Lender Liability and the Duty of Good Faith Essay

This essay has a total of 7515 words and 30 pages.

Lender Liability and the Duty of Good Faith

Lender Liability and the Duty of Good Faith

I. Introduction

From time to time, lenders and their attorneys announce that lender liability is no longer
an issue with which the lending community needs to be concerned. What usually prompts this
proclamation of the death of lender liability is a recent case in which a court has
summarily rejected a borrower's claim that the lender violated the duty of good faith and
fair dealing. Many courts have rejected borrowers' lawsuits which are based on allegations
of the violation of the lender's duty of good faith. Nevertheless, lender liability should
continue to be an area of concern to lenders.

Although courts often dismiss cases based on a borrower's claims of lender bad faith, in
other cases courts find that lenders have indeed engaged in conduct that constitutes bad
faith. Most courts carefully examine the unique facts of each case, consider the testimony
of experts, and listen to the ever-inventive arguments of counsel. A loan agreement, like
every other contract governed by the Uniform Commercial Code (the "U.C.C."), imposes on
both the borrower and the lender "an obligation of good faith in its performance or
enforcement." This simple good faith performance obligation may appear to be an
uncontroversial codification of a basic, minimal standard of human behavior. It is
proving, however, to be problematic to commercial lenders.

Some courts have been quick to hold that, under certain circumstances, a lender, which
believed it was merely exercising its contractual rights, nevertheless may have breached
the duty of good faith performance obligation. For example, in 1985 the Sixth Circuit,
invoking the good faith performance obligation, affirmed a jury verdict awarding
$7,500,000 to a borrower whose lender refused to advance funds under a loan agreement,
which specifically and unequivocally permitted the lender to exercise sole and absolute
discretion to refuse to advance additional funds. The Alaska Supreme Court, likewise
invoking the good faith performance obligation, held that a borrower could recover both
actual and punitive damages from a lender who had taken possession of collateral without
notice, notwithstanding the unambiguous terms of the loan and security agreement
authorizing such repossession.

On the other hand, many courts have abandoned the imposition of good faith obligations on
the lender beyond what is set forth in certain loan agreements. In 1987, the Bankruptcy
Court for the District of Massachusetts held that the holder of a demand note does not
need a good faith reason or any reason at all to demand payment. Additionally, the Seventh
Circuit in 1990 flatly rejected imposing the duty of good faith when calling a demand

Despite such far-reaching conclusions, courts have yet to articulate any specific criteria
to distinguish good faith performance from bad faith performance. Consequently, the issue
of a party's good faith performance under its contract is generally one of fact. In
analyzing such facts, however, many courts are using the good faith performance obligation
incorrectly. Instead of enforcing contract terms according to the expectations and intent
of the contracting parties, many courts are deciding for themselves what they believe the
parties ought to have done in "good faith," regardless of the terms of the contracts. The
doctrine thus has become a loose cannon used by some courts to further their own views of
fairness. In the commercial loan area, lenders are finding themselves increasingly
vulnerable to unpredictable and inconsistent applications of the vague good faith
performance obligation in situations where contractual terms, not questions of fact,
formerly controlled.

This paper will first discuss the good faith performance obligation and its definitions
under the U.C.C. Subsequently, it will discuss the use of the obligation to limit a
lender's ability to exercise its contractual rights. Next, the paper will discuss
criticisms of applying the good faith performance obligation to certain situations,
especially demand notes. Then a discussion of the objective and subjective test of good
faith will take place before finally concluding that the good faith obligation should not
be imposed in debtor-creditor situations to override express terms of a contract.

II. The U.C.C.

A. The Good Faith Performance Obligation and the U.C.C.

The central provision of the U.C.C.'s good faith requirement is found in § 1-203, which
provides that "every contract or duty within this Act imposes an obligation of good faith
in its performance or enforcement." With regard to debtor-creditor relationships in
particular, this obligation of good faith performance imposes on a lender a duty to deal
in good faith with its borrower in all situations, not only in situations where, because
of the circumstances of the loan, the lender has assumed actual control over and a
fiduciary responsibility for the borrower.

One troublesome but important aspect of the good faith performance obligation is its
application to contracts, which provide that one party to the contract may, in its "sole
discretion," take certain actions pursuant to the contract. In such cases, the actions of
the party who can exercise its discretion may affect all parties to the contract, and
dependent parties must rely on the "good faith" of the party given the right to exercise
its discretion. Often, the discretion exercised by the party in control will adversely
affect the dependent party. However, it does not necessarily follow that the controlling
party has acted in "bad faith" merely because the dependent party is in some way harmed
because of the controlling party's permissible exercise of discretion. So long as the
controlling party exercises its discretion for any purpose within the terms of the
contract as contemplated by the parties, then the dependent party should not be said to
have lost the "benefit of the bargain," and the party who exercised its discretion should
not be held to have acted in bad faith.

