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.
III. ANALYSIS
If you consider how these three very different cases are really very much alike, you will see the root cause of objectification in the cases: the outcome in each instance is based, fundamentally, on the creditor’s abuse of control over the debtor. By this abuse the creditor forfeited the protection of contract, and thereby lost the contractual privilege that shielded the creditor’s conduct. Thus, each result is largely consistent with contract doctrine, not opposed to it.
The confidential relation in Lala, which was founded on the debtor’s dependency on the creditor,[1] meant that the lender effectively dominated the debtor so as to rob her of free and independent will in the transaction between them. There was agreement in form, but not in substance. There was missing the kind of real, deliberate, considered consent that is essential for an agreement to be recognized as a contract. So the legality of the deal between them — the mortgage on Donna’s homestead — was not determined by their contract. In this situation, the law imposes greater duties. It expects the confidant to abandon self-interest, which is furthered by the usual contract, and to act instead in the interest of the other person.[2] The lender in Lola, however, played Donna like a puppet in getting her to hand over her homestead for the lender’s benefit, not Donna’s own.
In K.M.C., as the court there observed, the financing relationship was such that, as the lender knew, the debtor was totally dependent on the lender.[3] The lender’s control was complete to the extent that the debtor’s receivables were regularly impounded by the bank and kept in a “lock-box” account as further security.[4] When the bank stopped lending and declared a default, the receivables were applied to the debt. So not only was the debtor denied loan funds, it also was denied its own cash balances, which were essential to keep operating.
So K.M.C. can be explained in terms of Lala: dependency and control created duties that transcended the contract.
There is a further explanation of K.M.C. The purpose of the lender’s control in K.M.C. was to insure its loans. In fact, however, there was ample security for the loans that had been made and also for the additional loan the debtor sought.[5] The reason for enforcing contracts is to give effect to the purposes of the parties’ agreement. By foreclosing when the security was adequate, the lender went beyond the purposes of the agreement and so went beyond the legitimate boundaries of contractual immunity from liability.
The same is true of the lenders in Farah. The purpose of the management clause was to allow the lenders to realize on their collateral should a change in management jeopardize the value of the property. They used the clause, however, to dictate the internal affairs of the company. This conduct exceeded the purposes of the lenders’ contract rights and they thereby forfeited their contract protection. Moreover, because of the lenders’ control over the company, there was accompanying dependency, so that Farah, like K.M.C., can be explained in terms of Lala: when there is dependency there are higher duties that transcend the contract between the parties.
There is, however, something more about Farah. The lenders’ illegitimate use of their contract rights gave them such control over the debtor that the lenders crossed the boundary that separates creditor from owner. Creditor and owner are basically alike in that both put money into the enterprise. Yet, there is a basic difference in how the law treats them. Although a creditor’s ability to recoup its investment is naturally tied to the debtor’s success, the creditor’s right to recover from the debtor is not conditioned on the debtor’s success. A debtor cannot avoid repaying a debt to a creditor because the enterprise failed.
An owner’s ability and right to recoup her investment in an enterprise is, on the other hand, clearly tied to the success of the enterprise. Ordinarily, a company is not accountable to a stockholder when the market value of her stock declines. The owner’s investment is at risk in this sense, while the creditor’s is not, because the owner is empowered to share in the direction and management of the enterprise and thus must bear the consequences of her control.
When a creditor exercises control over a debtor’s enterprise in such a way as to assert the powers of an owner, there is good reason to treat the creditor as an owner by tying rights to recovery to the success of the enterprise. Contract law does not allow the form of the contractual relationship to obscure the real substance of the relationship. If the enterprise fails under the creditor’s owner-like control, the creditor should bear that loss as an owner, not as a wrongdoer, so that there is no need to show a proximate link between the creditor’s control and loss. This would justify the damages in Farah notwithstanding that causation was very weak or altogether lacking in that case.
