Reversing the lower court, the U.S. Court of Appeals for the Second Circuit recently ruled that a developer borrower was unable to rely on equitable estoppel, general principles of equity, or the covenant of good faith and fair dealing to prevent the bank from demanding payment of the interest and attorney fees, partly because the bank had not waived its right to payment through its course of conduct.
In so ruling, the Court reasoned that: (a) the developer could not demonstrate that it reasonably relied to its detriment on any alleged misrepresentations that the bank would not require payment of the accrued interest; (b) the bank's course of conduct was consistent with the express terms of the loan agreement; (c) the developer's failure to meet time-is-of-the-essence deadlines resulted in breach of a material term of the loan agreement; and (d) the collection of the accrued interest was a "debt" under the terms of the loan agreement entitling the bank to attorney fees.
A copy of the opinion is available at: Link to Opinion.
Plaintiff real estate developer ("Developer") entered into a subordinated loan agreement with a lender for the construction of a residential building located in New York City. Following defendant bank's ("Bank's") assumption of the loan, Developer defaulted on the loan, owing Bank $20.7 million in principal and over $10 million in interest. As a result of multiple defaults, Bank and Developer modified the loan agreement a number of times, each time expressly waiving Developer's prior defaults, setting a new maturity date with the option to extend, and defining as "events of default" the failure to obtain an occupancy certificate for a penthouse unit and the failure to substantially complete the development project by specific future dates.
The modified loan agreements also contained certain new provisions including an "Accrued Interest Waiver," an "Affiliate Purchase Right," and a "Lockbox Agreement." The Accrued Interest Waiver had the effect of, among other things, freezing interest at the $10 million amount, provided there were no future defaults on the loan. The Affiliate Purchase Right provision permitted Developer or its affiliates to purchase certain units in the building in order to avoid a default and foreclosure. Finally, the Lockbox Agreement allowed proceeds from the sale of units to be distributed in a specified priority such that Bank's loan would be paid in full, then Developer would recover its equity investment, and any remaining proceeds would be distributed on a 50-50 basis between Developer and Bank.
Developer subsequently defaulted on the modified loan agreement in part by failing to obtain an occupancy certificate for the penthouse and to substantially complete the project on time. Bank then notified Developer that Bank was reserving all its rights and remedies, and informed Developer that its willingness to extend the maturity date was not a waiver or modification of Bank's entitlement to the accrued interest.
Developer eventually exercised its right to purchase the remaining units with a loan obtained from a different lender. However, the proceeds from the sale of the units did not cover Developer's equity. Bank, therefore, was unable to receive any profits under the profit sharing provision of the Lockbox Agreement. In response to Developer's purchase of the units, Bank again indicated in part that Bank was not required to waive payment pursuant to the Accrued Interest provision.
Having obtained a loan from a different lender to cover the payment due to Bank, Developer, under protest, paid Bank $370,000 in attorney fees as well as the remaining $4.1 million in principal plus roughly $4.5 million in accrued interest, claiming that Bank had waived the accrued interest partly by failing to immediately provide notice of the events of default and waiting too long to inform Developer that the accrued interest payment was required.
Developer filed suit in federal court, alleging that it was entitled to the return of the accrued interest and attorney fees, and that it was also entitled to damages consisting of the funds it borrowed to cover the payment to Bank. Seeking a declaratory judgment, bank counterclaimed, arguing that it was entitled to the accrued interest and attorney fees under the express terms of the loan agreement, and that it was not liable for damages.
The lower court determined that equity required Bank to return the accrued interest and attorney fees and that Bank was liable for damages. Bank appealed.
The Second Circuit reversed, concluding in part that under the express terms of the loan agreement, Bank was entitled to accrued interest and fees, and that Bank never waived its rights to those funds.
Addressing whether equitable estoppel, principles of good faith and fair dealing, or general principles of equity prevented Bank from keeping the accrued interest, the Appellate Court concluded that the district court's analysis was faulty in several respects.
