Lender Liability and the Duty of Good Faith

Lender Liability and the Duty of Good Faith
From time to time, lenders and their attorneys announce that lender liability is no longer an issue with which the lending community needs to be concerned. What usually prompts this proclamation of the death of lender liability is a recent case in which a court has summarily rejected a borrower?s claim that the lender violated the duty of good faith and fair dealing. Many courts have rejected borrowers? lawsuits which are based on allegations of the violation of the lender?s duty of good faith. Nevertheless, lender liability should continue to be an area of concern to lenders.
Although courts often dismiss cases based on a borrower?s claims of lender bad faith, in other cases courts find that lenders have indeed engaged in conduct that constitutes bad faith. Most courts carefully examine the unique facts of each case, consider the testimony of experts, and listen to the ever-inventive arguments of counsel. A loan agreement, like every other contract governed by the Uniform Commercial Code (the ?U.C.C.?), imposes on both the borrower and the lender ?an obligation of good faith in its performance or enforcement.? This simple good faith performance obligation may appear to be an uncontroversial codification of a basic, minimal standard of human behavior. It is proving, however, to be problematic to commercial lenders.
Some courts have been quick to hold that, under certain circumstances, a lender, which believed it was merely exercising its contractual rights, nevertheless may have breached the duty of good faith performance obligation. For example, in 1985 the Sixth Circuit, invoking the good faith performance obligation, affirmed a jury verdict awarding $7,500,000 to a borrower whose lender refused to advance funds under a loan agreement, which specifically and unequivocally permitted the lender to exercise sole and absolute discretion to refuse to advance additional funds. The Alaska Supreme Court, likewise invoking the good faith performance obligation, held that a borrower could recover both actual and punitive damages from a lender who had taken possession of collateral without notice, notwithstanding the unambiguous terms of the loan and security agreement authorizing such repossession.
On the other hand, many courts have abandoned the imposition of good faith obligations on the lender beyond what is set forth in certain loan agreements. In 1987, the Bankruptcy Court for the District of Massachusetts held that the holder of a demand note does not need a good faith reason or any reason at all to demand payment. Additionally, the Seventh Circuit in 1990 flatly rejected imposing the duty of good faith when calling a demand note.
Despite such far-reaching conclusions, courts have yet to articulate any specific criteria to distinguish good faith performance from bad faith performance. Consequently, the issue of a party?s good faith performance under its contract is generally one of fact. In analyzing such facts, however, many courts are using the good faith performance obligation incorrectly. Instead of enforcing contract terms according to the expectations and intent of the contracting parties, many courts are deciding for themselves what they believe the parties ought to have done in ?good faith,? regardless of the terms of the contracts. The doctrine thus has become a loose cannon used by some courts to further their own views of fairness. In the commercial loan area, lenders are finding themselves increasingly vulnerable to unpredictable and inconsistent applications of the vague good faith performance obligation in situations where contractual terms, not questions of fact, formerly controlled.
This paper will first discuss the good faith performance obligation and its definitions under the U.C.C. Subsequently, it will discuss the use of the obligation to limit a lender?s ability to exercise its contractual rights. Next, the paper will discuss criticisms of applying the good faith performance obligation to certain situations, especially demand notes. Then a discussion of the objective and subjective test of good faith will take place before finally concluding that the good faith obligation should not be imposed in debtor-creditor situations to override express terms of a contract.

II. The U.C.C.

A. The Good Faith Performance Obligation and the U.C.C.

The central provision of the U.C.C.?s good faith requirement is found in ? 1-203, which provides that ?every contract or duty within this Act imposes an obligation of good faith in its performance or enforcement.? With regard to debtor-creditor relationships in particular, this obligation of good faith performance imposes on a lender a duty to deal in good faith with its borrower in all situations, not only in situations where, because of the circumstances of the loan, the lender has assumed actual control over and a fiduciary responsibility for the borrower.
One troublesome but important aspect of the good faith performance obligation is its application to contracts, which provide that one party to the contract may, in its ?sole discretion,? take certain actions pursuant to the contract. In such cases, the actions of the party who can exercise its discretion may affect all parties to the contract, and dependent parties must rely on the ?good faith? of the party given the right to exercise its discretion. Often, the discretion exercised by the party in control will adversely affect the dependent party. However, it does not necessarily follow that the controlling party has acted in ?bad faith? merely because the dependent party is in some way harmed because of the controlling party?s permissible exercise of discretion. So long as the controlling party exercises its discretion for any purpose within the terms of the contract as contemplated by the parties, then the dependent party should not be said to have lost the ?benefit of the bargain,? and the party who exercised its discretion should not be held to have acted in bad faith.