B. Definition of Good Faith Under the U.C.C.

Section 1-201(19) of the U.C.C. defines good faith as, in the minimum, "honesty in fact in
the conduct or transaction concerned." This "honesty in fact" definition appears on the
surface to be quite similar to the good faith definition of § 2-103(1)(b) of the U.C.C.
However, the two definitions should be distinguished. Section 2-103(1)(b) defines good
faith in the case of a "merchant" to mean "honesty in fact and the observance of
reasonable commercial standards of fair dealing in the trade." This section concerns sales
transactions, and does not involve relations between lenders and borrowers. Indeed, a
lender is not a merchant and is not generally bound to observe "reasonable commercial
standards." As one court has noted, the fact that lenders are under no burden to observe
reasonable commercial standards "reflects the Code drafters' recognition that sales
transactions are more amenable to the establishment of reasonable commercial standards
than are relations between secured parties and debtors."

C. Good Faith Performance and Demand Notes Under the U.C.C.

Accordingly, the U.C.C. defines "good faith" with regard to the contractual performance of
a lender only in terms of whether a lender has acted "honestly in fact in the conduct or
transaction concerned." In terminating a loan, the lender may accelerate the amount due,
demand the entire amount pursuant to a demand clause, or repossess the collateral. A
lender is subject to the implied duty of good faith in accelerating a note pursuant to an
"at will" provision. Section 1-208 of the U.C.C. provides that:

A term providing that one party or his successor interest may accelerate payment or
performance or require collateral or additional collateral "at will" or "when he deems
himself insecure" or in words of similar import shall be construed to mean that he shall
have the power to do so only if he in good faith believes that the prospect of payment or
performance is impaired.

The courts vary regarding whether good faith in this context constitutes an objective or a subjective standard.
Several courts have held that good faith does not apply to demand notes. As support, these
courts generally cite the Official Comment to § 1-208 which states, "Obviously this
section has no application to demand instruments or obligations whose very nature permits
call at any time with or without reason." This exception has been narrowly construed,
however, by several courts as inapplicable where the loan agreement, although labeled a
"demand note," contained various default provisions which otherwise condition the lender's
ability to accelerate or demand payment on the note. For example, in Bank One Texas, N.A.
v. Taylor, the Fifth Circuit upheld liability against a lender for bad faith acceleration
of note that, although containing a "payable on demand clause," also contained a monthly
repayment schedule and specified certain events of default.

III. Good Faith Performance and the Refusal to Advance Funds Without Notice

A. K.M.C. Co. v. Irving Trust Co.

Many trace the origin of what is commonly called "lender liability" to the good faith case
of K.M.C. v. Irving Trust. In K.M.C. the Sixth Circuit invoked the good faith performance
obligation to limit a lender's contractual right to refuse to make a cash advance without
notice under a discretionary line of credit. The K.M.C. court affirmed a jury verdict
awarding $7,500,000 to a retail and wholesale grocer who claimed that his business was
ruined by the defendant bank's refusal to make the cash advance. The court held that the
lender's discretion to advance funds under a negotiated, explicit discretionary line of
credit was limited by the obligation of good faith, as was the lender's power to demand
repayment of any funds advanced. Additionally, the K.M.C. court held that the good faith
performance obligation implied a requirement of notice to a borrower before acceleration
and demand, regardless of the specific terms of a loan agreement, to allow "a reasonable
opportunity to seek alternative financing," absent valid business reasons precluding a
lender from giving such notice.

The facts behind the K.M.C. decision are similar to ones that may arise every day. Irving
Trust and K.M.C. had entered into a financing agreement whereby Irving Trust provided
K.M.C. with a $3,500,000 line of credit. The loan agreement provided for discretionary
lending by the bank, based on a security formula derived from a percentage of K.M.C.'s
accounts receivable and inventory. Moreover, Irving Trust was permitted by the terms of
the loan agreement to demand, solely in its discretion, repayment of the advanced money.

