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FRBSF

WEEKLY LETTER

Number 91-32, September 20, 1991

The Negative Effects of Lender Liability
In a number of recent legal decisions, courts
have awarded large damages to borrowers who
sued their lenders for allegedly breaching the
terms of credit agreements. These lender liability
lawsuits have become an area of concern for
lenders at least partly because of the significant
damages awarded in some cases. This issue is
interesting to economists as well because lender
liability may have significant economic consequences for lending markets.
This Letter argues that lender liability limits the
scope for a lender to exercise control over a borrower. If lenders fear a lender liability lawsuit,
they may be reluctant to enforce loan covenants
or use discretion under credit agreements. As a
result, they may alter their criteria for making
credit decisions. For example, lenders may
choose to avoid loans where exercising control
is likely to be important. Or, they may increase
loan rates in order to be compensated for the loss
of control. This means that some firms may not
be able to borrow under the more expensive
terms, and that some profitable investment
opportunities may have to be abandoned. There
appear to be no economic benefits from lender
liability to counterbalance these negative effects.
Moral hazard in loan markets
When an investor does not manage the firm
in which he invests, a "moral hazard" problem
can arise: management may engage in certain
actions at the expense of the investor. To reduce
this problem, the investor uses a variety of financial instruments, although, in the case of banks,
the set of potential instruments is restricted
greatly by various statutes; bank assets are
effectively limited to debt instruments.

In writing loan agreements, lenders typically
include certain requirements, or covenants, that
borrowers must satisfy. These loan covenants
provide banks with (limited) means to control
moral hazard problems once they aredetected.
In general, covenants are written so that if the
lender detects management engaging in actions
detrimental to its interests, the lender can call the
loan or otherwise declare the borrower in default.

Because of this threat, management will be reluctant to engage in those actions. To help detect
moral hazard problems, lenders usually monitor
borrowers' behavior to protect their interests, and
sometimes require borrowers to disclose information about their activities.
What is lender liability?
Lender liability has to do with how a loan
agreement is enforced by the courts. The terms
of a loan agreement characterize the relationship
between the borrower and the lender. These
terms typically include the interest rate on the
loan, the repayment schedule, and any additional covenants describing activities the
borrower mayor may not engage in during
the Iife of the agreement.

A lender liability lawsuit arises when a borrower
claims that the lender acted improperly under
the explicit terms of the loan agreement or under
the terms implied by contract law. The terms implied by contract law are especially important,
since many suits allege breaches of implied-rather than explicit-terms, such as "good faith"
or "fiduciary responsibility."
An example of a lender liability lawsuit that
alleged improper explicit loan terms involved
a clothing manufacturer that sued its bank. One
covenant in the loan agreement stipulated that if
particular individuals were hired to manage the
company, the bank would consider this a breach
of contract and call the loan. The bank apparently felt that these individuals would be likely to
act in a manner contrary to the bank's best interests. The company subsequently brought in the
managers in question and then sued the bank
(and won) on the grounds that the loan covenants
illegally restricted the operations of the firm and
thereby cost it several million dollars.
Treatment in the courts
The emphasis on implied terms in loan agreements has given courts wide latitude in determining lender liability, and created a high degree of
uncertainty for lenders about the enforceability
of their contracts. For example, in one case, a

