Borrowers have gained leverage in bankruptcies.

One of the most unsettling aspects of lender liability litigation is that a borrower's spurious claims of lender misconduct are often resolved by a jury, whose members may identify more with the borrower than the lender.

Lenders' attempts to avoid the vagaries of jury resolution have received a mixed review in the courts. The standard clause in most lending agreements, in which the borrower agrees to waive trial by jury in any dispute with the lender, may or may not be enforced, depending on the particular jurisdiction in which a suit is brought.

Until recently, lenders could take some comfort at least in the situation where a borrower filed for bankruptcy while the loan was in default; the Supreme Court held that once the lender filed a claim in the bankruptcy, disputes between the lender and the borrower were part of the "claims resolution process" in bankruptcy.

|Equitable' Proceeding

Since the claims resolution process is classified as an "equitable" as opposed to a "legal" proceeding, and there is no right to a jury trial in equitable proceedings, disputes between lenders and borrowers in bankruptcy have traditionally been determined by a bankruptcy judge.

Now even that limited protection may be eliminated.

Last March 24, the influential U.S. Court of Appeals for the Second Circuit in New York decided in Germain v. Connecticut National Bank that unlike other disputes between lenders and borrowers (including lenders' efforts to collect their debts), lender liability claims are sufficiently distinct from the "claims resolution process" that, even in bankruptcy, the borrower has the right to jury trial on those claims.

A Routine Case

The complaint in Germain fit the pattern of a routine lender liability case. The debtor had filed Chapter 11 proceedings, but because of an inability to reorganize, the bankruptcy court in Connecticut converted the case to Chapter 7 some two years after the filing.

Germain was appointed trustee, and Connecticut National Bank, the company's primary lender, filed its proof of claim, claiming the lion's share of assets in the bankruptcy proceeding.

Some six months after that, Germain commenced an action against Connecticut National Bank in Connecticut state court, charging that the bank, through both pre- and post-petition attempts to control and dominate the debtor for its own benefit, had caused the debtor's destruction.

The complaint alleged the usual panoply of lender liability tort and contract claims, such as tortious interference with the debtor's business, breach of the implied duty of good faith, and misrepresentation.

Claims Deemed |Legal'

Connecticut National went to bankruptcy court, undoubtedly to avoid the inevitable jury trial in state court. The strategy failed. The second circuit court found that since the trustee's claims did not implicate the "claims allowance process" in bankruptcy court, and since the claims were legal and not equitable, the trustee had a constitutional right to try them to a jury.

That much was straightforward. But lurking in the background was the potential that, after resolution of the lender liability claims, the trustee might seek to equitably subordinate the bank's claims against the estate - an "equitable" action as to which there is clearly no right to a jury.

As to that possibility - and the impact that an equitable subordination claim might have on its ruling - the court noted cryptically that "we merely assume here that the trustee has waived his right subsequently to seek equitable subordination."

Enhanced Credibility

Despite the increased fashionability of lender liability claims outside of bankruptcy court over the last 10 years, the more usual response in bankruptcy of a debtor upset with his lender's conduct remains a claim against the lender for equitable subordination.

Compared with lender liability claims, equitable subordination actions have an established pedigree in bankruptcy court that gives them an enhanced credibility.

Also unlike most lender liability litigation, the test for recovery in equitable subordination actions is well established, and if the debtor or trustee prevails, then, depending on the economics of the case, the debt owed to the lender can be effectively wiped out or at least moved from the top to the bottom of the list of estate obligations.

That may seem small potatoes compared with the huge affirmative recoveries sought in other lender liability litigation, but it is usually more than sufficient for a debtor in bankruptcy and its other creditors.

Another Arrow in the Quiver

The second circuit's decision in Germain ostensibly adds a weapon to the debtor's arsenal by permitting the debtor (or, as in Germain, the trustee) to choose the characterization of his claims depending on whether he wants a jury. He can bring a claim for equitable subordination, and have no jury, or for legal lender liability claims and demand a jury.

By itself, there seems nothing novel about that result, since it is well established that a pleader can include or omit whatever claims he wants, and may do so specifically to deal with the right to jury trial. But for reasons peculiar to the bankruptcy context, that result will wreak havoc on the claims resolution process.

Germain raises the troubling possibility that many, if not most, bankruptcy claims carry with them a right to jury trial, notwithstanding Supreme Court authority that suggests a contrary conclusion.

The court rejected the bank's attempt to invoke mutuality - that since the bank had no right to a jury trial on its claim, neither should the debtor on the flip side of that claim - by commenting that maybe a creditor does have a right to a jury trial on its claim, except as to questions of "allowability."

Bankruptcy Code Limits

"Allowability" and the "claims allowance process," suggested the Germain court, are confined, for jury trial purposes, to questions that relate to express limitations imposed by the Bankruptcy Code, such as a claim that a lender is liable to a debtor for a preference or fraudulent transfer. Lender liability claims, according to the court, are simply not part of the claims resolution process.

Ironically, just two years before Germain the second circuit recognized the inseparability of lender liability claims from a primary lender's proof of claim. In Sure-Snap Corp. v. State Street Bank and Trust Co., the court held that an order confirming a plan of reorganization in which a lender's proof of claim was not challenged constituted a bar to a lender liability action commenced post-confirmation.

The court concluded that "the formal bankruptcy hearing, confirming as it did Sure-Snap's plan for reorganization and repayment, did necessitate preclusion of the lender liability action, as the claims premising Sure-Snap's petition for reorganization, and those alleging predatory banking practices, were integrally related."

Usual Procedures Ignored

In contrast, the Germain decision ignored the usual situation in bankruptcy, where lender liability claims are asserted merely to increase leverage in negotiating with the lender on its claim. When that occurs, the lender liability claims are very much a part of the claims resolution process, and there should be no right to jury trial.

The problems that arise from Germain are readily apparent. Frequently, in a lender liability action, the bank will counterclaim for its loan. In Germain, since the trustee's lender liability claims include a claim for breach of the implied covenant of good faith in the loan documents, it is hard to imagine the bank not counterclaiming for its loan under the same documents.

If Connecticut National does that, effectively replicating its proof of claim, is the matter thereby transformed into one that invokes the "claim allowance process," and if so, will the trustee lose his right to a jury trial?

Timing Considerations

Germain also gives rise to timing considerations as to when a debtor or a trustee will object to a proof of claim. Under the code, the debtor or trustee is under little pressure to object at any particular time; the creditor's claim can ride with the case as long as the case is pending.

Nevertheless, a debtor-in-possession or trustee will frequently object to major creditors' claims well in advance of confirmation, either to improve leverage with those creditors in negotiating a plan or to lend some certainty to anticipated distributions.

Germain suggests that if the debtor has offsets or counterclaims against a creditor, he can obtain a jury trial on those issues by delaying his objection to the creditor's claim and bringing what would otherwise be an objection and counterclaim by way of an adversary proceeding.

The bottom line is that under Germain, the determination of whether a claim impacts the "claim allowance process," and thus whether there is a right to a jury trial, will often turn on the procedural framework in which the debtor's counterclaim is advanced and ultimately resolved.

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