The Economics of Lender Liability

Abstract

In July 1986, the Hunt Brothers of Dallas, Texas, weakened by losses in the silver and oil markets, defaulted on a $1.5 billion loan. The Hunts then filed a $3.6 billion lawsuit against their lenders on theories, among others, of fraud, negligent misrepresentation, breach of fiduciary duty and duty of good faith, breach of contract, and violations of the antitrust laws and the Bank Holding Company Act.1 Ten years ago, the Hunt's action would have been wholly unprecedented, with virtually no probability of success. However, developments in the law since that time, in particular the emergence of the booming area of lender liability, have dramatically changed the conventional understanding of the relationship between lenders and their borrowers. In recent years banks have been subjected to liability in a number of diverse situations. State National Bank of El Paso v. Farah Manufacturing Co.2 is illustrative. William Farah was chief executive officer of FMC, a clothing company. From 1972-76, the company incurred large losses, and William Farah was subsequently replaced as CEO. In 1977, FMC and its three banks amended their outstanding loan agreements to provide that any change in FMC's top management considered by any of the banks to be adverse to their interests would constitute an act of default. The purpose of the management change clause was to prevent Farah from returning as CEO. Shortly thereafter, however, Farah sought reinstatement as CEO. The board of directors refused after the lenders took the position that Farah's return would constitute a default under the management change clause. Approximately one year later, FMC and the banks restructured the loan and deleted the management change clause-Farah subsequently regained control of the company. Under Farah's leadership, FMC's fortunes changed dramatically for the better, and the company regained profitability.