Raising Money

Borrower Beware: What you don't know about your bank's lending policies can hurt you.

By David R. Evanson

OLD SHAKESPEARE had it right with his "neither a borrower nor a lender be" business. John Smith (not his real name) learned that the hard way.

After a successful corporate career, Smith branched out on his own and formed a semiconductor manufacturing company. His firm grew quickly, largely because of Smith's management skills. In just a few years, the company's sterling list of customers included all the biggest names.

There were challenges, to be sure: ferocious competition, meeting payroll, and millions of moving parts in his factory. But among the most nettling were the continuing staff changes at his bank, which were caused in part by a series of mergers. "During my 10-year relationship with the bank," Smith recalls, "there were seven different branch managers, eight commercial loan officers, two regional vice presidents and four assistant regional vice presidents."

Sure, change is good, but in Smith's experience, like that of many other entrepreneurs, it has a darker side, too. "Basically," he says, "with every new loan officer, you have to start all over again-and each new person, it seems, wants to tighten up the loan."

Suddenly, Smith found himself issuing personal guarantees and pumping more equity into the business to satisfy the constantly changing requirements of the bank. More than angry, Smith was scared. "Here's an institution that holds your company's destiny in its hands, that has a lien on all your corporate and personal assets, and every time you walk in there's a different person who wants to play by a new set of rules," he says.

When a flood took out Smith's 20,000-square-foot manufacturing facility in January 1993, an already uneasy relationship with his bank took a turn for the worse. While the Feds were busy working out a Small Business Administration (SBA) disaster loan for Smith, his bank ratcheted up the rate on his line of credit by one and a half points. Reason: With the flood crippling manufacturing, Smith's company was a bigger risk. And when the SBA loan came through-a 30-year loan at 4 percent interest-the bank began requesting the proceeds be used to pay off the line of credit. Smith refused.

In June 1994, the bank terminated Smith's line of credit. Now the whole mess has inspired him to file a lawsuit against his former bank. "In some respects, I may have been naive about banking relationships," concludes a sadder but wiser Smith. "I was operating under the assumption that banks and borrowers share a common interest, but I found that's not really the case."

Words To The Wise

What happened to Smith is called lender liability, and it's hardly new, according to Barry Cappello, a managing partner of Cappello & McCann, one of the leading borrower's rights firms in the country and the firm retained by Smith. "Every small-business owner who has a line of credit or asset-based financing, or is in a joint venture or an equity participation arrangement, is subject to being wiped out of existence by unfair lending practices," he says.

The Santa Barbara, California, attorney says legal machinations and maneuverings in the late '80s regarding how cases were tried led some pundits to question whether lender liability cases were going to fade into the sunset. But no, he says, there are more of them than ever.

For entrepreneurs, that means there's more risk than ever that the loan you take will leave you worse off than before you got it. To ward off trouble before it starts and avoid the need to hire attorneys like him, Cappello offers what he calls words to the wary.

First, he says, never rely on what your banker tells you. "Always get it in writing!" asserts Cappello. Sounds obvious, yes, but Cappello says that a legal doctrine known as the "parol evidence rule," which applies in nearly every state, enables lenders to keep any oral agreements out of court.

For instance, says Cappello, "suppose a lender induces a borrower to sign a loan document by suggesting the more onerous provisions are mere boilerplate and are never enforced." Unfortunately, because of the parol evidence rule, the lender can deny ever making that statement, and the borrower is prevented from contradicting the lender's denial.

Or how about this? Suppose a lender commits to a loan over the telephone ("Bob, I've got great news . . ."), and on the strength of that statement, you go on a capital spending spree. If the loan never comes through, you have nothing to fall back on, according to Cappello.

And finally, Cappello says, some unscrupulous lenders rely on what are known as "reasonable reliance" rules to squirm out of harm's way. These rules help define what is considered reasonable for the borrower to have knowledge of and therefore what a lender can be liable for. "One court held that a borrower should have known, or did know, his or her lender's credit limits," he says, "and thus [the borrower's] reliance on an oral agreement to make a loan above those limits was unreasonable."

The Fine Print

But even once you've got the deal in writing, don't let your guard down just yet. At this point, keep in mind another vital rule: Read every document before you sign it. In an ideal world, of course, you always mean to do this. In the real world, however . . . well, you know the drill. You're sitting at the closing table or at the banker's desk, and let's face it, there's a lot of pressure to sign the papers as fast as possible and get everything over with.

Nothing doing, says Cappello. In the past, courts were a little more lenient and understood that not everyone reads and understands every single word buried in the fine print. "Those days are over," Cappello says. "Courts are strictly enforcing all terms on loan documents, whether or not they were read or understood, even if they are in language that is foreign to the borrower."

One way to avoid the pressure cooker of the closing table or banker's office, suggests Cappello, is to call your lender and have him or her send documents in advance for your review (and your lawyer's). And remember, says Cappello, "Nothing is superfluous. Every word, clause and comma in those loan documents is there to protect the lender."

The next axiom of borrowing: Never give a lender a security interest in something you cannot live without. When you guarantee your company's loan by pledging your home and other personal assets, Cappello says, "you must understand that your [personal] guarantee makes you just as liable as the company for the repayment of the loan." And there are real-life consequences when things go sour. Statements like "Don't worry, we never foreclose; it's just a simple bookkeeping matter" wither under the parol evidence rule.

Nor should you agree to sign jury trial waivers. Cappello says banks are increasingly including the waiver of a jury trial in their loan documentation or demanding the right to arbitrate, which means the borrower agrees to settle any disputes by a court trial or by arbitration. "This is bad for the borrower," says Cappello, "because juries tend to side with the underdog rather than the institution. By waiving your right to a jury trial, you lose this advantage over the bank."

Just as debilitating as waivers are liability releases, another piece of paperwork lenders are asking borrowers to sign with increasing frequency. If things go south after the loan is approved, the release makes the lender impervious to any legal liability for you or your company. Cappello counsels thinking long and hard before signing these releases. "Remember," he warns, "your signature on that paper results in a permanent loss of what could be substantial rights."

Finally, Cappello reminds us, perhaps the best rule to live by is to remember that your banker's first allegiance is to the bank, not to you. Yes, the banker is part of your community. Yes, he or she may even be your friend. But as borrower John Smith's banker friends told him, "We're not in the business of making loans. We're in the business of collecting the bank's money."

For More Info...

Cappello & McCann, 831 State St., Santa Barbara, CA 93101, (805) 564-2444.

David R. Evanson, a writer and consultant, is a principal of Financial Communication Associates in Ardmore, Pennsylvania.

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