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ARTICLE

When an Arm’s Length Isn’t Long Enough

Chris Hamborsky and Carlos Rendon

Summary

  • Recent developments raise the possibility of additional liability for commercial lenders, including the risk of an implied fiduciary duty.
  • Given the ubiquity of nontraditional commercial lending and the recent uptick in private credit funds, practitioners need to arm themselves with the right information to navigate these murky waters.
  • This article aims to raise awareness of developing variants of lender liability and outline some do’s and don’ts so you can guard against it.
When an Arm’s Length Isn’t Long Enough
Alexander Vorotyntsev via Getty Images

Consider the following questions: Does a debt or equity investor typically owe a fiduciary duty to other shareholders or to the entity itself? Is a debt investor liable for anything beyond breach of contract and running afoul of a smattering of commercial lending laws? If you answered no, you’d be correct . . . in most cases. However, recent developments raise the possibility of additional liability for commercial lenders, including the risk of an implied fiduciary duty. Given the ubiquity of nontraditional commercial lending and the recent uptick in private credit funds, practitioners need to arm themselves with the right information to navigate these murky waters. This article aims to raise awareness of developing variants of lender liability and outline some do’s and don’ts so you can guard against it.

Private Credit Funds Continue to Attract Investors

Commercial lending has undergone a transformation over the past few years as borrowers look for more options in accessing capital. In addition to traditional bank lenders, borrowers are finding that private credit funds are a viable alternative, and a steady stream of investors continues to invest in credit funds for greater diversification and return on investment. According to an article from the Brookings Institution, since the 2008 financial crisis, private credit has grown from $375 billion in assets under management to $1.6 trillion in March 2023 and is expected to grow to over $3.5 trillion by 2028.

Considering the influx of new participants in the commercial lending business, now more than ever, it is imperative that lenders, at all times, conduct themselves as creditors. Once dissatisfied lenders begin to involve themselves in management, direct borrowers on how to handle their business operations, or dictate which suppliers should be paid, courts may find lenders are exerting excessive control, sufficient to give rise to an implied fiduciary relationship where one would traditionally not exist. And even if a fiduciary relationship is not implied, lender liability may still arise.

Now, let’s turn to key cases in Delaware, New York, and Texas to better understand the contours of lender liability.

With Great Control Comes Great(er) Liability

Traditionally, a loan is an arm’s-length transaction that would preclude the lender from being a fiduciary. River Glen Assocs., Ltd. v. Merrill Lynch Credit Corp., 295 A.D.2d 274, 275, 743 N.Y.S.2d 870, 871 (N.Y. App. Div. 2022) (holding that an arm’s-length borrower-lender relationship is not of a confidential or fiduciary nature). Likewise, shareholders generally do not owe such duty to each other or to the entity in which they have invested. Yet, a 2020 decision from Delaware’s Court of Chancery, Skye Mineral Investors, LLC v. DXS Capital (U.S.) Ltd., 2020 WL 881544 (Del. Ch. 2020), indicated that an investor with only a minority stake can be a fiduciary if it possesses sufficient control.

Skye Mineral arose out of a dispute between members of a Delaware limited liability company (LLC), Skye Mineral Partners (SMP). SMP’s majority members alleged that certain minority members, DXS and PacNet, drew up a scheme to divest SMP of its sole asset, a wholly owned subsidiary, CS Mining, LLC (CSM), by pushing it into bankruptcy, then buying its assets at auction for a bargain. Id. at *1. Despite their position as the minority, they were granted certain blocking rights in SMP’s constitutive documents (referred to as the “SMP Agreement”). It was the use of those blocking rights that empowered DXS and PacNet to cause and then exploit CSM’s bankruptcy.

Notably, within the SMP Agreement, certain actions required the approval of 75 percent of Class A shares. Without that approval, SMP could not (1) grant or pledge a security interest, lien, or encumbrance; (2) issue units of any class to an existing member or new member; or (3) enter into a merger or sale of substantially all the company’s assets. Id. at *4. Together, DXS and PacNet owned 27.07 percent of Class A shares, giving them the ability to prevent any of these actions. In addition to this, DXS negotiated certain negative control rights by which DXS could prevent SMP from approving an annual budget or taking on new material debts without DXS’s approval. As if that was not enough, DXS also had “Observer Rights” whereby it could appoint someone to attend all SMP board meetings in a nonvoting capacity.

