Steve H. Nickles[1]

[1] Roger Noreen Professor of Law, University of Minnesota Law School. Remarks on the Occasion of the Inauguration of the Roger F. Noreen Profes­sorship, February 12,1988.


Let me briefly describe three recent cases of objectification that are particularly worrisome to creditors, especially commer­cial lenders. I will describe them in an ascending order of con­cern, and thereafter will address two main questions they pose, namely: what is the cause of objectification in the cases, and is it desirable?

The first case is Peoples Bank & Trust Co. v. Lala.[1] In this case Peoples Bank extended substantial sums of money to Leo and Donna Lala individually and to a couple of farm related corporations they controlled.[2] The Bank found itself under­secured, mainly on Leo’s debts, and asked for more collateral. The Lalas obliged. The additional collateral they gave included their homestead, on which both Leo and Donna executed a mortgage.[3]

The court held, however, that the mortgage on Donna’s homestead interest was invalid.[4] The stated reason was the Bank’s failure to fully educate Donna on what she was doing in encumbering the homestead: in effect, giving up her home pri­marily for debts on which she herself was not personally lia­ble.[5] The law generally allows a person to use property, even otherwise exempt property, to secure another person’s debts. The law does not generally require a contracting party to edu­cate the other party to any extent. One is bound by what she signs, especially in a business setting, which includes farming.

In the Lola case, however, the court found that a confiden­tial relationship existed between the Bank and Donna, and that the Bank thus owed extraordinary duties to her, including the duty to ensure that she was fully informed about the conse­quences of her actions.[6] In fact, the mortgage contained a clear notice of homestead waiver as required by enacted law.[7] The real reason the court invalidated the homestead mortgage as against Donna was the “unfairness” of the transaction. Gener­ally, a deal between parties in a confidential relation is subject to review for substantive fairness. The law is clear that no such relation exists between parties to a contract simply because they are related as creditor and debtor, and this absolute rule applies to a bank and a borrower even when collateral is given.[8]

Any relation can become confidential, however, if a situa­tion of trust develops between the parties to the extent that one of the parties justifiably comes to depend on the other to such an extent as to allow the other party’s judgment to control her own actions.[9] Such a situation had developed between Donna and the Bank, because the Bank’s president was a long time friend and financial advisor to Donna, who was un­schooled in matters of finance.[10] She trusted and relied on him, and depended on him to protect her interests. He therefore had great influence and control over her.

Recognizing a confidential relation in this case, or using any other device to invalidate the mortgage, was made easier by the fact that the president got the mortgage on the homestead when Leo, Donna’s husband, was hospitalized due to an appar-

MINNESOTA LAW REVIEW [Vol. 74:371 ent heart attack.11

Judged by the gut, even a banker’s gut, the Lola case is cor­rectly decided. It nevertheless is unsettling to lenders because the courts rarely, even in extreme cases like this one, put credi­tors in the role of confidants and thereby subject their con­tracts to the test of “fairness” according to external standards.

The second case, K.M.C. Co. v. Irving Trust Co.j12 is harder and more worrisome to creditors. Irving Trust agreed to lend K.M.C., a grocery wholesaler, as much as $3.5 million. At a time when K.M.C.’s debt to Irving Trust was only about $2.5 million, K.M.C. asked for an additional $800,000. The loan of­ficer was honestly convinced that even with the additional $800,000, K.M.C. could not meet its debts to suppliers and that the company was doomed to financial collapse.13 Because of this belief, and because the loan agreement explicitly allowed Irving Trust to terminate financing at will, the loan officer de­nied the additional $800,000 loan. K.M.C. thus had no cash to pay suppliers, and the suppliers stopped delivery. Conse­quently, K.M.C. collapsed.14

K.M.C. sued Irving Trust, arguing that in refusing the addi­tional loan the lender had violated an obligation of good faith, resulting in K.M.C.’s collapse.15 Relevant statutory law defines “good faith” in purely subjective terms as “honesty in fact,”16 which existed on the facts of this case. The lender had acted honestly in these terms and thus had met the enacted law’s subjective definition of good faith.

The trial court nonetheless instructed the jury to consider whether Irving Trust acted reasonably according to an objective standard of good faith defined by the industry or community of lenders. There was evidence that a reasonable lender would have made the $800,000 loan.17

Surprise! Surprise! The jury found for K.M.C., assessing damages of $7.5 million, an amount equalling the company’s value as a going concern just before the collapse.18 The Court of Appeals for the Sixth Circuit affirmed, even though the con­tract between K.M.C. and Irving Trust purportedly authorized

11. Id. at 187.
12. 757 F.2d 752 (6th Cir. 1985).
13. Id. at 762.
14. Id. at 754.
15. Id,
16. U.C.C. § 1-201(19).
17. K.M.C., 757 F.2d at 761-62.
18. Id. at 766.

The third and last case, which is the hardest and most wor­risome, is State National Bank v. Farah Manufacturing Co.[12] v Farah is a very large publicly-owned corporation that manufac­tures men’s clothing. The company had annual sales exceeding $100 million.[13] In 1976, its chief executive officer, Willie Farah, whose family started the company, was forced from office be­cause the company had losses exceeding $40 million dining the preceding four-year period.[14]the lender’s conduct.[11] Once again, the parties’ contractual standards were seemingly replaced by external standards.

