Banks and other lenders are getting increasingly insistent warnings from their lawyers to stay out of their customers' business. The time-honored banking practice of stepping into the operations of a troubled business borrower and trying to give it good advice has become increasingly dangerous.
Unless the company is magically turned around, the bank is almost certain to be sued. And it might very well lose the case.
The trend toward such suits was stimulated by a decision three years ago by a Texas appellate court, which agreed with a jury that State National Bank of El Paso had gotten too involved with the affairs of Farah Manufacturing Co., the sportswear maker.
The lender, with a $22 million loan at stake, had little faith in the leadership abilities of William Farah, who was in line to become chief executive officer of the firm. The jury found that the lender used threats of declaring the loan in default to force Farah and his allies off the board and to install their own representative as head of the company.
The jury told the bank to pay the company $18.9 million in damages stemming from decisions made by the person the bank named as CEO; the only problem the appellate court had with that decision was that it was $300,000 too high. With the precedent on the books, "lenders must be very careful to avoid involvement in the management of their borrowers' businesses," said Woodbridge, N.J., lawyer Helen Davis Chaitman.
The problem is not just that managers installed by the bank might be less than perfect. It's that by bridging the traditional distance between bank and customer, the bank is taking on a much higher obligation to the borrower.
"A lender who exercises control over a borrower's business operations exposes itself to an increased risk that it will be held to the standards of a fiduciary," Chaitman told an American Bar Association meeting. That means situations that by ordinary standards would be acceptable can give rise to damage claims.
Last year a judge ruled that because a San Diego Buick dealer relied on the advice of his loan officer at Security Pacific National Bank, the bank was remiss in advising the customer to buy a second dealership without revealing that the dealership to be acquired was a creditor of the bank -- and was in trouble. The judge not only gave the dealer $2.3 million to make up its losses on the deal, but ordered the bank to pay another $2.5 million in punitive damages for breaching its fiduciary responsibility.
In one key case, the U.S. Court of Appeals in Cincinnati upheld a similar recovery bid by the bankruptcy trustee. When the bank drew up a 13-point program for turning the company around, forced the president to slice his salary in half, insisted that the accountants be replaced, and demanded advance approval of all payments, it was so interfering with the operation of the business that it was liable for the resultant decline in value, the judges ruled.
And suits on behalf of the company itself are not the only kind a bank has to worry about, Chaitman said. Uncle Sam is not reluctant to go into court claiming that if a lender is really pulling the strings, then it is the one that must live up to the corporation's obligations.
The federal government might look to the bank to pay for the cleanup of a hazardous waste site, or to make up tax and social security payments withheld from worker's checks but never turned over to the Treasury.
Given the cost and time demands of litigation, even winning such a case can be a drain on a bank's resources. But given the current state of the law, bank counsel can't give a very good assessment of the chances of winning.
"There is no primary theory upon which liability is predicated," Los Angeles lawyer William M. Burke told the ABA meeting. "In reality, there is little existing jurisprudence in this area, although the issues are currently attracting national attention and the efforts of able scholars and practitioners."
Burke said the courts eventually will develop guidelines on how far a bank can go in helping a troubled client. But in the meantime, he tells bankers to draw a clear line between making suggestions and dictating results.
When it becomes clear that the present management isn't going to be able to repay the debt, Burke said the lender can hurry the transfer of power along by refusing to advance more money -- or to waive a declaration of default -- unless there's a change at the top. But he advises that the bank be very careful not to make the choice of who the new leader will be. It's okay to comment on names put forward by the company or even to present the company with a list of qualified possibilities, but not to make the final choice.
Similarly, Burke said the bank is wise to insist on a detailed business plan to get out of red ink, but foolhardy to impose the plan on the company. It's reasonable to insist the plan includes sale of some assets, but not to select which assets are to go on the block.
And he has one more suggestion: Banks that do get sued should not skimp on their legal defense bills. He said, "In the short run, questions will most likely be answered by those with the best tools of persuasion."
Moskowitz covers legal affairs for McGraw-Hill World News.