Initial Loan Negotiation
To some extent, the basic problem starts at the beginning of the lender-borrower relationship: during the initial negotiations, on signing a preliminary letter of intent or when a loan commitment is issued. At this stage, the lender and borrower have competing goals. The lender is motivated to have the borrower committed to the lender. The lender wants the borrower emotionally committed (if not yet financially committed) so as to forego pursuing other lenders. Not having completed its due diligence on the borrower or the property, however, the lender does not want to be irrevocably committed to making the loan. Until the loan closing, the lender wants to preserve maximum flexibility to build in new terms and conditions to the closing and in the loan documents.
The borrower's two goals during the early phase of the lending process are to qualify for a loan and lock in an interest rate as quickly as possible. In most cases, at this stage, the borrower has a limited amount of time to negotiate the fine points. Frequently the borrower does not retain a lawyer before signing a letter of intent or accepting a loan commitment.
The lender often prepares the loan documents when neither it nor the borrower has carefully considered all of the leasing issues that may be germane to the project. This flawed process is rather surprising because the leases are of paramount importance to both the borrower and the lender. The principal-if not exclusive-value of the property to the borrower is the income stream that the leases generate. Correspondingly, a lender often bases its credit underwriting decisions chiefly on the quality of the tenants, the rental amounts, the duration of the leases and the other lease terms and conditions. Even though lenders often say that they "loan to people, not to property," the creditworthiness of the tenants and the terms and conditions of the leases are often more important than the borrower's creditworthiness. This premise is particularly true when the loan will be nonrecourse to the borrower.
A body of modern law has been developing over the past few decades that has dismantled a lender's historical insulation from liability for its involvement with a borrower's affairs or the loan collateral. Although most reported lender liability cases do not involve leasing, the legal theories that a borrower/plaintiff may put forward in a lender liability case involving leasing will likely be no different from those in any other lender liability case.
Lender Liability in the Leasing Process
A plaintiff bringing a lender liability claim arising out of the leasing process will allege that the lender somehow improperly exercised or abused its discretion or exercised creditor control over the borrower's business. Improper lender discretion or improper control over the leasing process can occur either before or after the loan closing. Before the loan closing, a lender may want the right to exercise its discretion, if not control, over certain aspects of the leasing process and the existing leases. For example, the lender may want to approve or disapprove the creditworthiness of existing tenants and the terms and conditions of the existing leases and obtain acceptable estoppel certificates and subordination, nondisturbance and attornment agreements (SNDAs) from the existing tenants. After the loan closing, a lender may want to retain some degree of discretion or control over the leasing process. For example, the lender may want the right to approve future leases-sometimes even going so far as to set up specific parameters for future tenants and lease terms. In some instances, these parameters can be extraordinarily specific and restrictive.
Kinds of Leasing Issues
The kinds of leasing issues that can result in lender liability fit into four very general categories.
- Approval of existing leases. When a loan commitment is issued or when a lender and borrower execute a letter of intent, the borrower often believes that the lender has approved the existing leases. Nevertheless, the loan commitment or letter of intent typically preserves the lender's right to approve all lease terms and conditions. Although a loan commitment might identify minimum requirements for rents, duration of the lease terms and perhaps the creditworthiness of major tenants, the lender usually reserves the right to review all terms and conditions of all of the leases. The rent and other matters may meet the minimum requirements of the lender, but a host of provisions may be unacceptable to the lender. These may include the following:
- The tenant has the right to terminate the lease early with-or sometimes without-payment of a fee to the landlord.
- The tenant has an option to purchase the property.
- The tenant has the right of first refusal to purchase the property.
- The tenant has the right to make repairs and offset the cost of them against rent. (Lenders usually oppose any tenant offset rights.)
- The damage, destruction or condemnation provisions in the leases are contrary to the lender requirements for the use of insurance proceeds and condemnation awards.
- A single tenant leases an excessively large percentage of the property.
- The landlord has outstanding obligations to fund tenant improvements or the tenant is entitled to a rent-free period or other monetary concessions.