In sum, Lala, K.M.C., and Farah really are about creditors having control that breeds dependency that, in turn, produces an extraordinary level of responsibility and accountability to debtors; and the cases also are about creditors using their control over debtors in ways that exceed the legitimate purposes of the control.
Creditors do have lots of control, usually not through personal confidential relations with the debtor as in Lala, but through contracts, as in KM.C. and Farah, that give them the right to grab the debtor’s property — and thus collapse the debtor’s enterprise — upon default. Default is defined in the contract, which always is drafted by the creditor. Indeed, the largest part of typical financing agreements is devoted to defining default to mean everything and anything, including whenever the creditor feels like it.
With such a wide definition of default, the creditor is contractually free to cash out at any time. This invites — seemingly even permits — arbitrary action, as in K.M.C., and gives creditors the power to meddle in the debtor’s affairs, as in Farah. But collateral is not intended to be used as leverage for controlling the debtor’s enterprise; rather, it is designed as insurance that can be collected when there is a real likelihood that the debtor’s ability to pay, or the collateral’s value, is less than the seemed debt.
Cases like K.M.C. and Farah are simply saying that creditors must use collateral according to its real purpose; must use the control accompanying collateral in line with that purpose; and, factoring in Lala, that creditors must not abuse control — use it beyond its purposes — whatever the source of the control and without regard to how it is achieved.
Lenders worry that these three cases — Lala, KM.C., and Farah — and others like them, in objectifying debtor-creditor relations, are limiting creditor conduct and creditor control designed to reduce creditors’ risks. Objectification thus increases creditors’ risks, which will have the effect, ultimately, of increasing the cost of credit and reducing its availability.
There is no empirical evidence, but the law-and-economics types will tell you that this effect is indisputably intuitively inevitable; and then they will flash in front of your eyes an incomprehensible chart or graph that, they say, linearly proves the probable reliability of economic intuition.
I have four responses that lead ultimately to the conclusion that objectifying debtor-creditor relations so as to limit creditor control is, to a point, desirable.
First, I am not sure that Lala, K.M.C., or Farah is a true case of objectification in the sense that the parties’ rules are replaced by external rules, or — put more generally — that the cases are further examples of tort trumping contract. The reason I am not sure is that these cases might be explained as instances in which there was no true contractual agreement between the parties giving the lender the rights and powers that the lender exercised. I already have explained that this lack of true agreement is behind the decision in Lala.
In K.M.C., although the security documents empowered the lender to stop lending and declare a default, the scope and substance of this contractual provision is properly determined by reference to the meaning that the parties gave it. In light of the reason for the power, which was to protect the lender’s secured position, it is fair to interpret the language as conditioning the power on a genuine threat to the lender’s position. In other words, the power would not be invoked as long as there was adequate collateral. Evenly construed, therefore, the K.M.C. contract did not empower the lender to act for any reason, or arbitrarily for no reason, without regard to the true state of the threat to the lender’s collateral. So K.M.C. may be, in truth, nothing more than a simple breach of contract case in which the parties’ own standards were violated.
Farah can be explained in the same way. Indeed, the court noted that the evidence in the case reflected that the parties never anticipated that the management clause would be used, as the lenders used it, to work their will with respect to the internal affairs of the debtor.[6]
Both K.M.C. and Farah would be clear instances of objectification only if the conduct engaged in by the lenders had been explicitly authorized by the contract through clear agreement by the parties. But they were not such cases.
My second response to the warning that reducing creditor control as in Lala, K.M.C., and Farah will increase the costs of credit is that I am not sure that chilling the kinds of conduct involved in these cases increases risks that are meaningful and important to lenders. Lola, limits overreaching in circumstances involving vulnerable, individual debtors where risks were miscalculated. It does not limit the ability of lenders to take collateral before they make loans, at the time risks are calculated. Nor does it limit the ability of lenders in regular, arms length transactions to contract for more collateral if the risks increase. The Lola case simply forbids lenders from unilaterally grabbing property that the lender knew, from the inception of the deal, would not be available as security because of its exempt status.
