In re Prince Frederick Investment, LLC: Court Dismisses Equitable Subordination Claim Against Lender Exercising Contractual Rights | Practical Law

In re Prince Frederick Investment, LLC: Court Dismisses Equitable Subordination Claim Against Lender Exercising Contractual Rights | Practical Law

In Atlantic Builders Group, Inc. v. Old Line Bank (In re Prince Frederick Investment, LLC), the US Bankruptcy Court for the District of Maryland dismissed a creditor's equitable subordination claim against a bank on the grounds that by exercising its contractual rights under a loan agreement, the bank did not exert dominion and control over the debtor such that a fiduciary relationship was created that would result in the bank owing a fiduciary duty to the debtor's creditors, nor did the bank engage in egregious conduct that shocked the conscience of the court.

In re Prince Frederick Investment, LLC: Court Dismisses Equitable Subordination Claim Against Lender Exercising Contractual Rights

by Practical Law Finance and Practical Law Bankruptcy & Restructuring
Published on 29 Oct 2014 • USA (National/Federal)
In Atlantic Builders Group, Inc. v. Old Line Bank (In re Prince Frederick Investment, LLC), the US Bankruptcy Court for the District of Maryland dismissed a creditor's equitable subordination claim against a bank on the grounds that by exercising its contractual rights under a loan agreement, the bank did not exert dominion and control over the debtor such that a fiduciary relationship was created that would result in the bank owing a fiduciary duty to the debtor's creditors, nor did the bank engage in egregious conduct that shocked the conscience of the court.
On September 9, 2014, the US Bankruptcy Court for the District of Maryland, in Atlantic Builders Group, Inc. v. Old Line Bank (In re Prince Frederick Investment, LLC), dismissed a creditor's equitable subordination claim against a bank on the grounds that by exercising its contractual rights under a loan agreement with the debtor, the bank did not:
  • Exert dominion and control over the debtor such that fiduciary relationship was created that would result in the bank owing a fiduciary duty to the debtor's creditors.
  • Engage in egregious conduct that shocked the conscience of the Court.
(No. 12-29099, (Bankr. D.Md. Sept. 9, 2014)).

Background

Prince Frederick Investment, LLC (Debtor) was formed for the purpose of constructing and operating the West Lake Medical Center (Center). In August 2008, Atlantic Builders Group, Inc. (ABG) entered into a contract with the Debtor to construct the Center for $2,082,000, subject to additions and deductions as provided by the contract. In September 2008, ABG began construction of the Center. The following month, Old Line Bank (Bank) made an initial $2,976,000 construction loan to Westlake Investors, LLC for the construction of the Center. Before this initial loan, the Bank allegedly had actual knowledge that the Debtor would be undercapitalized and would not be able to fund the construction of the Center.
At the time construction began on the Center in the fall of 2008, the Bank and ABG entered into a Contractor's Agreement to Complete (Contractor Agreement). Under the terms of the Contractor Agreement, ABG could not terminate the contract until the Bank had an opportunity to remedy the default, provided that the Bank advanced funds for ABG's completion of the work. The Contractor Agreement also provided that ABG would give the Bank notice of any Debtor defaults under the construction contract and gave the Bank the right to review and approve ABG's change orders and payment requests.
In January 2010, the Bank increased the loan to $3,326,000. The loan was secured by a first priority lien in the Center and was guaranteed by the Debtor. Before increasing the initial loan, the Bank allegedly knew that the increase would remain insufficient to fund the projected additional cost to construct the Center and that the Bank purposefully withheld from ABG the fact that the increased loan would not cover ABG's construction costs and change orders to induce the Debtor to finish construction.
The project had a number of problems, which delayed construction by more than six months and resulted in delay claims of $318,656. The Debtor filed a voluntary Chapter 11 petition in June 2012, and scheduled the Bank's total claim as $3,194,640 secured by a lien on the Center, which was valued at $3,151,526.
ABG filed a complaint seeking the equitable subordination of the Bank's claims and liens under section 510(c) of the Bankruptcy Code.

