COVID-19 has not only created red tape for us—sheltering-in-place, staying six feet away from others, wearing masks in public—but it also has created new red tape for lenders. Each day new federal and state legislation, as well as executive orders, are issued establishing new accommodations for borrowers. In turn, lenders have more restrictions on protecting their own interests and enforcing their rights. Failing to properly navigate the red-tape could result in future liability litigation for lenders. Historically, after each economic downturn, the cycle is followed by lender liability lawsuits in which consumers bring myriad claims against lenders for, among other things, improperly denied forbearances, failure to consider or approve loan modifications, and declining to extend maturity dates.
Risk exposure for potential liability
Lender liability encompasses a body of laws from theories based in contract, tort, statutes, and common law. Legal action under one or more of these theories may be taken against lenders in connection with a loan in which a borrower or third-party directly or indirectly experiences losses. Contract claims can take the form of breach of contract for alleged failures to adhere to the express or implied terms. Tort claims may stem from purported fraud or negligence. In addition, provided the new legislation in response to COVID-19, consumers may have novel statutory law based claims. This last category, however, will depend on whether judges recognize private causes of action under these new measures, including for example, the Coronavirus Aid, Relief, and Economic Security Act” or the “CARES Act.”
Breach of contract claims are generally based on written loan agreements and oral express agreements. Evidence of indebtedness, including a promissory note, loan agreement and other credit documentation constitute a contract between a lender and borrower. To prevail on a breach of contract claim, a plaintiff is required to establish the existence of the agreement and that the lender has breached its obligations under the same. For example, some borrowers have in the past claimed that their lender made an oral agreement to modify a mortgage or extend a forbearance and later failed to follow through. In most states, however, oral commitments to lend money are barred by the applicable statute of frauds. The Federal Deposit Insurance Act (FDIC) further limits claims premised on oral agreements because it treats any unwritten agreement against a financial institution for which the FDIC has been appointed receiver or conservator as unenforceable. See D'Oench, Duhme & Co. v. Federal Deposit Ins. Corporation, 315 U.S. 447, 62 S. Ct. 676, 86 L. Ed. 956 (1942).Where there is no question of the existence of a contract, breach of contract litigation is centered around contract interpretation. Courts consider the “course of conduct” between parties and the “reasonable standard” based on industry practices in interpreting contract language.
Plaintiffs may also bring a related action for breach of the implied covenant of good faith and fair dealing. This concept protects parties’ contractual bargains by preventing one party from engaging in conduct that frustrates the other party’s rights to the benefits of the contract. Most states impose an obligation of good faith and fair dealing in every contract. Although good faith is defined by state law and common law, the Uniform Commercial Code (UCC) §1-201(20) defines good faith as “honesty in fact and the observance of reasonable commercial standards of fair dealing.” The “fair dealing” part generally requires that a party cannot act contrary to the “spirit” of the contract, even if you give the opposing party notice that you intend to do so. The issue of good faith and fair dealing is most common in cases where one party to the contract exercises discretion to perform or request performance from the other party. For example, a lender should consider whether a plaintiff’s default is attributable to COVID-19 before enforcing remedies prescribed by contract to determine whether taking action would be consistent with the covenant of good faith and fair dealing based on the effects of COVID-19, industry response, and regulatory action. While a lender is not forced to refrain from enforcing contract terms as written, this implied obligation means the lender must perform its obligations in good faith, i.e. employing honesty and fairness.
As a practical matter, a claim for breach of contract and breach of the obligation of good faith and fair dealing are duplicative because the obligation of good faith and fair dealing does not stand alone from the contract of which it is a part.
A key contractual term that will impact contractual performance under present conditions is a force majeure clause. This provision provides an express excuse to performance due to events outside the contractual parties’ control, such as war or natural disasters. Some contracts also specifically include “pandemics” or “epidemics” in the contract’s force majeure clause. If neither is specifically stated, the party seeking to avoid performance would have to show that pandemics and epidemics otherwise fall within the intention of the contract’s force majeure clause. COVID-19 may force courts to interpret force majeure clauses and their applicability to a lender’s obligations to perform while a borrower’s ability to perform remains “impossible.”
Although lender liability typically focuses on a breach of the underlying loan agreement, borrowers may pursue tort-based claims. While the relationship between a borrower and lender is not considered a fiduciary relationship, a borrower can pursue a duty to lend or a breach of fiduciary duty claim if the lender exercises control over the debtors. This may be demonstrated by business advice that exceeds the normal scope of services of the lender and advice on which the borrower relies. To the extent the lender makes any representations or omits material information from the borrower, such comments or omissions may form the basis of a negligent or fraudulent misrepresentation claim. Whether such conduct amounts to fraud would depend on whether the conduct was intentional or knowing. Negligence can be derived from independent representations that the borrower relies on but also from the loan management. Courts have historically refrained from imposing a duty on lenders to act upon loan commitments or applications, but lenders have been successfully sued in cases where the borrower showed the parties did not have a traditional lender-borrower relationship (i.e. allegations of a joint venture or where lender was on notice of the customer’s vulnerability or failed to adequately supervise a loan process) or in cases involving third parties. Another potential cause of action is tortious interference of business relations, which requires a showing that the lender was aware of a contract and acted improperly and intentionally to interfere with the contract.
