How small companies victimized by their lenders are fighting back

We've heard a lot lately about companies getting into trouble because of what their banks did or didn't do. A switch in loan officers, for example, throws a monkey wrench in a deal. Or a verbal agreement gets tossed aside. Over the past few years, more and more small companies have been taking their bankers to court. What happens then? Do the small businesses survive? And what about the banks -- are they changing their ways? -- J.F.

For Pittsburgh developer George Mowl, it was a leap into the big leagues. After working for years developing modest apartment complexes, he and his wife, Karen, teamed up in 1986 with former Pittsburgh Steelers star Randy Grossman. Together, they purchased Ligonier Highlands, a 700-acre complex in a scenic mountain region of southwestern Pennsylvania.

The property, complete with its own lake, was a developer's dream. Area recreation ranged from skiing and horseback riding to hunting and fishing. But what caught Mowl's eye were the 470 building lots. He pictured them sporting stylish homes -- "luxurious living in a rustic setting," as the brochures would put it. Profits, Mowl estimated, could approach $30 million.

To finance the deal, the developers turned to Horizon Financial, a large savings and loan near Philadelphia. Working with the commercial division, they obtained $1.9 million -- $1.3 million to buy the land and $600,000 to build roads, sewage lines, and model homes. According to Mowl, the S&L agreed to follow up with asset-based lending as the project grew in value. "We'd have a steady stream of money to keep on going," he says.

The work went well. The builders erected nine models, a restaurant, and a clubhouse. Before long they had made more than 30 sales. All systems were go.

A year later, however, when the commercial lending officer retired, Horizon moved the Ligonier Highlands account to its mortgage department. Officers there, unfamiliar with asset-based lending, insisted on rewriting the package as a traditional mortgage. "There was no way we could operate like that," Mowl says. "We needed money, but they wanted to play hardball." It wasn't long before Horizon called the loan due, in the process touching off a nightmare for the 46-year-old developer that continues to this day.

Ligonier Highlands lies dormant. Mowl says he can't repay the loan. Horizon has placed liens not just on the Highlands property, but also on Mowl's apartment complexes in Pittsburgh, obstructing his other development projects. Grossman lost his house in the process and is back at his old job as vice-president of operations and marketing at Bobby Rubino's Place for Ribs.

Not so long ago this episode might have ended quietly in bankruptcy, just one more failed business venture. No more. Over the past few years, lender liability has become a rallying cry for people like George Mowl. They've been fighting back in court, and with a vengeance.

Mowl has hired three law firms, all working on contingency. They have filed three separate lawsuits against Horizon, seeking a total of roughly $340 million in compensatory and punitive damages. Horizon, itself a "troubled thrift," has been seized by the Federal Deposit Insurance Corp., pushing the claims into federal district court in Pittsburgh. The trial is expected to take place in the next few months.

Mowl will tell you he didn't choose the legal route lightly. "I'm just a little guy," he says. "I don't like to sue. I don't like courts and lawyers and that whole ball game -- depositions, discovery, and all. It's very distasteful to me, especially since I'm dependent on other banks. But I had no choice. Horizon was very arrogant. They were out to crush me."

The era of high-profile lender-liability cases came in like a thunderclap in 1984, when a Texas appeals court upheld a jury's $18-million award to Farah Manufacturing Corp., a blue-jeans maker. Farah charged State National Bank of El Paso with fraud. The court agreed. In 1985 another appellate court fueled the fire. It upheld a $7.5-million jury verdict against Irving Trust Co. for terminating a line of credit without advance notice to a borrower. By 1987, of the 10 largest judgments in the country, 5 were lender-liability cases. Like product liability and medical malpractice before it, lender liability has evolved into a specialized legal field, complete with textbooks, a lively lecture circuit, and seminars galore.

