Lender liability law exists to ensure (often unsophisticated) borrowers are protected.
For lenders, this sounds simple enough — act in good faith, don’t commit fraud, and you won’t get sued. However, due to the complexity of loan agreements and duration of contracts, details can be mistaken, and circumstances can change, adding significant complexity to lender liability issues. Some borrowers (or their attorneys) are just unscrupulous, too. Often, these are simply “wrongful infliction of money” cases; but they still must be defended.
Lender liability is even more salient now than during the pandemic. The recession hasn’t helped, especially for real estate lenders. Properties are underperforming and borrowers may be seeking forbearance or extended lines of credit. This may prompt lenders to stray from original terms or become more involved in a borrower’s business affairs, exposing the lender to greater liability and the potential for costly litigation. Lenders should be aware of possible liability and understand how to proactively limit their legal risks.
Common Types of Lender Liability
Some of the most common lender liability claims arise from a breach of contract. This can occur during loan administration, for example, misapplying payments. It can also occur when a loan is in distress, for example, wrongful foreclosure. Lender liability claims may also arise from a breach of duty of good faith and fair dealing, or from fraud/negligent misrepresentation. An example of this might be a lender verbally promising a borrower forbearance, and later failing to follow through on this promise.
Oftentimes, when a borrower is exposed to foreclosure or eviction, they discover how unfair the loan has been since inception and sue. Prior to these “trigger” events, it is useful to review your file to ensure it is in order.
Lenders should also be aware of state laws regarding unfair practices and consumer protection, as well as any fiduciary relationship they may have with the borrower. Typically, a lender does not have fiduciary duty to a borrower. If a lender becomes involved in day-to-day operations of a borrower’s business, even (sometimes) advising on when to buy equipment, this can create a fiduciary relationship and a new area of liability for lenders.
How to Limit Lender Liability
Lenders can do many things to avoid and limit liability from the start. Here are five tips:
1. Draft protective loan documents
The most effective strategy to limit liability is to include provisions in loan documents anticipating claims. Some protective provisions include:
- “Integration” which is a provision to indicate the written contract is the extent of the agreement
- Prohibition of oral modification of the agreement
- “Jurisdiction and venue” indicating where claims can be filed
2. Don’t act without consulting the contract and your legal counsel
If a lender believes the borrower has defaulted on the loan, it is best to consult the contract and a lawyer before freezing the borrower’s line of credit. If the borrower disputes the default, the lender may be liable for a breach of contract.
3. Maintain open lines of communication with the borrower
All contracts imply good faith and require the borrower and lender to maintain the spirit of the agreement. Lenders can help maintain this through regular and timely communication with the borrower.
4. Document all discussions
Lenders should avoid making promises beyond what is written in the loan agreement. Any communication with the borrower and/or guarantors should be documented in writing and include context for the communication.
5. Keep a detailed loan file
Lenders should establish and maintain a loan file that includes essential documents, including the loan application, credit reports, and copies of communication with the borrower. This file can be a resource should any issues arise.