Nowhere in the banking world is the problem of lender liability more acute than in small-business lending, some experts warn.
"While all banks face lender liability, those that lend to small businesses are particularly vulnerable because they do so much hand-holding," said David E. Van Zandt, a law professor at Northwestern University. "Excessive hand-holding sometimes can be deemed a matter of control."
Ironically, it is the ability to monitor the fortunes of small businesses - through checking account activity and daily contact - that makes lending to them so alluring to bankers. Indeed, small-business consultants frequently recommend close ties with borrowers.
"Many banks get in trouble because they fall asleep at the switch when it comes to monitoring the management succession of their small-business customers," said Kevin Ringel, a banking consultant at Arthur Andersen & Co.
The recent wave of lender liability cases, however, is making bankers wary. While most of the well-publicized ones have focused on environmental liability or been related to big corporate loans, bankers are being warned to change their small-business procedures.
"Whenever a lender has anything other than an arm's-length relationship with its borrower, the potential for liability exists," said A. Barry Cappello, a partner specializing in lender liability at Cappello Foley & Bezek in Santa Barbara, Calif.
Banks are listening.
Saying No to Board Seats
Old Kent Financial Corp., a holding company in Grand Rapids, Mich., does not allow its bankers to sit on the boards of its customers, said John C. Canepa, the company's chairman. Old Kent owns 16 banks in Michigan and Illinois.
Another midwestern institution, Chicago-based Cole Taylor Bank, requires "so many levels of approval to sit on a customer's board that the issue really doesn't exist," said Richard C. Keneman, who heads small-business lending.
The main concern for bankers is that they can be held liable for having control if a customer is forced into bankruptcy. That would not only sacrifice their claims to seniority as lenders but open them to suits from other parties.
Suggest Rather than Demand
The key to handling the control issue is to suggest rather than to demand, lawyers advise. That means bankers must be careful to omit from loan covenants clauses that require major changes in operations under certain conditions or threats of default if certain actions are not taken.
Edward F. Mannino, a lawyer based in Philadelphia, identified a number of red flags that suggest lender control in his book "Lender Liability and Banking Litigation."
Banks, he said, must avoid giving their customers priority lists of creditors to be paid or checks to be honored. They also should not act as a collection agency or a bill-paying manager for the borrower.
Another temptation to be resisted: interference with a company's plans to expand or reduce operations. That includes dictating the hiring and firing of large numbers of employees.
Kingmakers Court Trouble
On a more basic level, creditors should not attempt to interfere with sales or inventory policies or even require a customer to hire a specific management consultant, Mr. Mannino wrote. And they must never impose their choice for a firm's senior executives or select board members.
Lawyers also wan bankers to be cautious about their oral communications with small-business customers. The courts do not look favorably on bankers who try to threaten or bluff a customer into taking an action, they said.
The new sensitivity to control has its origins in a 1984 Texas court decision involving the Farah Manufacturing Co., a men's apparel company. Farah, which went into bankruptcy, sued two banks that it said exacerbated its problems by insisting on new managers and imposing operational rules.
The court awarded Farah $18 million in damages, deeming the lenders to be in control because they had veto power over top management changes.
A Pandora's Box
The case unleashed a slew of lawsuits by investors and companies against banks. In determining control, courts have examined everything from a bank's internal lending guidelines to memos between bankers. Even expense reports have been vetted to determine how closely a banker worked with a customer.
In the Farah case, one oft-cited piece of evidence was an internal memo from one banker to another that said: "Tell Willie [Farah, who was seeking to become chief executive] we pull the plug if he goes in as CEO."
Mr. Mannino said banks retain their right to carefully control their collateral, but must do so with caution.
"Most courts employ a general distinction between monitoring and protecting a bank's security on the one hand, and dominating and controlling the borrower's daily business practices, on the other hand," he said.
Winning on Appeal
Lawyers said that lower courts have tended to rule in favor of companies suing their banks, but that banks have won on appeal. Nonetheless, many banks have attempted to steer clear of anything that smacks of control.
Mr. Canepa of Old Kent said his company avoids any language in its loan documentation that protects it against the death of the key player in a business - even though small businesses are frequently built around one entrepreneur.
"We prefer to require an insurance policy that will pay off the loan in the event of the owners' death," Mr. Canepa said.
Ms. Adkins is a freelance business reporter based in Chicago.