B. Definition of Good Faith Under the U.C.C.

Section 1-201(19) of the U.C.C. defines good faith as, in the minimum, ?honesty in fact in the conduct or transaction concerned.? This ?honesty in fact? definition appears on the surface to be quite similar to the good faith definition of ? 2-103(1)(b) of the U.C.C. However, the two definitions should be distinguished. Section 2-103(1)(b) defines good faith in the case of a ?merchant? to mean ?honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.? This section concerns sales transactions, and does not involve relations between lenders and borrowers. Indeed, a lender is not a merchant and is not generally bound to observe ?reasonable commercial standards.? As one court has noted, the fact that lenders are under no burden to observe reasonable commercial standards ?reflects the Code drafters? recognition that sales transactions are more amenable to the establishment of reasonable commercial standards than are relations between secured parties and debtors.?

C. Good Faith Performance and Demand Notes Under the U.C.C.

Accordingly, the U.C.C. defines ?good faith? with regard to the contractual performance of a lender only in terms of whether a lender has acted ?honestly in fact in the conduct or transaction concerned.? In terminating a loan, the lender may accelerate the amount due, demand the entire amount pursuant to a demand clause, or repossess the collateral. A lender is subject to the implied duty of good faith in accelerating a note pursuant to an ?at will? provision. Section 1-208 of the U.C.C. provides that:
A term providing that one party or his successor interest may accelerate payment or performance or require collateral or additional collateral ?at will? or ?when he deems himself insecure? or in words of similar import shall be construed to mean that he shall have the power to do so only if he in good faith believes that the prospect of payment or performance is impaired.

The courts vary regarding whether good faith in this context constitutes an objective or a subjective standard.
Several courts have held that good faith does not apply to demand notes. As support, these courts generally cite the Official Comment to ? 1-208 which states, ?Obviously this section has no application to demand instruments or obligations whose very nature permits call at any time with or without reason.? This exception has been narrowly construed, however, by several courts as inapplicable where the loan agreement, although labeled a ?demand note,? contained various default provisions which otherwise condition the lender?s ability to accelerate or demand payment on the note. For example, in Bank One Texas, N.A. v. Taylor, the Fifth Circuit upheld liability against a lender for bad faith acceleration of note that, although containing a ?payable on demand clause,? also contained a monthly repayment schedule and specified certain events of default.

