Two Bad Loans Don't Equal One Good Loan Bank Appeals $3 Million Judgment

Two Bad Loans Don't Equal One Good Loan
Bank Appeals $3 Million Judgment
by BOL Guru Sam Ott

The United States Court of Appeals for the 6th Circuit on April 15, 2002 decided the case of Sallee v. Fort Knox National Bank by holding that the bank was liable to a loan customer for failing to reveal a negative appraisal and inducing the execution of a release of all claims against the bank. The original judgment of $3,009,998.25 was reduced but the Court upheld the award of punitive damages against the holding company of the bank.

The Court was very graphic in its assessment of the actions of the bank and its customers. It described the case as the "unhappy collision between the bank's bad banking practices and the debtors' business naivete and incompetence".

The bank was painted as displaying the "go-go" mentality that infected banking in the mid-1980's. The loan officers were identified as possessing a dangerous combination of inexperience and incompetence. The bank was severely criticized for poorly documenting the loans, loosely collateralizing the loans and making loans with little financial information.

The bank's appraiser was assailed as the author of the worst prepared appraisal the court had reviewed in the last 10 years. It was noted the appraisals disingenuously found real estate had the exact value needed to support whatever loan amount that the loan officer wanted.

Keep in mind these are the comments of a Federal Judge in a legal opinion -- not a Regulator in an examination.

The Facts
The debtors were approached by another customer of the bank who wanted to sell the debtors a laundromat from which the debtors had previously purchase an adjacent convenience store. The bank that had previously financed the purchase of the convenience store for the debtors was contacted regarding the financing of the second transaction. The bank had financed both the convenience store and the laundromat originally and the loans were in default at the time of each sale.

The bank actively encouraged the sale and provided the buyers (the debtors) a pro-forma and site survey that suggested the laundromat would gross between $150,000 and $200,000 per year. In addition, the bank told the debtors it had a current appraisal of the property for $750,000.

The bank did not disclose two earlier appraisals conducted within a 1 and ? year period showing that the appraised value rose from $469,000 to $647,000 to $726,000 (the actual final appraisal amount). The same appraiser prepared all three appraisals. The bankruptcy court later said it was the worst prepared appraisal that it has had the opportunity to review in its past ten years and the appraisal amount found the real estate in question to have the exact value needed to support whatever loan amount the bank's loan officer wanted. The increases in appraised value occurred even though no improvements were made on the launderomat and the funds generated by the business could not service the debt.

When the debtors were unable to service their loans to the bank, they sought an extension and expressed a desire to refinance their entire loan package. The bank agreed to the extension and implied that a "package loan" would be forthcoming. The extension agreement, which was prepared by the bank, released the bank from "any and all rights, claims or causes of action with respect to the Loan Documents and Collateral."

During the time the debtors were involved in extension discussions with their loan officer, the bank's holding company, upon review of the loan portfolio, stopped all commercial lending by the bank. The loan officer continued with the discussions without informing the debtors of the change in the bank's lending policy. The debtors, in part on the belief that the bank would provide them a "package loan", executed the extension agreement.

The loans went into default and the bank initiated a foreclosure suit regarding the real and personal property including ESOP stock of the debtor that had also been pledged as collateral. The debtors filed a counterclaim against the bank alleging fraud in the inducement relative to the purchase of the laundromat and breach of contract for the financing of the purchase. The debtors then filed a petition for bankruptcy and the court action was removed to the bankruptcy court as an adversary action.

The bank filed a motion for summary judgment alleging that the extension agreement released the bank form liability for all claims. The bankruptcy court disagreed and entered judgment for the debtors. The bankruptcy court held the bank owed the debtors a fiduciary duty and breached that duty by failing to reveal material facts concerning the loan. In addition, the bank defrauded the debtors by misrepresenting the value of the laundromat. The debtors were awarded compensatory damages and punitive damages in the total amount of $3,009,998.25.

The bank appealed to the district court who reversed the measure of damages, ordered a reduction in punitive damages and affirmed the remainder of the bankruptcy court judgment.

Discussion
The bank argued that the courts made five errors:

In holding the release in the extension agreement did not preclude the debtors' claims
In concluding the bank owed a fiduciary duty to the debtors
The bank is not liable for fraud because the debtors could not prove reasonable reliance
In calculating damages
In awarding punitive damages.