Lessons from the 2008 mortgage crisis suggest that COVID-19 may lead to cases filed or counterclaims asserted against lenders for (i) negligently placing the borrower into a particular mortgage or (ii) failing to enter into a loan modification.
Lenders may be subject to various statutory laws based on the type of loan. For example, the Bank Holding Company Act generally does not permit an extension of credit or other services by a financial institution upon the condition, with certain exceptions, that a customer purchase some other credit, property or services from the institution or any of its affiliates. Lenders are also barred from conditioning an extension of credit or services upon a requirement that the customer not engage with other financial institutions for lending services unless the condition is reasonably related to maintaining the soundness of the credit. Including such terms in a loan could form a basis of a voidable contract or other enforceability issues. Courts have also recognized other statutory claims alleging violations of the UCC, Internal Revenue Code (IRC), Racketeer Influenced and Corrupt Organizations Act (RICO), and the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA).
Most recently, the CARES Act, enacted on March 27, 2020, presents circumstances that may expose lenders and their servicers to liability, especially those in the mortgage space. For example, the CARES Act offers relief to borrowers of federally-backed mortgages in the form of a forbearance, i.e. a temporary postponement of mortgage payments. During the covered period, a borrower with a federally-backed mortgage loan who is experiencing a financial hardship as a result of COVID-19 may request a forbearance of up to 180 days by affirming that he or she is experiencing a financial hardship due to the COVID-19 national emergency. During the forbearance period, a servicer may not assess fees, penalties or interest, that would not have been charged to a consumer if he or she made timely payments under the terms of their mortgage contract. Additionally, under the CARES Act, a servicer of a federally-backed mortgage loan may not initiate or advance foreclosure proceedings, or execute a foreclosure-related eviction, for a period of not less than the 60-days from March 18, 2020. Lenders and their vendors failure to adhere to these accommodations may subject them to future liability. Such liability, however, would be contingent on courts finding that borrowers have a private right of action to enforce the CARES Act. Courts may also extend liability under the CARES Act based on a contractual representation/warranty in which both parties agree to adhere to all applicable state and federal law.
Novel to this environment is the growing number of legislation and executive orders concerning loans and financing. Lenders failure to adhere to these new restrictions, whether knowingly or not, could also present potential liability.
The regulatory environment for lenders is especially dynamic and special attention should be afforded to protect lenders from future liability.
Lenders and their servicers are likely fielding daily phone calls and correspondence from customers trying to understand their rights to defer payments or other form of forbearance. All communications with borrowers should be well documented and employees should be reminded of the importance of properly maintaining such records. For example, in the mortgage space, lenders need to keep precise records to avoid or at least mitigate any CARES Act (e.g., credit reporting) based claims.
Policies and procedures
Lenders need to regularly revisit their protocols and procedures to determine whether changes need to be made or temporary practices need to be implemented in light of new legislation and executive orders. For example, Section 4021 of the CARES Act amends the Fair Credit Reporting Act (15 U.S.C. 1681s-2(a)(1)) by providing new instructions for reporting consumer credit information to credit reporting agencies during the COVID-19 pandemic. These types of modifications need to be implemented through reasonable education and training for employees as noted below.
Education and training
Employees of lenders and their agents, as well as consumers should be apprised of their rights and obligations under the circumstances. To that end, resources should be available internally to address expected questions and concerns for contract terms meaning (i.e. force majeure clauses applicability, material adverse change) and for processes (i.e. how to apply for loan modification or forbearance). Additionally, employers should provide training to employees so that they understand the impact of new legislation that may alter regular procedures (i.e. credit reporting, foreclosure referrals). Resources for customers should be readily attainable for customers too as appropriate (e.g., who to contact for relief; documentation, if any, needed to demonstrate financial hardship).
Due to changing judicial orders, executive orders, and legislation, lenders need to ensure they are properly monitoring these activities. These various regulatory efforts affect lenders’ ability to exercise their collection and litigation efforts set forth in its agreements. Additionally, lenders should consider what industry leaders and trade associations are doing and advising because future cases may consider what other lenders were doing in similar situations, i.e. “commercially reasonable” standard. Lenders should therefore not materially deviate from the industry behavior set by their peers.
As we have discussed herein, lenders should be cognizant of potential exposure to liability and take proactive measures to protect themselves.
Seyfarth Shaw is following all issues related to lender liability closely in the wake of COVID-19. Please stay tuned for further information about an upcoming webinar on this topic.