Outcome

Under section 510(c) of the Bankruptcy Code, a court may use the principles of equitable subordination to either:
  • Subordinate for the purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an interest to all or part of another allowed interest.
  • Order that any lien securing this subordinated claim be transferred to the estate.
Three criteria must be met for equitable subordination to be deemed appropriate in the Fifth Circuit, as set out in Benjamin v. Diamond (In re Mobile Steel Co.):
  • The claimant has engaged in some type of inequitable conduct, which may include:
    • fraud, illegality or breach of fiduciary duties;
    • undercapitalization; or
    • claimant's use of the debtor as a mere instrumentality or alter ego.
  • The claimant's inequitable conduct resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant. The severity of the conduct depends on whether the claimant owed a fiduciary duty to the debtor and the debtor's creditors. If a fiduciary duty is not owed, the conduct must be more egregious.
  • Under the circumstances, equitable subordination is not inconsistent with the provisions of the Bankruptcy Code.
(see 563 F.2d 692 (5th Cir. 1977)).
The Court dismissed ABG's complaint, with prejudice, because ABG failed to state a plausible claim for equitable subordination. The Court held that ABG failed to allege sufficient factual matter to show either that:
  • The Bank and the Debtor had a fiduciary relationship such that the Bank owed a fiduciary duty to ABG, and the Bank's conduct breached that duty.
  • The Bank engaged in egregious conduct that shocked the conscience of the Court.

Fiduciary Duty

The Court stated the general rule that a lending institution does not owe a fiduciary obligation to its customers. The Court then noted the exception to the general rule, which exists when the lending institution exerts "dominion and control" over its customer. A lending institution that usurps the power to make business decisions from its customer's board of directors and officers must also undertake the fiduciary obligation that the officers and directors owe the corporation and its creditors.
The Court noted that, because every lending institution exercises some degree of control over its borrower, a fiduciary obligation arises only when the lending institution has operating control of the borrower's business. Operating control occurs when a lending institution directs activities of the debtor by exercising actual managerial control. Financial leverage or the ability to exercise contractual rights, including the right to monitor the debtor's finances or make business recommendations, does not, by itself, indicate operating control.
The Court rejected ABG's argument that a fiduciary obligation arose because the Bank controlled the Debtor's financial affairs, primarily by reviewing and approving ABG's payment requests and change orders. It reasoned that this argument failed because:
  • The complaint recognized that ABG and the Bank entered into the Contractor Agreement in which ABG agreed that the Bank could review and approve change orders. In reviewing and approving change orders, the Bank was therefore acting in accordance with the contractual rights it obtained from ABG.
  • There were no allegations that the Bank inserted itself in the construction process other than to review and approve the requests for payment.
  • It does not shock the conscience that a construction lender would want to review and approve applications for payment and change orders for the construction work on the project funded by its loan.

Egregious Conduct

ABG alleged that, even in the absence of a fiduciary duty, the Bank engaged in egregious conduct by approving change orders while failing to inform ABG that there would be insufficient loan proceeds to pay it in full. ABG did not allege that the Bank made an affirmative representation or statement that there would be sufficient funds available to fund all change orders. Rather, ABG's claim rested on the allegation that the Bank engaged in egregious conduct by remaining silent on the issue, and that it benefitted by doing so because ABG's continued work on the Center enhanced the value of its collateral.
The Court rejected ABG's argument because:
  • The Contractor Agreement imposed no express duty on the Bank to provide ABG with information or updates on the loan relative to the costs being incurred by the Debtor.
  • The Bank's right to approve change orders did not create an implied duty to inform ABG of the lack of availability of loan funds to pay for the work performed on the orders.
  • Imposing an implied duty to inform on the Bank would be inconsistent with the terms of the Contractor Agreement, which expressly provided that ABG "will give the Bank written notice of any default by the [Debtor] under the Contract." If the Debtor failed to pay ABG, ABG was obligated to give the Bank notice of the Debtor's default, and then the Bank would either fund the defaulted payments or ABG could terminate the contract. The Court noted that ABG failed to comply with its own duty to notify the Bank of the Debtor's default.

Practical Implications

This decision demonstrates courts' willingness to absolve lenders when they comply with their rights and duties under a loan agreement and their reluctance to impose duties on creditors of a common debtor that are not expressly provided for under their agreements. Lenders are not in control where their influence over a debtor's actions arises by exercise of their arm's-length bargained for rights. However, they must be careful to not extend control so far that a court would find that the lender has operating control over the debtor.
For more information on equitable subordination, see Practice Note, The Risk of Equitable Subordination in Bankruptcy.