Case Snapshot

A borrower under a revolving line of credit sued its lender alleging various breach of contract and tort claims. The lender defended itself by relying on numerous releases in its favor provided by the borrower in connection with several forbearance agreements entered into between the parties. The borrower, however, contended that the lender obtained these releases through use of economic duress and, therefore, the releases were void and unenforceable.

Specifically, the borrower claimed that the lender compelled the borrower’s entry into these releases by wrongfully threatening the borrower with, and then taking actions exceeding, the lender’s rights under their agreements. The court dismissed the borrower’s claims, finding that the lender’s actions did not exceed its rights under their agreements and, therefore, did not constitute a “wrongful threat.”

Factual Background

Interpharm, a pharmaceutical manufacturer, entered into a credit agreement with the lender, whereby the lender, Wells Fargo Bank, extended a revolving line of credit to Interpharm secured by its inventory, equipment and accounts receivable. The line of credit allowed Interpharm to borrow up to $22.5 million, depending on the value of its inventory and account receivables. Specifically, the credit agreement provided that the borrowing base would be calculated as the sum of 50% of the value of eligible inventory and 85% of the value of eligible receivables.

The credit agreement, however, allowed the lender to exercise reasonable discretion to alter those percentages or to deem assets ineligible for calculation of the borrowing base. The credit agreement also provided the lender with a range of rights and remedies upon the occurrence of an event of default thereunder, including imposition of the default rate of interest, termination of the line of credit, acceleration of the loan obligations and liquidation of the collateral.

A decline in Interpharm’s revenues led to events of default under the credit agreement. Rather than exercising any of its rights and remedies, the lender agreed to enter into a Forbearance Agreement with Interpharm. The first Forbearance Agreement increased Interpharm’s credit limit by $2 million and imposed additional fees, a higher interest rate and new income and cash-flow requirements on Interpharm. Interpharm alleged that it conveyed its doubt about meeting the new financial requirements to the lender and alleged that the lender “vaguely propos[ed] to negotiate new financial covenants for the first half of 2008 that would provide Interpharm with the relief it needed to succeed.” Thinking it had “little choice” but to agree to these terms, Interpharm signed the first Forbearance Agreement, thereby releasing all claims it might have against the lender arising prior to its execution.

Interpharm’s failure to meet the new financial requirements resulted in additional events of default under the credit agreement. Upon the occurrence of these events of default, the lender imposed the default rate of interest and other penalties. The lender also excluded the receivables of four of Interpharm’s major wholesale customers from the calculation of Interpharm’s borrowing base because of these customers’ practice of charging-back to Interpharm certain price differences. Interpharm countered that such charge-backs were standard industry practice and the lender’s exclusion of these accounts was a pretext for constricting its available credit. Thereafter Interpharm’s financial condition deteriorated so badly that it could no longer pay its suppliers or meet its payroll, and Interpharm informed the lender that it would be forced to liquidate absent additional advances of credit for working capital.

Rather than pursue liquidation, the lender agreed to enter into a second Forbearance Agreement with Interpharm. The second Forbearance Agreement made additional advances of credit available to Interpharm but also specifically excluded receivables from wholesalers from Interpharm’s borrowing base, and required Interpharm to hire a chief restructuring officer. Interpharm signed the second Forbearance Agreement, thereby releasing all claims it might have against the lender arising prior to its execution.

Soon thereafter, the parties entered into a third Forbearance Agreement whereby the lender imposed additional fees, required Interpharm to provide additional collateral and required Interpharm to pursue a refinance or liquidation. Interpharm agreed to release all claims it might have against the lender arising prior to the execution of the third Forbearance Agreement.

Soon thereafter, the lender reduced the percentage of eligible inventory for Interpharm’s borrowing base from 50% to 39.6%, based on an inventory valuation obtained from a third party retained by the lender. In response to Interpharm’s protests that it needed more available credit to continue operating, the lender agreed to a fourth Forbearance Agreement in which the lender agreed to temporarily increase the percentage of eligible inventory for Interpharm’s borrowing base from 39.6% to 49%, while retaining sole discretion to reduce the percentage as it deemed appropriate. Interpharm signed the fourth Forbearance Agreement, thereby releasing all claims it might have against the lender arising prior to its execution.

Unable to secure new financing, a circumstance that Interpharm alleged arose because of the lender’s actions, Interpharm agreed to sell its assets to a third party, but informed the lender that its operations could not survive through closing without additional advances of credit. The lender agreed to enter into a fifth and final Forbearance Agreement, whereby the lender made additional advances of credit available to Interpharm, and Interpharm agreed to release all claims it might have against the lender arising prior to the execution of the fifth and final Forbearance Agreement.

