Most computerized forms of commercial loan agreements, notes and security documents include as “defaults” such events as:
“Lender determines in good faith that a material adverse change has occurred in Borrower’s financial condition ¼ or that the prospect for payment of the loan is impaired for any reason”
or the shorter:
“Lender in good faith believes itself insecure.”
Although by their literal terms such default provisions allow the lender to take drastic action (acceleration of debt; foreclosure on collateral) as long as the lender “believes” itself insecure, invoking such default provision is fraught with peril. This is so even under Missouri law, which defines “good faith” as subjective “honesty in fact” under Missouri Uniform Commercial Code Articles 3 (negotiable instruments – notes) and 9 (secured transactions) and Missouri common law, unlike the UCC and common law of most other states, which define good faith as not only subjective honesty in fact but also the objective standard of “the observance of reasonable commercial standards of fair dealing.” Uniform Version of UCC §3-103(6) and §9-102(43).
A bank recently experienced the perils of invoking an insecurity clause and as a result is facing a court trial (or agreeing to a settlement) on the issue of whether a default was properly invoked and, if not, the damages resulting to borrower.
In Frontenac Bank v. T.R. Hughes, Inc., et al., (Case No. ED97499, Mo. Ct. App. E.D.) issued September 25, 2012, borrower, a residential home builder, obtained various loans from the bank, beginning in 2003, reflected by seven promissory notes secured by deeds of trust on borrower’s properties. Each note included as a default: “Insecurity. Lender in good faith believes itself insecure.”
On the basis of those provisions and the generally deteriorating residential homebuilding industry in 2009, the bank refused to allow borrower to take advances on borrower’s line of credit note to make interest payments on the other loans (which was the agreed purpose of the line of credit) and declared all notes in default, demanded full payment, foreclosed on and acquired three of borrower’s properties as the sole (credit) bidder and subsequently sold the properties. The bank then sued the borrower and guarantors for the deficiencies on the seven notes.
Borrower and guarantors raised the affirmative defenses of breach of contract, breach of duty of good faith and fraud. The trial court granted the bank’s motion for summary judgment on all counts against borrower and guarantor Thomas R. Hughes (His spouse escaped liability because of the bank’s violation of Regulation B under the Equal Credit Opportunity Act – which will be the subject of a future Alert).
On appeal, the Court of Appeals reversed the trial court’s grant of summary judgment after doing its own independent review of the facts and held that there were genuine disputes of material fact as to whether the bank improperly declared itself insecure and whether the bank breached its duties (which are implied in every contract) of good faith and fair dealing. The Court of Appeals remanded the case to the circuit court for trial on that issue.
The Court of Appeals noted that the bank had renewed several of the notes shortly before declaring the defaults “without any subsequent material change taking place” and found that such fact could be seen as circumstantial evidence of the bank’s subjective lack of good faith in its belief that it was insecure about the prospect of repayment. In so doing, the court did not say that the bank had to act reasonably but that arguably unreasonable actions could be evidence of a subjective lack of good faith.
This case holds several lessons, including:
- Lenders should invoke an insecurity default only as a last resort. Courts are likely to look unfavorably upon such action when the inevitable deficiency suit is filed against the borrower and guarantors, especially, as in this case, where the borrower was current in its loan payments and apparently in compliance with all other loan covenants (if any) immediately prior to declaration of insecurity.
- Before invoking an insecurity default, lenders should carefully review the history of loan administration to be sure that actions of the lender prior to invoking default are not inconsistent with its “insecurity.” In this case, the lender had allowed the borrower to renew and extend the maturity dates of several of its loans shortly before declaring its insecurity and, the court found, no material change had occurred between the time of such renewals and the time lender invoked the insecurity default.
- Lenders should consider establishing specific financial covenants to gauge borrower’s financial health and performance in lieu of or in addition to insecurity default provisions. Failure to meet a minimum debt service coverage ratio should be an easily proven fact, not a subjective belief.