Some of these issues can be resolved by means of an acceptable SNDA, but the borrower is sometimes stunned by what it views as the lender's extraordinary conservatism and unreasonableness, if not outright onerousness and irrationality. In these situations, the borrower feels that it has been misled by the lender because the borrower had assumed (perhaps based on prior discussions with the loan officer) that there would be no lease issues for the lender to approve or disapprove, as long as the leases verified a certain income level for the property, were of sufficient duration and were with creditworthy tenants.
If tenants ultimately refuse to subordinate certain of their lease rights to the lender's lien to satisfy the lender's objections, the borrower will not be able to close the loan. In the case of a refinance, the borrower may not have sufficient time to get a new lender in place to pay off the existing financing before it comes due. In the case of a purchase and sale transaction, the borrower/buyer may not have sufficient time to arrange for new financing. If the purchase contract does not include a financing contingency, the borrower could face a breach of contract claim by the seller. In either case, the borrower is in a very tight spot and may threaten a lender liability claim.
- Estoppel certificates. Most lenders require that all commercial tenants, or at least the more important ones, deliver an estoppel certificate as a condition to a loan. Although estoppel certificates are often somewhat routine in nature and merely require the tenant to confirm such noncontroversial matters as the existence of the lease, the duration of the term and the rent, some lenders require a form of estoppel that effectively modifies the lease, imposes new obligations on the tenant or results in the relinquishment of certain tenant rights. Sometimes these additional requirements are controversial. For example, if a lender requires that the tenant agree not to modify the lease without the lender's prior consent, or requires the tenant to give the lender notice of any landlord default, there is no material substantive change in the tenant's rights or obligations. A lender may go further, however, and include in its estoppel certificate unacceptable tenant obligations. A tenant may justifiably object to provisions that modify or relinquish the tenant's existing leasehold rights. If a lender refuses to make the loan because of tenants' unwillingness to agree to those provisions, the borrower may pursue a lender liability claim on the basis that the lender has unreasonably required the leases to be modified as a condition to closing the loan.
- SNDAs. SNDAs can create enormous difficulties for a borrower and carry with them the potential for a lender liability claim. Unless a tenant's lease requires the tenant to sign an SNDA, the borrower is completely at the tenant's mercy. In those situations, the borrower, at a minimum, will have to cajole and may have to bribe the tenant with concessions. Even if a lease requires the tenant to sign an SNDA, there may be no deadline by which the tenant must do so. Moreover, leases frequently require the tenant to sign a "commercially reasonable" SNDA or one "reasonably satisfactory to a lender," or include a similarly vague standard. Finally, the tenant's concept of an SNDA might be simply that, following a foreclosure, the tenant will attorn to the new owner as long as the tenant's leasehold rights remain intact. The lender, of course, has a more expansive view of an SNDA, and this is where the trouble begins.
For example, a tenant might not want insurance proceeds or any condemnation award to be used in a manner that is inconsistent with its lease, yet many lender form SNDAs require those monies to be used to pay down the loan. Alternatively, a lender may condition the landlord's use of these funds in a manner that is inconsistent with the lease terms. A lender often requires a tenant to agree that (vis-à-vis the lender or any purchaser at a foreclosure sale) the tenant will have no offset against rent (which might otherwise be permitted under the lease) and no right against the lender (or other foreclosure purchaser) to a return of the security deposit. The tenant cannot see why it should surrender any rights it may have to offset rent, much less agree that it will lose its security deposit, if the borrower's interest is foreclosed.
A lender's SNDA form will usually provide that the lender has no obligation to pay any tenant improvement allowance or otherwise be bound by any monetary concession that the borrower has granted to the tenant. Again, a tenant cannot see why it must relinquish an economic benefit in its deal just because the landlord fails to pay its mortgage. All of these provisions might be considered "reasonable" by many lenders and their counsel, but they do not seem so to a tenant or, for that matter, many borrowers. If a tenant refuses to agree to such an SNDA, the borrower will not be able to close its loan and might claim lender liability under the theory that the lender's SNDA requirements are unreasonable.
- Communications/negotiations with tenants. Sometimes lenders go beyond merely delivering their forms of estoppel certificate and SNDA to the borrower and actually engage in direct communications or negotiations with a tenant in an effort to resolve lease issues. The borrower is only too anxious to have the lender deal directly with the tenant. After all, if the lender and tenant are satisfied, the borrower is satisfied.
