Mitigate Risks of Lender Liability Claims When Reworking Troubled CRE Loans

I recently had the opportunity to present during a Strafford CLE webinar on strategies for mitigating the risks of lender liability claims when reworking troubled commercial real estate loans. A central theme throughout the webinar was that the risk of lender liability claims remains top-of-mind for stakeholders. Given the increasing challenges in today’s market, below are key takeaways for lenders to consider to minimize the risk of liability claims as they navigate solutions around troubled CRE loans.

How It Started, How It’s Going:

As widely reported, the COVID-19 pandemic led to a rise in remote and hybrid work, increasing vacancy rates, and decreasing property values. Rising interest rates and inflated operating and maintenance costs have made properties more expensive to maintain, further depressing values and making financing and refinancing extremely difficult. Difficulties in maintaining existing tenants, and finding replacement ones, further deflate value. Lenders face increased numbers of troubled commercial mortgage loans and spend more time on workouts, short sales, deeds-in-lieu, and foreclosures and other enforcement remedies. It is in these situations that lenders are most vulnerable to facing lender liability claims from borrowers and third parties.

A good first step is to get ahead of problems:

• Avoid being surprised by a default.
• Monitor property performance, market conditions, and borrower/guarantor reporting closely.
• Be prepared for discussions about a possible modification or restructure before loan maturity and before an actual default occurs.
• Watch out for trouble signs: nonpayment or late payment; construction problems; lease-up and selling problems; illiquidity in the refinance market; tightening in underwriting standards; and rising interest rates.

Going forward, avoid building a counterproductive record and taking positions that create lender liability risk:

Keep records as factual as possible.

Do not send emails, text messages, or other communications to the borrower, internal colleagues, or others containing derogatory or confrontational comments or threats—these could become evidence in a future legal action that could taint the lender’s legal position.

Make efforts to include two lender representatives on calls or in meetings with the borrower/guarantor, to enhance the credibility of future testimony.

Avoid taking inconsistent positions and precipitous actions—provide reasonable notice before changing positions.

Exercise approval rights consistently with status as a lender, and take into account applicable standards in the loan documents for the granting or withholding of approvals.

Understand “lender liability”: It is not a legal cause of action as such; rather, it is a phrase used to describe claims that a lender is liable to its borrower or to other parties involved in a lending transaction or affected by the lender’s actions. Typical claims falling under the “lender liability” rubric include the following:

Lender “control” of the borrower or its employees:

Loan documents often contain provisions giving the lender certain control rights as to the borrower upon default. In the lender liability context, this can bring to mind the saying “Be careful what you wish for.” Lenders have been sued by borrowers or their employees on the theory of control in various situations. In Bailey Tool & Mfg. Co. v. Republic Bus. Credit, 2021 WL 6101847 (Bankr. N.D. Tex. 2021), a bankruptcy court found the lender exercised excessive control over the borrower, held the lender liable for causing the borrower company’s failure, and awarded substantial compensatory, lost profits, and punitive damages against the lender. And while, as a general proposition, the relationship of lender and borrower does not create a fiduciary duty on the part of the lender, some courts have found that a lender can become a fiduciary by exercising excessive control over its borrower’s business or by fostering a relation of dependence on the lender’s business advice to the borrower.

Breach of the loan documents:

Loan documents are contracts that may be breached by either party. Typically, in the lender liability context, these are claims by a borrower that the lender has failed to make an advance (or part of one), has failed properly to credit a payment, or has taken steps after failing to give notice of such steps required by the loan documentation.

Oral modifications or waivers, or “course of conduct”:

These may be the most common form of lender liability claims and are in theory available notwithstanding language in the loan documents requiring that all modifications etc. be made in writing. The borrower typically argues that it changed its position in reliance on the lender’s statements or course of conduct, giving rise to promissory or equitable estoppel.

Breach of the implied covenant of good faith and fair dealing:

The availability of this doctrine and its specific meaning varies across jurisdictions. A recent decision in New York’s Commercial Division shows that the doctrine still presents risk for lenders. Newage Garden Grove, LLC v. Wells Fargo Bank, N.A., 2024 WL 1052886 (Sup. N.Y. March 11, 2024) (sustaining claim for money damages by borrower against lender for alleged breach of the implied covenant of good faith and fair dealing).

If a difficult situation with a borrower is approaching, consider a pre-negotiation agreement (PNA) with the borrower. PNAs serve as frameworks for discussions between borrowers and lenders in workout situations. These agreements set expectations, ensure confidentiality, and help avoid misunderstandings, clarifying that the parties are not yet committing to any binding modification. The PNA can help reduce lender liability risk.

If you are interested in downloading the Strafford CLE webinar to hear more about this topic, click here.