K.M.C. Co., Inc. v. Irving Trust Company
92 A.L.R. Fed. 661, 757 F.2d 752, 1 Fed. R. Serv. 3d 1095 (1985)
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Rule of Law:
A lender's implied duty of good faith and fair dealing requires it to provide notice to a borrower before refusing to advance funds under a discretionary line of credit, especially when the refusal would effectively destroy the borrower's business and the lender has sole control over the borrower's incoming cash.
Facts:
- In 1979, K.M.C. Co., a wholesale and retail grocery business, entered into a financing agreement with Irving Trust Company (Irving).
- The agreement provided K.M.C. with a line of credit, eventually increased to $3.5 million, and gave Irving a security interest in all of K.M.C.'s accounts receivable and inventory.
- A supplementary agreement required all of K.M.C.'s receipts to be deposited into a 'blocked account' to which only Irving had access, giving Irving sole control over K.M.C.'s cash flow.
- K.M.C. relied on advances from the line of credit, deposited into its operating account by Irving, to run its business.
- On March 1, 1982, K.M.C. requested an $800,000 advance, which would have kept its total borrowing just under the $3.5 million limit.
- Without any prior notice, Irving refused to advance the funds.
- Due to the blocked account arrangement, Irving's refusal left K.M.C. without operating capital, causing checks to bounce and ultimately leading to the collapse of the business.
Procedural Posture:
- K.M.C. Co. filed a diversity action against Irving Trust Company in federal court for breach of a financing agreement.
- The case was tried by a U.S. Magistrate with the consent of both parties.
- Over Irving's objection, the Magistrate ordered a jury trial despite a jury waiver clause in the contract.
- The jury returned a verdict in favor of K.M.C., finding Irving liable for breach of contract and awarding $7,500,000 in damages.
- The Magistrate denied Irving's post-trial motions for judgment notwithstanding the verdict (n.o.v.), a new trial, or a remittitur.
- Irving, as the appellant, appealed the judgment to the United States Court of Appeals for the Sixth Circuit; K.M.C. is the appellee.
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Issue:
Does a lender's implied duty of good faith performance require it to give notice to a borrower before refusing to advance funds under a discretionary line of credit agreement where the lender has sole control over the borrower's receipts and the refusal will destroy the borrower's business?
Opinions:
Majority - Cornelia G. Kennedy, Circuit Judge
Yes. A duty of good faith performance is implied in the financing agreement, and this duty required Irving to give K.M.C. notice before refusing to advance funds. The court reasoned that the combination of the financing agreement and the 'blocked account' mechanism gave Irving life-or-death power over K.M.C., leaving K.M.C.'s continued existence entirely at Irving's 'whim or mercy.' To interpret the contract otherwise would be unreasonable. The obligation to act in good faith requires a period of notice to allow a borrower a reasonable opportunity to seek alternative financing, unless valid business reasons preclude the lender from doing so. The court rejected Irving's argument that the 'demand' provision gave it an absolute right to cease advances, stating that the power to demand repayment is also limited by the good faith obligation. The court found there was ample evidence for a jury to conclude that no reasonable loan officer would have refused the advance without notice, especially since Irving was fully secured and its action was tantamount to a unilateral decision to destroy K.M.C.
Analysis:
This case is a landmark decision in the area of lender liability, significantly strengthening the implied covenant of good faith and fair dealing in lending agreements. It established that a lender's discretionary powers are not absolute and must be exercised reasonably and in good faith. The ruling puts lenders on notice that they cannot arbitrarily cut off financing, especially in arrangements where they control the borrower's cash flow, without providing reasonable notice. This decision shifted the balance of power slightly from lenders to borrowers by imposing a quasi-fiduciary duty on lenders in certain circumstances and moving the good faith standard from a purely subjective 'honesty' test to one that incorporates objective commercial reasonableness.
