Article

Topics: Breach of Duty of Good Faith and Fair Dealing; Breach of Fiduciary Duty; Financial Standby; Interest Rate Swaps

Note: Starting in July 2004, Executive Management Services (Debtor) entered into a number of standard loan agreements with Fifth Third Bank (Creditor) subject to a floating interest rate. In October 2004, Debtor re-financed the loans using variable rate demand notes (VRDNs), which allowed Debtor to borrow from Creditor at a lower interest rate than with a conventional term loan. It is undisputed that Creditor did not disclose the risks involved with VRDNs, although Debtor allegedly relied on Creditor to advise on the risks. Under the terms of one of the VRDNs, Creditor issued a standby to assure payment on the bonds to investors. These bonds were sold to investors in a weekly auction process and had variable interest rates that were tied to Creditor’s credit rating, rather than Debtor’s.

When the variable interest paid by Creditor increased between 2004 and 2005, Creditor suggested using interest rate swaps to convert the variable rates into fixed rates starting in January 2006. Under this mechanism, a nominal amount was selected and Creditor was to provide Debtor a fixed 30-day London Interbank Offered Rate (LIBOR) based on the selected nominal amount.

At the time, Creditor did not disclose the basis risk associated with the LIBOR-based rate diverging from the variable interest rate on the VRDN with Debtor. Both parties agreed to an interest rate swap that was governed by an ISDA Master Agreement and accompanying Schedule, which explicitly stated that Creditor “is acting for its own account and is not acting as a fiduciary for, or a financial or investment advisor to [Debtor].” The parties never formally discussed the terms before the agreement was finalized, but Debtor was free to review its terms.

Under the agreement between January 2006 and April 2008, Debtor entered into four interest rate swaps. Debtor received weekly interest rate notices on the VRDNs and monthly rate reset notices advising them of the LIBOR rates that Creditor was paying under the swaps during this time period. Creditor also entered into a counter-swap with another bank to ensure the swaps were “completely hedged,” leaving no risk for Creditor. This fact was not disclosed to Debtor. On 13 March 2008, an email memorandum (March 2008 Memo) circulated throughout Creditor’s office that indicated how basis risk could be reduced at a higher fixed interest rate. Creditor did not disclose this information to Debtor.

Starting in September 2008, however, the financial crisis related to the Great Recession temporarily increased the VRDN interests to rates higher than conventional interest rates. As a result, the amount that Debtor received from Creditor was lower than the amount of interest Debtor had to pay on the VRDNs. For instance, in September 2008, Debtor’s VRDN rate rose from 2.95% to 6.63% in one week. Subsequent rate notices showed higher increases as the weeks progressed. After rejecting Creditor’s proposal to transform Debtor’s loans into LIBOR-based variable rate term loans with higher fixed rates, Debtor continued its discussion with Creditor about how to covert the VRDNs to conventional loans while looking for other lenders.

Both parties negotiated an extension of Debtor’s line of credit to 31 May 2009, and eventually to 5 September 2010. The extension of the Credit Agreement signed in February 2010 stated that Debtor was required to show reviewed financial statements to Creditor before further extending the Credit Agreement. Debtor refused to comply with several times. The overdue lines of credit accumulated as Debtor struggled to find a replacement bank. During this period, Debtor requested “detailed accounting of all of their loan payments” and “all fees and costs assessed by [Creditor],” of which Creditor provided some, but not all. In October 2011, Creditor demanded Debtor to pay USD 577,905 in early termination fees to terminate the four interest rate swaps, or it would not release the collateral on Debtor’s corporate debt. Creditor had the contractual right to terminate those swaps based on Debtor’s defaults under the ISDA Agreement. Debtor’s new bank, Pittsburgh National Corporation, required the release of the collateral on the corporate debt to close on the new loan. Debtor reluctantly paid early termination fees of USD 577,905 to Creditor.

Debtor sued Creditor for breach of duty of good faith and fair dealing; breach of fiduciary duty; fraud by omission/fraudulent concealment; constructive fraud; negligent misrepresentation; and quantum meruit/unjust enrichment. Creditor moved for summary judgment and the United States District Court for the Southern District of Indiana, Indianapolis Division, Lawrence, J., granted the motion while denying Debtor’s motion for a hearing.

The Judge reasoned that Debtor’s first claim had to be dismissed because the implied duty of good faith and fair dealing from the contracts between Debtor and Creditor could not create duties that negated the explicit rights under a contract. The Judge further acknowledged that the mere relationship between Creditor and Debtor did not create a fiduciary relationship under usual circumstances and so created no fiduciary duty. The Judge rejected Debtor’s argument that this case presented extraordinary circumstances, and insisted that, though Creditor gave financial advice to Debtor, this was not sufficient to impose a fiduciary duty on Creditor. Creditor’s superior knowledge also did not change the circumstances, because most banks, if not all, will naturally have superior financial knowledge than their debtors.

The Judge also dismissed claims of omission/fraudulent concealment and constructive fraud because Debtor failed to establish that Creditor had the duty to disclose the information at issue. Citing Martin Hilti Family Tr. v. Knoedler Gallery, LLC, 137 F. Supp. 3d 430, 483 (S.D.N.Y. 2015), the Judge held that, if Debtor had the means of knowing “by the exercise of ordinary intelligence” regarding certain information that was supposedly not disclosed to them, then Debtor could not impose a duty to disclose on Creditor. The Judge pointed out that all information pertaining to this alleged fraud by omission was available to Debtor. The Judge also dismissed a claim of negligent misrepresentation for the same reason. Lastly, Debtor argued that Creditor was unjustly enriched at Debtor’s expense, even if it did not explicitly breach the terms of their contracts. The Judge, however, stated that a quasi-contract was a mechanism to provide remedy for situations in which no enforceable contract existed. The Judge concluded that Creditor reserved the right to seek the motion for summary judgment on this claim because it was undisputed that the payments made by Debtor to its Creditor were made in accordance with the parties’ contractual agreements.

[JWC]

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