FABSF
lender was held not to have acted in good faith
because it failed to provide the borrower with
advance notice that more credit would not be
forthcoming under a line of credit agreement.
In another case, a borrower sued its lenders
because they had warned the borrower that certain actions it was contemplating would represent
default under a covenant of the loan. As Fischel
(1989) points out, putting the two cases together
creates a Catch-22 for lenders: advance notification is simultaneously required and penalized.
A similar lack of consistency pervades the
damage phase of lender liability cases. Under
the law, actual damages serve as compensation
only for unavoidable injury. Thus, if the lender
breaches, a borrower may collect for the cost
of finding alternative financing, but not for lost
profits if alternative financing was available. Yet,
in one case, a borrower collected $105 million
for alleged lost profits due to a lender's refusal to
lend $3 million. The court's opinion implies that
the borrower would not have been able to borrow elsewhere, despite the allegation that the
project was highly profitable.
The precedents set by these lender liability
cases call into question not only the rights of
lenders to exercise discretion in applying loan
covenants, but also a lender's legal authority to
enforce restrictive loan covenants at all. In the
extreme, it is conceivable that loan agreements
could be reduced simply to setting an amount
to be lent, the appropriate collateral, an interest
rate, and a repayment schedule. The effective
consequence, then, of present lender liability
case law is to require that all loan agreements
belong to a restricted set of contracts in which
only very specific, and limited, covenants are
permitted. Any agreement outside this set will
not be enforced as written.
Economic theory suggests that such restrictions
will reduce the efficiency of financial intermediation; that is, funds may not flow to their most
economically productive uses. If borrowers voluntarily sign contracts from outside the restricted
set, they do so because such contracts are preferable to contracts from within the restricted set.
Requiring them to choose from the restricted set
thus would seem to make them worse off. However, there may be a few situations in which
restrictions on contracts can enhance efficiency.

justifications for lender iiability
One potential rationale for restrictions, offered
by Fischel, is that some lender liability is necessary to prevent lender misbehavior. Indeed, it is
easy to conceive of lender misbehavior; a recurring theme in early melodramas involved the
wicked banker threatening to foreclose on the
family farm unless the heroine acquiesced to his
advances. In a business context, a lender conceivably could attempt to extract additional
concessions from the borrower with the threat
of enforcement of the loan contract.
But in practical modern settings, two important controls exist to limit such misbehavior.
First, misbehavior anticipated by the borrower
is best handled in the loan agreement itself. If
the borrower is worried about the lender invoking a covenant capriciously or unfairly, then the
borrower should insist that the loan agreement
clearly specify the terms under which the loan
can be called (or other features enforced). If the
borrower is still worried, then the boriOwer
should insist on clauses restricting the lender's
actions. For example, the agreement can specify
particular commercial penalties that will be imposed upon the lender if capricious actions are
taken. In short, just as the lender attempts to
prevent misbehavior by the borrower through
various covenants, the borrower can use the
same method to prevent misbehavior by
the lender.
A second constraint on lenders protects the
borrower even from unanticipated actions of
the lender: competition from other lenders. In a
competitive capital market, a lending institution
that develops a reputation for capricious behavior
will find itself at a competitive disadvantageborrowers will go to other institutions.
Indeed, economists believe that the relationship
between a lender and its borrowers is what justifies the existence of the banking sector in the
first place. Relationships with borrowers are carefully cultivated, costly to develop, and difficult to
replace. To intermediate credit to bank borrowers
safely, a bank must expend resources developing
the ability to monitor the creditworthiness of its
loan clients. These monitoring relationships have
mutual value to borrowers and lenders, and capricious action by the lender threatens this major
source of the value of a bank.

Another rationale for restricting loan agreements
is that the private actions of the borrower and
lender may injure some third party whose interests were not represented in the loan negotiations. For instance, some other creditor's claim
on the borrower's collateral may be diluted by
the new loan. Such an "externality" is, however,
easily (and commonly) dealt with by the covenants that this other creditor puts in his agreement with the borrower.

Asymmetric information and loan covenants
A third argument for restricted contracts argues
that restrictions may be beneficial when the parties to the contract are asymmetrically informed;
that is, when one of the parties has the advantage
of superior information about the facts relevant to
the loan contract. Loan agreements are often negotiated in situations of asymmetric information;
the borrower generally has better information
than the lender about the risks underlying the
transaction. Nevertheless, it is questionable
whether the problems posed by information
asymmetry in practice justify the restrictions
implied by lender liability.
In an environment of asymmetric information,
the terms of a contract play two roles. The first
role is to fix the terms of the agreement (e.g.,
the amount to be lent, the interest rate, etc.). The
second role is to transmit information (e.g., if the
borrower refuses to offer collateral, you might
reasonably infer that he views himself as likely
to default on the loan). It is this second role that
can lead to distortions from efficiency. Specifically, because of a desire to transmit favorable
information, a party to a contract can feel compelled to ask for an inefficient contract. For
example, to convince the lender that the risk
of default is low, the borrower might offer too
much collateral, putting himself in an overly
risky position.
Asymmetric information may lead the parties to
include different terms in the contract than they
would have if the same information were available to all. Of course, many loan covenants likely
would be included even under symmetric information. This is true for those covenants that are
intended to prevent the borrower from engaging
in certain behavior at the expense of the lender
(e.g., undertaking excessively risky projects).
However, some covenants may be a rational response to asymmetric information. For instance,