Later, when SMP’s sole subsidiary, CSM, was at risk of defaulting on a large loan, DXS and PacNet used their blocking rights to prevent SMP from raising capital. And again, when constituents of SMP attempted to make a $5 million equity investment, DXS and PacNet blocked it, as they had the power to prevent issuance of stock.

The plaintiffs asserted claims for direct and derivative breach of fiduciary duty, among others, against DXS and PacNet. The court framed the issue as follows:

Because Delaware law recognizes the primacy of contract when addressing governance issues in the alternative entity space, the plaintiffs may not saddle [DXS and PacNet] with common law fiduciary duties if doing so would contradict the SMP Agreement’s plain language. On the other hand, if the SMP Agreement does not unambiguously disavow common law fiduciary duties, I must look to corporate law principles by analogy when determining whether and to what extent fiduciary duties are involved.

Id. at *25.

In reviewing the SMP Agreement, the court concluded that if the drafters wanted to exempt members from the fiduciary duty of loyalty, they would have only been able to do so with “express disclaimer language, not ‘by implication.’” However, the analysis did not end at contract language.

The court moved on to consider whether the DXS and PacNet so qualified as member fiduciaries. In general, stockholders (like DXS and PacNet) owe no fiduciary duty to other stockholders per Delaware law, but they may owe such a duty if they are deemed a “controlling stockholder.” A controlling stockholder is one who either (1) owns more than 50 percent of the company’s voting power or (2) “owns less than 50% of the voting power of the corporation but exercises control over the business affairs of the corporation.” Id. at *26. Declining to mince words with respect to the defendants’ degree of control, the court wrote that “the Blocking Rights amounted to a self-destruct button which allowed DXS and PacNet to wield control by driving SMP into the ground if it suited their interests.” Id.

Notably, the Skye Mineral court drew from Basho Technologies Holdco B, LLC v. Georgetown Basho Investors, LLC, 2018 WL 3326693 (Del. Ch. 2018), for the proposition that a blocking right standing alone is unlikely to support a reasonable inference of control. Skye, 2020 WL 3326693, at *27. In that case, the court found a minority stockholder owed fiduciary duties when it used its contractual rights to cut off the company’s access to other sources of financing, forcing the distressed entity to accept financing from the minority stockholder. Basho Technologies Holdco B, 2018 WL 3326693, at *35.

Takeaway: Know your blocking rights and use them judiciously. It’s not the existence of a blocking right per se, but rather, its function and use that may give rise to implied fiduciary duties.

The power to “block all of SMP’s efforts to finance any of its ongoing operations—with either debt or equity” is what got DXS and PacNet in trouble. Skye, 2020 WL 881544, at *27 (Del. Ch. 2020). As the court held, “[w]hen blocking rights empower a minority investor to channel the corporation into a particular outcome, they contribute to an inference of control.” Id.

Quantity Has a Quality of Its Own

While the Skye Mineral court held that control is the operative factor when determining whether an implied fiduciary duty attaches, another decision held that the cumulative effect of control mechanisms can get lenders in trouble, too.

In re PNB Holding Co. Shareholders Litigation, No. CIV.A. 28-N, 2006 WL 2403999 (Del. Ch. Aug. 18, 2006), arose out of a merger of PNB Holding that resulted in PNB reclassifying itself as a subchapter S corporation. The resulting entity would be limited to no more than 75 stockholders, down from over 300, which were to include directors of the company and their family members, dubbed the “golden circle,” who owned 59.5 percent of the stock. Id. at *1.

Following the merger, two classes of shareholders sought recovery. First, the plaintiffs asserted that the transaction should be characterized as a “squeeze-out merger” proposed by a controlling stockholder. The court disagreed, noting that the golden circle was not a monolith and therefore not bound to vote similarly, and no single director held more than 10.6 percent of voting shares. Id. at *9–10.

