If a lender exercises excessive control over a borrower’s business, the lender may face potential lender liability exposure under either a control or instrumentality theory of lender liability.
A finding of excessive control could even be result in a court determining that a lender owes a borrower fiduciary duties. It is important for a lender to steer clear of these twin dangers when working with a borrower, particularly one in financial distress.
Underlying the control or instrumentality theory of liability is an analysis similar to the theory of “piercing the corporate veil” to reach the shareholders of a corporation. If a lender exercises too much control over the decisions made by its borrower so as to transform the relationship between borrower and lender to one of principal and agent, the lender may be liable for any harm to the borrower’s business caused by the lender’s control. Generally, this theory of liability has been used by third-party creditors, especially in a bankruptcy context, to seek to hold a lender liable for the unsecured debts of the borrower, although principals of a borrowing entity may also attempt to hold the lender responsible for the failure or insolvency of their entity, premised on a control theory of liability.
How does this type of lender liability arise? Initially it should be noted that the mere existence of a creditor-debtor relationship inherently gives rise to certain control issues since most loan documents contain lists of covenants as to what actions are permitted and prohibited by a borrower. A level of control by the lender more intrusive and/or more forceful than customary loan covenants however is required for instrumentality liability to arise; if it were otherwise, lenders would, with good reason, be reluctant to extend credit.
As a foundational case in this area observed, to establish liability under the instrumentality theory, courts have required “a strong showing that the creditor assumed actual, participatory, total control of the debtor.” The creditor’s control and dominance over the borrower must be so substantial as to indicate that the effective control of the borrower’s operations and affairs rests with the creditor.
So how does a bank get into trouble in regard to control liability? The classic case is when a lender with a senior security interest in inventory directs the borrower to buy as much inventory as it can on credit, in anticipation of a secured party sale by the lender, whereby the lender will sell this newly acquired inventory and use the proceeds from such sale to recoup what it is owed and leaving the unsecured suppliers (who just sold the inventory to the borrower on credit) without recourse or recovery.
Generally, it is a good rule of thumb to never tell a borrower who it should pay or not pay, but rather to tell a borrower what availability may exist under a line of credit and then to let the borrower decide which creditors to pay out of the resources available to it. The good news for lenders is that it is always permissible for the lender to tell the borrower that it must pay the lender on account of its outstanding loans.
A related concept to control liability arises if a lender acts in such a way as to convert the lender-borrower relationship from a non-fiduciary one to a fiduciary one. Ordinarily the relationship between a lender and a borrower is not a fiduciary one. That means the lender may act in a manner directed solely to advancing its own economic interests, without regard to whether such actions are beneficial or harmful to the borrower. (Obviously the lender must not engage in wrongful conduct in advancing its interests, such as misrepresenting facts or violating other duties, or act in bad faith.) A fiduciary relationship can arise, however, where the borrower significantly reposes its trust and confidence in the lender and the lender knows of and accepts the borrower’s trust. The catalyst in changing the relationship to a fiduciary one is the lender’s knowledge of the borrower’s reliance upon the advice of the lender. If the lender’s actions result in the lender becoming a fiduciary, this alters the rules governing the lender-borrower relationship. If deemed a fiduciary, the lender must make decisions and take actions in a way that is beneficial to the borrower, rather than solely to the lender. The lender’s actions may no longer be based solely on self-interest, but must be based on or take into account what is best for the borrower. This would be similar to how registered investment advisors must act as fiduciaries for their customers according to SEC rules.
To avoid converting the lender-borrower relationship to a fiduciary one, care should be exercised not to make business decisions for a borrower, especially an inexperienced borrower who is seeking advice as to ordinary business decisions in such a manner that it is apparent that the borrower has placed all of his/her trust in the lender’s judgment. If a lender’s participation in or exercise of control over the business of a borrower is too active or excessive, the lender may find itself having responsibility or liability for any harm caused by the decisions and strategies suggested by the lender and implemented by the borrower.
This does not mean that a lender cannot offer advice and use the leverage which its position gives it vis-a-vis the borrower. What it does mean is that the lender cannot control the borrower’s business operations in such a way that the borrower no longer makes its own business decisions.
A good relationship between a lender and a borrower is a positive thing. A borrower may often ask the lender for an opinion on a particular issue and a lender can respond to such inquiries. The key however is to observe and the appropriate formalities which should exist between lender and borrower and not cross the line and attempt to control the business. Advice and general conversation are perfectly fine, but these should not devolve into directing a borrower as to who to pay or not pay or what strategies and decisions a borrower should make in its day-to-day business operations. A borrower is a lender’s customer, not his friend or ward or agent.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.