What the law says lenders can and cannot demand

Banks have a right to protect their loans, but not to run your business.

By Steven C. Bahls and Jane Easter Bahls

One morning in 1983, Donald Bottrell and his partner, Ed Reeve, met their banker for a routine review of their loans. Their company, Northern Line Layers, a cable concern based in Montana, had six operating loans from American Bank totaling about $175,000, and had never missed a payment.

During the meeting, the bank's loan officer suggested that Northern reorganize its debts and switch from short-term to long-term financing. Bottrell signed new agreements that slightly reduced his loans' interest rates in exchange for a security interest in his company's equipment.

Later that afternoon, Bottrell and Reeve learned that their lender suddenly felt uneasy about Northern's loans. Their bankers apparently felt that Northern's debts were too high and feared it might default. To prevent that, American Bank seized $66,000 from the company's checking and savings accounts. It even reversed a federal payroll tax deposit. With no money in its checking account, Northern's payroll checks bounced, and its employees soon quit. Moreover, the absence of financing prevented the company from bidding on new jobs. Robbed of its financial foundation, Northern Line Layers sued American Bank and ultimately won $500,000 in damages.

During the past five years, hundreds of companies have blamed their downfall on the capricious behavior of their lenders and filed lawsuits. In one instance, a bank encouraged a business to expand, promising long-term financing, then suddenly cut off credit. In another case, a bank exerted too much control over the daily operations of a company, insisting on steps that later proved disastrous. In numerous cases, juries have awarded millions in damages.

Consider the case of K.M.C. Company Inc., a family owned wholesale grocery business in Knoxville, Tennessee. The business had relied on accounts-receivable financing. For undetermined reasons, the bank suddenly refused to extend additional financing, contrary to its own policies. K.M.C. was unable to obtain other financing on short notice and went out of business.

"The hardest day's work I ever did was to lay off 140 employees," says Leonard Butler, then president of K.M.C. "When you have to shut down a viable business because of an irrational decision by a bank, it's like cutting your wrist and watching the blood drip on the floor." Butler sued the bank for breach of contract and won $8.5 million in damages.

After sustaining such legal blows, bankers have become more cautious in their dealings with borrowers. Many have attended seminars on lender liability and now seem more aware of the issue. "The lesson all banks have learned from lender liability is that they have to steer away from taking too much control of a borrower's business," says William E. Trautman, a San Francisco banking attorney.

Still, lenders have a right to protect themselves. A bank may require a business to meet certain financial covenants, such as maintaining a certain level of inventory or placing a ceiling on salaries. It may also require a business to take steps to protect the value of its collateral. Such provisions usually are spelled out in the loan document.

 

When a bank demands that a business take steps unrelated to protecting its financial interest, though, it's gone too far. A bank, for example, can't call its loan just because it disapproves of someone a business has hired, unless it can prove that the individual is a genuine threat to repaying the loan. In short, a bank has no right to run someone's business.

An extreme example of what can happen when a bank steps over the line of proper conduct is the case of Contempo Metal Furniture of California, a family owned business. When owner Robert Schuster sought a $250,000 loan from Union Bank in Los Angeles, a loan officer required the company to hire two consultants to update the business. One of them turned out to be a personal friend of the loan officer. He seized control of the company's accounting and production departments and was responsible for losses of $100,000 a month. The bank officer also threatened to call in the loan unless the consultants were able to obtain part of the company's stock. By the time Contempo closed its doors, the consultants had owned half of the enterprise, which was by then $3 million in debt. Schuster sued, and a jury awarded his company $12.5 million in actual damages. The jury was debating the amount of punitive damages to award when the bank agreed to settle out of court for an undisclosed sum.

As Schuster learned, business owners should assert their right to run their own business. When faced with a demand by a bank to do something or face a loss of credit, though, asserting one's rights is easier said than done. If the bank's demands seem unreasonable, it's time to consult your attorney.

This caution does not imply that banks should never get involved in the business side of a borrower's operation. Indeed, many small business owners believe it's important for bankers to offer business advice. The law permits bankers to give suggestions, so long as the borrower makes the ultimate business decision.

If you decide it's in your interest to follow the lender's guidelines, make sure you obtain competent, independent counsel. "The biggest mistake I made was to rely on Union Bank's recommendation," says Schuster. "I assumed that if the bank recommended these consultants, they must really be top."

Similarly, although banks are not obligated to continue loans indefinitely if they believe they won't be repaid, they need to abide by the loan documents and by bank policy when altering the terms of the loan. If they don't, as in the Northern Line Layers case, there may be grounds for a lender liability lawsuit.

Although some companies have won multimillion-dollar judgments in lender liability suits, don't let the possibility of winning in court forestall careful negotiation. Filing a lawsuit against your lender, no matter how sure you are that the law is on your side, is no guarantee of victory. When a bank in Missoula, Montana, pushed a family owned livestock brokerage business to hire a nephew of a bank officer, the Montana Supreme Court found nothing wrong. The court ruled that the nephew had offered good advice.

Further, some of the largest lender liability judgments have been overturned in appeals courts, leaving borrowers with nothing. New laws may also tip the balance in favor of lenders. For example, California, the leader in lender liability lawsuits, recently enacted a law prohibiting lawsuits against lenders for terminating credit unless the promise to continue credit is clearly documented in writing.

Because the future of lender liability law is in doubt — and any lawsuit is expensive, stressful, and time-consuming — do all you can to avoid problems with lenders in the first place.


Steven C. Bahls is a professor at the University of Montana School of Law. Jane Easter Bahls is a free-lance writer.