Barry Cappello, of the Santa Barbara, Calif., law firm of Cappello & Foley, a pioneer in the field, has practiced this brand of courtroom combat almost exclusively since 1981. He claims to have sued two thirds of America's 10 largest banks. "Borrowers have sued banks for a long time," he says. "It's only recently that the suits have coalesced under the title of lender liability. Borrowers are just taking advantage of basic rights that the law provides when they are injured in a business transaction and applying them to a banking situation." What is new is the size of the awards.

Most lawsuits are brought by small companies like George Mowl's -- companies that may not know how to protect themselves when dealing with banks and bankers. Problems often start when agreements aren't in writing or there's a switch in loan officers. Often it's not an isolated transaction that's critical, but the pattern of a bank's actions that sways a judge or jury. And often jury verdicts -- which tend to rule in favor of the companies -- are overturned on appeal. Consequently, Cappello is careful in his case selection.

"I only take the real horror stories now, the nightmares," Cappello says. "Of the 30 cases I look at each month, maybe 10 are horror stories. I'll take just one of them. The conduct of our clients has to be completely pure for us to take on a major case, and the bank's behavior has to be really egregious, because we're going to be involved in that litigation for four or five years. You have to take banks all the way to trial, and the jury has to hit them over the head before they'll write the check."

How egregious must the bank's behavior be? Consider the following example, one of Cappello's horror stories.

Contempo Metal Furniture of California, in Los Angeles, was a family business operated by Louis Schuster and his son Robert. The company was profitable until the 1979-82 recession, when it began to lose money for the first time.

In mid-1982, Robert Schuster, then 42, was running the company alone; his father was in ill health. To turn Contempo around, he brought out a new product line: metal furniture painted in high gloss to give it a lacquered-wood appearance. Introduced at trade shows, the line was an immediate success. Schuster figured the new product would restore the company to good shape in short order. He asked Union Bank in Los Angeles for $250,000 in working capital to supplement a $400,000 loan Contempo already had. The bank agreed to lend the money only if outside consultants analyzed the company and recommended investment of the $250,000.

The Contempo account had been bounced from one loan officer to another as Union Bank wrestled with rapid change. At the time it was handled by James Goswiller, whom Schuster had known for about six months. Goswiller suggested as consultants a local firm, Leider, Murphy & Associates. William Leider and Gerald Murphy, he said, were "excellent," and indeed, they presented themselves as an experienced turnaround team. And so, on Goswiller's word, Schuster brought them on board.

As it turned out, the firm had rather limited experience; it had been in business only eight months. But that wasn't the only problem. While Leider had been chief financial officer and chief operating officer of a number of small and midsize companies, neither man had any experience in furniture manufacturing. And it was only much later that Schuster found out Leider and Goswiller were business friends.

Leider and Murphy's analysis of Contempo recommended a major overhaul. Goswiller told Schuster he would lend the money only if Schuster gave the consultants 100% support in implementing the changes they had suggested. Their fees would total $10,000 a month. Schuster agreed.

The consultants took over in late 1982. Sales dropped while they revamped and computerized the production process. Within 45 days, according to Schuster, the company had overdrawn its account by $400,000.

"They told me to stick to sales and marketing and keep my nose out of every other phase of the company," Schuster says. "I wasn't worried. I thought these consultants were very sharp people. Leider in particular was very meticulous, beautifully spoken, and well dressed. They seemed like real pros."

Meanwhile, the bank debt topped $1 million, and the newly installed production process was losing serious money as Murphy underpriced the goods.

"At this point, money was being spent drastically," Schuster recalls. "When I called the bank to ask what was going on, I was told to stay in my area, that these guys were heavyweights, that they knew what they were doing. When I asked the bank for the financial statements, they told me there weren't any."

Undaunted by their own lackluster progress, the consultants tried to buy stock in Contempo. Disturbed by this turn of events, Robert Schuster called the bank again. What would happen, he asked, if Leider and Murphy did not become shareholders? Under those circumstances, a loan officer warned, the bank would call all the loans due. Leider and Murphy acquired 50% of the stock.