Unfortunately, K.M.C. experienced serious financial difficulty. Consequently, it requested
an amount far in excess of the amount acceptable under the security formula. In fact, the
amount requested would have increased the line of credit to $4,000,000. In the
alternative, K.M.C. requested at least $800,000, the maximum amount available under the
financing agreement. Although the alternative advance would have increased the loan
balance to just under the $3,500,000 limit, Irving Trust's loan officer refused to make
either requested advance, believing that the entire debt was insecure, that the funds
advanced would not cover all of K.M.C.'s outstanding checks, and that K.M.C.'s business
was collapsing. Although Irving Trust did make further smaller advances enabling K.M.C. to
survive a few more months, eventually the business failed.

K.M.C. brought suit against Irving Trust, alleging that its refusal to make the requested
advance without notice was in bad faith, even though permissible under the terms of the
line of credit agreement. K.M.C. claimed that Irving Trust's acts amounted to a unilateral
decision to wind up K.M.C.'s business. Irving Trust responded by arguing that under the
terms of the loan agreement it had absolute discretion in deciding whether to make
advances. Furthermore, Irving Trust argued that because the loan was a demand loan and
could have been called at any time, any implied requirement of notice prior to a refusal
to advance cash would be inconsistent with this right to demand full repayment at any

The Sixth Circuit rejected Irving Trust's arguments, and held that the lender had a duty
to exercise good faith in deciding whether to refuse to make further advances or to demand
repayment of the loan. Specifically, the court found that Irving Trust's loan was
adequately secured on the day the additional advance was refused and ruled that a lender
cannot terminate financing without notice even if the financing is governed by a demand
loan and a discretionary right to make advances.

The court noted that had it applied a subjective standard of good faith, its outcome
probably would have been different. In other words, had the court depended on the actual
state of mind of the loan officer at Irving Trust, who believed the loan was insecure, it
might have been constrained to hold that the evidence was insufficient to support the
$7,500,000 verdict. However, the court concluded that the loan was secure and that a loan
officer's business reasons for terminating the financing without notice were to be judged
against an objective standard: whether a reasonable loan officer, with a secured loan,
would have refused to advance funds without notice to the borrower.

The K.M.C. decision startled the lending industry. It was important in several respects.
First, it marked the first time a court had invoked the good faith performance doctrine to
imply an obligation, which generally is governed only by the express terms of a contract:
the obligation to give notice. The loan agreements at issue required the lender to give no
notice to the debtor before it either refused to make advances of funds or demanded
repayment in full, yet the court implied such a requirement.

Second, not only did the court require the lender to provide notice not required by the
contract, it upheld an enormous damages award based on the lender's failure to give
notice. Therefore, the court penalized the lender for not doing something that, under the
terms of its contract, it was not required to do. The K.M.C. court went beyond holding
that lenders must meet certain implied obligations under contract; it penalized a lender
which satisfied express contractual terms but which failed to meet implied obligations.

Third, the K.M.C. decision appeared effectively to redefine traditional demand
obligations, a form of financing which was critical to the lending industry. K.M.C.
indicated that lenders could no longer simply demand repayment of loans or exercise their
security interest rights under their loan agreements. Under K.M.C., good faith required
lenders to provide notice sufficient to allow borrowers to seek alternative financing, an
obligation never contemplated by the parties at the time their demand loan was negotiated.
This simply provided a grace period for financially troubled borrowers and could result in
further endangering the lender's chance of repayment.

K.M.C. presents a troublesome precedent to all lenders who extend credit payable on
demand. Demand obligations allow lenders to evaluate their credit and collection risks and
to evaluate the administrative and legal costs associated with such financing. Loose
application of an undefined and unlimited good faith performance obligation to the simple
act of calling a demand obligation could seriously harm the ability of lenders to make
proper evaluation of such risks and costs, and thus could jeopardize the continued
availability of that type of financing. Faced with uncertain risks and potentially
enormous liabilities arising from the collection of such obligations, lenders would likely
be forced to change the terms and increase the cost at which such financing is made
available to borrowers. This result could be detrimental to both lenders and borrowers.

K.M.C. is important in another respect. Although not explicit in the decision, the court
seemed to imply that a demand obligation, standing alone with no mention of notice, did
not inherently allow lenders to declare their loans immediately due and payable.
Therefore, when a notice provision was omitted entirely from a contract, courts could look
to extrinsic facts to determine whether a notice requirement was contemplated by the
parties. Courts could further determine that an agreement without a notice provision is
ambiguous, and imply a notice requirement. Accordingly, K.M.C. appears to have placed a
burden on lenders, and specifically their lawyers, to draft demand obligations that
include some notice provision, even if it is minimal. If a lender wishes to omit a notice
period, then the words "without notice" should be included in the demand obligation. As a
practical matter, then, liability under the K.M.C. holding to a certain extent could be
avoided by drafting very detailed loan agreements that include specific notice
requirements prior to demand, acceleration, or repossession of collateral.

