Recently, in In re Moon Group Inc., a bankruptcy court said no, but the district court, which has agreed to review the decision on an interlocutory appeal, seems far less sure.

The bankruptcy court held that a lockbox lender has no obligation to make advances under its line of credit with the borrowers when the credit agreement expressly provides that the lender may make or withhold advances in its sole discretion. The District Court for the District of Delaware, however, granted a chapter 7 debtor trustee’s motion for leave to appeal the bankruptcy court decision. In doing so, the district court joined the very few courts who address the unique role of a lockbox lender in a company's capital structure, given its control over essential liquidity and cash flows, and whether, as a result, an implied covenant of good faith and fair dealing may be interpreted as effectively expanding a lockbox lenders’ obligations well beyond the express terms of its lending agreement.

Any such expansion may potentially have a broad impact, inasmuch as many receivables-financing facilities and other asset-based lending facilities have elements of broad lender discretion built into them, whether or not the lending facility is a committed one. As an example, even "committed" asset-based revolving lending facilities usually include lender discretion to establish reserves in unspecified (and thus perhaps unlimited) amounts, which can effectively block additional borrowing under them. Lender discretion in such cases is typically defined under a "permitted discretion" standard that has evolved in the market. The decision to be rendered by the district court in this case may potentially impact such financings, particularly if based on an implied covenant of good faith and fair dealing that presumably may not be waived or modified contractually.

Background

The In re Moon ruling arose out of an adversary proceeding filed by the debtors, Moon Group Inc. and certain of its affiliates (collectively, “Moon” or the “Debtors”), against their principal lender, Kore Capital Corporation (“Kore”) during their chapter 11 cases, and which was later prosecuted by their chapter 7 trustee following the cases’ conversion.

The Debtors operated several business lines, including a wholesale tree and shrubbery nursery, a commercial landscape maintenance and site management company, and a landscape construction business, which, due to the seasonality of the business, required a substantial line of credit to ensure adequate cash flow. In May 2020, prior to the bankruptcy, Kore provided a revolving line of credit to the Debtors, secured primarily by accounts receivable. The financing used a lockbox structure, with all accounts receivable paid directly by Moon’s customers into a lockbox account maintained by Kore. Kore would re-lend repaid amounts at the request of the borrowers, subject to a borrowing base formula and other terms of the credit agreement.

In July 2021, after several amendments of the credit documents increasing both the credit limit and the advance rate, Kore refused to fund a further requested draw on the line of credit. As a result, the Debtors asked their largest customer to begin making payments to Moon directly, outside of the Kore lockbox structure, in violation of the terms of the Kore financing. Kore issued a notice of default and commenced suit against the Debtors and the customer which had commenced making payments outside the lockbox structure.

The Debtors filed for chapter 11 a few weeks later, in August 2021. Shortly thereafter, the Debtors repaid the outstanding amounts under the line of credit (though not certain post-default fees and other charges asserted by Kore). But they also filed a complaint with the bankruptcy court commencing an adversary proceeding against Kore. The complaint, as amended, sought damages from Kore for various breaches of the credit agreement, including for breach of the implied duty of good faith and fair dealing. When the cases were converted to chapter 7, the chapter 7 trustee assumed the litigation. Kore filed counterclaims seeking post-default and other charges.

The Bankruptcy Court’s Decision

The Bankruptcy Court granted in part a motion by Kore for judgment on the pleadings, in which Kore argued that it had unfettered discretion to exit the lockbox lending arrangement based on the plain language of its credit agreement with Moon. Kore pointed out that the credit agreement expressly provided that “Lender in its sole discretion may make Advances to the Borrower.” The Bankruptcy Court rejected the trustee’s arguments that precedents impose a duty on lockbox lenders (due to their heightened ability to limit a borrower’s liquidity) to provide reasonable advance notice and an opportunity for a borrower to seek alternative financing in the event a lender sought to exercise its discretion to withhold advances.

In reaching its decision, the bankruptcy court distinguished the federal cases relied upon by the trustee and cited Maryland law, the credit agreement governing law, which, although recognizing an implied duty of good faith and fair dealing (including in the lending context), does not obligate a party to take affirmative actions that it is not otherwise clearly required to take under a contract.  The Moon trustee sought leave to appeal.

Discussion

In its ruling granting the trustee’s motion, the district court analyzed, as it must, the legal standards underpinning a decision for leave to appeal an interlocutory decision, and found the necessary elements to be present. One of these elements is that substantial grounds for difference of opinion exist as to the correctness of the decision whose appeal is being sought.

The issue at hand is whether a lockbox lender is subject to a duty of good faith and fair dealing that would impose on it duties beyond those set forth in its contract. Under existing law in many states, an implied duty of good faith and fair dealing would impose only a requirement that a lender act on some good faith or rational basis in making its decisions, and not act purely whimsically and arbitrarily.

Perhaps surprisingly, the district court found that substantial difference of opinion exists as to the correctness of the bankruptcy court’s decision that the implied covenant of good faith and fair dealing did not obligate Kore to take actions (i.e., provide advance notice) beyond those specified in its credit agreement.  The district court noted that at least three federal courts had imposed a heightened duty of care on lockbox lenders, based on the substantial control they hold over a borrower’s cashflow. And, according to the district court, the precedent relied on by the bankruptcy court did not involve lockbox lending relationships.

Conclusion

While the mere grant of leave to appeal an interlocutory order is unlikely to generate significant waves in legal or financial circles, the In re Moon ruling could portend more significant developments.  The laws of the handful of states most often selected as governing credit agreements are generally viewed by market participants as empowering lenders to shut off credit when their credit agreement specifies that loans are in the lender's sole discretion, at least so long as the credit decision has some basis and is not purely whimsical or arbitrary.  A future decision by the district court requiring such lockbox lenders to, say, provide notice to the borrower before refusing to fund advances, as a result of duties imposed by the implied covenant of good faith and fair dealing, would be a significant development.

The appeal should therefore generate considerable interest among finance professionals. For now, however, the In re Moon decision serves as a reminder that duties of good faith and fair dealing remain relevant, as always.

In re Moon Grp. Inc., 2023 WL 3848338 (D. Del. June 6, 2023), is available here.