iii. Good Faith Performance and the Refusal to Advance Funds Without Notice

A. K.M.C. Co. v. Irving Trust Co.

Many trace the origin of what is commonly called ?lender liability? to the good faith case of K.M.C. v. Irving Trust. In K.M.C. the Sixth Circuit invoked the good faith performance obligation to limit a lender?s contractual right to refuse to make a cash advance without notice under a discretionary line of credit. The K.M.C. court affirmed a jury verdict awarding $7,500,000 to a retail and wholesale grocer who claimed that his business was ruined by the defendant bank?s refusal to make the cash advance. The court held that the lender?s discretion to advance funds under a negotiated, explicit discretionary line of credit was limited by the obligation of good faith, as was the lender?s power to demand repayment of any funds advanced. Additionally, the K.M.C. court held that the good faith performance obligation implied a requirement of notice to a borrower before acceleration and demand, regardless of the specific terms of a loan agreement, to allow "a reasonable opportunity to seek alternative financing," absent valid business reasons precluding a lender from giving such notice.
The facts behind the K.M.C. decision are similar to ones that may arise every day. Irving Trust and K.M.C. had entered into a financing agreement whereby Irving Trust provided K.M.C. with a $3,500,000 line of credit. The loan agreement provided for discretionary lending by the bank, based on a security formula derived from a percentage of K.M.C.?s accounts receivable and inventory. Moreover, Irving Trust was permitted by the terms of the loan agreement to demand, solely in its discretion, repayment of the advanced money.
Unfortunately, K.M.C. experienced serious financial difficulty. Consequently, it requested an amount far in excess of the amount acceptable under the security formula. In fact, the amount requested would have increased the line of credit to $4,000,000. In the alternative, K.M.C. requested at least $800,000, the maximum amount available under the financing agreement. Although the alternative advance would have increased the loan balance to just under the $3,500,000 limit, Irving Trust?s loan officer refused to make either requested advance, believing that the entire debt was insecure, that the funds advanced would not cover all of K.M.C.?s outstanding checks, and that K.M.C.?s business was collapsing. Although Irving Trust did make further smaller advances enabling K.M.C. to survive a few more months, eventually the business failed.
K.M.C. brought suit against Irving Trust, alleging that its refusal to make the requested advance without notice was in bad faith, even though permissible under the terms of the line of credit agreement. K.M.C. claimed that Irving Trust?s acts amounted to a unilateral decision to wind up K.M.C.?s business. Irving Trust responded by arguing that under the terms of the loan agreement it had absolute discretion in deciding whether to make advances. Furthermore, Irving Trust argued that because the loan was a demand loan and could have been called at any time, any implied requirement of notice prior to a refusal to advance cash would be inconsistent with this right to demand full repayment at any time.
The Sixth Circuit rejected Irving Trust?s arguments, and held that the lender had a duty to exercise good faith in deciding whether to refuse to make further advances or to demand repayment of the loan. Specifically, the court found that Irving Trust?s loan was adequately secured on the day the additional advance was refused and ruled that a lender cannot terminate financing without notice even if the financing is governed by a demand loan and a discretionary right to make advances.
The court noted that had it applied a subjective standard of good faith, its outcome probably would have been different. In other words, had the court depended on the actual state of mind of the loan officer at Irving Trust, who believed the loan was insecure, it might have been constrained to hold that the evidence was insufficient to support the $7,500,000 verdict. However, the court concluded that the loan was secure and that a loan officer?s business reasons for terminating the financing without notice were to be judged against an objective standard: whether a reasonable loan officer, with a secured loan, would have refused to advance funds without notice to the borrower.
The K.M.C. decision startled the lending industry. It was important in several respects. First, it marked the first time a court had invoked the good faith performance doctrine to imply an obligation, which generally is governed only by the express terms of a contract: the obligation to give notice. The loan agreements at issue required the lender to give no notice to the debtor before it either refused to make advances of funds or demanded repayment in full, yet the court implied such a requirement.
Second, not only did the court require the lender to provide notice not required by the contract, it upheld an enormous damages award based on the lender?s failure to give notice. Therefore, the court penalized the lender for not doing something that, under the terms of its contract, it was not required to do. The K.M.C. court went beyond holding that lenders must meet certain implied obligations under contract; it penalized a lender which satisfied express contractual terms but which failed to meet implied obligations.
Third, the K.M.C. decision appeared effectively to redefine traditional demand obligations, a form of financing which was critical to the lending industry. K.M.C. indicated that lenders could no longer simply demand repayment of loans or exercise their security interest rights under their loan agreements. Under K.M.C., good faith required lenders to provide notice sufficient to allow borrowers to seek alternative financing, an obligation never contemplated by the parties at the time their demand loan was negotiated. This simply provided a grace period for financially troubled borrowers and could result in further endangering the lender?s chance of repayment.
K.M.C. presents a troublesome precedent to all lenders who extend credit payable on demand. Demand obligations allow lenders to evaluate their credit and collection risks and to evaluate the administrative and legal costs associated with such financing. Loose application of an undefined and unlimited good faith performance obligation to the simple act of calling a demand obligation could seriously harm the ability of lenders to make proper evaluation of such risks and costs, and thus could jeopardize the continued availability of that type of financing. Faced with uncertain risks and potentially enormous liabilities arising from the collection of such obligations, lenders would likely be forced to change the terms and increase the cost at which such financing is made available to borrowers. This result could be detrimental to both lenders and borrowers.
K.M.C. is important in another respect. Although not explicit in the decision, the court seemed to imply that a demand obligation, standing alone with no mention of notice, did not inherently allow lenders to declare their loans immediately due and payable. Therefore, when a notice provision was omitted entirely from a contract, courts could look to extrinsic facts to determine whether a notice requirement was contemplated by the parties. Courts could further determine that an agreement without a notice provision is ambiguous, and imply a notice requirement. Accordingly, K.M.C. appears to have placed a burden on lenders, and specifically their lawyers, to draft demand obligations that include some notice provision, even if it is minimal. If a lender wishes to omit a notice period, then the words "without notice" should be included in the demand obligation. As a practical matter, then, liability under the K.M.C. holding to a certain extent could be avoided by drafting very detailed loan agreements that include specific notice requirements prior to demand, acceleration, or repossession of collateral.
Drafting detailed, specific loan agreements, however, may not solve the problems facing lenders as a result of cases such as K.M.C. No matter how specific loan agreements may be, lawyers can never anticipate what requirements courts may later imply under the doctrine of good faith. Surely, Irving Trust believed its loan agreements were adequate and clear until the K.M.C. court advised it otherwise. Nevertheless, lawyers must take the initiative to draft contracts in as much detail and as unambiguously as possible to avoid liability on the part of their clients for breach of the good faith performance obligation.

