Repudiated Contracts: The Bailout Law's Nasty Surprise

Many middle-market companies rely on the availability of a single revolving line of credit backed by one financial institution.

Larger borrowers rely on multimillion-dollar revolving credit facilities funded by a consortium of financial institutions. If the lender or a participating bank is a "troubled" institution, future advances may not be available in the not-too-distant future.

Hypothetical No. 1 demonstrates a situation in which a manufcturing corporation has a line of credit with a savings and loan association. The borrower has had a long-term exclusive credit relationship with the lender.

Consequences of Insolvency

The borrower learns that the lender is insolvent and that the Resolution Trust Corp. has been appointed the receiver of the lender. Three weeks after the appointment of the receiver, the borrower receives a notice that:

* The receiver has determined that performance under the line of credit by the lender is burdensome.

* Repudiation of the line of credit will promote the orderly administration of the lender's affairs.

* The line of credit is repudiated, effective as of the date of the appointment of the receiver.

The notice states that because no advance request was pending on the date of the appointment of the receiver, no damages may be collected. The borrower is advised that interest will accrue and payments will be due in accordance with the terms of the line of credit.

Possible Reactions to Repudiation

In Hypothetical No. 2, a parent holding company has a $100 million revolving credit facility split equally between the lead bank and four other institutions. One participant becomes insolvent and the Resolution Trust Corp. is appointed the receiver of the insolvent participant.

The borrower and the lead bank each receive a repudiation notice similar to that given in the preceding hypothetical.

The first example is an uninformed and unprepared borrower's worst nightmare, if it relies on a single lending relationship and the financial institution is a troubled institution. The second hypothetical may force the lead bank and/or the other participants to increase their funding to a particular borrower or curtail the borrower's advances.

In both hypotheticals, the receiver may repudiate the loan agreement pursuant to a little-known provision of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. As most of the public is now aware, Congress enacted FIRREA in August 1989 to speed up the resolution of hundreds of insolvent thrifts and to provide for the orderly disposition of the assets of the failed institutions.

One section of FIRREA confirms "the historic right" of a conservator or receiver to disaffirm or repudiate contracts. Both the Resolution Trust Corp. and the Federal Deposit Insurance Corp., acting as a conservator or receiver, have the right to repudiate burdensome contracts, including loan commitments, entered into by an institution prior to the appointment of the conservator or receiver.

Contracts entered into by a lender before the appointment of a conservator or receiver may be repudiated if the conservator or receiver determines the performance of the contract to be "burdensome" and that the disaffirmance or repudiation will promote the orderly administration of the insolvent institution's affairs.

Limits to Receiver's Liability

The statute does not require the conservator or receiver to consider the impact of the repudiation on the borrower or other parties. The statute requires the conservator or receiver to determine whether to repudiate the contract within a reasonable period following its appointment.

The liability of the conservator or receiver for the repudiation of any contract is limited to "actual direct compensatory damages" determined as of the date of the appointment of the conservator or receiver.

Borrowers, lead banks, and their respective counsel considering a lender-liability suit should be aware that the term "actual direct compensatory damages" expressly excludes:

* Punitive or exemplary damages.

* Damages for lost profits or opportunity.

* Damages for pain and suffering.

Calculation of Damages

Specific provisions for the calculation of damages are provided for the repudiation of leases under which the financial institution is either the lessee or the lessor; contracts for the sale of real property by the institution; and "qualified financial contracts" -- but not for loan agreements or commitments.

The legislature history of the repudiation powers conferred by FIRREA is extremely limited, but states that a receiver is granted "certain rights and power of a receiver in equity." The requirement that the determination of whether to repudiate be made within a "reasonable period" was substituted for the original requirement that the repudiation be made within 90 days of the date of appointment of the receiver.

The legislative history specifically mentions that the repudiation of a lease should consider that all of the circumstances of the lease, including whether, in the case of a sale and lease-back, the lease was executed as part of an arms-length transaction.

Cases dealing generally with FIRREA-based "repudiation" powers are scarce, and cases dealing with the FIRREA based on repudiation of loan agreements are almost nonexistent.

In Union Bank v. Federal Savings and Loan Insurance Corp., the conservator was allowed to repudiate a contract related to the disposition of foreclosed property.

The contract, apparently repudiated by a conservator prior to the enactment of FIRREA, was repudiated again by the conservator three weeks after the effective date of FIRREA. The court stated that "in enacting the FIRREA, Congress specifically elected not to impose a particular time limitation within which the conservator may properly repudiate."

Defining a |Reasonable' Period

After considering the "large sum of money involved," the "unusual nature" of the contract, and the "necessity of determining the potential resale value" of the property and thus the value of the contract, the court found that the repudiation had been made "within a reasonable period under the circumstances."

The repudiation was also challenged on the grounds that the contract was not "burdensome" because it would not cause "actual loss" to the failed institution. The court rejected this argument by stating that a conservator may repudiate a contract the performance of which the conservator believes, in its discretion, would be "detrimental" to the conservation of the assets of the institution.

Another court has stated that FIRREA authorizes a receiver to repudiate any contract which "it determines to interfere with the process of winding up the bank's affairs." (Bayshore Executive Plaza Partnership v. Federal Deposit Insurance Corp.).

Supporting Facts

At least one court has stated that the party challenging a repudiation must allege facts that, if true, would support the decision that the repudiation was "untimely or unjustified." (American Medical Supply Inc. v. Resolution Trust Corp.)

In American Medical, the court denied a request for specific performance of a real estate contract and loan commitment repudiated 15 days after the appointment of the receiver.

Any challenge by the hypothetical borrower and/or lead bank of the repudiation of the line of credit or revolving facility will be difficult and expensive. The injured party will first have to exhaust the administrative procedures required by FIRREA.

Priorities in Successful Claims

The next hurdle is convincing a court that the performance of the respective credit facility, in the receiver's discretion, is not burdensome; that the repudiation, in the receiver's discretion, will not promote the orderly administration of the insolvent lender's affairs; or, alternatively, that the repudiation power was not exercised within a reasonable period after the appointment of the receiver.

Any successful claim would be subject to the priority established by FIRREA and paid only to the extent that assets of the insolvent institution are available. In the meantime, the borrower's business operations may have been severely impaired or a lead bank and other loan participants may be forced to increase their commitment to a borrower or reduce the amount of funds available.

The risks of repudiation and the burden of challenging a repudiation mandate that borrowers and lead banks dependent on subsequent advances continually monitor the financial condition of lenders and credit facility participants.

Notwithstanding the current "credit crunch," diversification of lending relationships should be explored, at least in the context of borrowing from troubled institutions. A prudent lead bank should also consider the consequences of repudiation when drafting the participation agreement or credit facility.

Mr. O'Connor is managing partner of the law firm of Tarkington, O'Connor & O'Neill, San Francisco, and specializes in banking and FDIC issues. Ms. Vavalides, who practices in the firm's Phoenix office, specializes in corporate finance and banking law.

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