Lenders should take comfort in a recent bankruptcy court decision in Maryland dismissing a creditor’s attempt to equitably subordinate a construction lender’s claim against their common debtor. See Atlantic Builders Group, Inc. v. Old Line Bank, et al. (In re Prince Frederick Investment, LLC), Bk. No. 12-20900-TJC, Adv. No. 13-00461, (Bankr. Md. September 9, 2014). The court’s decision is a good reminder that lenders who comply with the terms of their loan documentation are typically protected from lender liability or, in a bankruptcy case, from equitable subordination of their claims. Further, the court’s decision reflects judicial reluctance to impose duties not expressly set forth in ancillary agreements between creditors of a common debtor.
The three main players in the case are:
- the Debtor, Prince Frederick Investment, LLC, which was formed to construct and operate the West Lake Medical Center;
- Old Line Bank, which made a loan to fund the Center’s construction costs secured by a first priority lien in the Center; and
- Atlantic Builders Group, Inc., the contractor hired by the Debtor to construct the Center pursuant to a construction contract.
At the time construction began, the Contractor and the Bank entered into a Contractor’s Agreement to Complete (separate from the Contractor’s construction contract with the Debtor). The Agreement provided that the Contractor could not terminate its construction contract with the Debtor until the Bank had an opportunity to remedy any default, so long as the Bank advanced funds for the Contractor’s completion of the work. The Agreement called for the Contractor to inform the Bank of any Debtor defaults under the construction contract. It also gave the Bank the right to review payment requests and change orders submitted by the Contractor to the Debtor.
Typical of many construction projects, there were numerous problems and delays which increased the cost of construction. The Bank agreed to increase the initial loan and approved certain change orders submitted by the Contractor, but the Bank knew that the additional funds would still be insufficient to fund all of the extra construction costs and that the Debtor was undercapitalized and would not be able to fund the remaining construction costs on its own. Wanting the Contractor to finish construction on the Center—the Bank’s security for repayment of the loan — the Bank did not inform the Contractor of either of these facts.
The Debtor ultimately filed for bankruptcy, and scheduled the Bank’s claim as $3,194,640, secured by a lien on the Center, which was valued at $3,151,526. The Contractor, also owed funds by the Debtor, filed a complaint seeking to equitably subordinate the Bank’s claim pursuant to Bankruptcy Code section 510(c).
Section 510(c) of the Bankruptcy Code allows the court, under principles of equitable subordination, to (i) subordinate for purposes of distribution all or part of an allowed claim to all or part of other allowed claims, or (ii) order that a lien securing a subordinated claim be transferred to the estate. In the Fifth Circuit, where this case was pending, three factors must be met before equitable subordination is warranted:
- The claimant engaged in some type of inequitable conduct;
- The conduct resulted in injury to the creditors of the debtor or gave an unfair advantage to the claimant; and
- Equitable subordination is not inconsistent with the provisions of the Bankruptcy Code.
In determining whether the Bank had engaged in inequitable conduct, the court noted that the severity of conduct needed to be deemed “inequitable’ depended on whether or not the Bank owed a fiduciary duty to the Debtor and its creditors. If the Bank had a fiduciary duty to the Debtor, its conduct could be deemed “inequitable” simply by a breach of that duty. However, if no duty existed, the Bank needed to engage in “egregious conduct that shocks the conscience of the court.”
Review of Lender Liability
This is where the familiar term “lender liability” comes into play. Generally, a lender does not owe a fiduciary obligation to its customer borrower. However, if the lender exercises a sufficient degree of “operating control” over its borrower, courts will find that the lender had a fiduciary obligation to that borrower. Operating control exists when the lender seeks to control the direct activities of a borrower (commanding employee hiring/firing, dictating which creditors are paid, etc.). Exercising contractual rights or simply having financial leverage over a borrower does not necessarily constitute operational control over a borrower. This allows lenders to monitor a borrower’s finances and even make business recommendations to the borrower, without saddling themselves with a fiduciary obligation to their borrowers.
In this case, the Contractor asserted that the Bank exercised operating control over the Debtor in reviewing and approving the Contractor’s requests for payment and, in two instances, approving such payments without consulting the Debtor. The court disagreed, noting that the Bank’s actions were permitted under the loan and Contractor Agreement and, regardless, such actions fell far short of the degree of operating control required under case law. The court stated “it does not shock the conscience that a construction lender would want to review and approve applications for payment and change orders for the construction work on a project funded by its loan.”
The Contractor then asserted that, even if the Bank had no fiduciary duty to the Debtor, the Bank had engaged in egregious conduct when the Bank, in approving change orders, purposely withheld from the Contractor the fact that the Debtor did not have sufficient funds to pay the Contractor for the total construction costs, including the change orders. The Contractor asserted that the Bank benefited from staying silent because the Contractor continued to work on the Center and thereby enhanced the value of the Bank’s collateral.
While the Bank’s withholding of facts relating to the Debtor’s inability to pay the Contractor may have been suspect, the court found that the Bank’s silence was not “egregious.” While not dispositive, the court noted that the Contractor Agreement between the Contractor and the Bank did not impose an express duty on the Bank to provide updates to the Contractor on the costs being incurred by the Debtor. And, in approving change orders, the Bank was simply doing what the Contractor Agreement expressly authorized it to do and did not constitute an implied guarantee that loan proceeds would be available to pay the Contractor for the work reflected in the change order. The Contractor could have, but did not, require the Bank to provide updates to the Contractor on the loan status. The court refused to read into the Contractor Agreement an implied duty by the Bank to inform the Contractor when available loan funds were not sufficient to pay for a change order.
Moreover, the court noted that the Contractor Agreement called for the Contractor to give the Bank notice if the Debtor was in default under the construction contract. The Debtor had defaulted in making timely payments under that contract, yet the Contractor did not provide notice of this default to the Bank under the Contractor Agreement. Accordingly, the court found that these two facts together—the Bank’s right to review change orders and the Contractor’s failure to give notice of default under the Contractor Agreement—made the Contractor’s request for equitable subordination implausible.
Lenders should feel comfortable exercising their contractual rights under loan documentation in monitoring borrowers’ businesses. This case serves as a good example of courts’ willingness to absolve lenders of liability when they act in strict compliance with their rights and obligations under loan documentation. Having said that, lenders are smart to ensure that these rights and obligations do not extend so far into the daily operational activities of a borrower such that a court would find that the lender has operational control over the debtor. When that control is present, the lender may find itself in a much less bearable position in the borrower’s bankruptcy case.