B. Criticisms of K.M.C.

The strongest criticisms of the good faith doctrine are that it destroys the bargain, limits contractual freedom, creates uncertainty, and creates inefficiencies. The good faith doctrine is responsible for these when it is applied to override express contract terms. When this is done in commercial lending, the argument maintains that the lender is unexpectedly forced to bear additional costs that it cannot avoid by careful planning. The demand provision illustrates this point. If unable to protect itself with this provision, the lender is forced to expend greater costs to gather information and to insure it against risks that the borrower may be more willing to bear. At best, this requires the borrower to pay higher interest rates or to repay on less favorable terms; at worst, it causes the lender to refuse the loan altogether.
The K.M.C. court held that Irving Trust had a duty to act in good faith in exercising its right to demand payment of the loan under U.C.C. ? 1-208. With respect to this holding, the Sixth Circuit?s interpretation of New York law in K.M.C. conflicts with the New York Court of Appeals? interpretation in Murphy v. Am. Home Prod. Corp., and has been widely criticized for overlooking the Comment to U.C.C. ? 1-208. The comment unequivocally indicates that ? 1-208 has no application to demand instruments. Accordingly, the courts applying New York law have declined to follow K.M.C. to the extent that the obligation of good faith performance enunciated there would imply an obligation of good faith upon a lender inconsistent with the express terms of a contractual relationship with a borrower.
Despite the expanding application of the good faith obligation to the lending area, some courts have rejected altogether any debtor?s contention that the exercise by creditors of any contractual right is governed by an obligation of good faith. These courts have enforced the specific and literal provisions of the contract between the parties, emphasizing that an implied obligation of good faith and fair dealing will not override the express terms of a contract.
For example, the court refused to apply a good faith standard in Spencer v. Chase Manhattan Bank. Spencer executed notes held by Chase, where Spencer also had two accounts. After three years, Chase informed Spencer that it wished to terminate their relationship. Subsequently, Chase set off the balance of Spencer?s accounts against Spencer?s debt and Spencer alleged that no demand for payment was made before this setoff occurred. Generally, demand notes are considered due and payable immediately upon their execution with or without a prior demand. There was evidence that a formal demand was required before setoff could have occurred. While demand notes ordinarily do not require a formal demand, the court found that in this case it appeared the parties intended that such a demand was required as the notes listed various contingencies for rendering them due and payable. The court stated:
Where the terms and conditions of a so-called demand note indicate that the parties intended the obligations to become due and payable upon the happening of a future event, the debt is not mature upon execution of the note. The obligation matures only when the agreed-upon even occurs. Until then, a bank may not set off its depositor?s account to satisfy the debt.

Although the court agreed with Spencer that demand for payment was a prerequisite to a proper setoff in this case, it disagreed with the contention that the good faith obligations imposed by the U.C.C. prohibited Chase from acting in an arbitrary and capricious manner in requiring payment of the notes. The court reasoned that:
The holder of a demand note does not need a good faith reason or any reason at all to demand payment. Demand instruments are specifically exempted from the good faith obligation applicable to accelerated clauses under U.C.C. ? 1-208. As the Comment to that section states, ?Obviously, this section has no application to demand instruments or obligations whose very nature permit call at any time with or without reason.?

