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A Brief Look At Lender Liability Litigation: Awareness & Risk Mitigation

A Brief Look At Lender Liability Litigation: Awareness & Risk Mitigation

What is “lender liability” and when do risks arise? These questions—while quite elemental—naturally occur to professionals at the outset of their finance and banking careers. Awareness of the topic helps lenders assess credit facility risks and mitigation strategies.

“Lender liability” is an umbrella term encompassing regulations, contract and tort common law theories, and state and federal statutory theories. Borrowers claim that the lender did something that had consequential damages—like the lender made a loan that it should have known that the borrower could not repay, leading to financial ruin. Or the lender intentionally misallocated payments, causing a loan default and an adverse credit report. Or the lender failed to renew a maturing note, causing borrower’s business to fail. As gatekeepers and stewards of the financial institution’s assets, lenders must work to prevent litigation or to reduce the institution’s exposure when litigation becomes unavoidable.

These lawsuits could be frivolous—or they could be meritorious. Either way, the common denominator is the diminution of the financial institution’s assets through credit or legal exposure. Plaintiffs file lawsuits to avoid debt or liens, to prime lender’s liens, or to win some financial recovery. Lenders should remain diligent throughout the lending cycle—risks may arise during loan origination, servicing, or default. Single lender loans and multiple lender loans present distinct issues and varied complexity, but the legal claims are generally the same.

Breach of contract claims constitute the backbone of “lender liability” litigation. These are the most frequently litigated claims in the lending context. Parties can breach written or oral contracts. Parties can also breach implied contracts such as an obligation inferred from the course of dealing between a lender and a borrower. There could be allegations that breach occurred during a pre-loan conduct, loan administration, or post-default. The best way to avoid these claims is to consult the terms of the loan agreement and your lawyer. Lenders should act in good faith at all stages of the lender-borrower relationship and frequent but careful communication with the borrower can often prevent misunderstandings.

While loan documents generally disclaim the existence of a fiduciary relationship, lenders should be careful not to create a fiduciary or special relationship with borrowers. In those circumstances, borrowers sometimes assert that the transaction was not “arms-length”—that the lender had a special duty to advise the borrower or to act in the borrower’s best interests. These claims can arise when the lender has a close, non-business relationship with the borrower, or when the lender exercises excessive control over the borrower’s business. Lenders should avoid involvement in the borrower’s daily management and operations.

Other popular claims include fraud and misrepresentation, either intentional or negligent. Those claims focus on the lender’s alleged deception of the borrower. A negligent misrepresentation claim may arise when a lender provides false information regarding the status of the loan or the possibility of obtaining a loan modification. Lenders should not make promises outside the terms of the loan agreement and should document discussions to make clear that the lender made no promises outside the written agreement.

A list of lender liability claims would not be short—nor would the list of available defenses or mitigation strategies. Thorough documentation of the transaction and careful communication are essential to minimizing lender liability risk.