By Theresa Driscoll, Esq., Partner, Moritt Hock & Hamroff
In a case study of the recent decision in the Bailey Tool & Manufacturing Company bankruptcy case, Theresa Driscoll of Moritt Hock & Hamroff provides best practices for lenders to pursuit repayment without risking lender liability.
A lender’s successful enforcement of loan documents following one or more events of default turns on a variety of factors, the most important of which is compliance with the terms of the relevant loan documents. When a lender deviates from those governing agreements, it runs the risk of exposure for claims of breach of contract and, worse, bad faith.
The line between proper enforcement and breach often is not clearly delineated and is highly fact driven. In the asset-based lending context, lenders have significant control over a borrower’s financial position through
discretionary adjustments to borrowing base formulas. Lenders typically will adjust borrowing base formulas and the amount of funding based on concerns over the value of the borrowing base assets; however, if the decision to reduce funding is not tied to the loan documents or a rational concern regarding the lenders’ collateral position, lender liability may result.
Recently, one court examined these very issues. On Dec. 23, 2021, a bankruptcy court in Dallas issued a 145-page decision in the Bailey Tool & Manufacturing Company bankruptcy case, finding the debtor’s pre-petition inventory and receivables lender liable for breach of loan documents, breach of duty of good faith and fair dealing, fraud (through fraudulent misrepresentations) and tortious interference with business and contractual relationships. The court awarded damages to the debtor totaling approximately $17 million.1 This article will explore this decision and note the key considerations for lenders going forward.
Bailey Tool’s Business And Lending Relationships
Bailey Tool was a metal fabricator whose customers were Tier-One and Tier-Two suppliers to automotive manufacturers in the United States and Mexico as well as the U.S. Department of Defense. Bailey Tool’s primary lender decided it no longer wanted to provide for the company’s working capital needs and asked the company to transition to a new lender in 2014. At that time, the company chose a new bank to replace its existing lender; however, the new bank suggested the company obtain a factoring arrangement to aid in the transition to a new lender and recommended a nationally recognized commercial finance company (hereafter referred to as “the lender”) for Bailey Tool’s working capital needs.
The lender performed due diligence regarding Bailey Tool for several months (from October 2014 through February 2015). Internal diligence memos contained notes indicating that the proposed lending relationship would be a “strong deal” for the lender, which became aware in underwriting that Bailey Tool was past due on ad valorem taxes and trade payables, and that its accounts receivable from the U.S. Department of Defense were slow or irregular in payment. Notwithstanding, the lender approved the loans, and Bailey Tool and the lender entered into both a factoring agreement and an asset-based loan facility (together, the “loan agreements”).
Just before the loan agreements were signed, the lender expressed concerns internally (not to Bailey Tool) regarding a slow paying receivable and decided to reduce the advance rate to 65%, but it did not communicate this to Bailey Tool. Within only several months of entering into the loan agreements, the lender determined that Bailey Tool was in an “over-advanced” position and declined or limited additional requests for funds from the company. As a result, Bailey Tool became unable to make its payments to vendors, continue its manufacturing business to fulfill customer orders and make payroll. These events (described in more detail later in this article) propelled Bailey Tool to file a petition for relief under Chapter 11 of the U.S. Bankruptcy Code. Bailey Tool’s Chapter 11 case was thereafter converted to a case under Chapter 7 of the U.S. Bankruptcy Code.
A month into its Chapter 11 case, Bailey Tool filed a complaint against the lender claiming that it refused to advance funds under the loan agreements in bad faith; charged, without transparency, a multitude of fees, expenses and penalties; and exercised excessive control over Bailey Tool’s business by controlling payments to vendors and employees and attempting to make changes to the company’s management. Following a seven-day trial with more than 1,000 exhibits and 11 witnesses, the bankruptcy court found that the lender breached the loan agreements and acted in bad faith, leading to an award of $17 million for Bailey Tool.