The court said K.M.C. was not persuasive authority for imposing a good faith obligation on Chase?s right to demand repayment whenever it chose to do so. In K.M.C. the court premised applying the obligation of good faith to a lender?s right to demand repayment of a debt evidenced by a demand instrument on U.C.C. ? 1-208 which imposes a good faith obligation on a lender?s exercise of an option to accelerate a debt at will. The K.M.C. court apparently overlooked the Comment to that section which excuses the holder of demand instruments from the obligations imposed by ? 1-208. For this reason, the court did not accept K.M.C. as a correct statement of New York law.
One of Spencer?s allegations was that Chase breached its duty of good faith and fair dealing by dishonoring Spencer?s checks wrongfully in contravention of a long-standing course of dealing with Spencer. The court stated that although it seemed that Chase had the right to refuse to honor checks drawn on uncollected funds, where the course of dealing indicated that Chase had never asserted the right against Spencer, a jury could find that good faith required Chase to give notice to Spencer before the rule took effect.
The complaint also indicated that Chase?s demand for payment might not have been made in good faith. Spencer asserted that the letter demanding payment was sent to Spencer?s officers immediately prior to the deadline set for payment, if not thereafter, and at a time when Chase knew that Spencer?s officers would not be available to receive the letter, ensuring that Spencer would not have an opportunity to respond to the demand. While Spencer was not entitled to notice of the setoff, the court said Chase was required to exercise good faith in performing its contractual obligation to make a demand. If it deliberately sent the demand letter in a manner calculated to disadvantage Spencer, then a claim for the violation of the good faith obligation imposed by the U.C.C. has been stated.
If the court accepted Spencer?s argument, imposing good faith to the call for payment of the demand note would have gone above the performance of the contract and in fact added a term to the agreement that the parties had not included. The additional term would be that the note was not payable at any time demand was made, but only payable when the demand was made in good faith. The parties by the demand note did not agree that payment would be made only when demand was made in good faith but agreed that payment would be made whenever demand was made.
The great weight of authority is that a creditor holding a demand instrument need not exercise good faith in determining when to demand payment. The Seventh Circuit was most critical of K.M.C. in Kham & Nate?s Shoes No.2 v. First Bank. When a lender is not contractually obligated to advance additional funds under an otherwise sufficient line of credit, its refusal to do so does not amount to ?bad faith.? The Kham court concluded that there is no duty to decide in good faith when to call a demand note and that a creditor can demand payment when it wants and for whatever reason it wants (or for no reason).
In July 1981, First Bank (?Bank?) extended unsecured credit to Kham & Nate?s Shoes (?shoe retailer?). In late 1983, the shoe retailer experienced cash flow problems. In January 1984, the shoe retailer filed for Chapter 11 bankruptcy and received a debtor-in-possession (?DIP?) loan from Bank. Bank received administrative super-priority status in exchange for the dip loan, which was cancelable on 5 days? notice. The bankruptcy court approved the loan and its terms. On January 23, 1984, the loan agreement was signed and Bank was transformed from an unsecured lender to a supersecured lender over time as inventory was converted into new accounts receivables that arose after the making of the dip financing loan on a secured basis.
On February 19, 1984, Bank notified the shoe retailer that all advances would stop in a week. Although the note underlying the line of credit required payment on demand, Bank did not make the demand. In the spring of 1988, the shoe retailer proposed its fourth plan of reorganization. In this plan, Bank was subordinated (its loans were treated as general unsecured debts) and the shoe retailer?s shareholders would keep their stock if they guaranteed new loans. The bankruptcy court held an evidentiary hearing in which it found Bank behaved inequitably by waiting until there was a complete turnover and its entire loan had become fully secured before declaring default and vacated the previous financing order. The bankruptcy court subordinated Bank?s debt and confirmed the shoe retailer?s plan of reorganization.
On appeal, the Seventh Circuit held, ?If creditors fear that the rug will be pulled out from under them, they will hesitate to lend . . . . A judge lacks the power to undo the priority granted by a financing order without first finding that the creditors acted in bad faith.? The Seventh Circuit was not willing to embrace a rule that requires participants in commercial transactions not only to keep their contracts but also to do ?more? resting in the discretion of a bankruptcy judge assessing the situation years later. The Kham court further stated that unless pacts are enforced according to their terms, the institution of contract, with all the advantages of private negotiation and agreement, is jeopardized. Additionally, the court stated that:
?Inequitable conduct? in commercial life means breach plus some advantage taking. . . . Firms that have negotiated contracts are entitled to enforce them to the letter, even to the great discomfort of their trading partners, without being mulcted for lack of ?good faith.? Although courts often refer to the obligation of good faith that exists in every contract, this is not an invitation to the court to decide whether one party ought to have exercised privileges expressly reserved in the document.

