A recent decision by Bankruptcy Judge Stacey Jurnigan in the U.S. Bankruptcy Court for the Northern District of Texas is being touted as the new Farah Manufacturing lender liability opinion for the 2020s.

While an extreme case, Judge Jurnigan’s decision in in Bailey Tool & Mfg. Co., et al. v. Republic Bus. Credit (In re Bailey Tool & Mfg. Co.), Adv. No. 16-03025-SGJ (Bankr. N.D. Tex. Dec. 23, 2021) will likely open the door to future litigation by distressed borrowers and trustees, and it serves as a cautionary tale on what lenders should avoid when entering into, executing, and performing obligations under lending agreements.

  • Lenders should address any concerns they discover during the due diligence process with clarity and before entering into agreements.
  • Regardless of the discretion a lender has under an agreement or any alleged breach of the agreement by its counterparty, it is imperative that they follow and comply in good faith with the terms of the agreement.
  • Lenders should not exceed their duty by micromanaging and taking an active role in controlling business decisions for the borrowers.
  • Lenders should not unilaterally withhold advances in an erratic manner.
  • Lenders should keep clear records that are accessible to the borrower, and document fees and expenses with full transparency.
  • Lenders should not communicate in a confusing or misleading manner.
  • Lenders should turn over excess funds to the borrower after the loan is paid in full.

Lenders are well-advised to seek counsel from their trusted advisors when facing difficult issues with borrowers, in order to avoid the fate of the lender in Bailey Tool.

The following is a summary of the Court’s factual findings and legal conclusions in Bailey Tool & Mfg. Co., et al. v. Republic Bus. Credit (In re Bailey Tool & Mfg. Co.), Adv. No. 16-03025-SGJ (Bankr. N.D. Tex. Dec. 23, 2021). We note that Republic Business Credit contested many of these factual findings and did not consent to the characterizations of its actions by the Court. 

The Debtors Enter Into an Inventory Loan and Factoring Agreement with Republic.

Baily Tool & Manufacturing Company and its affiliates were long-standing metal fabrication, product engineering, and design companies. In 2015, they entered into a financing arrangement with Republic Business Credit as a short-term bridge while they transitioned to a new long-term working capital lender.

The financing included two components: an inventory loan and a factoring agreement. Borrowings under the factoring agreement were treated as “purchases” of the debtors’ receivables at an advance rate of “up to” 90% of the face value of invoices, subject to certain eligibility requirements.

Republic was permitted to pay amounts owing under the inventory loan with amounts otherwise payable to the debtors under the factoring agreement, even absent an event of default.

Republic Misrepresents Eligible Receivables and Declares the Debtors “Over Advanced” Shortly Following Execution of the Agreements.

Shortly before the agreements were signed, Republic became concerned about one relatively large receivable. It decided internally to advance only 65% of the receivable, but did not notify the debtors of this decision.

Instead, in late February 2015, it sent final documents to the debtors for signature, along with a borrowing base certificate showing only $17,000 in ineligible accounts.

In mid-March 2015, the debtors made their first draw request.

In response, Republic sent the debtors a new borrowing base certificate showing that their ineligible accounts had jumped to $142,310.87. Although it honored the draw request, Republic treated the funds as an “over-advance” (a term not defined in the factoring agreement) and imposed a 2% service fee and higher interest rate.

Republic’s Failure to Adequately Fund Causes the Debtors Financial Distress.

In April, Republic advanced only 70% on receivables. The lower-than-expected funding put the debtors in a position of financial distress. The following month, the debtors were unable to make a $20,000 property tax payment.

As a result, Comerica Bank (the debtors’ separate term lender) declared an event of default.

Republic, in turn, declared an event of default based on the Comerica default.

In early July, Republic stopped advancing any funds to the debtors due to the debtors being “over-advanced” and lacking “availability.” At the same time, however, an internal Republic email stated that “[w]e are in the best position we have been in right now with around $100k in availability on A/R.”

Without notice to the debtors, Republic made payments of approximately $250,000 to itself to pay down the inventory loan during the same month.

The debtors were unable to make payroll in July.

As a result, the debtors’ employees walked out and the debtors’ plant temporarily shut down. Republic then issued a second notice of default based on the debtors “ceas[ing] to trade.” Republic’s records showed that the debtors had $159,000 in availability, while it represented to the debtors that it had none.

Republic Micromanages the Debtors’ Businesses and Conducts an “Unannounced Liquidation” of the Debtors.

After the shutdown, Republic took complete control of the debtors’ cash and controlled all collections and payments. Advances were no longer tied to any receivables purchased. Republic directly paid payroll, vendors, and other parties of its own choosing.

Republic also began micromanaging the debtors’ businesses. For example, it decided whether the debtors should pay $2,330 to retrieve from a repair shop an electric motor necessary to make parts for an important customer. Republic even micromanaged the debtors’ purchase of office supplies and hired armed guards to patrol the debtors’ premises, a fact which the Court viewed as an “unnecessary intimidation tactic.”

Despite these difficulties, the debtors continued to generate significant receivables, and Republic internally recognized that the debtors had availability.

While Republic maintained an “information portal” for customers, it was incomprehensible. The failure of funding resulted from Republic’s use of collections to prepay the inventory loan without notice to the debtors (for which it even imposed a prepayment penalty). There was no competent evidence that the inventory loan was undercollateralized at the time.

All of this led the Court to conclude that Republic was conducting an “unannounced liquidation” of the debtors, even while it viewed the debtors to be in the “best position” they had been in with respect to its collateral. Despite significant cash collections coming into the debtors’ accounts between April and July 2015, Republic “advanced” only 57% on receivables during that time (though the funds were not actually advanced directly to the debtors as such). Between July and November 5, it “advanced” only 33%.