By midsummer 1984, however, the company's performance was degenerating further, and debt was rising fast -- by August it was $3.2 million in the hole. Union Bank, now alarmed, shifted the account to a workout committee. Shortly thereafter, it foreclosed on all of Contempo's equipment, inventory, and assets. In the aftermath, the Schusters lost their entire company as well as their equity in the real property.

The bank then turned around and sued the Schusters for the remaining debt, arguing that their mismanagement had brought on the failure. Robert Schuster was appalled. "I knew what the bank did to me was wrong," he says. "I didn't know if I should get any money for it, but I felt they shouldn't get away with it. They had basically ruined our lives."

He asked four prominent Los Angeles law firms to represent him, but each refused. "They all said it would cost too much money and that my case wasn't good -- too marginal." Schuster then called Cappello, who concluded that the facts met his standards of "egregious" bank conduct and relatively "pure" action by the plaintiffs.

The case finally reached Los Angeles Superior Court in December 1988, a month after Louis Schuster, Robert's father, died. Last February the jury awarded the Schusters $12.5 million in compensatory damages. The family was seeking an additional $20 million in punitive damages, but bank lawyers settled out of court before that phase of the trial began. The final settlement was not made public, but Cappello says his clients were "delighted" with it.

"We agreed to the settlement because we were afraid if we got a big punitive award, the bank would appeal it," Schuster explains. "We didn't want to take the chance of having it reversed. Banks have deep pockets, and they could have worn us down. As it was, we had some $100,000 in court costs for depositions and court reporting. By the time you're through, you have a lot of money tied up in this."

In retrospect, Schuster recognizes his own culpability in Contempo's demise. For starters, he says, he barely knew Goswiller. "We didn't thoroughly research the consulting firm or even verify their backgrounds," he says. "We depended completely on Goswiller. If we had known about those guys, we never would have hired them. But by the time they were entrenched, I was powerless. I had agreed to give them carte blanche."

Second, he says, he should have gotten his accountant involved on a monthly basis and insisted on regular financial reports. Finally, after Leider and Murphy urged such a radical restructuring, he should have gone to another bank, where he might have obtained less austere conditions. "We didn't need to revamp the whole company," he says. "Computerizing the inventory would have been enough."

Leider, Murphy & Associates is still in business. Bill Leider looks back on the episode with regret and bitterness. An equity infusion of $1 million, he says, could have saved Contempo. "We were in striking distance of success when we ran out of resources." He also believes that the verdict had less to do with the facts of the case than with Cappello's courtroom theatrics. "The trial was about winning money," Leider says. "It had very little to do with what happened in the company. Cappello & Foley had to create a link between the bank and the consultants -- us. What they did was tell a story that we were like secret agents of the bank. We wound up in the cross fire."

As for Schuster, he is now in sales with Beverly Hills Office Supply.

A ruling about a year ago in New York State -- on a case known as Gillman v. Chase Manhattan Bank -- is seen by some legal experts as a watershed in lender liability, with the pendulum swinging firmly back in favor of lenders.

In the early 1980s the Jamaica Tobacco & Sales Corp., of Jamaica, N.Y., obtained a renewable letter of credit for some $400,000 from Chase. It used the letter to secure a bond from an insurance company. The bond in turn was posted with New York State and New York City authorities against purchase of tax stamps for cigarette packs. The company was a wholesaler, distributing tobacco products and candy to stores in the metropolitan area.

The letter of credit required certain pledges. Jamaica could not allow liens to be placed against company assets, for example. And any loans due the company would be subordinated to the bank's debt if the letter ever matured into an obligation.

In October 1982, under pressure from Chase, the company provided financial statements that showed it was insolvent. Shortly before that, though, the bank had told company president Stephen Frohlich not to worry -- his letter of credit had already been renewed for another year.

But clearly unhappy with Jamaica's condition, the bank had a workout officer examine the account. He discovered that the parents of a principal of the firm had recently placed a lien against the company's inventory and receivables.