Second, the plaintiffs argued that, given the formidable voting power of the defendant stockholders, they were “no differently situated than if they had majority control” such that the law imposed on them a fiduciary duty. Id. at *9. The court emphasized that this is a difficult standard to meet and that there is “no absolute percentage of voting power that is required in order for there to be a finding that a controlling stockholder exists.” Id. Ultimately, the court rejected that argument as well, distinguishing In re Cysive, 836 A.2d 531, 535 (Del. Ch. 2003), in which this exacting standard for sufficient control was met. There, a challenged merger had been proposed by the chairman and chief executive officer, who held 35 percent of outstanding shares and wielded significant influence over another corporate director who held 1 percent with the option to buy an additional 4 percent and who had family members who owned a few additional percentages of shares. Id. This constellation of factors gave this individual “managerial dominance” and “practical blocking power . . . over other transactions.” Id.

Although the PNB Holdings court found that the defendants in that case had, as a practical matter, far less control than the defendants in Cysive, the PNB Holdings court nonetheless found that the merger was subject to entire fairness review—the reason being that there was no cleansing device “such as approval by a special committee of independent directors or an informed majority-of-the-minority vote,” which might have redressed a clear conflict of interest. Id. at *1. Ultimately, the court found that the merger was financially unfair to those plaintiffs who had not objected to the merger or gone through the appraisal process as the defendants “employed no effective mechanism to protect the chased-out stockholders’ interests.” PNB Holding, 2006 WL 2403999, at *22. See also New Enter. Assocs. 14, L.P. v. Rich, 292 A.3d 112 (Del. Ch. 2023) (minority equity investor possessed blocking rights and controlled one-third of the company’s voting power through preferred stock and could appoint two of five directors and influence selection of third, giving mathematical control of the board).

Takeaway: Beware of “stacking” more controls than necessary. The stacking of control mechanisms such as significant share ownership, substantial influence over corporate officers and directors, and practical blocking power, have led courts to impose fiduciary duties on lenders. As a result, in drafting such agreements, counsel should examine closely which levers of control a client actually needs, rather trying to get every possible aspect of control.

Courts in New York and Texas Have Reached Similar Conclusions

Delaware courts are not the only ones raising the specter of surprise fiduciary liability. New York courts have laid out a similar control analysis, and Texas courts have developed comparable law, focusing their analysis on the degree of control possessed by the lender. E.g., In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 211 (5th Cir. 2018) (“A minority shareholder exercises ‘actual control’ only when it has ‘such formidable voting and managerial power that [it], as a practical matter, [is] no differently situated than if [it] had majority voting control.’”); Roswell Capital Partners LLC v. Alt. Const. Techs., 638 F. Supp. 2d 360 (S.D.N.Y. 2009) (holding that New York law requires present control by a lender over a borrower to support an inference of a fiduciary relationship).These developments should put lenders on notice that they may have to contend with additional obligations and potential liability.

In Roswell Capital Partners LLC v. Alternative Construction Technologies, 638 F. Supp. 2d 360 (S.D.N.Y. 2009), the U.S. District Court for the Southern District of New York, applying New York law, alluded to the possibility of an implied fiduciary duty for lenders. There, the plaintiffs brought an action to foreclose on their security interests in the collateral of Alternative Construction Technologies, Inc. (ACT) and for breach of various loan agreements created in connection with rounds of funding provided to ACT (where the plaintiffs would provide funds in exchange for convertible notes and warrants to purchase ACT common stock). Id. at 362.

In response, ACT asserted breach of fiduciary duty as an affirmative defense. ACT argued (1) that the plaintiffs, through their acquisition of ACT shares, were fiduciaries and (2) that the plaintiffs had ultimately been more interested in profiting from their role as stockholders than in serving as mere lenders. Id. at 368.

The court recited the general rule that a borrower-lender relationship is not of a confidential or fiduciary nature. But, the court continued, “[a] lender-borrower relationship may give rise to fiduciary duty under New York law where there exists ‘a confidence reposed which invests the person trusted with an advantage in treating with the person so confiding, or an assumption of control and responsibility.’” Id. at 368–69.