The Kham court explained that when the contract is silent, principles of good faith fill the gap. They do not block the use of terms that actually appear in the contract. Indeed, parties to a contract are not each other?s fiduciaries; lenders are not bound to treat customers with the same consideration reserved for their families. It appears the court was saying that any attempt to add an overlay of ?just cause? to the exercise of contractual privileges would reduce commercial certainty and breed costly litigation. The Seventh Circuit cited the Official Comment to U.C.C. ? 1-208 stating that the obligation of good faith in accelerating a term note does not apply to a bank?s decision to call demand notes, and therefore the obligation cannot apply to Bank?s decision to call the demand in this case. The principle is identical to that governing a contract for employment at will: the employer may dismiss its employee for any reason except one forbidden by law, and it need not show ?good cause.?
The shoe retailer stressed that Bank would have been secure in making additional advances. The Seventh Circuit stated that the contract did not oblige Bank to make all advances for which it could be assured payment. ?Ex post assessments of a lender?s security are no basis on which to deny it the negotiated place in the queue. Risk must be assessed ex ante by lenders, rather than ex post by judges.? The Seventh Circuit explained that good faith is a compact reference to an implied undertaking not to take opportunistic advantage in a way that could not have been contemplated at the time of drafting, and which therefore was not resolved explicitly by the parties. Although Bank?s decision left the shoe retailer searching for other sources of credit, Bank did not create this need, and it was not contractually obliged to fill it. The Kham court said Bank was entitled to advance its own interests, and it did not need to put the interest of the shoe retailer first. The Seventh Circuit held, ?To the extent K.M.C., Inc. v. Irving Trust Co. holds that a bank must loan more money or give more advance notice of terminating than its contract requires, we respectfully disagree.?
As illustrated by the Seventh Circuit, when consciously faced with the question, most courts have tended not to imply a new substantive obligation derived from the good faith doctrine that contradicts the unambiguous terms of the contract. Unless the provision violates public policy or is unconscionable, courts will typically enforce the provision before implying an inconsistent duty of good faith.
Courts have repeatedly ruled that a lender?s exercise of rights under its loan agreement cannot form the basis of a claim of bad faith. For example, in Ed Schory & Sons, Inc. v. Soc?y Nat?l Bank, the court stated, ?Society?s decision to enforce the written agreements cannot be considered an act of bad faith. Indeed, Society had every right to seek judgment on the various obligations owed to it . . . and to foreclose on its security.? That court also ruled that since the bank did no more than stand on its right to require payment of its borrower?s contractual obligations, the bad faith claims had been properly dismissed. Ohio courts uniformly reject the holding in K.M.C., and instead find that a lender does not act in ?bad faith? when it decides to enforce its contract rights.
The extent of this rule is demonstrated by Allonas v. Boyer. In Allonas, two inventory lenders sought repayment while the borrower store owners were on vacation. The store owners allegedly offered to return immediately, but claimed that the lenders told them no repossession would occur until their return from vacation. In fact, repossession occurred approximately four hours after the telephone conversation with the store owners. On appeal, the court affirmed a summary judgment ruling that the repossession was proper. Since repossession was a right granted to the lenders by contract, and since the loan agreements stated that no modification or waiver would be effective unless in writing signed by a duly authorized officer, the evidence of a purported agreement not to repossess did not create a triable issue of fact.
Courts in New York have been reluctant to apply a duty of good faith to demand instruments as in K.M.C. In Murphy v. Am. Home Prod. Corp., the New York Court of Appeals held that ?no obligation [of good faith] can be implied . . . which would be inconsistent with other terms of the contractual relationship.? In so holding, the court followed its own mandate that although the obligation of good faith is implied in every contract, it is the terms of the contract that govern the rights and obligations of the parties. The court stated that the parties? contractual rights and liabilities may not be varied, nor their terms eviscerated, by a claim that one party has exercised a contractual right but has failed to do so in good faith. In Gillman v. Chase Manhattan Bank, N.A., the New York Court of Appeals concluded, in the context of a security arrangement, that the duty of good faith does not require a bank to provide notice to its customer of its intent to segregate and seize collateral. Thus, where there is a risk that notice may threaten the secured position of a bank, the duty of good faith does not compel advance notice of a charge against collateral.
The good faith obligation may not be imposed to override express terms in the contract. For example, in Flagship Nat?l Bank v. Gray Distribution Sys., Inc., G.D.S., the court held that whether or not the lender loaned money was solely a matter within the lender?s discretion. Gray borrowed funds from Flagship by executing a promissory note. After Gray defaulted, Flagship discontinued Gray?s original loan and restructured it under a workout agreement. As part of the agreement, Flagship took control of Gray?s inventory and accounts. Flagship ordered partial liquidation of Gray?s business, but Gray?s indebtedness grew, and Flagship refused to lend additional monies (Flagship had already extended Gray credit well beyond the limits of the loan agreement). The court held that:
Under some circumstances, a written agreement may be modified by a course of dealings, however, when a course of dealings and the express terms of an agreement appear to conflict, the practice of the parties and the agreement must be construed, wherever reasonable, as consistent with each other. If no reasonable consistent construction can be drawn, the express terms of the agreement control. . . . [T]he express terms of the note and loan agreement override any inconsistent interpretation of the parties? agreement which might be inferred from their dealings.

