Federal Appeals Court Shoots Down Loan Guarantor’s Claims of Fraud and Duress

This month we review a recent federal appeals court decision with important lessons for lenders engaged in commercial loan workouts. A business owner tried to void his personal guaranty of two large business loans and two subsequent forbearance agreements by alleging fraud and duress on the part of his lenders. The effort failed but reached the appellate court, and the opinion highlights the value of a carefully prepared forbearance agreement, as well as what does and does not constitute “duress” sufficient to void a loan document.

The Case[1]

The guarantor, Mr. Lockwood, owned businesses in the energy and construction industries. The businesses received loans totaling $90 million from two banks and soon breached certain loan obligations. The banks became concerned with the deterioration of their collateral, the rate of the borrowers’ cash burn, and the businesses’ poor accounting controls. A loan modification ensued, in connection with which Mr. Lockwood personally guaranteed the loans and the businesses employed a Chief Restructuring Officer (“CRO”).

The businesses’ finances continued to falter. The lenders then warned Mr. Lockwood that if the CRO was not given full control of the businesses within 48 hours, they might repossess their collateral and accelerate the loans. In the face of that threat, Mr. Lockwood handed over full control to the CRO.

However, the businesses continued to default, and to stave off loan acceleration they entered into a forbearance agreement with the lenders that imposed new controls and in which Mr. Lockwood ratified his personal guaranty, acknowledged his indebtedness, and waived any defenses or claims against the lenders that he might have. A second forbearance agreement followed, in which Mr. Lockwood provided the same ratification, acknowledgement, and waiver.

The businesses remained in default upon expiration of the second forbearance agreement, and the banks then accelerated the loans. The businesses and Mr. Lockwood responded with a federal lawsuit against the lenders, alleging negligence and other business torts. Mr. Lockwood also alleged that his personal guaranty and the forbearance agreements were void as the products of fraudulent inducement and duress. The businesses and Mr. Lockwood lost on summary judgment and were ordered to pay over $58 million to the lenders. They appealed to the Fifth Circuit Court of Appeals, which affirmed the judgment.

The Fifth Circuit noted that even if Mr. Lockwood’s personal guaranty was voidable, he had nonetheless ratified it in the first forbearance agreement - which stated that the “The Obligors hereby acknowledge, ratify, and confirm … the Guaranties…and all of their respective debts and obligations to Credit Parties thereunder” - and therefore he was bound by it unless the first forbearance agreement was itself voidable.

Mr. Lockwood first claimed that the first forbearance agreement was voidable because he had been fraudulently induced into signing it. He claimed that the lenders promised him he would control the businesses in order to get him to sign, but once he signed they forced him to turn over full control to the CRO. But Mr. Lockwood’s claim did not square with the fact that he had already turned over full control to the CRO before he signed the first forbearance agreement. Therefore, the court ruled against his fraudulent inducement claim.

Mr. Lockwood then argued that his personal guaranty and both of the forbearance agreements were voidable because they were the product of economic duress. He claimed that the duress was the banks’ threat to accelerate the loans if he did not turn over full control to the CRO, as acceleration would have subjected the businesses to financial ruin. The court acknowledged that the banks used Mr. Lockwood’s fear of acceleration and the harm it would cause as leverage to get him to transfer control of the businesses to the CRO, but wrote that “using leverage is what negotiation is all about” and that “difficult economic circumstances do not alone give rise to duress.” Looking to the law of Texas, which governed Mr. Lockwood’s claims, the court wrote that in order for Mr. Lockwood to prove duress he would have to show, among other things, that the banks threatened to do something they had no legal right to do. However, Mr. Lockwood could not meet that burden because the credit agreements allowed the banks to accelerate the loans upon default, and Mr. Lockwood had not shown that the banks had no legal right to demand that he turn over full control to the CRO.

The Takeaways

The banks prevailed, and without having to go to trial, for two reasons. First, they prepared forbearance agreements that the guarantor was required to sign and in which he acknowledged and ratified his guaranty and waived any defenses or claims he might have against the banks. This created a substantial, and ultimately impenetrable, barrier against his legal attacks on the enforceability of the guaranty. This is one of the main reasons to use a forbearance agreement in a workout situation: to eliminate the borrower’s ability to use claims or defenses arising from events that occurred prior to the forbearance agreement.

Second, the banks operated within the law of “duress”, which protects those who merely enforce their legal rights, even if they drive a hard bargain. The banks threatened to do only what they were entitled to do under their loan documents - accelerate the loans - and demanded nothing improper in exchange for refraining from doing so. Texas law governed Mr. Lockwood’s claims, but the result would likely have been the same had Virginia law governed. In Virginia, a “threatened act must be wrongful to constitute duress. Consequently, a threat to do what one has the legal right to do, such as to foreclose or exercise the power of sale on a mortgage, is not such duress as to justify rescission of a transaction induced thereby.”[2] Stated differently, in Virginia, “[b]ecause the application of economic pressure by threatening to enforce a legal right is not a wrongful act, it cannot constitute duress.”[3]

In sum, careful planning and adherence to the terms of their loan documents paid off for the banks, saving them at the least from the substantial legal fees that surely would have been involved in going to trial.

[1] The case is Lockwood Int’l, Inc. v. Wells Fargo Nat’l Ass’n, 2021 U.S. App. Lexis 24385 (Aug. 16, 2021).

[2] Bond v. Crawford, 193 Va. 437, 444 (Va. 1952).

[3] Goode v. Burke Town Plaza, 246 Va. 407, 411 (Va. 1993).