Daily Development for Wednesday, April 17, 2002

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

LENDER LIABILITY; FRAUDULENT MISREPRESENTATION; APPRAISAL INFORMATION: Where lender releases to borrower information concerning appraisal of property for which lender is financing borrower's purchase, lender has duty either to disclose other information in lender's possession placing value of appraisal in doubt or to otherwise limit inference that the information is accurate and complete.

Sallee v. Fort Knox National Bank, 2002 Fed. App. 0128p (6th Cir. 4/15/02)

This case is a colorfully written account of "when bad lenders get worse." The court excoriates both the Bank and the borrowers for incompetence and naivete, and ultimately concludes that the borrowers were just a little less dumb than the lenders, and affirms an verdict upon fraud and punitive damages, although modifying the damages and remanding for recalculation.

The story begins when a small bank, with traditional activity as a consumer lender, decided in the early 80's to devote 40% of its portfolio to commercial loans. (Sound familiar so far?)

Bank loaned quite a lot of money to a consortium of interests controlled by a local family. Almost all the loans were sloppily documented and poorly analyzed, and many were supported by appraisals from the same appraiser, which the court characterized collectively as the worst it had ever seen in ten years on the bench.

The borrower family, the Brambletts, predictably got into deep trouble on its loans and the bank officers, not ready to admit its own failures, repeatedly refinanced the borrowers by funding new and higher loans, justifying the increases based upon the questionable appraisals, and using the loan proceeds to pay off defaulted amounts.

In the court's words: "Into this sorry mix stepped Worth and Sandra Sallee." The Sallees moved to the area when Worth was appointed manager of a large chain store for which he had worked for some time. They elected to remain rather than to accept a transfer to another store, and looked for local businesses in which to invest. The Brambletts had plenty of businesses to sell.

The Sallees first acquired a convenience store and car wash business from a Bramblett, with financing provided by Bank. Soon thereafter, the Sallees discovered they could get better terms from another bank, and refinanced the Bank loan on the convenience store, giving a mortgage on the store and a second mortgage on their home. In both of these loans, there was some discussion of a pledge of Worth Sallee's accumulated assets in a pension account with his old employer. Worth agreed to make the pledge to the second lender, but it does not appear that a formal pledge was ever entered into because Worth never delivered the stock certificates that were part of the account.

Within a year, Sallees were in serious trouble on the store, and their alternate lender had determined to no longer finance their operation with new loans.

During basically the same period when the above events were occurring, the Brambletts were dealing with financial problems on a laundromat the owned located adjacent to the convenience store. Two Brambletts financed an acquistion of the store from their son, to resolve his problems with Bank, and Bank loaned the entire purchase price, based on an appraisal of the laundromat at $469,000. A year later, after operating unsuccessfully and falling deeper into debt, the owner Brambletts came back to Bank and borrowed more money to deal with their deficits. This time the appraised value was raised to $647,000, even though no improvements had been made and the laundromat had run at losses all year.

In order to bail out, the laundromat owner Brambletts then commenced negotiations to sell the property to Sallees, who had been so accommodating when there was a need to dump the store and car wash. Five months after the refinancing described above at an appraisal of $647,000, and with losses continuing, Bank loaned the entire purchase price of $575,000 to the Sallees, and obtained an appraisal (again from the "can do" appraiser it had used throughout,) showing a value of $726,000.

In the course of negotiations, Sallees had extensive conversations with Bank loan officers, who assured them that they would have comfortable banking relations in the future if things got bad and that they were getting a "good deal" on the laundromat. Specifically (and fatally), a bank lending officer told Worth Sallee that the property had been appraised at $750,000. This revelation was not only a mild exaggeration, but more importantly did not disclose that the property had been regularly reappraised higher and higher by the same appraiser over the preceding 18 months, during which the laundromat had sunk deeper and deeper into red ink. (As they say in business school - you can't make it up on the volume.) This time Sallee did in fact assign his stock certificates in his ESOP retirement plan to Bank.

