Circuit Court Ruling Empowers Lender Strategies in Forbearance Cases

Following a loan default, borrowers and guarantors often assert a multitude of claims and defenses to improve their bargaining leverage. A recent decision by the United States Court of Appeals for the Fifth Circuit[1] offers a prime example of that scenario and a lender’s successful arguments to rebuff these borrower-side assertions. In Lockwood, the Court refused to invalidate a personal guaranty and employed an exacting standard for the avoidance of loan agreements on duress grounds. Equally important, the Court concluded that the lenders were within their rights to insist that the defaulted borrowers engage a chief restructuring officer. The Lockwood opinion also serves as an important reminder of how lenders can utilize loan forbearance to their strategic advantage.

Facts of Lockwood

In Lockwood, several related businesses (collectively, the “Borrowers”) entered into revolving credit notes (collectively, the “Notes”) evidencing loans made by two lenders (collectively, the “Lenders”). After the Borrowers breached some of their obligations, the Lenders demanded that the sole owner of the Borrowers (the “Guarantor”) execute a personal guaranty (the “Guaranty”) of the outstanding indebtedness. The Lenders also recommended, or insisted as the Borrowers allege, that the Borrowers retain a chief restructuring officer (“CRO”) to help turn the companies around.

After that restructuring, the Borrowers’ finances continued to deteriorate and they once again defaulted. The Lenders presented the Borrowers with an ultimatum: grant the CRO full authority to operate the businesses or face repossession of collateral and acceleration of the loans. The Borrowers acquiesced and vested the CRO with full authority “to right-size their businesses.” To avoid acceleration, the Borrowers and Guarantor also executed a forbearance agreement in which the Guarantor: (i) acknowledged that his obligations under the Guaranty were legal, valid and binding; and (ii) waived any defenses or claims against the Lenders. As that forbearance agreement was set to expire, the Guarantor and Borrower signed a second forbearance agreement which included similar stipulations and waivers.

Protracted litigation ensued after the second forbearance agreement expired. The Lenders sought to enforce the Notes and Guaranty. The Borrowers and Guarantor, in turn, asserted numerous tort claims against the Lenders.  The Guarantor argued, among other things, that he was fraudulently induced into signing the Guaranty. The trial court concluded that the waiver and release provisions in the forbearance agreements foreclosed any claim of fraudulent inducement.[2] On appeal, the Guarantor focused on his duress argument claiming that economic duress compelled him to guaranty the debt and execute the forbearance agreements. He asserted that the Lenders improperly threatened him with loan acceleration if he did not surrender full authority to the CRO.

Lockwood’s Holding

The Fifth Circuit rejected this argument noting that financial distress is not tantamount to duress. Although the Lenders used their bargaining leverage to secure a transfer of authority to a CRO, the Court reasoned that use of leverage “is what negotiation is all about.” Much of the foundation for this holding was steeped in commercial realities and public policy. The Lockwood Court recognized that if financial distress gave rise to a duress defense, many loans would be voidable. The Court similarly observed that forbearance opportunities would be limited if a distressed borrower could later void the forbearance documents because it faced economic pressure at the time they were executed.

To establish duress, the Court held that the party asserting the defense must prove: (i) the lender made a threat to do something it had no legal right to do; (ii) an illegal exaction or some fraud or deception; and (iii) an imminent restraint that destroys the victim’s free agency and leaves him without a means of protection.

The Guarantor’s duress defense failed to satisfy the first element because there was no evidence that the Lenders threatened to take an illegal action. Importantly, the Court found that the Guarantor failed to establish that the Lenders had “no legal right” to demand that the companies empower the CRO. Importantly, the Court instructed:

Nor are we aware of anything that bars a lender from seeking a change in management as a condition of loan modification.

Lockwood’s Lessons

The Lockwood decision is significant for several reasons. First, the impact of this case may extend beyond the jurisdictional confines of the Fifth Circuit, a well-regarded federal appellate court. The opinion offers compelling persuasive authority that may be followed in other jurisdictions.

With respect to the duress challenge, the Court employed an exacting standard that borrowers and guarantors must satisfy to invalidate loan documents. Indeed, it will be a rare case where a borrower can establish that its lender engaged in illegal or fraudulent conduct.

Although the Lockwood decision focused on duress, the Court’s rationale may be advanced to thwart other claims and defenses. For example, the Lockwood Court opined that uneven bargaining leverage does not give rise to an actionable claim.  Lenders may invoke this rationale to undermine claims and defenses premised on a borrower’s financial distress.

Additionally, the opinion offers an important reminder of how the forbearance process may be utilized to insulate lenders from claims and defenses. Waiver and release provisions are a critical component of forbearance documents. As this case demonstrates, such provisions prove to be an effective means to bar defenses and claims following default.

Lockwood’s discussion regarding the retention of the CRO is also compelling. In lender liability actions, borrowers often argue that their lenders exerted “undue control” or improperly interfered with the management of the company.  As stated above, the Court recognized that the Lenders were well within their rights to request a change in management in consideration for loan forbearance. Lenders may argue that this edict equally applies to lender liability claims based on a lender’s request for a change in management or appointment of a CRO.[3]

For more information, please contact John Kilgannon at 215.751.1943 or reach out to the Stevens & Lee attorney with whom you regularly work.

This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.

[1] Lockwood International, Inc. v. Wells Fargo Bank, N.A., et al., 2021 WL 3624748 (5th Cir. 2021).

[2] A guaranty otherwise voidable due to fraudulent inducement or duress cannot be voided once ratified. Lee v. Wal‑Mart Stores, Inc., 943 F.3d 554, 560 n. 11(5th Cir. 1991)

[3] The Lockwood opinion did not state whether the Lenders requested or demanded the engagement of a particular CRO or whether the Borrowers were free to select their own candidate. This may be a critical distinction in any lender liability action. Additionally, in evaluating the engagement of a CRO or other remedies, lenders should be mindful of potential claims that may be asserted by unpaid creditors claiming that the lenders exercised pervasive control over the borrowers and, as such, are liable for the unpaid creditors’ debt.