Topaz Johnson | When lenders default

That there are increased borrower defaults during times of economic turbulence may be a truism. Less considered is the obligation of lenders to lend, the consequences of wrongful refusal to lend, and how lenders may avoid this in commercial lending.

Contract law decides questions as to the parties’ obligations, in the absence of any property right created by way of security. Evaluating lending obligations, therefore, involves determining whether there is a binding contract to advance funds to a borrower, and whether it provides the lender with grounds to refuse to advance funds.

Smaller loans are often made by use of a commitment letter containing the basic terms of the loan and constitutes an offer, which the borrower accepts. In larger loans, the letter is usually followed by formal documentation. The commitment letter in the latter situation may constitute: a binding obligation to lend; a commitment to lend if certain conditions are met; or an expression of intent to enter a contract.

A contract is formed when there is an accepted offer and consideration passes, if the parties intend to create legal relations. So, an important question is whether the parties, objectively speaking, intended for an agreement to have been reached. In making its assessment, a court may ask how a reasonable man, versed in business, would have understood the exchanges between the parties.

In discerning intention, a court may consider market practices such as whether it is usual for contracts to be concluded over the telephone. Signatures to agreements, while desirable, are not generally necessary to evince an intention to enter into a legal agreement. Signatures are the best evidence of what had been agreed, but they may themselves not be conditions of the agreement.

It is possible to provide that there is no binding contract by stating in a preliminary document, such as a commitment letter, that it is ‘subject to contract’. However, merely including this phrase will not prevent the parties from being contractually bound if their subsequent conduct contradicts this. A letter with essential terms required to operate a loan but stating that no obligation will arise unless formal contracts are prepared, may turn into a contract if the lender advances funds, and the borrower accepts them.

For a contract to be binding, the parties must express their agreement in a form which is sufficiently certain to be enforceable. Agreements sometimes contain clauses whereby the parties are to later decide on a particular aspect of the arrangement. Whether such an ‘agreement to agree’ will be enforceable is not entirely predictable.

One leading case determined that a contract “may leave something which still has to be determined, but then that determination must be a determination which does not depend upon the agreement between the parties”. Another case decided “an agreement is not incomplete merely because it calls for some further agreement between the parties. Even the parties’ later failure to agree on the matters left outstanding will vitiate the contract only if it makes it ‘unworkable or void for uncertainty’.”

Where there are uncertain or missing terms in loan agreements, courts may imply terms, even referencing established customs and trade usage or previous dealings between parties. However, courts are restricted in this respect. A United Kingdom Supreme Court judgment emphasised that it must be ‘necessary’ to the case to imply the term. Further, the reasonable reader is treated as someone who read the contract at the time it was made, and would consider the term to be so obvious as to go without saying.

A lender is sometimes given discretion in an aspect of the arrangement, such as for interest rate changes. Limits on such discretion may include that it ought not to be exercised in a manner which is dishonest, for an improper purpose, capricious or arbitrary.

If a lending contract is breached the normal remedy is damages. Damages may be awarded to a borrower that proves its loss, shows that it mitigated the loss, and the loss is not too remote from the lender’s breach.

Damages are nominal where replacement funds could be found. However, where funds could not be found elsewhere, substantial damages are a possibility. Substantial damages have been given in the UK, where a bank had express notice of the purpose for which the money was required and by reason of the refusal of the bank to lend, the potential borrower was unable to complete a contract.

Loss of future business that might have reasonably been expected to flow from a transaction that the borrower can no longer perform is also a potential claim. It has been suggested that loss of creditworthiness and business reputation may be claimed, analogous to a case of wrongful dishonour of a business cheque.

Damages are to put the borrower in the same position as if its rights had been observed. However, it is entitled to recover only such part of the loss actually resulting or reasonably contemplated as likely to result from the breach of contract, and the type of loss was contemplated as a serious possibility.

Lenders’ hesitancy may result from regulatory, market or credit risk changes. To prepare for these eventualities, lenders use protective provisions. They often include conditions precedent, events of default, material adverse change or effect, market disruption, and/or market flex clauses.

Care in documentation and communication between lenders and borrowers can allocate risks between them in a manner that minimises unexpected outcomes. Since risks may be more significant during times of economic turbulence – which may arise suddenly – this care is best taken at all times.

Topaz Johnson is an attorney-at-law at the law firm DunnCox in Kingston.topaz.johnson@dunncox.com