Although there is nothing per se wrong with a lender's direct communication with a tenant, the lender runs the risk that the tenant might later claim that the lender gave inducements or made promises that are outside of the four corners of the lease, the estoppel certificate or the SNDA and that the lender has some unwritten but legally binding obligation to the tenant. Moreover, the borrower might contend that the lender has somehow interfered with the borrower's relationship with its tenant. Therefore, a lender generally should not communicate directly with a tenant and should instead insist that the borrower conduct all negotiations over lease issues. This, of course, is easier said than done. If it is necessary for a lender to communicate directly with a tenant, the lender should make a clear record of what was discussed to show that it has promised nothing beyond any written agreement it may ultimately have with the tenant.
Causes of Action
Although many lawyers have the impression that lender liability claims involve new and creative legal theories, lender liability claims are all based on existing, legally recognized causes of action. Like many other kinds of business litigation, the potential causes of action span a considerable range of legal theories, from the simple (breach of contract) to the more rarefied (prima facie tort).
Breach of Contract
An old-fashioned breach of contract claim is frequently one of the easiest claims for a borrower to frame. A breach of contract claim has the added advantage of being relatively easy for a judge or a jury to understand. Of course, this does not mean that the case is easy to prove. Most lender liability breach of contract cases involve interpreting the terms of a contract, proving that an oral contract exists or proving that the lender waived (or is estopped from enforcing) certain contract requirements.
Good Faith and Fair Dealing
Although much has been written about good faith and fair dealing, it still remains a somewhat complicated and misunderstood legal theory. In some jurisdictions it is considered a tort. In others, it is considered a contract claim. In some jurisdictions it can be either.
The concept of good faith under a contract reaches back as far as Roman times, when a court could order payment ex bona fides, meaning "what was within the requirement of good faith." Section 205 of the Restatement (Second) of Contracts (1981) provides that every contract imposes on each party the obligation of good faith and fair dealing. The UCC also requires a somewhat comparable good faith standard in transactions governed by it. The topic of good faith and fair dealing is extensive, and the following represents an extremely brief sampling of some of the major issues.
- Contract obligation. Language from two cases best summarizes the contract obligation of good faith and fair dealing. In Palisades Properties, Inc. v. Brunetti, 207 A.2d 522, 531 (N.J. 1965), the court cited Williston on Contracts as follows:
[I]n every contract there is an implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract; in other words, in every contract there exists an implied covenant of good faith and fair dealing.
The court also stated that even though the parties to a contract have not expressed an intention in specific language, courts may impose a constructive condition to accomplish such a result when it is apparent that it is necessarily involved in the contractual relationship.
This theme was supported in Van Gemert v. Boeing Co., 553 F.2d 812 (2d Cir. 1997). In that case, the Second Circuit applied the principle that "'in every contract there is an implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract. . . .' Simply stated, every contract contains the implied covenant of good faith and fair dealing." Id. at 815. Accord KMC Co. v. Irving Trust, 757 F.2d 752 (6th Cir. 1985) (finding that lenders are required to deal with their borrowers in good faith, irrespective of the specific terms of the loan documents).
Not all states, however, have ap-plied the contract obligation of good faith and fair dealing in the same manner. For example, in Sunbelt Savings v. Birch, 796 F. Supp. 991 (N.D. Tex. 1993), the court held that the covenant of good faith and fair dealing applies only when a "special relationship" exists between the parties to the contract. That case involved guarantors' liability under a promissory note. The court determined that the guarantors could not assert a claim against the lender for breach of "fiduciary duty" (that is, the covenant of good faith and fair dealing) when they were not deemed to be partners of the borrowers. See also Black Canyon Racquetball v. First National Bank, 804 P.2d 900 (Idaho 1991), which also refers to good faith and fair dealing in terms of a fiduciary duty.
It is important to remember that the concept of good faith and fair dealing under contract arises only if a contract is already in existence. Contrary to the misconceptions of many lawyers, good faith and fair dealing is not the basis for creating a contract that otherwise does not exist.