Hence, the refusal here of Flagship to loan money was not a breach of a contractual obligation.
Gray relied on K.M.C. to support its contention that Flagship was bound by the established course of dealings and obligations of good faith to continue lending in excess of the loan agreement. The court found the K.M.C. holding suspect and said it was inapplicable to demand notes. The court concluded that Flagship was under no obligation, either by statute or by contract, to continue lending beyond the loan limit.
The recognition that good faith does not stand as a bar to contractual freedom promises to add analytical clarity to the doctrine?s application. If we accept broad good faith rationales, the court should not override clear and unequivocal language. If we accept that the doctrine exists to protect the spirit of the bargain and reasonable expectations, it cannot consistently exist to prevent parties from forming their own reasonable expectations in certain ways or from achieving a particular spirit of their own particular bargain.

IV. Objective v. Subjective Standard

A number of courts have considered whether, in applying the good-faith standard of U.C.C. ? 1-208, such standard is to be determined by the subjective, actual feelings of the creditor, or by a more objective standard. The subjective test of good faith is a narrower test for the creditor to meet (empty head, bad heart), while the objective test holds the creditor to a higher standard (what a reasonable creditor would do in the same circumstance). Thus, some courts have ruled that an objective standard is appropriate since a declaration of insecurity on the part of the creditor places a great burden on the debtor, and it would be unfair to allow the creditor to accelerate the debt based on facts that would not make a reasonable person feel insecure about payment of the debt. On the other hand, some courts, frequently noting that the definition of ?good faith? in other portions of the U.C.C. requires a subjective test of honesty in fact, reasoned that a subjective test is appropriate under U.C.C. ? 1-208. Other courts have turned to the particular facts of the case in determining whether a particular acceleration was made in good faith.
In K.M.C., the Sixth Circuit quoted from the Official Comment to U.C.C. ? 2-309, ?The application of principles of good faith and sound commercial practice normally call for such notification of the termination of [an ongoing] contract relationship as will give the other party reasonable time to seek a substitute arrangement.? It seems inconsistent that the K.M.C. court quoted from Article 2 and its objective viewpoint on the matter. It is a different standard of good faith than the subjective standard found in Article 1, which the court based its imposition of the good faith performance obligation.
Irving Trust requested the following charge to the jury: Did Irving Trust in good faith believe that the prospect of performance was impaired. This is a subjective test. Irving Trust argued that the sole factor determinative of whether it acted in good faith was whether its loan officer believed that there existed valid reasons for not advancing funds to K.M.C. on March 1, 1982. The Sixth Circuit disagreed, reasoning that if the test were solely subjective, the evidence might be insufficient to support the verdict. Additionally, the court referred to Blaine v. G.M.A.C., in which that court said the test has dual elements: (1) whether a reasonable man would have accelerated the debt under the circumstance, and (2) whether the creditor acted in good faith. The Sixth Circuit then stated, ?There is ample evidence in the record to support a jury finding that no reasonable loan officer in the same situation would have refused to advance funds to K.M.C. without notice as [Irving Trust?s loan officer] did on March 1, 1982.?
The proof presented at trial is telling in K.M.C. Two of Irving Trust?s own officers gave damning admissions. The executive vice president (superior of the loan officer who called in the loan) testified that Irving Trust owed its clients a duty of good faith; that it was not a policy of Irving Trust to terminate financing without notice; and that if the loan officer believed Irving Trust was adequately secured, he would not have been acting in accordance with that duty of good faith to have refused without notice to advance funds to K.M.C. The president of the depository bank (where the blocked account was maintained), and a twenty percent loan participant, testified that he also believed there is a duty of good faith from a banker to his client requiring notice prior to termination of financing if loan was well secured. He went on to say that on March 1, 1982, he believed that the loan was fully secured as to both the interest and principal and that any reasonable banker looking at the loan would agree that it was fully secured.
K.M.C. presented some compelling evidence of its own. The general counsel for a large wholesaler and prospective purchaser testified that he had a conversation with the Irving Trust loan officer earlier on the day when that loan officer refused to advance more funds. The counsel stated that the loan officer acknowledged calling the loan would destroy K.M.C. Additionally, the loan officer decided to extend additional funds to permit the prospective purchaser to evaluate K.M.C. as a possible acquisition. The loan officer later that day changed his mind and decided to proceed ?with his game plan.? Several days later Irving Trust reversed its position and made a $600,000 advance to K.M.C., however it was too late. The Sixth Circuit appeared to make a thorough inquiry into the facts surrounding the case before determining whether the duty of good faith applied to this situation.

