Kentucky Court Recognizes Lien Based on Stock Purchase Agreement

In a recent decision, the Kentucky Court of Appeals sent a clear message to lending institutions.  Namely, to carefully examine existing due diligence practices prior to extending financing to borrowers.  The case, Fifth Third Bank v. Rogers et al., concerned five brothers that organized multiple corporations and served as their sole shareholders and directors.  After the death of a brother and pursuant to the terms of an existing Stock Purchase Agreement, the deceased brother’s estate offered his stock to the corporations and remaining shareholders.  After failing to elect to purchase the deceased brother’s stock, the Estate initiated an action to have the corporations dissolved and their affairs wound up in accordance with the Stock Purchase Agreement.

Subsequently, the remaining brothers sought to obtain a loan in the amount of $2,500,000 from Fifth Third Bank.  The Bank’s internal lending policy required searches for pending state civil litigation and judgments.  As commonplace, the Bank relied on an outside vendor to perform such due diligence.  No pending action or judgment was revealed in the search.  Further, the Bank’s loan officer requested a resolution from the directors authorizing the borrowing of funds.  The resolution received by the loan officer contained four signatures, in contradiction with the bylaws of the corporations previously reviewed by the loan officer that stated that a minimum of five directors must serve at all times. Lastly, there was some evidence advanced in the action that the loan officer had personal knowledge of the existing of the Stock Purchase Agreement and the death of one of the brothers.  Despite the foregoing, the Bank proceeded with the loan and the corporations defaulted.

After the foreclosure and subsequent sale of some of the property securing the loan, the Estate of the deceased brother sought to intervene by claiming a one-fifth interest in the collateral pursuant to the terms of the Stock Purchase Agreement.  The trial court held that the Stock Purchase Agreement created an equitable lien on the corporation’s assets of which the Bank had actual notice.  Thus, the trial court determined, the Estate had priority to one-fifth of the proceeds.

The Court of Appeals agreed.  Specifically, the Court determined that the Stock Purchase Agreement created a contractual equitable lien as it satisfied all requirements for a valid contract (i.e. offer, acceptance and consideration).  Second, the Court provided that even in the absence of contractual requirements, a non-contractual equitable lien was created due to equitable principles of justice.  In response, the Bank argued that since the contract or complaint in the dissolution action failed to expressly provide for the creation of a lien, no such lien can be in place.  The Court profoundly disagreed.  Namely, the judges found the idea of imposing a forfeiture on the deceased brother’s corporate interests unjust and unacceptable.  As a result, the Stock Purchase Agreement created an enforceable lien.

In determining the priority, the Court took great distaste with the fact that the Bank obtained all necessary documents (i.e. bylaws, articles of incorporation, etc.) yet failed to adequately inspect them.  As a result, the Court determined that the Bank had actual notice of the equitable lien.  In light of the foregoing, the Court affirmed the trial court’s holding.  Thus, the Estate was properly entitled to a one-fifth interest in the collateral securing the loan.

The Rogers decision sends a clear message to lending institutions:  perform thorough due diligence prior to extending credit.  Namely, when a lending institution receives all documentation (i.e. articles of incorporation, bylaws, existing agreements, etc.) necessary to discover the existence of potential contractual and equitable liens, Kentucky courts may impose actual notice on the institution of their existence.  Upon this occurrence, lenders run the risk of having their liens subordinated and the collateral securing the indebtedness shared with existing debtors.  Absent adequate inspection of documents and due diligence prior to extending credit, a lender may very well be in danger of being only partially secured for the indebtedness.

Jim Dressman is a Partner in the law firm of Dressman Benzinger LaVelle, with offices in Cincinnati, Ohio, Crestview Hills, Kentucky, and Louisville, Kentucky.