Part I of this two-part article looked at when an obligation to lend arises. Examples of issues that have been debated as to whether obligations arose were examined by considering the contracting process for loan agreements. The desirability of avoiding the consequences that may follow a wrongful refusal to lend from a lender’s perspective and how lenders may seek to prevent these are explored in this part of the article.
Consequences for Lenders’ Breaches
According to Professor Treitel, “[a] breach of contract is committed when a party without lawful excuse fails or refuses to perform what is due from him under the contract, or performs defectively or incapacitates himself from performing”. Damages and specific performance may be the main remedies that have been contemplated for breaches of contracts to lend.
Damages
If a lender’s refusal to lend constitutes a breach, the normal remedy is damages. To succeed in this claim, the borrower would need to prove the loss it has suffered, mitigate its loss and claim within the rules of remoteness. Generally, the borrower will only be entitled to nominal and not substantial damages because it is assumed that replacement funds can be obtained elsewhere. It is therefore worthwhile to consider possible liability where this assumption is not valid.
Types of Losses
That substantial damages can be awarded is not new. In the 1883 case of Manchester & Oldham Bank v Cook an award for substantial damages was upheld. “Here the bank had express notice of the purpose for which the money was required…and… that it was by reason of the refusal of the bank to find the money that Cook was unable to complete his contract.”
Loss of future business that might have reasonably been expected to flow from a transaction that the borrower can no longer perform is also a potential claim. In Essentially Different Ltd v Bank of Scotland plc the defendant bank was to have made a loan in two tranches, but made only the first. Here, Burton J concluded that the Defendant:
“was not entitled to withhold the second tranche… The Claimant needed money to finish off its development and secure sales prospects which it plainly had…”
This would presumably extend to loss in the form of damages payable to a third party with whom the borrower had entered into an agreement in reliance on the lender’s obligation to lend.
Conceptually, loss of creditworthiness and business reputation may also be claimed. In Sealy v. First Caribbean International Bank (Barbados) Ltd Sir David Simmons CJ found that dishonour of a cheque when there were sufficient funds in a customer’s account to honour the value of the cheque was a breach of the bank’s contract. He usefully included reference to the fact that for a long time, the authorities held that a distinction had to be drawn between the wrongful dishonour of a cheque of an ordinary person and that of a trader and that the former recovered only nominal damages whereas the latter was entitled to substantial damages without pleading and proving actual damage.
The duty to mitigate the loss is relevant. In Essentially Different the judge accepted that the Claimant was unable to obtain other financing, by virtue of the provisions of the facility letter preventing them from borrowing further without the Defendant’s prior written consent, the granting of a debenture to the Defendant, and the threatened litigation with a major bank.
The Remoteness Bulwark
A limit to a borrower’s successful claim is that the loss claimed is not too remote. The Hadley v Baxendale remoteness test seems applicable. By this the lender is liable for the types of loss that: (i) arise naturally from the breach or (ii) might reasonably have been foreseen as likely to arise from particular circumstances of which the lender was aware at the time of the contract.
In Transfield Shipping Inc v Mercator Shipping Inc. Lord Hoffman and Lord Hope of Craighead introduced assumption of responsibility as a further limitation on contractual damages. In Attorney General of the Virgin Islands v Global Water Associates Ltd the UK Privy Council saw the Transfield Shipping case as having dealt with “the recoverability of damages caused by unusual volatility in the market or questions of market understanding” and stated more generally the principles governing remoteness of damage as follows:
“First, … the purpose of damages for breach of contract is to put the party whose rights have been breached in the same position, so far as money can do so, as if his … rights had been observed.
…secondly, the party in a breach … is entitled to recover only such part of the loss actually resulting as was, at the time the contract was made, reasonably contemplated as liable to result from the breach. To be recoverable, the type of loss must have been reasonably contemplated as a serious possibility…
Thirdly, what was reasonably contemplated depends upon the knowledge which the parties possessed at that time or, in any event, which the party, who later commits the breach, then possessed.
Fourthly, the test to be applied is an objective one … one assumes that the defendant at the time the contract was made had thought about the consequences of its breach.
Fifthly, the criterion for deciding what the defendant must be taken to have had in his or her contemplation as the result of a breach of their contract is a factual one.”
Courts have generally proceeded by assuming that an intended borrower should be able to obtain funds from an alternate source, so the damages would only be any additional amount which it would have to pay to obtain the funds from such a source, if they exceed the costs it would have incurred under the original agreement.
Under the second limb of Hadley v Baxendale it has been suggested that a borrower may be able to recover substantial damages by showing that the prospective lender was aware, as at the time of contracting, of the borrower’s actual financial circumstances that it knew that the borrower was unlikely to obtain alternative finance in the time available and that the lender knew of the specific purpose for which the finance was to be provided.
Specific Performance
The specific performance remedy had for a long time been considered inapplicable to a breach of a contract to lend, perhaps owing to Lord Herschell’s statement in South African Territories Ltd v Wallington that, “I do not think it is open to any doubt that a person with whom a contract to lend money has been entered into cannot obtain specific performance of that contract.”[16] However this may have been based on the assumption that alternative funds are available in the market, and this case could be distinguished from cases in which funds were not so available.
Avoiding Breaches
To prevent complications when regulations, market or credit risk profiles change, lenders use protective provisions. They often include conditions precedent, events of default, material adverse change (or effect) (“MAC”), market disruption and market flex clauses.
Conditions Precedent
A lender usually makes its obligation to disburse funds contingent on the borrower complying with stipulated conditions. Through a requirement of delivery of items “in form and substance satisfactory” to the lender, the lender can retain control of its obligation to disburse funds. Legal limits on discretion would apply.
Events of Default
The contract is typically structured so that occurrence of an event of default gives the lender the right to: a) cancel the commitment, b) declare that funds previously advanced are immediately repayable together with interest thereon, or c) declare that the funds are repayable on demand. There is case law to suggest that the court would read each described event separately and give them a literal effect.
The MAC
A loan agreement will normally include a MAC clause. This allows the lender to declare an event of default and withdraw if a material adverse change occurs. Of note is Professor Rawlings judicially accepted view that “the lender cannot trigger the clause on the basis of circumstances of which it was aware at the date of the contract, although it may be possible to invoke the clause where conditions worsen in a way that makes them materially different in nature”. However the UK Privy Council has found that order to satisfy a MAC clause, an event need not objectively have such an adverse effect: all that is required is that the lender believes that it has such an effect but that the belief has to be both honest and rational.
Market Disruption
Banks may find it prudent to incorporate loan agreement provisions for the possibility that funds may not be available at some point in the term of the facility because of market disruptions that arise from events outside an individual bank’s control. On the other hand, the borrower could insist that exercise of the provision would entitle it to prepay the loan.
Market Flex
In syndicated loan arrangements a market flex clause may be included whereby if an arranger believes a successful syndication cannot be achieved without changing the terms of the agreement it may amend among other terms, the pricing of the loan.
Conclusion
Care in documentation and communication between lenders and borrowers can allocate risks between them in a manner that minimizes unexpected outcomes. The law relating to contracts is not only foundational but pervasive in lending transactions. Since the consequences of risks may be more significant during times of economic turbulence – which may arise suddenly – this care is best taken at all times.
This article is intended to provide general information only and is not to be relied on in place of legal advice.
Topaz Johnson is an Attorney-at-Law at the law firm DunnCox. You may contact her at topaz.johnson@dunncox.com