K.M.C. says, at most, that a lender cannot abruptly exercise its power over the debtor when the lender’s secured position is, in fact, not endangered. It does not limit the lender’s right to exercise its contractual power when the risks the lender sought to protect against actually occur.
Farah simply adds that the power must be exercised for the purposes for which it was designed: to allow the lender to realize on collateral when there is a default. It does not limit that fundamental right, which is the lender’s basic and best insurance against loss.
Further — and this is my third response — even if these cases do tend to increase credit risks and thus credit costs by limiting creditor control, it may be that allowing creditor control involves a greater economic cost by stifling debtor freedom to make entrepreneurial decisions. Preachers of economic analysis in commercial law, who are conservative in the sense of protecting creditor power and position, have conceded — and I now quote two of these preachers — that creditors should not: place too many restraints on their debtor. Creditors lend money in the first instance because the debtor has entrepreneurial skills that they do not have. To take advantage of the debtor’s skills, creditors must give their debtor a certain amount of freedom. To give the debtor the power to make correct decisions, creditors must to some extent give him the power to make wrong decisions.[7]
I would add that creditor control that stifles debtor decision-making, and that effectively puts creditors in charge of debtors’ enterprises, may well rob the economy of wealth that creditors lack the expertise to generate. Also, paradoxically, control that is intended to reduce creditors’ risks actually may
increase their risks by preventing debtors from putting their greater expertise to full use.
Furthermore — and this is my final response — if I am wrong and these cases that threaten creditor control do have a net economic cost, that alone is not sufficient reason to disapprove of them. Balanced against the economic costs of limiting creditor control is the social cost of allowing it: subjecting debtors to an overt form of economic slavery or, put more mildly, transforming debtor-creditor relations into investment robotiza- tion where the debtor’s will is subjugated, willy-nilly, to that of the creditor, and the debtor is used like a sponge to absorb the losses for enterprises that really are run by the creditors. It is undemocratic; it is exploitation; it ensures the concentration of wealth; it is wrong.
It is not wrong, however, for a creditor to end credit and seize the debtor’s property in satisfaction of secured claims when there is a real risk of loss of the security. Objectification or other means to curb creditor control should not go so far as to dilute that basic right of creditors. The true and proper goal of objectification should be to ensure that creditor control is not used arbitrarily or to manipulate the debtor. The line between proper and improper exercises of control should be drawn so that a creditor is deemed to have acted rightfully whenever its actions toward the debtor are authorized by a true agreement and are directly related to preserving the creditor’s collateral against a genuine risk to that property.
CONCLUSION
You will have noticed that, in the end, my analysis becomes a weighing and balancing of economic, social, and human concerns and values not controlled by specific and detailed legal rules characteristic of commercial law. It appears that, alas, commercial law teachers are like constitutional law teachers: unrestrained by law.
In fact, law teachers of all subjects, practicing lawyers, legislators, and judges — the whole legal community — do the same thing in the end: we argue the priority of competing interests, and those in power decide the matter. That, in the end, is law.
My goals as a teacher are to urge students to see and appreciate a wide range of interests, concerns, and values; to train them so that they can reliably interpret decided law to determine how those interests presently are accommodated; and to
show them how that law can be reshaped to respond to changes that argue for a different, fairer, more just accommodation.
[1] Peoples Bank & Trust Co. v. Lala, 392 N.W.2d 179,190 (Iowa Ct. App. 1986).
[2] Id. at 188.
[3] K.M.C. Co. v. Irving Trust Co., 757 F.2d 752, 759 (6th Cir. 1985).
[4] Id.
[5] Id. at 762.
[6] Farah, 678 S.W.2d at 686.
[7] Baird & Jackson, Fraudulent Conveyance Law and Its Proper Domain, 30 Vand. L. Rev. 829, 834 (1985).