As Chase saw it, that violated one of the pledges on the letter of credit. It immediately froze the company's regular business account, a demand checking account containing some $300,000. The company, unaware of the freeze, deposited another $60,000 the very next day, which was seized as well. Before long Jamaica was getting calls from Philip Morris, American Brands, and other suppliers complaining that their checks from Jamaica were bouncing. The company's credit was cut off. In short order, it shut down.

Frohlich, now retired in Miami Beach, selected businessman Seymour Gillman as a fiduciary agent, a sort of bankruptcy trustee. Gillman liquidated the company. But he also hired Manhattan attorney Harold Berzow to sue Chase on several counts -- breach of contract, wrongful seizure of funds, and unlawfully preferring itself over other creditors. "Our theory was that the contract on which the bank based its rights was unconscionable," Berzow recalls.

The case came before a judge -- no jury -- in Jamaica in 1986. The judge awarded the company $1.2 million, including punitive damages of $500,000.

"The judge felt that the contract, written on the reverse side of the letter of credit, was in print so small that you couldn't read it," Berzow explains. "Second, he felt the language so one-sidedly favored the bank that no businessman in his right mind would agree to it if he could read it. And third, he said the bank's actions were so cavalier and outrageous that it should be punished."

The following year Chase won a reversal on the basis that its actions were perfectly legitimate. Berzow appealed the decision to the New York Court of Appeals, the highest court in the state. In a six-zero decision, the court held in favor of the bank.

"They felt the contract on the reverse side of the letter was readable and that Frohlich had ample time to review it," Berzow says. "They also said in a commercial setting the court would not upset a contract based on unconscionability. They felt that businesses have as much negotiating leverage as the bank."

This ruling may not seem terribly striking, but to Chicago attorney Michael Weissman, it's "a very, very important case." Weissman, an expert in the field and the author of a book on lender liability, believes that in the long run the Gillman case may be one of the most significant of all.

Its importance has to do with what lenders call "the insecurity clause," he explains. When a borrower does something that causes the lender to believe the loan may be in jeopardy, the lender reserves the right to accelerate the maturity date of the loan and seek immediate collection.

"There had been a lot of controversy about the use of these clauses, because they basically reside in the subjective judgment of the lending officer," Weissman says. "But the court said it was OK for Chase to seize those funds without notice, simply because if it had given notice, the borrower might have pulled the money from the account. The whole remedy would have been useless."

Equally important, he believes, is that the opinion came from the New York Court of Appeals. "That court, when it speaks, speaks with great authority. So this decision, when you couple it with several other key reversals, indicates to me that there is a very strong movement away from favoring borrowers."

Weissman might be right, but the nebulous nature of the field makes hard analysis difficult. Cases can land in state or federal court; some settle in arbitration or out of court; and no one seems to keep track of it all. The newsletter "Inside Litigation" reported that lender-liability judgments failed to place in the 20 largest awards of 1988, a far cry from 1987, when such judgments took 5 of the top-10 awards. (At least 2 of these have since been successfully appealed.)

Analysts speculate that more cases may now be settling in arbitration. Others suggest that banks have so radically cleaned up their acts for fear of lawsuits that fewer cases are being lodged. Some states, pressed by banks, are tightening the body of law surrounding lender liability. At least 20, for example, now allow claims only when banks violate written contracts -- oral agreements are no longer binding.

Lender liability's poor showing in the 1988 litigation sweepstakes might be just a fluke. These cases, after all, take years to work their way to final awards. Some attorneys predict a liability surge in the wake of the S&L debacle, as new owners move swiftly to eliminate problem accounts.

Barry Cappello notes a strong correlation between economic conditions and the number of liability cases. In fat times, he says, banks will carry problem loans and try to work them out. But in lean times they tend to tighten up.

