United States: Finding The Unicorn In Lender Liability Litigation

Last Updated: October 12 2017
Article by Gerald L. Blanchard

Investors frequently talk in terms of trying to find the next unicorn, that small start-up company that is going to turn into a billion dollar valuation.  Lawyers are like that as well, always looking for that new decision where a court opens a crack in the door of some long held legal theory. Something like this occurred in the 1980's when the courts in California held that a party could bring a tort action for the breach of the obligation of good faith. The courts were expanding a doctrine that then existed only in the area of insurance contracts. The expansion of this theory to noninsurance contracts generated universal criticism by other courts and scholars across the US and after a ten year experiment the California Supreme Court reversed its earlier decision for the following reasons: (1) the different objectives underlying the remedies for tort or contract breach, (2) the importance of predictability in assuring commercial stability in contractual dealings, (3) the potential for converting every contract breach into a tort, with accompanying punitive damage recovery, and (4) the preference for legislative action in affording appropriate remedies. [See: Blanchard, Lender Liability: Law, Practice and Prevention, Chapter 4, Bad Faith Tort Claims]

When a party enters into a loan agreement or a promissory note, one understands what the consequences of a breach might be. If a lender is found to have improperly failed to fund under a line of credit it knows that it may have to pay compensatory damages to the borrower. Likewise, guarantors understand that if the borrower fails to pay the underlying obligation the guarantor must step in and pay the obligation.  Our commercial banking industry is built on this understanding that parties will need to put the nonbreaching party into as good of condition as they would have been if there had been no breach. Damages for breach are therefore predictable.

The unicorn for borrowers counsel today is to tag a lender with punitive damages. This has traditionally been a difficult endeavor. Courts almost uniformly dismiss breach of fiduciary duty claims because absent some unusual set of facts, the normal lender/borrower relationship is not a fiduciary one. Lenders owe no special duty to borrowers or guarantors to advise them on whether a particular business transaction for which the borrower is obtaining funds is a "good" one or not. Fraud claims are a bit easier for a borrower to keep from being dismissed but such claims are subject to heightened pleading standards and require specificity in making the claim, a general claim of "fraud" without more will be dismissed.

The recent decision in PNC Bank, N.A. v. Star Group Communications, Inc., Linda-Rosanio-Talamo and Jannaro Talamo, 2017 WL 3638763 (D NJ August 24, 2017) offers debtors counsel the hope that a unicorn has finally arrived in the lender liability context. The case arose from a $10 million loan made by PNC Bank to Star Group Communications, Inc., and guaranteed by the Talamos. The company's financial condition deteriorated after the recession and the Talamos, after investing $3 million of their savings in the company, sought outside investors in late 2014. In early 2015 the banking relationship was moved to the Bank's workout group. The company eventually closed its doors and the Bank sued to enforce the note and the guarantees. The borrower and guarantors raised eight different counterclaims based on the theory that the Bank "acting irrationally and capriciously, ... seized control of the accounts, the personnel, and the operations of Star, and interfered with any and all attempts of Star and the Individual Defendants to obtain financing or to consummate transactions that would have recapitalized Star and paid off the Bank."

The borrower/guarantors raised the following defenses:

Count 1–Rescission; the guarantees that the Talamos executed were not supported by consideration and were procured by fraud and/or economic duress

Count 2–Fraud; intentional misrepresentation, specifically:

  • failing to disclose to the Individual Defendants that the Bank believed the line of credit [extended to Star] was excessive;
  • failing to advise the Individual Defendants that they should not utilize the full extent of the line of credit extended by the Bank [to Star];
  • representing that the Individual Defendants should avoid raising capital [for Star] through equity grants, and [Star] would be better off continuing bank debt that the Bank believed was excessive in amount;
  • inducing Individual Defendants to enter into guarantees (for amounts which it surreptitiously raised) and releases that were solely to the benefit of the Bank;
  • representing that the Bank would support a [Star] transaction with Peachtree/SMC when, in fact, the Bank had no intention of consummating such a transaction; and
  • representing that the Bank would take a reduced payoff and support a [Star] transaction with Allied when, in fact, the Bank had no intention of consummating such a transaction.

Count 3–New Jersey Consumer Fraud Act based on the same alleged misrepresentations as the common law fraud claim

Count 4–Negligent misrepresentation based on the same alleged misrepresentations as the common law fraud claim

Count 5–breach of fiduciary duty based on the same alleged misrepresentations as the common law fraud claim and additionally

  • interfering with the operations of the Individual Defendants and their business;
  • failing to honor checks and otherwise interfering with the reputation of the Individual Defendants in the business community that they served;
  • interfering with [Star's] transaction with Peachtree/SMC; and
  • interfering with [Star's] transaction with Allied.

Count 6–Breach of Good Faith and Fair Dealing based on the same alleged breaches as the breach of fiduciary duty claim

Count 7–Tortious interference with contract and/or business opportunity: "[t]he Bank interfered with [Star's] transactions with Peachtree/SMC and Allied."

Count 8–Negligence based on the same alleged wrongs as the breach of fiduciary duty claim

In reviewing the Bank's motions to dismiss the claims, the first issue that the court focused on was who actually held a particular claim. The basic rule of law is that shareholders and officers do not have standing to assert claims alleging wrongs to their corporation. For example, the tortious interference count alleges that the Bank interfered with contemplated contracts and business opportunities that were Star's, not the Talamos'. Thus, Count 7 is barred by the derivative injury rule. Likewise, to the extent Counts 5, 6 and 8 are predicated on the same alleged interferences—such claims are also barred. On the other hand, claims based on allegations that PNC fraudulently induced the Talamos themselves to sign personal guarantees are clearly not barred by the derivative injury rule.

Count 3 based on the NJ Consumer Fraud Act, was dismissed because the loan transaction in question was a commercial one. The court also found that Count 5, the breach of fiduciary duty claim, failed as a matter of law because as a general rule a lender owes no fiduciary duty to either a borrower or a guarantor.

The two remaining counts arose out of fraud and negligence. Significantly for both parties, these are tort claims that can give rise to punitive damages. Regarding the fraud claim the court found that the Talamos had separately identified six alleged misrepresentations or omissions that supported their fraud claims (see Count 2), and they had sufficiently pled facts placing those alleged misrepresentations and omissions in context. The fraud claim would thus not be dismissed. Regarding the negligence claim the Bank argued that it simply owed no duty to the Talamos outside of what was contained in the loan documents themselves. The court, citing cases that have nothing to do with loan transactions, found that a duty of reasonable care existed and refused to dismiss the negligence claim.

While the case has a long way to go and the negligence claim might still be defeated on a motion for summary judgment at a later date, the court has truly opened a Pandora's box. Allowing the potential for punitive damages in a typical commercial loan transaction creates unknown potential legal liability for lenders of all types. When compared with the vast number of cases that have addressed this issue and come to a contrary conclusion, the court's decision should be treated as an aberration. A more reasoned analysis of the issues should lead other courts to conclude that the borrower/lender relationship is not one that should create the type of duty necessary to authorize the imposition of punitive damages for a simple breach of contract.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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