Addressing Today’s Bank Litigation Issues: Fraud Schemes,Lender Liability Disputes and Loan Agreements
From Ponzi schemes to simple frauds to lender liability claims and disputes over loan agreements, South Florida banks are facing a host of challenging legal and compliance issues. It’s also a tough economic climate for banks seeking to make new loans, while dealing with loan defaults, workouts, bankruptcies and other problems of the past five years.
With the influx of banking litigation, South Florida Legal Guide asked several experienced attorneys to discuss what banks and other institutional lenders should do to avoid the legal minefields, while fulfilling their client obligations and complying with regulatory requirements.
“Many institutional lenders have downsized their workout/troubled asset departments, and may not realize that certain loan practices could expose them to potential liability,” said Paul Singerman, chair of the Miami firm Berger Singerman.
“In other cases, banks are unwitting players in their borrowers’ misconduct or have been accused of turning their head in the face of red flags because of the revenue opportunities.”
When victims of Ponzi schemes and other frauds file a lawsuit, one of the goals may be to recover funds from the bank or banks used by the criminals. “The key questions in these cases are whether the bank had knowledge of the schemer’s wrongdoing and whether the bank aided and abetted this misconduct,” said John H. Genovese, partner and head of Genovese Joblove & Battista’s reorganization and insolvency practice.
A related issue is whether a bank has a fiduciary duty to defrauded investors who are not its customers. “The courts have struggled with this issue of extending liability to a third party,” Genovese said. “In criminal law, an accomplice can be charged with aiding and abetting a robbery. In civil law, someone who knows a fraud is being perpetrated has the same liability as the fraudster. But in the banking world, it’s not always clear.”
In cases of fraudulent transfer of funds, a bank can argue that it served only as a conduit and acted in good faith as an innocent participant, and it is not subject to liability. In negligence cases, the courts have ruled that a bank owes a duty of care to its customers only.
Over the years, a number of federal regulations have been put into place requiring banks to know their customers (KYC) and comply with a wide range of laws. In effect, banks have been asked to perform the role of gatekeepers for the government, alerting regulators of potential frauds, money laundering schemes or filing of SARs (suspicious activity reports) for large cash transactions.
“Now the courts are trying to reconcile that obligation with the rights of individuals who have been harmed by banks failing to do their job,” Genovese said. “The big question is how much responsibility banks should have for the harm done to individuals.”
In recent years, the courts have limited the ability of trustees to go after the banks for these types of liability issues, according to Paul Battista, partner, Genovese Joblove & Battista, who focuses his practice on bankruptcy, business litigation and insolvency.
Battista points to a recent ruling — Lawrence v. Bank of America, N.A., 455 F. App’x 904, 906 (11th Cir. 2012) — that stated a bank must have “actual knowledge of fraudulent activities” in order to be held liable for aiding and abetting a criminal scheme. The ruling noted that a cause of action for aiding and abetting requires (1) an underlying violation on the part of the primary wrongdoer, (2) knowledge of the underlying violation by the alleged aider and abettor, and (3) the rendering of substantial assistance in committing the wrongdoing by the aider and abettor.
“Even though a bank may be aware of suspicious activity — with millions of dollars flowing in and out — the bank does not have an obligation to look further,” Battista said. “So who is looking out for the victims? Right now, federal prosecutors are overburdened and underfunded. I think our banks need to be more vigilant and take proactive steps to deter fraud.”
Genovese agrees, noting that accountants, attorneys and auditors are subject to malpractice lawsuits if they take advantage of their advisory roles or fail to fulfill their fiduciary requirements to clients. “On a national level, laws like Sarbanes Oxley clearly reflect a national desire for a higher level of responsibility from corporate officers and outside auditors,” he added. “But there has not yet been a major shift in banking law to impose a broader liability on banks.”
When a lender’s expectations of payment are frustrated or disappointing, banks seeking to maximize their recovery, sometimes react in ways that exposes them to liability, according to Singerman, whose practice focuses on troubled loan workouts, insolvency matters and commercial transactions. “In general, lenders get into trouble by over involvement,” he said, “and there are many variations on that theme.”
