Home » Lender Liability and the Duty of Good Faith

Lender Liability and the Duty of Good Faith

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 note. 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.

The central provision of the U. C. C. 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.

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.

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.

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