The new management immediately sought financing, and a group of banks made millions of dollars in loans secured by the company’s assets. The security agreement between Farah and the banks included a management clause that said, in essence, that the banks could declare a default if the company installed new management personnel unacceptable to the banks.[15] The purpose, which everyone understood and accepted, was to keep Willie Farah from returning to power.[16] This was understanda­ble since under his leadership the company had substantially declined.

Within a year, however, Willie began a campaign to be re­turned as chief executive officer, and he had enough votes among the company’s board of directors to succeed. The banks were not amused. They informed the board that they would declare a default if Willie was elected chief executive officer. The Board realized that a default would put the company in bankruptcy, so they did not elect Willie. They elected other in­dividuals that the banks approved of, and the Board was recon­stituted to include several people connected with the banks.[17]

During the next year, the company performed poorly, los­ing by some estimates more than $50 million.[18] The banks were facing such large losses on the loans that they restructured Farah’s debt in a deal that eliminated the management clause.[19] Willie then returned to power, and one of his first acts was to

cause Farah to sue one of the banks — State National.[20]

Farah won $19 million for losses supposedly suffered dur­ing the year Willie was not chief executive officer.[21] The losses were found to be the legal result of the banks threatening to invoke the management clause to declare a default, which caused the Board to elect management other than Willie, which led to the election of managers who were inept leaders, which inept leadership caused bad marketing and other decisions, which explains the poor sales during the year, which produced the loss.[22]

Liability was technically bottomed on a tiny lie. When the banks told the Farah Board that a default would be declared if the company returned Willie to power, the banks had not actu­ally made that decision. They clearly could have decided to de­clare a default if Willie was elected and, in that event, could have enforced their decision or changed their minds and waived the default. Either course would have been legally accepta­ble.[23] The banks’ wrong was in saying they had decided to de­clare a default — which they were contractually free to do — when, in fact, no such decision had been made.[24] This lie in it­self was technically a fraudulent misrepresentation — a tort. This tort, however, was a slim basis for the kind and amount of damages Farah sought.

The court also decided that the banks were guilty of duress for threatening to invoke the management clause. The threat in itself was not wrongful for purposes of duress because the contract allowed the banks to do what they had threatened. The threat was wrongful for purposes of duress, however, be­cause the banks violated the duty of good faith that is implied in every contract.[25] The banks violated that duty, which the court defined according to an objective, external standard, be­cause the banks’ threat constituted fraudulent misrep­resentation.[26]

So the tiny he bred both fraud and duress, but duress ordi­narily is not thought of as a tort; rather, it usually is a contract defense. In Texas, however, people do things their own way.

The court said duress is a tort, but that still is small support for the outcome of the case.

The tiny lie was not yet exhausted. The court decided that the banks had committed the tort of interference with prospec­tive economic advantage.[27] The whole purpose of this tort es­sentially is to allow the recovery of the kinds of damages that Farah sought and won. The interference tort is not clearly de­fined or bounded. It is committed when a person improperly interferes with another’s business activities and loss proxi­mately results. Interference is improper when it occurs by im­proper means or with improper motive. In this case there was improper means because the banks had made a fraudulent mis­representation and committed duress.

That tiny lie certainly was a fertile thing.

The lie itself, of course, was not the first link in the chain. Rather, it was the management clause in the security agree­ment that gave meaning and force to the banks’ threat. So the Farah case is viewed by many lenders, and perhaps properly so, as invalidating management clauses and the like.

The Farah opinion tends to support this view by suggesting that fraud and duress really were not critical to the finding of interference liability. The court said: even though “the lenders may have been acting to exercise legitimate legal rights or to protect justifiable business interests [which is usually a defense to the tort of interference] . . . the social benefits derived from permitting the lenders’ interference are clearly outweighed by the harm to be expected therefrom.”[28] This statement may be the second most significant part of the Farah opinion. It im­plies that a creditor’s interference with the debtor’s business may be improper and thus wrongful even when the creditor’s conduct is not otherwise tortious and is contractually permitted and the motive is pure — if, on balance in the wider economic and social context, the benefits of absolutely prohibiting the conduct outweigh the costs of allowing the conduct. In such a case, once more, external standards of conduct displace the par­ties’ own contractual standards.

The most significant aspect of the Farah case is that any of the banks’ torts honestly could be said to be the proximate cause of the damages recovered.

[1]     392 N.W.2d 179 (Iowa Ct. App. 1986).

[2]     Id. at 181.

[3]     Id.

[4]    Id. at 190-91.

[5]    Id. at 189.

[6]     Id. at 186.

[7]    Id. at 188-89 (citing IOWA CODE § 561.13 (1985)).

[8]     Id. at 186.

[9]    Id. at 185-86.

[10]    Id. at 189.

[11]    Id.

[12]    678 S.W.2d 661 (Tex. Ct. App. 1984).

[13]    Id. at 667.

[14]    Id.

[15]    Id.

[16]    Id. at 668.

[17]    Id. at 671, 676.

[18]    Id. at 679.

[19]    Id.

[20]    Id. at 668.

[21]    Id. at 667 (stating that actual losses were estimated at $18,947,348.77).

[22]    Id. at 691-92.

[23]    Id. at 672.

[24]    Id. at 681-82.

[25]     See Tex. Bus. & Com. Code Ann. § 1.203 (Vernon 1968) (imposing an obligation of good faith in the performance or enforcement of contracts).

[26]    Farah, 678 S.W.2d at 683-87.

[27]    Farah, 678 S.W.2d at 690.

[28]    Id at 681-82.