Singerman points to a landmark 1983 South Florida case — Atrio Consol. Indus., Inc. v. Southeast Bank, 434 So. 2d 349 (Fla. 3d DCA 1983) — which involved an asset-based line of credit and a financially distressed borrower. “In this case there was a lot of acrimony between the lender and the company management,” Singerman said. “In discovery a memo was produced from the bank’s files that said ‘We’re going to take this company down when it hurts the most.’ After the bank sued to foreclose, the borrower counter-claimed for lender liability and won a judgment in the courts.”
Other types of lender liability claims can arise if a bank encourages another institution to take a problem loan off its hands. In one seminal case, a Florida bank encouraged a second customer to buy the loan or do business with the borrower to improve its cash flow, but withheld information about the first loan being troubled, Singerman said.
“In my practice areas, I see the same mistakes being repeated that resulted in bank liability cases in the 1980s,” Singerman said. “Lenders that are nervous because their institutions are not as stable as they were in the past, and are anxious to resolve a cited asset or a write-off.” That situation is compounded by the fact that fewer lenders are making middle market loans, making it harder for troubled borrowers to refinance out of a loan. As a result, Singerman said, borrowers have less maneuvering room today and creditors may be feeling desperate as well.
Singerman has some suggestions for lenders facing a troubled loan: “Are you adequately represented? is there an animus between the loan officer and the borrower? Is the loan officer feeling defensive about having booked the loan or made earlier decisions about the workout? If so, separate those people from the problem at the earliest opportunity.”
A lender should also look at its in-house legal team, Singerman added. “Have they erred in a documentation issue that is motivating them to take a harder line? Are the lawyers behaving in a manner that encourages or discourages a negotiated settlement? Can additional litigation be avoided?”
Most importantly, the lender must resist the temptation to get involved in the borrower’s decisions, including the selection of lawyers, financial advisors or which bill will be paid. As he said, “Those are the types of actions that the borrower and other creditors will say caused them harm for the benefit of the lender.”
When it comes to loan agreements, lenders need to be sure to put everything in writing, according to Phillip M. Hudson, III, partner in the Miami office of Arnstein & Lehr LLP, whose practice concentrates on commercial litigation, bankruptcy and insolvency.
“The Florida Legislature has beefed up legal defenses for bankers,” said Hudson, who represents financial institutions. “If you have a loan agreement in writing and a borrower alleges an oral modification that modification will not be enforced. That’s a substantial benefit to the lender community.”
Because of the importance of written documentation, prenegotiation letters have come into vogue, said Hudson. “Most institutions now require borrowers and lenders to sign a statement that just because the two sides are negotiating doesn’t mean there is a deal.” Hudson adds that the “paper trail” also needs to be very clear in workout discussions or negotiations about restructuring loans. For example, an email message should say, “This is not binding until signed by both parties in writing.”
Another solid line of defense is a good set of loan documents, Hudson said. “Too often, those documents are not consistent or complete. We also advise lenders to review their documents and update them from time to time to reflect changes in the laws and regulations.”
Staying out of Trouble
Many South Florida banks have had an opportunity to “catch their breath” after the financial recession of 2008-09, according to Hudson. “Now lenders are being more aggressive in terms of their compliance measures, documentation and other regulatory requirements,” he said.
Those steps are vital to avoiding liability litigation, added Battista. “There are plenty of regulations out there,” he said. “The banks need to comply with the rules, rather than cut corners and relax their standards.”
Hudson says one of the best ways for banks to stay out of trouble is to “touch the files.” That means getting out of the office to meet borrowers and maintain those relationships. “In most cases, when there’s a problem loan, the borrowers aren’t entirely truthful about the situation,” he said. “It’s harder for someone to lie to your face than to send a text.”
Genovese agrees, adding that a lender can best assess the legitimacy of a borrower’s operations by meeting the client at the workplace. “It may be easier to look at the data on your computer, but it’s not the same thing as going there in person,” he said.
Strong internal checks and balances need to be in place regarding account information, fund transfers and other transactions to protect against “insider” criminal actions, Genovese added. “An institution can never defend itself completely against the risk of corruption. That’s why cross checking and auditing functions are so important when it comes to internal reports.”
A final bit of advice from Hudson. “Banks should stick to the basics. You can’t always prevent fraud or liability lawsuits, but you can reduce your risks by complying with regulations, making sure you have good documents on hand and engaging experienced professional representation when needed.”
South Florida Legal Guide 2012 Financial Edition
Back to 2012 Financial Edition