By James Tecce and Bennett Murphy (Quinn Emanuel Urquhart & Sullivan)
Lender liability cases invariably invoke the question of whether a lender who exercises a contractual right under a loan agreement can still be liable for breach of the “implied covenant of good faith and fair dealing.” As the New York Court of Appeals has observed, “the implied covenant embraces a pledge that ‘neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.” Singh v. City of New York, 40 N.Y. 3d 138, 145 (2023) (internal quotation marks and citations omitted). Lender liability claims typically advance the theory that a lender’s conduct should be judged by whether the borrower lost the fruits of a loan agreement. This could mean access to credit, or freedom from the harm, sometimes catastrophic, caused by a lender exercising post-default remedies.
Forty years ago, the Sixth Circuit Court of Appeals rocked the lending industry with its decision in K.M.C. Co. v. Irving Trust. Affirming a jury verdict, it held that a lender breached the implied covenant when it swept the borrower’s operating cash from a “cash collateral” account under the lender’s control, without notice, putting the borrower out of business. The panel held that the implied covenant required the lender to refrain from sweeping the account for a reasonable period, so the borrower could obtain alternative financing. The case gained immediate notoriety, as lenders recoiled from the notion that courts could not police the exercise of their contractual remedies. Over time, the case law on lender liability claims has moved toward the lender’s perspective – where the decisive question is whether the lender acted within the letter of its contract – but not without exceptions.
Lender liability claims can implicate the borrower’s financial condition, the parties’ course of dealing and the lender’s motivations, among other things. Lenders hope to resolve implied covenant cases early, to avoid scrutiny into such matters. Two recent decisions from Delaware deciding implied covenant claims illustrate this tension. In one case involving a cash collateral sweep remarkably similar to the one in K.M.C.’s, the Court was highly sympathetic to the borrower’s position, but determined that applicable state law did not provide an independent cause of action for breach of the implied covenant. Because most states do provide for such a remedy, including New York, the decision shows there is vitality to implied covenant lender liability claims. In another decision, the court held that lender actions expressly authorized under a loan agreement cannot be the basis for an implied covenant claim. Even though the court acknowledged the lender’s actions had a perilous impact on the borrowers, the court found the borrower had no remedy as a matter of law.
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