• May 16, 2011

What is a bank to do when it realizes it is “the lender of choice” to a fraud from whom the bank will never be repaid?

When debts are in the millions of dollars, this can be an uncomfortable spot.  Add a subtle variation to complicate the question a great deal more:  what does the law require a bank to do when it has some reason to believe the borrower is a deadbeat fraud, but does not have definitive knowledge — does not have “knowledge beyond reasonable doubt” as we say in the criminal law context?

Specifically, what duties, if any, does a lender in that situation owe to another bank, who is considering refinancing the fraud’s debt?

The harsh answer is that Minnesota law is fairly unsympathetic to the lender that is passively duped by an “upstream lender” that has good reason to suspect borrower fraud but says nothing, that sits on the sideline, while the upstream lender’s exposure to liability is mitigated (or eliminated) and it effectively “passes the lack of buck” to the new lender.

On the other hand, if the savvy lender is actively involved in the borrower’s efforts to seek additional funding to keep his doomed juggernaut afloat (and, in so doing, mitigate the upstream bank’s risk), this might be a situation of “too clever by half” and the originating bank will still be on the hook.

This is the upshot of a decision by U.S. District Court Judge Ann D. Montgomery (D. Minn.) last week in the case of American Bank vs. Mercantile Bank in which she granted in part and denied in part defendant’s motion for summary judgment.

The underlying key principle is that banks are sophisticated commercial actors in competition.  If the due diligence of one bank falls short of the due diligence of anothers, the sloppier lender will pay the price.  The law won’t shift the loss back on the bank that heeded the red flags or that had a more complete understanding of the riskiness of a particular transaction.

If, on the other hand, the evidence suggests the possibility that the savvy bank was not merely a passive bystander, but was an accomplice in the borrower’s deceit of its next bank victim, the buck-passing transaction might be unwound by a court of law.

Finally, Judge Montgomery’s opinion is of interest in its analysis of American Bank’s claimed damages.  If it prevails at trial, should it get back all of the money that it invested (about $5 million) or the larger amount of the entire loan in which it purchased a “participation” (over $20 million)?  Judge Montgomery held that American Bank is limited to the lesser amount but allowed for the Bank to seek “ratification” under the rules to get all of loan participants on board in the case to get the damages claim to the full amount invested in the disastrous transaction.

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