A few months later, Sallees were back, still losing money. The bank agreed to some kind of 48 day extension of their laundromat loan (which then was only five months old). This 48 days later was extended for additional periods. In connection with each extension, Bank required Sallee to sign a general waiver of "any and all rights, claims, or causes of action with respect to the Loan Documents and Collateral." At this time, Bank discussed that there later would be a "package" loan by which it would resolve Sallee's problems going forward, covering all Sallee's loans with Bank.

The owner of Bank had finally caught wind of what was going on there, and at the time of the extension deal with Sallee, Bank was undergoing an investigation from its owner following a highly critical audit, which investigation resulted in a suspension of commercial lending authority a few months later. This made it highly unlikely that Bank would be able to do the promised "package" loan.

When the other lender discovered that Worth had transferred his stock to Bank, when he had originally agreed to pledge it for the convenience store loan, it reacted with threats. Bank then agreed to refinance the convenience store loan, and entered into the third extension of the other loans. At this time, a bank officer again assured Sallee that everything would shortly be wrapped up together in a comprehensive package loan going forward. It also sold some of Sallee's stock and applied it to reduce his debts. Bank apparently told Sallee that this was a "mere technicality," and that it would sell some of the stock but later replace it when it refinanced all of Sallee's lines in the comprehensive new business loan.

Unfortunately, at the same time that the loan officer was saying these things to Salleea the fact was that the Bank's owner had cut off Bank's commercial lending authority. The loan officer believed that he might be able to get all this resolved, but at the time in fact knew he had no further authority to negotiate new loans with Sallee in the future.

Note that the court is somewhat mushy in its discussion of the time relationship between the execution of the various waivers and the fact of the Bank's ability to deliver on the promised "package" loan. It appears to assume that all of the waivers were obtained by fraudulent representations of some kind, even though the first two times a waiver was signed Bank had not yet lost it's ability to make commercial loans.

Perhaps there was a looming threat of loss of lending rights that ought to have been disclosed, but the court does not tell us.

There is a lot in this opinion to discuss, but for purposes of this report, we'll take up only the court's conclusion that the failure to disclose fully all of the information concerning the accuracy of the appraisals amount to fraud, thereby rendering Bank liable for the difference between the actual value of the laundromat and the appraised value report to Sallee. Punitive damages were tacked on to that. As indicated, the court found the waivers bootless because also induced by fraud. Lower courts had found them too broad to be effective, but the court here didn't choose to based its decision on that ground. The court found that the duty to disclose existed even though there was no fiduciary relationship between Sallee and Bank. The duty arose from Bank's affirmative disclosure of some information, leading to a duty to provide complete information.

The court commented that when asked for information in a commercial context, has three choices: (1) refuse to answer; (2) answer, but indicate that the information is given without any responsibility for accuracy or reliability; (3) answer fully without qualification, in which event the party must also disclose any significant qualifications other information that might impact on the accuracy of the answer. "Where one party to a contract knows that the other relies on him to disclose all material facts, the duty rests on him not to conceal anything material to the bargain or assume responsibility for damage caused by the concealment."

The court also upheld the punitive damages award, even though the Bank had been sold to others. The purchase was made under indemnity by the Seller concerning damages, so the Seller had been paid to assume the risk. Further, the court commented, that even the entry of punitive damages, although indemnifiable, is likely to provide a deterrent to wrongful conduct for the current owner of the Bank.

Comment 1: There's more to this case, to be discussed in a subsequent DD. But as to this part of the case the editor must agree, although the editor understands that there is a significant liability trap here for the accommodating lender. The case can be distinguished from the more innocent cases because of all the other data indicating that the Bank was disclosing the appraisal information for the purpose of influencing the borrower's conduct. Where the release of the information is not made in that context, there is certainly a good argument that the recipient of the appraisal information had no reason to believe that the lender was disclosing all it knew about the deal.

Still, lenders should crank up the training programs again. Officers should not release appraisals. Period.

Comment 2: Here's a puzzler: What if the bank has one appraisal, and releases it. But the bank has other information that affects whether the house is a good deal at all, or a good deal for the borrower. Still, the bank thinks the security is adequate and is willing to make the loan. No funny business (unlike here). Is it liable for not spilling its guts? This case could be construed to say yes.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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