Although the bankruptcy court found that much of the factoring company’s conduct was permissible under the agreements, the court nonetheless found that the factoring company had breached both the agreements and the duty of good faith and fair dealing.
In Bailey Tool & Mfg. Co. v. Republic Bus. Credit, LLC, 2021 Bankr. LEXIS 3502 (Bankr. N.D. Tex. Dec. 23, 2021), the United States Bankruptcy Court for the Northern District of Texas clarified how aggressive a secured lender can be when enforcing its rights. The 145-page opinion details how a lending arrangement went “terribly wrong” and why awarding millions in damages was warranted.
Background
Bailey Tool & Manufacturing Company, along with its two subsidiaries, Hunt Hinges, Inc., and Cafarelli Metals, Inc. (collectively, “Bailey”), operated a metal manufacturing business primarily servicing the automobile industry. Like many automotive vendors, Bailey faced certain setbacks during the 2008-09 economic downturn. Despite its best efforts to expand its business, Bailey was unable to regain previous revenue levels, and when Bailey’s original bank terminated its loan agreement, the company was forced to find a replacement lender. Bailey subsequently entered into both a factoring agreement and inventory loan agreement with a factoring company.
Months after executing the agreements, the factoring company declared that Bailey was in an “over-advanced” position (a term not defined in either of the agreements). The factoring company then restricted Bailey’s access to funds it required for payroll and vendors, among other things. The factoring company also took control of certain aspects of Bailey’s operations, such as (i) ordering Bailey’s customers to pay the factoring company directly; (ii) deciding which employees and vendors to pay; (iii) stationing armed guards to patrol the Bailey plant as an intimidation tactic; and (iv) drafting an employment agreement in an attempt to replace Bailey’s president and CEO with a consultant handpicked by the factoring company.
Bailey ultimately filed a Chapter 11 voluntary petition under the United States Bankruptcy Code. The bankruptcy case was later converted to Chapter 7 of the Bankruptcy Code and a Chapter 7 bankruptcy trustee was appointed. The trustee then filed an adversary proceeding against the factoring company asserting lender liability claims. Bailey’s former owner filed an independent adversary proceeding against the factoring company asserting similar claims.
Ruling
The bankruptcy court found in favor of the trustee and the owner, ruling that (i) lender liability can arise under a tortious interference theory if, among other things, the lender intentionally interferes with the management of the borrower’s company or its business contracts, and (ii) the bankruptcy of the company and former owner likely would have been avoided but for the factoring company’s improper actions. Although the bankruptcy court found that much of the factoring company’s conduct was permissible under the agreements, the court nonetheless found that the factoring company had breached both the agreements and the duty of good faith and fair dealing.
The bankruptcy court also found that some of the factoring company’s conduct amounted to fraud and tortious interference with Bailey’s business and contractual relations. As to fraud, the bankruptcy court found, among other things, that the factoring company improperly and repeatedly advised Bailey that it was in an “over-advanced” position, creating the false impression that Bailey had defaulted on its collections obligations under the agreements. As to tortious interference, the bankruptcy court found that the factoring company improperly interjected itself into Bailey’s business and began micromanaging its expenses, including deciding which employees would and would not receive payment. The factoring company also interfered with many of Bailey’s long-term contracts by threatening customers with litigation if they chose to pay Bailey instead of the factoring company.
Additionally, the bankruptcy court held that the factoring company had willfully violated the automatic stay under Section 362(k) of the Bankruptcy Code, and that its conduct satisfied elements of equitable subordination under Section 510(c) of the Code. The court awarded the trustee compensatory and punitive damages for the factoring company’s violations of the automatic stay, and deemed the factoring company’s claims in the Chapter 7 case (if any) subordinated to all other classes of creditors and interests.
Separately, the bankruptcy court held that the factoring company had committed fraud as to Bailey’s longtime owner when, among other things, it levied an invalid lien on the owner’s personal and exempted homestead. The factoring company told the owner that if he paid the them a portion of the proceeds from the sale of his home, this would cure Bailey of its “over-advanced” position and the factoring company would resume funding to Bailey. The bankruptcy court held that this was fraud and awarded the owner over $1 million in damages.
Conclusion and Commentary
The Bailey case confirms that lender liability actions in bankruptcy are possible, even today. Although the conduct described in the opinion appears extreme, bankruptcy courts will continue to scrutinize a lender’s pre- and post-petition conduct if there is evidence that the lender’s actions either forced the borrower into bankruptcy or prevented the borrower’s successful reorganization.
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