V. Conclusion

Lenders, like all parties to commercial contracts, should be required to perform in good faith their obligations under the terms of their contracts. Without question, the good faith obligation requires lenders, as well as borrowers, to cooperate in the performance and enforcement of their contractual obligations, so that neither party will be deprived of the benefit of its bargain. The obligation to perform in good faith should not, however, require lenders, or any contracting party, to perform beyond the terms of their contracts. Courts should not invoke the good faith doctrine to justify large damage awards in situations where lenders do nothing more than exercise their rights under the provisions of negotiated contracts. Lenders and borrowers, when they negotiate their agreements, define their rights and obligations, and each party is fully aware of what the other party expects. Difficulties and uncertainties arise when courts imply additional specific obligations on the parties, and then approve damage awards when those implied additional obligations are not met.
Ironically, in most situations where a lender is deemed to have breached the obligation of good faith, that lender has done nothing more than exercise its contractual rights arising from a default by the borrower. Often the borrower first fails to perform its obligations under the contract. The borrower is fully aware of the consequences of its failure; after all, it agreed to the contract imposing these consequences. When the borrower defaults, the borrower should not be heard to claim that it was entitled to greater protection, such as notice, than the contract afforded.
Lender liability claims are an unfortunate by-product of lending and, in particular, loan workouts. Familiarity with the types of complaints typically raised by borrowers can help lenders avoid claims. A word of caution is in order: that is, lenders should not let their guard down, or fail to exercise the utmost caution in conducting themselves in relation to borrowers, even though certain lender liability claims may be difficult to prove.
Lender liability theories advancing a theory of good faith vary considerably. They range from arguments that the obligation of good faith imposes additional restrictions on the parties? agreements to claims that the obligation of good faith requires a lender to go along with the debtor?s workout proposals. One of the early significant good faith cases was K.M.C., which held that the duty of good faith might impose obligations on the lender beyond those set forth in the loan documents. This case is obviously unfavorable to lenders since it imposes uncertain and unspecified standards of conduct upon them beyond what is set forth in the loan agreements. However, courts have resoundingly rejected K.M.C. to the extent that it stands for the proposition that the obligation of good faith may bar the exercise of rights explicitly granted by a contract.
Courts adopting the reasoning of the Sixth Circuit in K.M.C. essentially rewrite contract terms by imposing additional obligations not specified in the contracts and not contemplated by the parties at the time the contracts were negotiated. Consequently, the contracting parties cannot know what is expected of them. Notwithstanding the favorable treatment on this issue for lenders by most courts, it would not be wise for lenders to abandon their efforts to deal carefully and cautiously with borrowers in collection matters. In spite of the courts? protection of a lender?s right to enforce its loan documents under most circumstances, avoidance of even the appearance of lenders of unfair treatment of borrowers can protect lenders from liability, not to mention having to act in the defense of its actions and its reputation in the business community.
Lenders, however, must carry the burden of providing their borrowers with specific and unambiguous loan agreements. One effect of decisions like K.M.C. in the lender liability area is that loan agreements have become more and more specific regarding the express obligations of lenders and borrowers (in what constitutes events of default and the consequences of such events). Ambiguities are open to interpretation by courts and often will be construed against the drafting party, who in most cases is the lender. Absent contract ambiguities caused by lenders, however, courts should construe contracts according to their terms. Problems arise when courts define good faith not in terms of the parties? own expectations, arising from their own negotiations concerning their benefits of the bargain, but rather in terms of what a particular judge or jury perceives to be decent, fair, or reasonable.

Lender Liability and the Duty of Good Faith 8.5 of 10 on the basis of 3373 Review.