Drafting detailed, specific loan agreements, however, may not solve the problems facing
lenders as a result of cases such as K.M.C. No matter how specific loan agreements may be,
lawyers can never anticipate what requirements courts may later imply under the doctrine
of good faith. Surely, Irving Trust believed its loan agreements were adequate and clear
until the K.M.C. court advised it otherwise. Nevertheless, lawyers must take the
initiative to draft contracts in as much detail and as unambiguously as possible to avoid
liability on the part of their clients for breach of the good faith performance

B. Criticisms of K.M.C.

The strongest criticisms of the good faith doctrine are that it destroys the bargain,
limits contractual freedom, creates uncertainty, and creates inefficiencies. The good
faith doctrine is responsible for these when it is applied to override express contract
terms. When this is done in commercial lending, the argument maintains that the lender is
unexpectedly forced to bear additional costs that it cannot avoid by careful planning. The
demand provision illustrates this point. If unable to protect itself with this provision,
the lender is forced to expend greater costs to gather information and to insure it
against risks that the borrower may be more willing to bear. At best, this requires the
borrower to pay higher interest rates or to repay on less favorable terms; at worst, it
causes the lender to refuse the loan altogether.

The K.M.C. court held that Irving Trust had a duty to act in good faith in exercising its
right to demand payment of the loan under U.C.C. § 1-208. With respect to this holding,
the Sixth Circuit's interpretation of New York law in K.M.C. conflicts with the New York
Court of Appeals' interpretation in Murphy v. Am. Home Prod. Corp., and has been widely
criticized for overlooking the Comment to U.C.C. § 1-208. The comment unequivocally
indicates that § 1-208 has no application to demand instruments. Accordingly, the courts
applying New York law have declined to follow K.M.C. to the extent that the obligation of
good faith performance enunciated there would imply an obligation of good faith upon a
lender inconsistent with the express terms of a contractual relationship with a borrower.

Despite the expanding application of the good faith obligation to the lending area, some
courts have rejected altogether any debtor's contention that the exercise by creditors of
any contractual right is governed by an obligation of good faith. These courts have
enforced the specific and literal provisions of the contract between the parties,
emphasizing that an implied obligation of good faith and fair dealing will not override
the express terms of a contract.

For example, the court refused to apply a good faith standard in Spencer v. Chase
Manhattan Bank. Spencer executed notes held by Chase, where Spencer also had two accounts.
After three years, Chase informed Spencer that it wished to terminate their relationship.
Subsequently, Chase set off the balance of Spencer's accounts against Spencer's debt and
Spencer alleged that no demand for payment was made before this setoff occurred.
Generally, demand notes are considered due and payable immediately upon their execution
with or without a prior demand. There was evidence that a formal demand was required
before setoff could have occurred. While demand notes ordinarily do not require a formal
demand, the court found that in this case it appeared the parties intended that such a
demand was required as the notes listed various contingencies for rendering them due and
payable. The court stated:

Where the terms and conditions of a so-called demand note indicate that the parties
intended the obligations to become due and payable upon the happening of a future event,
the debt is not mature upon execution of the note. The obligation matures only when the
agreed-upon even occurs. Until then, a bank may not set off its depositor's account to
satisfy the debt.

Although the court agreed with Spencer that demand for payment was a prerequisite to a
proper setoff in this case, it disagreed with the contention that the good faith
obligations imposed by the U.C.C. prohibited Chase from acting in an arbitrary and
capricious manner in requiring payment of the notes. The court reasoned that:

The holder of a demand note does not need a good faith reason or any reason at all to
demand payment. Demand instruments are specifically exempted from the good faith
obligation applicable to accelerated clauses under U.C.C. § 1-208. As the Comment to that
section states, "Obviously, this section has no application to demand instruments or
obligations whose very nature permit call at any time with or without reason."

The court said K.M.C. was not persuasive authority for imposing a good faith obligation on
Chase's right to demand repayment whenever it chose to do so. In K.M.C. the court premised
applying the obligation of good faith to a lender's right to demand repayment of a debt
evidenced by a demand instrument on U.C.C. § 1-208 which imposes a good faith obligation
on a lender's exercise of an option to accelerate a debt at will. The K.M.C. court
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