After completing the sale of substantially all of its assets, Interpharm paid its obligations to the lender. Sometime thereafter, Interpharm advised the lender that it was repudiating all of the Forbearance Agreements, which necessarily included the release provisions. Interpharm then filed suit against the lender, alleging breach of contract, breach of the implied duty of good faith and fair dealing, tortious interference with business expectations, unjust enrichment and breach of fiduciary duty. The lender sought dismissal of the suit, citing the release provision in the final Forbearance Agreement. Interpharm opposed the motion, arguing that the release was obtained wrongfully as a result of economic duress.

Court Analysis

The court began its analysis by emphasizing that the doctrine of economic duress is based on the principle that courts will not allow one party to unjustly take advantage of the economic necessities of another and thereby threaten to do unlawful injury. In other words, “a mere demonstration of financial pressure or unequal bargaining power will not, by itself, establish economic duress.” Rather, conduct must be wrongful, (i.e., “outside a party’s legal rights.”)

Therefore, a threat to withhold contractually required performance in order to compel submission to new demands can constitute a wrongful threat, but a threat to exercise legal rights in pursuit of those same demands is not wrongful. In other words, a party cannot be guilty of economic duress by merely exercising its contractual rights or failing to forbear from exercising those rights when it has no legal duty to do so.

The court then found that, once Interpharm defaulted under the credit agreement, the lender could have exercised its rights and remedies under the agreement, including terminating the line of credit, accelerating the loan obligations and liquidating the collateral. In other words, after the default, the lender was under no legal obligation to continue to extend credit to Interpharm or forbear from exercising its rights and remedies. Rather, the lender’s only legal obligation was to act within the confines of those rights and remedies.

The court concluded that the lender had acted within its contractual rights and remedies and, while the lender may have driven a hard bargain for each Forbearance Agreement, it had not acted wrongfully. In the words of the court: “If Interpharm had little choice but to agree to the covenants of the October Forbearance Agreement, it was not because [the lender] was threatening to withhold performance under its contract with Interpharm, but because [the lender] was otherwise unwilling to forbear from its contract right to terminate the line of credit. The former circumstance might evidence a wrongful threat; the latter illustrates only permissible hard bargaining.”

The court specifically addressed three alleged “wrongful acts” of the lender: .1) the imposition of the default rate of interest; 2.) the exclusion of the receivables of four of Interpharm’s major wholesale customers from the calculation of Interpharm’s borrowing base because of these customers’ practice of charging-back to Interpharm certain price differences; and 3.) the reduction of the percentage of eligible inventory for Interpharm’s borrowing base from 50% to 39.6%, based on the inventory valuation obtained from the third party retained by the lender. The court found that each of these acts was either expressly permitted by the credit agreement or within the reasonable discretion afforded to the lender under the credit agreement to take certain actions.

In particular, the court found that “even assuming that charge-backs are a customary pharmaceutical industry practice, it would hardly be unreasonable for a lender to view receivables subject to such reductions as a less reliable indicator of anticipated borrower income than receivables not subject to such reductions.” Furthermore, the court compared each act taken by the lender with the rights and remedies available to the lender under the credit agreement, each time emphasizing that, from Interpharm’s perspective, the lender consistently chose the lesser of two evils.

Practical Considerations

This case presents a familiar fact pattern where a borrower is in default of its financial covenants. The lender, therefore, seeks to increase its level of security in a Forbearance Agreement as the borrower is now less creditworthy; and, with each subsequent default and successive Forbearance Agreement, the lender makes higher and higher demands on the borrower. Then when the borrower faces liquidation, it turns around and blames the lender’s hard bargaining along the way as the reason the borrower reached that point, rather than the borrower’s financial decline that caused it to breach its financial covenants in the first place. The borrower then sues the lender claiming, in essence, that the lender is liable for the worsening of the borrower’s financial condition.

This court makes clear that a lender is entitled to drive hard bargains when agreeing to forbearance agreements so long as the lender acts within the scope of its contractual rights and reasonable discretion, and such hard bargaining does not cross the line into the realm of wrongful conduct and economic duress.

Brian Schenker is a member of Reed Smith’s Financial Industry Group (FIG), practicing in the area of Commercial Restructuring & Bankruptcy. FIG is the firm’s 220-lawyer practice focused on representing clients in the financial sector in the areas of bankruptcy & commercial restructuring, financial services regulation and litigation, and investment management and structured finance. Schenker can be reached at [email protected].