However, on the facts before it, the court held that Roswell did not owe fiduciary duties, despite possessing several indices of control. Roswell had ownership shares, power to appoint two members to the ACT board, and powers under a novel funding provision, which empowered Roswell to invest additional funds for a specified time or, if waived, permit ACT to seek outside funding. Id. at 365–66. Notably, Roswell used this provision as leverage when ACT needed funding, agreeing to waive its exercise and, in exchange, receive 2,000,000 warrants to purchase ACT stock, which hampered ACT’s ability to secure outside funding on at least one occasion.

But the court concluded that while Roswell’s funding provision came close to suggesting control, ACT did not have sufficient evidence to establish that Roswell was controlling the conduct of ACT’s business. Instead, the court concluded only that the plaintiffs were merely exercising their rights as creditors. And looking ahead, the court noted its weariness of “dramatically expand[ing] the doctrine of investors’ fiduciary liability to every transaction where some payment occurred in the form of stock.” Id. at 369.

Takeaway: In New York, it is unlikely, though not impossible, to be a lender-fiduciary. At least in New York, courts may be hesitant to upset the traditional no-fiduciary rule. The fact pattern in Roswell likely would merit a finding of a fiduciary duty under the precedent in Delaware. So jurisdiction and the entity’s state of formation could prove to be critical.

Like New York courts, Texas courts have held that there is generally no fiduciary duty between lenders and borrowers. But at least one court has indicated that Texas law may recognize fiduciary liability for lenders who possess sufficient control over the borrower. That issue arose in Salek v. SunTrust Mortgage, Inc., 2018 WL 3756887 (S.D. Tex. 2018), though the case involved an insurer, not a lender, holding on to insurance proceeds on behalf of the insured pending an audit. A dispute arose, and the plaintiff asserted, among other things, a claim for breach of fiduciary duty.

In the rejecting the plaintiff’s fiduciary argument, the court reasoned that “when a special relationship between a borrower and lender has been found, it has rested on extraneous facts and conduct, such as excessive lender control over, or influence in, the borrower’s business activities.” Salek, 2018 WL 3756887, at *4 (citing Mattar v. BBVA Compass Bank, NA, 2018 WL 2440382, at *7 (Tex. App. Corpus Christi 2018), and Davis v. West, 317 S.W.3d 301, 312 (Tex. App. Houston (1st Dist.) 2009)). Yet, “a lender’s conduct that is ‘merely consistent with protecting [its] interest in the property securing the loan,’ does not constitute the ‘extraordinary circumstance’ of excessive control justifying the imposition of a special relationship.” Id.

Takeaway: In Texas, it is unlikely, though not impossible, to be a lender-fiduciary. Similar to a New York court, a Texas court may very well adopt a Delaware-esque approach and impose a fiduciary relationship where one would not traditionally exist. But doing so would disrupt well-settled legal doctrine and introduce a new form of widespread and ill-defined liability. Case law in Texas strongly suggests a reluctance to do so.

Conclusion

There are three points that can be gleaned from these cases.

First, how control mechanisms are used may be more important than their substance. Control is a fact-intensive analysis. Courts look beyond mere contractual language and examine the exercise of creditors’ rights and the relationship between borrowers and lenders. So the analysis does not stop at what the contract says; what the lender does with its contractual rights is equally, or perhaps more, important.

Second, counsel and their clients should beware of stacking and should establish no more control than reasonably necessary to protect the investment. Fortunately, this does not mean that a client cannot exercise any control. There are several permissible ways to safeguard an investment, including strengthening covenants such as financial ratios, financial reporting requirements, limiting restricted payments, and budgeting. Further, lenders may disclaim any fiduciary obligation in the loan documents, which must be stated in clear and unambiguous terms, be supported by consideration, and not be the product of fraud, duress, coercion, or mutual mistake. Specific disclaimer requirements vary by jurisdiction and may be closely scrutinized by a reviewing court. So be sure to avoid form agreements and fully understand any state’s specific requirements.

Third, though Texas and New York may be more reluctant to find implied fiduciary duties, decisions there have indicated that courts will look for evidence of sufficient control, which, if found, may enable the court to find Delaware-like implied obligations.

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