Ideally, lending is a mutually beneficial endeavor. People want homes, stores need goods to sell, and farmers require land to farm. Lenders derive income from financing those deals. Each side needs what the other has, so why do so many disputes arise?
In our experience, the most common basis for lender liability is the lack of clarity in loan documents, including commitments to lend. That is, a borrower thinks it’s getting X while the lender thinks its providing Y. That disconnect often originates in unclear loan-commitment letters—a problem that’s usually avoidable.
Example: A Clear Scope of Lending[1]
Francis General Construction applied for financing from Society National Bank to build the first phase of a four-phase condominium development. Society sent a loan commitment letter to Francis approving the loan, which stated that Society would not consider future funding until Francis sold part of the first phase.
Francis eventually sued Society for breach of the commitment letter by arguing that Society’s commitment and lenders orally promised to finance all phases. On appeal, the Ohio Supreme Court rejected Francis’s claims by refusing to accept evidence of Society’s verbal discussions with Francis. The Court rejected that evidence because the commitment letter was clear and obligated Society to lend only for the first phase.
The clear drafting in Society’s commitment letter saved it from funding millions in potentially bad loans.
Consistency factors heavily in establishing clear loan commitment terms, for even the clearest terms can become ambiguous when contradicted. If the loan commitment requires a going-concern appraisal where federal regulation forbids it, which controls? Or if the commitment states the loan will auto-renew if conditions are met but the loan documents don’t, can the loan auto-renew? Or worse, will patently erroneous but clear terms in a commitment bind a lender? The answers vary, but courts usually bind lenders to their written promises.
Example: Conflicting Commitment and Loan Terms[2]
The Gildows sought a loan from Citfed Mortgage to build a home. Citfed sent a commitment letter to the Gildows that required them to approve each construction draw and the contractor’s corresponding work in writing. The loan documents did not, however, contain those requirements.
The Gildows were unhappy with the builder’s work, so they sued. The builder filed for bankruptcy, so the Gildows amended their lawsuit to sue Citfed. They claimed that the commitment letter, not the loan documents, governed and required them to approve the builder’s work as well as payment. The Second District Court of Appeals avoided that argument by finding that the Gildows did approve the builder’s work in writing, which precluded a breach-of-contract claim against Citfed. Importantly, however, the court alluded that Citfed might have breached the loan commitment if the Gildows hadn’t waived their claims.
The takeaways from this example are two: (1) terms found only in a commitment may supplement final loan documents, and (2) merger clauses may prevent issues with inconsistent loan and commitment documents.
Merger clauses are terms in any contract that limit the scope of an agreement. In short, they state that the contract (i.e., loan) is the exclusive agreement between lender and borrower about the proposed loan. They usually work to prevent a borrower from claiming that other terms (often verbal) are part of the loan. A clause like that can render conflicting commitments inapplicable and avoid problems like those in the Gildow case.
Equally important to risk management in loan commitments is the use of appropriate conditions precedent. As it concerns loan commitments, conditions precedent are conditions that must be met before the bank has a legal obligation to close and fund the loan. Many conditions are common: passing an environmental inspection or meeting an appraisal threshold, for example. Others less so: sufficient participation from other banks or debt restructuring. Regardless, lack of sufficient conditions precedent is often the basis for loan-commitment disputes.
To avoid those issues, loan commitments should contain deal-killer terms—that is, terms that are so important that the bank would not lend without them. Those terms may include guarantor requirements, detailed collateralization requirements, LTV and its basis, participation amounts, lockbox terms, major restrictive covenants, debt subordination, cognovit terms, and the like. And the same is true if the loan is guaranteed by the SBA or the USDA or held by participating banks. The commitment should include terms required by those parties as well. Without adequate conditions, you may be required to fund a bad loan.
Takeaways From this Post
- Use clear, plain English in your loan commitments.
- Ensure the terms in your commitments don’t contradict each other.
- Be specific.
- Use merger clauses in your letters and loan documents.
- Prepare for the unforeseen by using clear conditions precedent to condition your obligation to lend.
- Include any term that’s important enough that you wouldn’t lend without it.
[1] Ed Schory & Sons v. Francis, 75 Ohio St.3d 433, 662 N.E.2d 1074 (1996).
[2] Gildow v. Citfed Mortg. Corp. of Am., 2nd Dist. Miami No. 2000CA10, 11, 2000 Ohio App. LEXIS 4317 (September 22, 2000).