- UCC standard. To the extent that the UCC applies to a loan transaction, the UCC standard of good faith will apply. UCC § 1-201(19) requires that the parties act with "honesty in fact." UCC § 1-103 provides that "[e]very contract or duty within this code imposes an obligation of good faith in its performance or enforcement." A comment to UCC § 1-203, however, states that good faith only applies to interpreting a contract and does not create a separate duty that can be independently breached.
UCC § 1-102(3) provides that the parties cannot disclaim the good faith performance requirement of the UCC. Thus, at least as far as the UCC is concerned, it would appear that a party's good faith performance cannot be subject to waiver by the other party. See Reid v. Key Bank of Southern Maine, Inc., 821 F.2d 9 (1st Cir. 1987).
- Tort obligation. Many legal analysts believe that the tort aspect of the duty of good faith and fair dealing has its roots in California cases involving insurance companies' bad faith conduct. Because of the inherent inequality in the bargaining position between the insurer and the insured, courts stepped in to protect the insured's rights. This concept of good faith and fair dealing was steadily expanded. For example, in the California case of Schoolcraft v. Ross, 146 Cal. Rptr. 57 (Cal. Ct. App. 1978), a lender was required to allow its borrower to use insurance proceeds to reconstruct the improvements (instead of applying the proceeds to pay down the loan), even though the loan documents provided otherwise.
It is presently unclear how far courts in the various jurisdictions will go in allowing tort-based remedies in commercial cases based on the concept of good faith and fair dealing. Nevertheless, whether the claim of good faith and fair dealing is couched in terms of breach of contract or tort, the only meaningful difference is whether punitive damages will be recoverable. They are generally recoverable only in tort and not in contract.
Waiver and Estoppel
The doctrines of waiver and estoppel are important when considering lender liability arising out of either a basic breach of contract claim or a claim for the breach of the covenant (or duty) of good faith and fair dealing. Waiver constitutes the knowing, intentional relinquishment of a specific right or remedy. Estoppel, on the other hand, precludes one from enforcing rights one did not intend to give up. As a practical matter, this distinction may not be terribly germane. The result is often the same-namely, the lender is prevented from enforcing stated loan document terms. Waiver or estoppel can result over time from a particular course of dealing between a lender and borrower.
Waiver or estoppel in the leasing context often occurs when a lender has the right to approve tenants or leases. Over time, the lender may eventually waive or be estopped from exercising its right to exercise discretion in approving or disapproving tenants or leases. Alternatively, the scope of the lender's discretion may be deemed to be limited. For example, if the lender has consistently refrained from exercising its discretionary rights to approve or disapprove leases, it may have lost the right altogether. Alternatively, if the lender has consistently approved short-term leases (e.g., two year terms), even though the loan documents require minimum five year terms, the lender may have waived or be estopped from enforcing the five year minimum requirement.
The tort of fraudulent misrepresentation can be the basis for a claim of lender liability. This cause of action is really no different from any other fraud claim and involves five elements: (1) a false statement is made; (2) it is made with knowledge of its falsity; (3) there is an intention to induce the other party to act or refrain from acting; (4) the other party acts in justifiable reliance on the misrepresentation; and (5) damages to the other party result. Negligent misrepresentation is essentially the same as fraud, but without the requirement that the plaintiff prove that the defendant acted with knowledge that its statement was false.
Negligence can also be a basis for a borrower's claim against a lender. The success of a negligence cause action hinges on, among other things, the borrower's ability to prove that the lender owed it a duty. This duty might arise out of an obligation of good faith and fair dealing, but there can be other bases for a duty to exist.
Many lender liability claims arise when the lender allegedly exercises control over the borrower's business. This kind of lender liability claim can arise even when the loan documents allow the lender discretion to approve various aspects of the borrower's business. By exercising any degree of control over the borrower's business (including exercising discretion that the loan documents specifically granted to the lender, such as for leasing matters), the lender can subject itself to a borrower's claim that the lender has become a de facto partner or joint venturer of the borrower, that the lender has created a principal-agent relationship (pursuant to which the lender is the principal) or that the lender is the alter ego of the borrower. See, e.g., A. Gay Jenson Farms Co. v. Cargill, Inc., 309 N.W.2d 285 (Minn. 1981). A lender's exercise of its contractual right to approve prospective tenants or certain lease terms might seem a weak basis for a claim that the lender controlled the borrower's leasing program. Nevertheless, a lender's involvement in the leasing process can be a slippery slope that sometimes leads to the lender's dictating which leases will be acceptable and which will not.