First, the Court ruled that Developer could not rely on equitable estoppel to recover the accrued interest because Developer was unable to demonstrate that it had reasonably relied to its substantial detriment on a concealment or misrepresentation of Bank. In so ruling, the Second Circuit rejected Developer's contention that Bank had committed an act of concealment by not notifying Developer immediately that events of default had occurred and that payment of the accrued interest was required. See General Electric Capital Corp. v. Armadora, S.A., 37 F.3d 41, 45 (2d Cir. 1994)(setting out four elements of equitable estoppel: an act of concealment or misrepresentation; intention or expectation that such act will be relied upon; knowledge of true facts by wrongdoers; and reliance on misrepresentation causing innocent party to detrimentally change position).
Noting that silence does not give rise to a claim of equitable estoppel when there is no duty to speak, the Second Circuit pointed out that under the terms of the loan agreement, an event of default automatically existed upon the occurrence of a described default, and that Bank had no duty under the loan agreement to accept any cures or to provide notice of its intention to collect interest.
Further, partly acknowledging that any written agreement can be modified by a course of actual performance, and that the loan agreement here expressly provided that Bank could waive any conditions or obligations, the Appellate Court also concluded among other things that: (1) Bank's course of performance was consistent with the written loan agreement because, whenever Bank waived provisions of the loan agreement, it reserved all other rights and expressly stated that the waiver of events of default had no effect on Bank's right to collect the accrued interest; (2) Developer's reliance on monthly statements and communications from Bank's loan servicer was unreasonable, given its expertise in real estate development and that the plain language of the loan agreement specified when an event of default had occurred; and (3) Developer was not induced to detrimentally change its position in justifiable reliance on any alleged concealment on Bank's part, because Developer had an existing legal duty to perform under the agreement, and the modifications to the loan agreement occurred prior to the alleged concealment period.
Second, with respect to the covenant of good faith and fair dealing, the Appellate Court, disagreeing with the lower court, concluded that the doctrine was not implicated here, as Developer failed to demonstrate that Bank had violated an expected obligation. See Thyroff v. Nationwide Mutual Ins. Co., 460 F.3d 400, 407-08 (2d Cir. 2006)(breach of implied covenant requires a direct violation of "an obligation that may be presumed to have been intended by the parties."). Taking into account such factors as the express language of the loan agreement, Bank's previous written waivers, and the contractual terms limiting the effect of such waivers, the Second Circuit ruled that Developer had no reasonable basis to expect that Bank would forgo its right to collect the accrued interest.
Third, turning to general principles of equity, the Second Circuit also rejected the lower court's conclusion that the events of default were only technical in nature and that Developer's obligation to pay accrued interest was thus an improper "forfeiture." See Fifty States Mgmt. Corp. v. Pioneer Auto Parks, 46 N.Y.2d 573, 576-77 (1979)(ruling that equity operates to "prevent a substantial forfeiture occasioned by a trivial or technical breach."). In so doing, the Court pointed out in part that the agreement contained a time-is-of-the essence clause which rendered the deadlines material, and that Developer's failure to meet those deadlines resulted in the contracted-for financial consequence of having to pay the accrued interest. The Court stressed that neither Developer nor the lower court could "re-write the contract to impose its own definition of materiality."
Finally, as to the attorneys' fees, the Second Circuit observed that the lower court was incorrect in finding that the fees provision did not apply to the Bank's counterclaim for the accrued interest, reasoning that interest was included in the agreement's definition of "debt," and that Bank's counterclaim was thus in connection with its collection of a debt, and moreover that the attorney fees were properly incurred in connection with Bank's protection of its rights and remedies under the loan agreement.
Accordingly, the Second Circuit reversed as to the accrued interest, liability for damages, and attorneys' fees, and remanded for a determination as to the amount of attorneys' fees Developer owed Bank.
Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
The Loop Center Building
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Chicago, Illinois 60602
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Email: RWutscher@mwbllp.com
Admitted to practice law in Illinois
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