Lessons for Lenders in Avoiding Liability When Exercising Setoff Rights

by Poyner Spruill LLP

[authors: Christopher H. Roede, Jill C. Walters]

Last year the Superior Court of Forsyth County, North Carolina awarded approximately $2.1 million in damages against a large lender for its decision to offset debt against a deposit account of a guarantor. The trial court ruled that the lender’s decision to offset against the deposit account rose to the level of an unfair trade practice considering the lender’s past dealings with defaults by other borrowing entities owned by the guarantor. On appeal the North Carolina Court of Appeals (Appellate Court) overturned the trial court’s ruling that the exercise of the setoff against the deposit account violated North Carolina’s statute regarding unfair or deceptive trade practices (UDTPA) that entitled the guarantor to treble damages. The Appellate Court vacated the award of treble damages, but upheld the jury’s verdict that the lender was not permitted to collect on the remaining balance of the loan after the setoff. This case is an important reminder to lenders to be cognizant of lender liability issues when exercising its setoff rights. Below is a short history of this case followed by a few valuable lessons learned from it.

The guarantor was a residential real estate developer who formed the borrowing entity to develop a townhome project in Guilford County, financed by the lender. The guarantor was a long term customer with the lender and its predecessor institutions. In the past, whenever any of the guarantor’s loans were in trouble, a representative of the lender would contact the guarantor by phone and work with him to resolve the issues. In August of 2009, the lender transitioned the guarantor’s banking relationship to the lender’s special assets department. By this time the lender believed that the value of the townhome project was no longer sufficient to secure the borrower’s loan. The lender’s special assets officer telephoned the guarantor in 2009 to discuss the various troubled loans, and when the conversation eventually turned to the townhome project loan, the lender was not satisfied with the guarantor’s claims that the loan was not in jeopardy. During this phone call, the lender informed the guarantor that his deposit accounts maintained by the lender would be frozen due to the lender’s concerns that the borrower’s loan for the townhome project was in default.

In January of 2010 the lender filed suit to recover amounts owed to it under the terms of the townhome project loan. The guarantor counterclaimed asserting that the freezing of the guarantor’s deposit account and eventual offset denied the borrower access to the working capital needed to keep the townhome project going, caused that project to fail and was unfair and oppressive in light of the lender’s history with the guarantor. In a confusing and contradictory jury verdict, the jury determined that neither the lender nor the borrower breached the underlying loan contract (despite the fact that the loan remained unpaid), but still awarded $700,000.00 in damages (this $700,000.00 award was later dismissed on procedural grounds) to the borrower based on a theory of lost business opportunities and profits for the townhome project. Despite the fact that the jury’s verdict included a determination that the lender did not breach the loan contract, the court sided with the guarantor and borrower and ruled that as a matter of law the lender’s sudden decision to freeze the guarantor’s accounts without prior notice was unfair and an oppressive and inequitable exercise of power by the lender in light of its past practice of giving the guarantor notice and opportunity to cure loan defaults. This ruling resulted in UDTPA liability for the lender in the amount of $2.1 million (triple the amount of the $700,000.00 jury award).

On appeal the lender argued that UDTPA liability cannot arise as a matter of law where the lender never breaches the loan contract and is simply exercising legitimate, contractually agreed to remedies, absent any kind of fraud, constructive fraud, misrepresentation or other malicious conduct of the lender. The Appellate Court largely sided with the lender on this issue, noting that UDTPA liability generally arises under two circumstances: (1) a UDTPA claim separate and distinct from a breach of contract claim combined with allegations of fraud, constructive fraud, misrepresentation or the like; or (2) a claim based on a breach of contract together with substantial aggravating circumstances making the alleged conduct immoral, unethical, oppressive, unscrupulous or deceptive. Because the misconduct alleged by the borrower and guarantor related exclusively to actions the lender took pursuant to the terms of the loan contract, and the jury determined that the lender never breached this contract, the Appellate Court ruled there was no legal basis for imposing UDTPA liability. The borrower and guarantor never made any allegations relating to malicious conduct occurring outside of the loan contract that could support any UDTPA liability.

While the lender was successful in overturning UDTPA liability, the Appellate Court refused to order a verdict in favor of the lender for the unpaid balance of the loan. The Appellate Court reasoned that even though the jury’s finding that there was no breach of the loan contract by the borrower - despite the loan remaining unpaid - was factually contradictory and confusing, it was not necessarily legally inconsistent if the jury believed the remaining unpaid balance on the loan resulted from the lender’s own actions. Presumably, this is what the jury believed since it found no default under the loan contract by the borrower.

The primary lesson for lenders to take from this case is to stick to the terms of the loan agreement when dealing with borrowers and guarantors. In this case, the written agreement governing the terms of the deposit account maintained by the borrower and the guarantor with the lender expressly permitted the lender to offset against the account for monies owed to the lender. This is likely to be what the jury relied on in determining that the lender’s exercise of its setoff rights did not constitute a breach of the loan contract. Additionally, it was the lender’s deviation from the written terms of the loan agreement in repeatedly permitting the guarantor extra time to cure loan defaults that was the ultimate basis of the borrower and guarantor’s defenses to the enforcement of the loan contract. Where the lender has knowledge of a history of significant deviation from the written terms of the loan agreement for any particular loan, it would be well served to put the borrower and guarantors on notice of the lender’s insistence of strict performance under the written terms of the loan agreement whenever the loan becomes seriously troubled.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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