• Protect Yourself: Lessons for Lenders from the Tennessee Supreme Court
  • March 11, 2011 | Author: Michael T. Harmon
  • Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
  • No one is sure how much of a crunch small business lending saw in the past two-and-a-half years. Different definitions of “small business” give us different numbers. The one thing we do know is that small business lending has changed, and in fundamental ways. Lenders are requiring more capital, more assurances and more protection. In a moment of truth, most lenders will admit that this is not best for the economy because the more restrictive small business’ access to capital, the less the economy will grow. There must be a balance, but this balance is difficult to strike as lenders struggle with what protections are available and what protections they should seek. 

    Although it does not provide all of the answers, a recent Tennessee Supreme Court case, Sanford v. Waugh, 2010 WL 5139496 (Tenn. Dec. 17, 2010), provides lenders with good information about the protections Tennessee law provides in the event of the insolvency of a small business. The Sanford case dealt with the narrow question of whether an individual creditor of a closely held corporation could assert a direct, as opposed to derivative, cause of action for breach of fiduciary duty against a member of the board of directors of a closely-held corporation when the corporation became insolvent. In reaching its decision that no direct cause of action was available, the Court outlined for lenders the protections they can expect in the event of insolvency and emphasized the need to address the protections sought at the beginning of a relationship with a borrower.

    Factual Background of the Sanford case

    In the mid-nineties, Michael Sanford and Bruce Prow formed a company called SecureOne that sold and serviced security systems. A dispute developed between the two, and Mr. Sanford sold his interest in the company to Mr. Prow and his wife. Under the terms of the sale, Mr. Sanford received a note for $2 million. With this note, which was at the center of the Sanford decision, Mr. Sanford become a creditor of SecureOne.   

    In early 2004, SecureOne began to wind down its operations. The company ultimately defaulted on Mr. Sanford’s note. Mr. Sanford sued Troy and Carol Waugh, Mr. Prow’s in-laws who were also directors and creditors of SecureOne. In his suit against the Waughs, Mr. Sanford brought multiple claims including a “direct” claim against the Waughs in their capacity as directors of SecureOne for purported breach of fiduciary duties. Any recovery under a direct claim would have gone directly to Mr. Sanford whereas recovery under a derivative claim would have gone to the corporation, SecureOne, and may not have ultimately inured to Mr. Sanford. Although Tennessee law recognizes a derivative cause of action for breach of fiduciary duty brought by a creditor against a director of an insolvent corporation, Tennessee law had not recognized any direct cause of action in a similar situation.

    The Tennessee Supreme Court’s Decision

    The Tennessee Supreme Court determined that allowing direct causes of action like the one Mr. Sanford sought would cause more harm than good, especially given the protections that individual creditors already have under Tennessee law. The Tennessee Supreme Court noted that creditors are: (1) able to protect their interest through loan and security agreements before lending money to any firm, (2) protected by federal bankruptcy law in the case of an insolvent corporation, (3) protected by the “trust fund doctrine,” (4) have a right to bring a derivative claim in certain instances and (5) can bring certain direct claims against a director, just not a claim for breach of fiduciary duty. 
    The first two protections are well known to most, but it is worth noting that the Tennessee Supreme Court emphasized that loan contracts provide the lion share of the protection needed by any lender, so long as the contracts are properly drafted. Many lenders take their loan contracts for granted because form contracts provide the protection needed in most instances. Each loan is a unique agreement between a borrower and a lender that has it own idiosyncrasies. It never hurts to look at the contracts for each substantial loan because it is the idiosyncrasies of a borrower that can make a difference. As the Tennessee Supreme Court noted, the time to address the complete relationship between a lender and a borrower, including what will happen in the event of insolvency, is during the creation of the loan contract, not when insolvency rears its head. Federal bankruptcy law provides the framework for distributions of assets, and any distribution is influenced by the protections a lender receives in its loan contracts. 

    The last three protections are designed to protect a lender from actions taken at the end of a company’s life.  The trust fund doctrine holds that any shareholders to whom assets of an insolvent corporation were transferred can be liable to creditors when the corporation is dissolved. If a director harms the corporation by breaching his or her fiduciary duties, a creditor of an insolvent corporation may attempt to step into the shoes of the corporation and seek recovery on behalf of the corporation through a derivative cause of action. And of course, if a director of a corporation commits a tort directly against a creditor, then the creditor may seek recovery directly from the director. These three protections, though rarely used, can be powerful when available. 

    At first blush, a case about whether a creditor can be bring a direct action for breach of fiduciary duty may not seem that important to a lender. But in reaching its decision, the Sanford Court laid out the five protections every lender should remember when entering into a loan agreement. The role these five protections play in how a loan agreement should be structured depends on the circumstances of each loan relationship, and each loan relationship should be developed with these protections in mind.