A variety of torts involving interference with a contract or a prospective economic advantage exists in most jurisdictions. In its simplest form, the tort of interference with contract constitutes an action against a defendant that has induced a breach of contract by a third party with whom the plaintiff has contracted. Sometimes this tort involves a breach of a contract; sometimes it involves the defendant's merely having interfered with the performance of a contract; and sometimes it involves interference with prospective economic advantage generally. In the lender/borrower context, there would be an allegation that the lender, without justification, interfered with a contract between the borrower and a third party or prevented a prospective advantage for the borrower. Although the elements of this cause of action may differ in various jurisdictions, one required element is proving that the lender's interference was without justification.
The underlying principle is that a party has the right to pursue its contractual relations free from the interference of others. The paradox is that lenders sometimes have specific contractual rights to be involved with third-party contracts. For example, a loan commitment or loan documents may give the lender the right to approve the terms of future leases, to require an acceptable SNDA or to require an acceptable estoppel certificate. Unfortunately, by the very exercise of those rights, the lender can run the risk of a claim of tortious interference. Two hypothetical examples are instructive.
First, assume that a lender has set up leasing requirements in the loan documents for future leases that are not entirely definitive or specific, so that the lender has retained some general discretionary rights to approve or disapprove certain lease terms. If the lender disapproves of a lease that the borrower believes is commercially reasonable or otherwise within the general parameters of the loan documents, the borrower may claim interference with prospective business advantage.
Second, assume that there are very specific leasing parameters in the loan documents. In particular, assume that the lender has required a minimum rent and a minimum duration for each lease. The leasing market has changed, however, since the closing of the loan. Due to market conditions, the borrower simply cannot find tenants to lease space in the building under those terms and conditions. If the borrower previously leased 90% of the space in the building under very long-term leases, each at a rental rate that is much higher than the lender's minimum required rent, would the borrower be justified in claiming that the lender is unreasonable in holding to the strict loan document requirements if the average rents and average lease term for the building were considerably higher and longer than the stated leasing parameters? A lender should not be too cavalier in taking a hard line with a borrower-even when the loan documents permit it to do so. The borrower may be able to paint the lender as somehow having unreasonably "interfered."
Prima Facie Tort
A somewhat complicated tort-based theory is that of prima facie tort. This legal claim is by no means universally recognized, and the elements of proof are somewhat vague. Basically, however, the tort constitutes an act by the defendant made with the intent to cause injury without any, or with insufficient, justification. Although the tort has not met with much success in the lender/borrower context, it could be an emerging area of lender liability. For a case that held a bank liable under the theory of prima facie tort, see Schmitz v. Smentowski, 785 P.2d 726 (N.M. 1990).
Borrower's Damages and Remedies
When considering damages and remedies for lender liability cases, one must first distinguish between a claim sounding in contract and one sounding in tort. If the borrower's claim is essentially a breach of contract claim, the general contract damages rule of foreseeability apply, as initially expressed in Hadley v. Baxendale, 156 Eng. Rep. 145 (Ex. 1854). If a lender improperly fails to approve a lease or otherwise causes the loss of an existing or prospective tenant, the measure of damages would normally be lost rents during the time it takes the borrower to find a new tenant. If the borrower eventually procures a tenant at a lower rental rate, further damages would be the difference between the rental rate of the new tenant and the lost tenant.
Bear in mind, however, that the damage suffered by the borrower might not just be the loss of a prospective tenant. The borrower's damages could be much more substantial if the lender unjustifiably refuses to accept the tenant's estoppel certificate, accede to the tenant's changes to the lender's form SNDA or approve existing leases and then refuses to close the loan. For example, if interest rates subsequently rise and the borrower procures a loan from a different lender at a higher rate, the borrower's damages could, in theory, equal the difference between the two interest rates over the entire life of the loan that the defendant lender was to make. If the borrower is unable to procure a different lender in sufficient time to pay off its existing loan, and the borrower thereby suffers a foreclosure, would the borrower be entitled to recover from the lender the lost equity in the property? If the loan is sought in connection with an attempt to purchase the property, would the lender be liable for the loss of the benefit of the borrower's bargain if the borrower cannot consummate the purchase by reason of the lack of funds? There does not appear to be a great body of lender liability cases addressing these questions; a developer has recovered lost profits in at least one case against a lender. See Landes Construction Co. v. Royal Bank of Canada, 833 F.2d 1365 (9th Cir. 1987).