Fiduciary Relationship
After review of the facts and listening to the arguments of the parties, the Court held that the debtors had failed to show a fiduciary relationship existed with the bank.

The Court noted a fiduciary relationship creates the highest order of duty imposed by law. If a fiduciary relationship exists, the fiduciary cannot profit from the relationship without the knowledge and permission of the principal. A fiduciary relationship requires more than the generalized business obligation of good faith and fair dealing.

The Court stated "except in special circumstances, a bank does not have a fiduciary relationship with its borrowers." Courts traditionally view a relationship between a bank and a depositor to be one of debtor-creditor and do not ordinarily impose a fiduciary duty of disclosure upon the bank. As a matter of business, banks seek to maximize their earnings by charging interest rates or fees as high as the market will allow.

Banks seek as much security for their loans as they can obtain. In contrast, debtors hope to pay the lowest possible interest rate and fee charges and give as little as security as possible. Without a great deal more, a mere confidence that a bank will act fairly does not create a fiduciary relationship obligating the bank to act in the borrower's interest ahead of its own interest.

Fraud Claims
The Court then considered the fraud claims. The bankruptcy court found the bank defrauded the debtors when the bank gave them the misleading pro-forma, site survey and appraisals that the bank officers knew or should have known were inflated. The Court referenced a passage from an English case regarding a banker who received an inquiry about the credit-worthiness of a customer that indicated the banker has three options:

The banker can decline to give the information;
he can give an answer with a clear qualification that it is given and accepted without any responsibility or is given without reflection or research; or
the banker can give an answer without qualification.

If the banker adopts the third alternative he can be held to have accepted some responsibility for answering carefully or to have accepted a relationship with the inquirer which requires him to exercise such care as circumstances require.

The Court held the record supported the finding of the bankruptcy court. It reasoned that the bank having shown the pro forma, the site survey and one appraisal, could not avoid revealing the other appraisals without making its earlier representations fraudulent.

Extension Agreement Waiver
The bankruptcy court rejected the bank's argument that the debtors had released their fraud claims when they executed the extension agreements due to the finding that the agreement was not broad enough to release or discharge the claims. The waiver language only mentioned claims regarding the loan documents or the collateral. The district court held that the extension agreement was unenforceable because it was obtained through fraudulent misrepresentation and the promise of the "package" loan had fraudulently caused the debtors to execute the extension.

After a review of the actions of the lower courts, the Court found that the bank obtained the extension agreement through fraud and therefore rejected the bank's argument that the extension agreement language prevents the debtors' claims.

Compensatory damages
The bankruptcy court awarded damages to the debtors for the misrepresented value of the laundromat and the lost value for the sale of ESOP stock that was also pledged as collateral and punitive damages. The district court found that the bankruptcy court erred in the calculation of the value of the laundromat and adjusted the amount of damages.

The bank argued that the debtor was not entitled under state law to recover for both fraudulent misrepresentation and fraudulent inducement. The Court held that the debtors made an election to affirm the laundromat loan transaction that allowed them to sue for fraudulent misrepresentation but not for fraudulent inducement. The debtors were therefore precluded from receiving damages regarding the inducement claim.

In addition the Court determined the calculation by the district court was correct and the proper damage award was the difference between the final appraised value of the laundromat and what it was actually worth on the day the debtors purchased it.

Punitive Damages
The bank argued that the punitive award against it should be set aside due to the fact the original bank no longer existed. The original bank was sold by its holding company to a third party. The Court noted that there was a provision in the bank sale contract in which the holding company agreed to pay any damages arising from this case. The bank argued that the bankruptcy court held that the holding company was absolved of all liability in the case. The district court specifically rejected this argument. The Court also agreed that punitive damages should be awarded but the amount should be remanded to the district court for recalculation.

Summary
The Court held that a lender absent special circumstances is not in a fiduciary relationship with its borrowers. A lender however does have any obligation to disclose known facts regarding the appraisal value of real property and may be liable for fraudulent misrepresentation if such disclosures are not made. In addition the existence in an extension agreement of a blanket waiver of all claims against the bank may be held unenforceable if the bank induces the debtor to execute the agreement with the promise of future financing.

First published on BankersOnline.com 4/16/02