Secured Party Not Liable for Failure to Sell Pledged Stock Before It Declined in Value
May 16, 2005
Michael Weissman - Chicago
Layne v. Bank One, Kentucky, N.A., 395 F.3d 271 (6th Cir. 2005) revisits an issue that has been before a number of different courts, i.e., whether a secured party’s duty to use reasonable care in the custody and preservation of collateral includes a duty to sell stock before it declines in value.
The plaintiffs were Charles E. Johnson, Jr. and Geoff Layne, each of whom owned shares of PurchasePro.com, Inc. (PurchasePro), which made a successful public offering of stock. As a result, Johnson and Layne had considerable net worth even though there were restrictions on the sale of their stock. To increase their liquidity, they entered into separate loan agreements with Bank One secured by their shares in PurchasePro.
The loan agreements each contained loan-to-value ratio requirements which meant that the value of the collateral had to be equal to a stipulated percentage of the amount of the loan. The agreements provided that if the LTV ratios were not satisfied, the borrowers had five days in which to notify Bank One and either increase the collateral or reduce the outstanding balance of the particular loan. If this did not occur, there was a default and Bank One could exercise all rights and remedies including, at its discretion, a sale of the stock. Although Bank One had the right to sell the stock, it was not obligated to do so.
If Bank One planned to sell the stock, it had to give the borrowers 10 days advance notice. To facilitate the sale, the borrowers executed trade authorization agreements that permitted Bank One to sell without their consent.
In February 2001, the stock of PurchasePro dropped dramatically along with all of the other Internet stocks and the LTV ratios were exceeded. Commencing at that time and continuing until May 2001, Layne and Johnson made repeated overtures toward pledging additional collateral to satisfy the LTV requirements. But they never provided any additional collateral.
Bank One sold the stock over a four-day period in July 2001 realizing $524,757 in net proceeds which left an unpaid balance of about $2.2 million.
The borrowers then filed suit against Bank One claiming that (a) the bank had not used reasonable care in the custody and preservation of the collateral, (b) the sale of the stock was not commercially reasonable, (c) there was a breach of fiduciary duty on the part of the bank, and (d) there was a violation of the covenant of good faith and fair dealing. The court rejected each of these contentions.
As to the secured party’s duty to preserve the value of collateral, citing a number of cases from other jurisdictions, the court held that the bank had no obligation to sell the pledged stock simply because of a decline in market value. The court noted that UCC Section 9-610 “does not impose an obligation on the lender to liquidate and sell the collateral stock at a specific time during the life of the loan.”
Applying UCC Section 9-627(2), the court also held that the sale of the stock on the NASDAQ national market was commercially reasonable. And although the price of the stock dropped between the time the bank decided to liquidate in May and the time of the actual sale in July, the delay was solely in order to comply with Rule 144 requirements.
The borrowers argued that Bank One violated a fiduciary duty by failing to sell the stock earlier on when the LTV ratio requirements were violated. But the court said that, except in special circumstances, banks do not have a fiduciary relationship with their borrowers. And the court declined to find any special circumstances that created a fiduciary relationship. Indeed, the security agreement stated that the lender may exercise its remedies, that one of the permitted remedies was a sale at the lender’s discretion, and that the lender was not obligated to sell even if a notice of sale had been given.
Finally, the court said that in light of its earlier rulings there was no breach of the covenant of good faith and fair dealing.
What’s the point?
This case reiterates that ordinarily the terms of the loan documents will
give the lender wide latitude in deciding upon the timing of the liquidation
of collateral, the exception being where the lender is over-collateralized
and the borrower has requested a sale, or the collateral threatens to
speedily decline in value due to spoilage.
For more information, e-mail Michael L. Weissman at
michael.weissman@hklaw.com or call toll free, 1-888-688-8500.