowers. However, in later cases, lenders were successful in limiting the ability of borrowers to contend that the lender-borrower relationship is fiduciary in nature.
In Waddell v. Dewey County Bank, the court attempted to define the elements of a fiduciary relationship between lender and borrower as follows: 1) the borrower must have faith, trust and confidence in the bank; 2) the borrower must be in a position of inequality, dependence, weakness or lack of knowledge; and 3) the bank must exercise dominion, control or influence over the borrower’s affairs.
If a lender-borrower relationship is kept at arm’s length (the typical debtor-creditor scenario), the relationship is not fiduciary. Lenders typically argue that all lender-borrower relationships fall under this category. Fortunately for borrowers, however, the courts have delineated exceptions where the situation is not arm’s length or where the bank is more than merely a lender.
For example, when a lender holds itself out as a financial advisor, the lender will be held to the same fiduciary standard as any financial advisor.
In Scott v. Dime Savings Bank, the fiduciary relationship was established because the bank failed to keep its banking and investment advice separate. Scott approached his bank seeking a $5,000 loan for himself and his 97-year-old mother, Evelyn Scott. The bank employee he spoke with encouraged him to get a larger loan and to invest the money with Invest, an investment firm operating out of the bank branch.
On the advice of the bank employee, instead of the $5,000 he initially sought, Scott borrowed $100,000, secured by his mother’s home. He then opened a trading account with Invest and invested approximately $52,000 of the loan proceeds. The account was eventually wiped out in the 1987 stock market crash, and Evelyn Scott later defaulted on her mortgage. The Scotts sued the bank and Invest for breach of fiduciary duty and negligence. The Scotts settled their claims against the bank before trial, but the suit against the bank went ahead.
After a six-day trial, the jury found in favor of the Scotts on a claim for breach of fiduciary duty. The trial court, on a subsequent motion, acknowledged the rule that a debtor-creditor relationship does not alone create a fiduciary relationship. However, the court found the jury verdict of a fiduciary relationship was supported by the manner in which the bank: 1) extended credit to the Scotts, 2) used promotional devices to persuade them to invest loan proceeds with an affiliated company with whom the bank shared profits, and 3) continued to advise the Scotts about their investments through employees that worked for both the bank and the investment company.
Besides monetary awards of $36,000, the bank established a life tenancy for Evelyn Scott so she could stay in her home in spite of foreclosure.
Inappropriate Collateral Sales
Lenders can also run into trouble by inappropriately selling collateral after a loan defaults. The Uniform Commercial Code requires that the method, manner, time, place and terms of the sale be “commercially reasonable.” Courts have found sales to be commercially unreasonable where the lender relied on an appraisal that it knew or should have known was too low, or provided insufficient publicity for the sale to generate a sufficient number of bids.
In one case, Caterpillar Financial Services Corp. v. Wells, the lender refused to hold a public auction of the plaintiff’s repossessed equipment, and instead offered the equipment to a limited wholesale market made up of its own dealers at prices much lower than the equipment’s value. Not surprisingly, the court found the sale failed to meet the test of commercial reasonableness.
When collateral has been wrongfully repossessed or disposed of, the lender may lose the right to collect a deficiency, forfeit its security interest or be liable for damages. The provisions on commercial reasonableness protect guarantors as well in many jurisdictions.
As the area of lender liability matures, expect additional changes and refinements of this body of law as lenders and borrowers’ rights activists lobby in state legislatures and Congress for their representative sides.
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