How Much Control Can the Lender Exercise in Workouts?

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March 25, 2014
Thomas Scherschel
SmithAmundsen Financial Services Alert
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There has been much discussion on the amount of control a lender can exercise over the borrower’s business in workout situations, and a lot of uncertainty. It’s time to revisit this issue and provide a few guidelines for lenders.

While it is true that a lender can incur liability if it becomes intimately involved in the business of the borrower during a workout situation, in most cases it is equally true that a lender can do whatever is necessary to protect its collateral even if those actions, in the absence of a loan and security agreement, might otherwise be considered an attempt to control the business of the borrower.

Many of the acceptable and unacceptable actions of a lender in workout situations have been referenced in Pearson v. Component Technology Corporation (80 F. Supp.2d 150). In Pearson, the borrower complained that the lender exercised excessive control over the borrower’s business in a workout situation, including voting the borrower’s stock and dismissing the borrower’s board of directors and replacing it with a board selected by the lender. While that certainly sounds like control of a borrower by a lender, the court found that each and every action of the lender was authorized by the loan documents and specifically designed to protect the collateral of the lender.

First, let’s begin with the general rule adopted by the Eighth Circuit: “only when a lender becomes so entangled with its borrower that it has assumed responsibility for the overall management of the borrower’s business” will the degree of control necessary to consider a secured creditor as an employer have been reached. Still, there is a point at which the actions taken by a lender to secure its investment exhibit such a high degree of control over the debtor corporation that the creditor assumes the overall management of the business (Pearson v. Component Technology Corporation, 80 F.Supp.2d 510, at 518). Presumably the Pearson Court was referring to a lender becoming actively involved in the hiring, firing and management of the business, as opposed to a lender who controls the borrower’s business only by using voting rights to replace the board or members of the board for the purpose of turning the business around or for the purpose of selling the collateral, including the business itself. So, with that degree of confusion, what is the rule?

Let’s start with what is allowed, assuming the loan documents provide for the following:

  1. allowing the creditor’s agent to negotiate settlements and claims, and to designate the order in which other creditors are paid, does not show that the lender had actual control over the debtor;
  2. monitoring the borrower’s operations and offering management advice is not sufficient control to incur liability;
  3. taking an active part in managing the borrowing company, without more, does not constitute total and actual control;
  4. exercising the right to approve the debtor’s business expenses does not constitute total and actual control;
  5. a creditor corporation exercising the right to elect one of its employees as president of the debtor corporation and thereby giving management direction does not constitute total and actual control of the debtor; and
  6. giving instructions to subcontractors and requiring access to books, and requiring debtor to pay over all receipts does not constitute total and actual control.

It must be emphasized that 1) the loan documents must provide for each of the above actions on the part of the lender; and 2) any of the above actions must be taken for the direct purpose of protecting the collateral.

One opinion has held that “the control necessary to invoke the 'instrumentality rule' is not mere majority or complete stock control but such domination of finances, policies and practices that the controlled corporation has, so to speak, no separate mind of its own and is but a business conduit for its principal.” (Id at 522)

Therefore, the amount of control over the borrower’s business is not the key question. The right questions are: 1) what powers are granted in the loan documents; and 2) are the actions taken by the lender rationally related to protection of the collateral, even if by doing so, it might be arguable that the actions of the lender are consistent with a certain amount of control over the business of the borrower.

In summary, the lender cannot roll up its sleeves and manage the day-to-day affairs of the borrower, but the lender can exercise its right to vote the shares of the company, vote in a new board with the intention of turning the borrower company around and thereby protecting the lender’s collateral. The lender can also exercise its voting rights to facilitate the sale of the company. None of the above will be considered controlling the management or operations of the company, provided the loan documents grant the lender the right to do so to protect its collateral.

One last caveat: When the lender finds itself in a position to control or appear to be controlling the borrower’s business, each such matter should be looked at on a case-by-case basis with the business loan agreement in hand. Lenders in these situations should consult with their attorneys prior to engaging in any actions that could be construed as “taking over” the borrower’s business.