Republic’s protocol of deciding who was paid resulted in delays and damaged the debtors’ relationships with their customers.

In one instance, the Oklahoma plant of a long-standing customer nearly shut down due to delays. Republic’s mismanagement eventually resulted in the debtors losing seven important customers and having to file for bankruptcy protection in February 2016.

Republic Coerces the Debtors’ President to Give It a Lien on His Exempt Homestead

Republic also coerced the debtors’ president and owner to give Republic a lien on his exempt Texas homestead as a condition of future funding. Republic represented that the debtors were “over-advanced” and that the homestead would be used only as backup collateral.

Because Republic had taken him off the payroll, however, the president had no way to pay the monthly mortgage on his home and was forced to hurriedly sell it in October 2015. He paid Republic $225,000 of the proceeds to remove Republic’s lien, believing that Republic had agreed to resume funding the debtors, which it never did.

Republic Holds Debtors’ Funds After Payment in Full in an Attempt to Extract a Release

By mid-November, Republic appeared well aware that it had collected more than enough to pay off its facility in full (even taking a $75,000 termination fee). But it refused to turn over the balance of over $150,000 without a release, despite there being no contractual basis for demanding the same.

Republic continued to collect the debtors’ receivables through a lockbox arrangement. By the time of the bankruptcy filing in February 2016 it held $584,250 in excess funds, which it refused to turn over.

During the bankruptcy proceedings, Republic contended that the factoring agreement had not been terminated and gave Republic title to the debtors’ receivables in perpetuity. It even sued certain of the debtors’ customers post-petition. Republic used the retained funds as a “sword” to hinder reorganization attempts, hoping to force a conversion to a Chapter 7 liquidation.

The debtors intended to pivot to becoming an ammunition manufacturer and had good prospects in that regard. But without the funds that that Republic held at the time, they were unable to do so and the case ended up converting. Republic celebrated the debtors’ demise in internal emails.

The Chapter 7 Trustee and President Prosecute Claims Against Republic.

The debtors brought an adversary proceeding against Republic shortly after filing for bankruptcy, which the Chapter 7 trustee prosecuted after conversion to Chapter 7.

The suit asserted claims against Republic for breach of contract, fraud, tortious interference with contract and business relations, and violation of the automatic stay.

The president brought claims individually against Republic for fraud, fraud in a real estate transaction, and negligent misrepresentation.

The parties consented to entry of final judgment by the bankruptcy court, which held a seven and one half day bench trial and then issued a 145-page written decision.

The Court Awards the Trustee Damages of $16,966,982.

The Court analyzed the breach of contract claim under Louisiana law, made applicable by the relevant agreements.

The Court held that the agreements’ prohibition on consequential damages was invalid under Louisiana law as to bad faith breaches. It found that Republic breached the agreements in bad faith “by not funding [the Debtors] directly, but instead putting in place a procedure to only pay certain vendors and employees that Republic deemed advantageous to enhance its collections.”

Further, Republic breached the factoring agreement by charging a $75,000 termination fee but taking the position that the agreement was not terminated and refusing to turn over funds it collected. The breaches were intentional or the result of gross misconduct and caused the debtors to fail as a going concern and file bankruptcy. Republic over-collected $584,250, caused the loss of the debtors’ legacy business, worth $4.974 million, and the loss of their prospective ammunition-focused business, worth $7.3 million.

The Court found that Republic also violated an implied duty of good faith and fair dealing by the same actions, as well as:

  • essentially taking over the manufacturing function through, inter alia, approving or not payments to certain vendors and material suppliers,
  • controlling the debtors’ workforce by choosing which employees to pay, and
  • attempting to force vendors to pay Republic directly.

Fraud

The Court found that Republic committed fraud by “repeatedly creat[ing] the impression in communications . . . that [the Debtors were] in default by being over-advanced.” Further, Republic misrepresented that funds were not available, without disclosing that it was using collections to pay down the inventory loan.

Had Republic not made these misrepresentations, the debtors would not have continued forwarding account invoices to Republic for processing. These actions caused the destruction of the debtors’ existing and prospective businesses.

Tortious Interference

The Court found that Republic grossly interfered with the debtors’ contracts and business relations by injecting itself into corporate governance, micromanaging which expenses were paid, and insisting on paying vendors and employees directly. It interfered with customer contracts by, among other things, wrongly withholding funds from the debtors, resulting in the debtors not paying these customers. The debtors suffered damages in the amount of $2,044,844 in lost net profits.

Violation of the Automatic Stay

The Court found that Republic violated the automatic stay by demanding post-petition that the debtors’ customers pay Republic instead of the debtors, refusing to turn over funds, and insisting that the factoring agreement was still in place, all in an effort to obtain a release.

These actions caused the debtors’ reorganization to fail. The Court ordered Republic to pay $490,000, the amount of administrative fees during the Chapter 11 phase of the case. Finding that the violations were willful, it awarded punitive damages of three times the amount ($1,470,000).

The Court Awards the President damages of $1,160,000

The Court found that Republic misrepresented to the president that it would honor the agreements and restore funding to the debtors if he provided collateral. The injuries caused included:

  • obtaining an improper mortgage on the homestead,
  • taking $225,00 in proceeds from the sale of the home, and
  • pressuring the president to hurriedly sell his home, resulting in him selling it for $185,000 less than market value.

The Court also awarded exemplary damages of $750,000 “to serve as notice to the financial community that similar conduct will not be tolerated.”