Lender Liability: Can Enforcing the Terms of a Loan Agreement Be a Breach of Contract?

by Michael Odom

Can a bank be held liable for breach of contract for calling a loan after the maturity date, or where the note says it is payable on demand? Can a lender be held liable for refusing to make an advance under a discretionary line of credit? In Alabama, you probably think the answer is “no.” Alabama law has historically provided banks with significant protection from claims of lender liability in these situations, but other jurisdictions have recently been more inclined to allow claims of lender liability in similar scenarios.

The U.S. District Court for the Western Division of Louisiana recently found that a regional bank breached the contract with its borrower when it failed to continue funding after maturity. (It should be noted that this case is currently on appeal.) In this case, the borrower executed two promissory notes in favor of the bank (this article addresses the second note). All of the loan documents were form documents. The loan agreement stated that the loan was for a temporary overline to provide funds for a particular contract with a named company for a term of one year. Because the start of the contract was delayed, the maturity date was extended only once, despite the fact that the contract was not yet complete.

After both loans matured, the bank filed suit on the two promissory notes. The trial court denied the bank’s claim on the note because it found that the bank had breached the note by failing to fund the loan through the completion of the contract, despite the stated maturity date, because the stated purpose of the loan was to provide funding through the completion of the contract.

Finding the enforcement of express contractual terms to be in breach of a loan agreement is not unprecedented, at least not outside of Alabama. The Sixth Circuit, applying New York law, has found that a lender’s discretion whether or not to advance funds under a line of credit, as well as its power to demand repayment pursuant to the demand provision in the loan agreement, is limited by an obligation of good faith performance. The court found that the lender’s refusal to make an advance under a fully secured discretionary line of credit started the borrower’s demise. Therefore, the lender was arbitrary and capricious, and breached the implied duty of good faith by refusing to fund a requested advance without giving prior notice.

Similarly, the Fifth Circuit has affirmed a jury’s verdict against a bank under Texas law for failure to act in good faith when it accelerated loans. The notes stated a payment schedule and said, as an alternative, that the obligation was “due and payable on demand.” The notes also contained an acceleration clause in the event of default or if the bank deemed itself insecure. Despite the payable-on-demand language, the court found these to be installment notes, payable on demand only in the event of default.

Alabama courts have rejected the logic and holdings of the cases from the Fifth and Sixth Circuits. The Alabama Supreme Court has held that where a promissory note contains both a payment schedule and the words “on demand,” and provides that the bank may declare an event of default if the bank in good faith deems itself insecure, the bank did not have to declare a default in order to demand payment. The court held that the Uniform Commercial Code (UCC) does not support a cause of action for failure to exercise good faith on the right to demand payment under a demand note. The court also held that the UCC did not impose any limitations of reasonableness or fairness on the demand provision.

The Alabama Supreme Court has expressly held that failure to act in good faith in the performance or enforcement of contracts arising out of the UCC does not state a claim for relief. In fact, Alabama courts have refused to recognize the independent tort of bad faith outside of the insurance context.

Under current Alabama law, a bank should be able to call a loan after the maturity date and demand payment under a demand note without fear of breaching the loan agreement or being accused of bad faith. Nevertheless, use caution when filling in the open fields in form loan documents, because the words used may have unintended consequences. Also, while a lender has many rights under the loan documents, it is wise to think about all of the potential implications before exercising a particular right.

Michael Odom is Of Counsel in McGlinchey Stafford’s Birmingham office. He represents lenders in commercial loan closings, commercial foreclosure matters, problem loan remediation, negotiation of forbearance and loan modification agreements, and deficiency/recovery litigation, as well as in real estate transactions and litigation. Michael can be reached at modom@mcglinchey.com or (205) 725-6411.