"I can show you lender-liability cases and a sine curve based on the economy," he says. "When the economy is bad, cases go up. The banks get in trouble, and they put orders out to their people: 'Get out of agricultural loans! Get out of real estate!' The people at the lower levels, who aren't well trained or are incompetent, don't know how to extricate themselves without a lot of blood on their hands. By the time word gets down to the branch managers, they're just whacking away with hatchets."

But most bankers, Cappello is quick to note, are more than willing to deal with problems once they are pointed out. "People ask me, 'Should I let the bank act and wipe me out, and then maybe I can sue for millions of dollars?' I tell them every time, 'Don't do it. You're better off staying in business. Let's get with the bank and do a workout.' So we sit down, and if the bank has made a mistake, it will usually write the loan down, or write the interest off, or renegotiate. The bottom line is, the bank doesn't want to be sued."

* * *

Research assistance was provided by Teri Lammers.


HOW BANKS ARE CHANGING

What commercial lenders are doing to counter the threat posed by large lender-liability awards

Since losses come straight from their bottom lines, bankers have acted quickly to cut down the risks of suits.

New Jersey lawyer Helen Chaitman, a partner at Ross & Hardies who chairs an American Bar Association subcommittee on the subject, has written a treatise, "The Ten Commandments for Avoiding Lender Liability," now in its eighth edition. Among her edicts: thou shalt not run thy borrower's business, and thou shalt honor thy commitments. Her final dictum may be the most telling of the new climate: thou shalt not be arrogant.

"There's been a tremendous education effort on behalf of lending institutions, and it's really paying off," Chaitman says. "But I think the atmosphere surrounding loan negotiations has been deeply affected."

Indeed, it has. Silicon Valley Bank senior credit officer Jay Kerins remembers "the old days," when loan agreements were typed on 3 pages, signed by the parties, and that was it. Now, they are more like 33 pages. And lawyers on both sides negotiate the entire deal, straining to address every conceivable eventuality.

Some of the other trends in banking include:

* Written contracts. The new cardinal rule for lending officers: get it in writing. Oral commitments, which lie at the core of many liability fights, are history practically everywhere. Banks now establish elaborate paper trails tracing every action concerning a loan.

* Arbitration. At California's giant Bank of America, beset by some 35 liability suits, loan contracts now include binding arbitration clauses. Waiving their right to a jury trial, borrowers agree to turn disputes over to professional arbitrators. This will make settlements faster and cheaper. (There is no appealing these decisions, and unlike a case brought before a jury, there is no opportunity for punitive damages.)

* Personnel changes. California attorney Barry Cappello, something of a scourge to banks, is encouraged by the changes banks are making. "I have seen the loan-adjustment departments or the special-assets divisions of banks literally clean the storm troopers out of that business. They have been replaced by more sensitive pros. By using better tactics, they've been able to cut lender-liability suits by huge numbers."


HOW COMPANIES CAN PROTECT THEMSELVES

Don't consider yourself helpless in dealing with banks

To guard against problems with loans, here are some commonsense precautions:

* Get all loan agreements in writing. Don't expect banks to honor oral commitments.

* Make sure that loan documents accurately reflect all pertinent terms, conditions, and covenants, and that you fully understand them. Question any ambiguous items.

* Do all you can to help your lending officer -- and his or her manager -- understand your business. If officers change, meet with the new person as soon as possible. You're best off if more than one person at the bank knows your business.

* Be open and honest with your banker even if your company takes a turn for the worse. This is one time when your optimism can be a problem. Secrecy or indirectness makes most lenders very nervous.

* Remember, banks need you as much as you need them. And not all banks are alike. If a bank imposes onerous loan conditions, then you should seek more favorable terms elsewhere.

* If a bank makes sudden, unethical, or illegal moves that imperil your business, that may be the time to get a good lawyer. If possible, arrange new terms with the bank to save your company.

* If all else fails, sue. But keep in mind that it might be years before you see relief. And bitter legal battles can exact a heavy financial and emotional toll on you and your company.