In reaching this decision, the bankruptcy court found that the lender “grossly interfered” with the company’s business and any hope for a successful future. Specifically, the bankruptcy court determined that the following actions taken by the lender amounted to interference with Bailey Tool’s operations:
- Injecting itself into corporate governance by attempting to remove Bailey Tool’s president and owner, requiring the hiring of an independent consultant/manager and working with that consultant to have them replace the company’s president and assume sole authority to make business decisions
- Insisting on directly paying the company’s vendors and employees itself
- Micromanaging what expenses Bailey Tool paid while not allowing Bailey Tool to pay certain vendors, resulting in disruption to the company’s manufacturing process
- Communicating directly with certain of Bailey Tool’s customers and demanding that they not pay the company but instead direct payments to the lender, threatening litigation in the process
- Employing armed guards at the company’s locations (where there was no evidence of any real threat to the safety or security of the company and its facilities)
- Withholding advances in an inconsistent or arbitrary manner The bankruptcy court also found that, in addition to exercising extensive control over Bailey Tool’s business operations, the lender acted in bad faith by demanding that Bailey Tool’s principal pledge their homestead as collateral (and force the sale thereof) even though such interest was exempt from the lender’s reach under state law. Further, the court found the lender’s communications with Bailey Tool to be misleading, confusing and inaccurate. Specifically, the court found that:
- The lender misrepresented Bailey Tool’s funds availability status by repeatedly creating the impression in communications with the company that Bailey Tool was in default due to being over-advanced, when, in fact, the represented over-advanced status was simply not true.
- The online portal maintained by the lender for Bailey Tool’s customers to view their account status was “incomprehensible.”
- The lender applied Bailey Tool receivables to prepay the inventory loan without notice to the borrower. (While it was unclear whether notice was required under the terms of the loan documents, the court focused on the fact that the lender applied receivables to pay down the inventory loan even though no payment was due, thereby creating a deficiency in availability of the receivables factoring.)
- The lender did not disclose to Bailey Tool why it considered the company to be in default, the status of its funds availability or lack thereof and what the lender was doing with the funds (paying down an unmatured inventory loan and charging fees and expenses).
- There was a lack of transparency with regard to at least 15 categories of fees and expenses the lender charged to Bailey Tool.
In view of the totality of the facts, the bankruptcy court determined that the lender’s conduct in the administration of the loan amounted to bad faith. Based on the evidence presented, the court found that Bailey Tool had a “promising future” based on its defense contracting and new technology to manufacture bullets. The court further found that the lender had represented to Bailey Tool that the advance rate would be 90% (the loan agreements provided for “up to 90%”); however, according to the court’s decision, immediately following execution of the loan agreements, the lender limited advances to well below 90% and acted arbitrarily in making the eligible/ineligible determination. Further, after constricting Bailey Tools’ funding in the weeks following loan closing, the lender called a default based on accumulated additional unpaid property taxes due on real property owned by Bailey Tool (which was known to the lender in underwriting). The bankruptcy court was particularly troubled by the fact that the lender called a default for a condition known to it before a decision was made to close the loan.
Conclusion And Key Takeaways
The Bailey Tool case offers valuable takeaways for lenders. Here are seven best practices lenders should undertake to help ensure they remain safely on the side of aggressive enforcement without risking lender liability:
- Lenders should consider requiring issues identified during underwriting be cleaned up and addressed before closing the loan and be mindful that reliance upon such issues down the road when enforcement steps are taken could create risk of claims of bad faith.
- Lenders should clearly communicate to borrowers all actions taken under loan documents throughout the life of a credit facility, particularly with the application of what could be viewed as borrower funds.
- Lenders should disclose all fees and expenses being charged at the time they are charged, and loan documents should clearly explain the basis and entitlement for such fees and expenses.
- Follow the loan agreements. Deviating from the process for making advances could result in claims of breach of contract or, worse, bad faith. If a lender wants to sever the relationship, it should take steps consistent with the loan documents. Don’t misrepresent a borrower’s cash position to create the illusion of default solely to achieve a quick repayment and exit from the loan.
- Step back and look at the big picture. Lenders should consider the consequences of their actions. If a large receivable is applied by a lender to another loan obligation (inventory loan) and the borrower’s access to some portion of that receivable is needed to make payroll or pay for needed supplies, the borrower’s company may lose key customers from the interruption in the manufacturing process caused by the lack of funding for payroll or key supplies.
- Be careful with what you put in writing. Never put in writing the lender’s motives or its views of the borrower. The contents of letters or emails can be disclosed in litigation. Internal communications about borrowers should be devoid of emotion and epithets that could demonstrate an improper motive in making decisions under loan documents.
- Do your diligence before asking for, and exercising rights against, additional collateral from individual guarantors or obligors to confirm that such property is not exempt under applicable state law. Recognizing the difference between aggressive enforcement and bad faith is critical to minimizing risk for lenders. The Bailey Tool decision should serve as a potent reminder of what can happen when a lender takes enforcement too far. Obtaining repayment in full without subsequent liability should always be the goal. •