an if-we-fi nd-you-m isrepresented-yourself-wecan-call-the-Ioan covenant would serve to
amel iorate some of the problems created by
asymmetric information.
Research by Hermalin and Katz (1991 and
forthcoming) suggests that externalities and
asymmetric information may be the only significant economic grounds for restricting the
contracts rational agents can write. Absent those
exceptions, we argue, the courts should not reinterpret the intent of written contracts. This is a
strong conclusion, and one that is not universally
accepted.

The negative consequences of lender liability
We have argued that lender liability effectively
limits the use of loan covenants and lender discretion, and that banks will be less able to control moral hazard problems in loan markets. This
reduced ability to control moral hazard will have
two consequences. First, since loss of control is
costly to a bank, it will require compensation in
the form of higher interest rates. This, in turn, will
lead to lower rates of investment by firms. Second, banks may not lend to enterprises where
the moral hazard problem is potentially greatest
(or, equivalently, these enterprises may be priced
out of the bank-lending market). This represents
a change in the allocation of credit, which may
not be desirable. For instance, as argued in the
June 1, 1990 FRBSF Weekly Letter, the moral
hazard problem is particularly great with new
ventures. Thus, a potential consequence of
lender liability is that new ventures will find
it even harder to obtain financing.

Benjamin E. Hermalin
Visiting Scholar, FRBSF, and Assistant Professor,
University of California at Berkeley
References
Fischel, Daniel. 1989. "The Economics of Lender
Liability." Yale Law journal 99, pp. 131-154.
Hermalin, Benjamin, and Michael Katz. Forthcoming.
"Moral Hazard and Verifiability: The Effects of
Renegotiation in Agency." Econometrica.
_ _ _ _ , and
.1991. "Contracting
between Sophisticated Parties: A More Complete
View of Incomplete Contracts and Their Breach:'
Working Paper No. 91-165. U. of California at
Berkeley.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Judith Goff) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

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Index to Recent Issues of FRBSF Weekly Letter
DATE

NUMBER

3/15
3/22
3/29
4/5
4/12
4/19
4/26
5/3
5/10
5/17
5/24
5/31
6/7
6/14
7/5
7/19
7/26
8/16
8/30
9/6

(91-11)
(91-12)
(91-13)
(91-14)
(91-15)
(91-16)
(91-17)
(91-18)
(91-19)
(91-20)
(91-21 )
(91-22)
(91-23)
91-24
91-25
91-26
91-27
91-28
91-29
91-30

9/13

91-31

TITLE

AUTHOR

Droughts and Water Markets
Schmidt
Inflation and Economic Instability in China
Cheng
Banking and Commerce: The Japanese Case
Kim
Probability of Recession
Huh
Depositor Discipline and Bank Runs
Neuberger
European Monetary Union: Costs and Benefits
Glick
Zimmerman
Record Earnings, But...
Walsh
The Credit Crunch and The Real Bills Doctrine
Changing the $100,000 Deposit Insurance Limit
Levonian/Cheng
Cromwell
Recession and the West
Financial Constraints and Bank Credit
Furlong
Ending Inflation
Judd/Motley
Using Consumption to Forecast Income
Trehan
Free Trade with Mexico?
Moreno
Is the Prime Rate Too High?
Furlong
Consumer Confidence-and the Outlook for Consumer Spending Throop
Real Estate Loan Problems in the West
Zimmerman
Aerospace Downturn
Sherwood-Call
Public Preferences and Inflation
Walsh
Bank Branching and Portfolio Diversification
Laderman/Schmidt!
Zimmerman
The Gulf War and the U.S. Economy
Throop

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.