A borrower might also be entitled to specific performance. It might be able to compel the lender to make the loan. In the context of approving leases, the borrower might be able to obtain a decree of specific performance compelling the lender to approve a lease. As a practical matter, it may not be feasible for a borrower to file a lawsuit and obtain a decree of specific performance in sufficient time to consummate the desired lease. By the time the borrower gets to court and obtains a decree of specific performance, chances are good that the prospective tenant will have gone on to lease other premises. Nevertheless, depending on the time deadlines the borrower is facing to refinance a property or close a purchase transaction, specific performance might be a viable remedy.
If a borrower's claim sounds in tort, there is the possibility to recover punitive damages. This is a most frightening scenario for a lender, because the amount of punitive damages is unlimited and the likelihood of a punitive damage award, especially from a jury, is unpredictable.
Practical Tips for a Lender
Generally, there are two means of avoiding lender liability. The first lies in the loan documentation itself. The less control or discretion the loan documents grant the lender in the leasing process, the less likelihood there is for a lender liability claim. The less involvement a lender has with the borrower or its tenants, the less trouble the lender can get into. To the extent that loan documents require minimum standards for leasing matters, the more definitive those standards are, the less likely there will be a claim that the lender inappropriately abused its discretion.
Sometimes documenting leasing standards early on in the loan process is problematic. A lender is often disinclined to spell them out in the letter of intent or loan commitment. Nevertheless, a lender's paper trail (written record of communications with the borrower) should make it clear that the lender forewarned the borrower- early and often - that the lender would require strict adherence to its leasing standards and its forms of estoppel certificate and SNDA. Indeed, the sooner the lender provides the borrower with its SNDA and estoppel certificate forms and its leasing parameters, the better it is for all parties. Therefore, the better practice is to have these leasing issues negotiated before the issuance of the loan commitment. Unfortunately, that is not the standard practice among most lenders, either private or institutional.
The second and equally important means of avoiding lender liability is for the lender to conduct itself in a reasonable and cooperative fashion. The lender must be vigilant to keep a clear record of its communications with the borrower, demonstrating that the lender responded promptly, courteously, and with commercial justification for its actions. A lender should confirm substantive conversations with the borrower by means of a prompt letter so that there is no misunderstanding of what was said and when it was said.
Many a lender has severely damaged its litigation position by internal memoranda or conversations reflecting its conduct in insensitive, vulgar, rude or gratuitously critical of the borrower. A lender is certainly entitled to be frustrated with a borrower, but the lender's communications should demonstrate a business-like approach to any issue. Hand in hand with the lender's demeanor toward the borrower is, of course, the substantive basis for the lender's action in either approving or disapproving a lease matter or otherwise dealing with the borrower. This documentation may involve procuring reports, information or guidance from appraisers, real estate brokers, lawyers, accountants or other advisors sufficient to justify its conduct. Again, a lender's goal is to demonstrate that it acted in a timely, prudent and commercially reasonable fashion.
To the extent that a lender foregoes enforcing any of its rights or otherwise takes any action that could be construed as a waiver or estoppel of any of the provisions in the loan documents, the lender should make clear that it is taking action or refraining from taking action without the waiver or other loss of any of its rights or remedies.
In certain instances, a lender will have promulgated internal guidelines for various borrower or lease matters. Although these internal guidelines may not be included in the loan documents, it is generally better for the lender to be consistent in following its own guidelines than to make exceptions for a particular borrower.
One final thought about lender liability cases. In a jury trial, a typical juror is probably more inclined to identify with a borrower than a lender.
Potential liability of a lender to its borrower/landlord lurks throughout the life of a loan, beginning with initial loan negotiations, as the lender exercises control over leases. A plaintiff may assert liability under numerous tort and contract theories. Lawyers for lenders should counsel them to document carefully the standards for involvement with leases. Lenders must also use good judgment in exercising discretionary rights over leases.