The Vermont Supreme Court has traditionally had very little sympathy for banks and financial institutions who do not follow their own lending agreements to the letter, and then ask for court relief when they end up in litigation with a borrower.

This theme was reinforced in a recent decision by the Court involving Berkshire Bank, which had made a loan to a borrower for a business start-up, to be collateralized (in part) by an investment account owned by the brother of the bank’s borrower.

It’s not uncommon for a commercial loan to be collateralized by a lien on a third party’s assets. But because the third party providing the collateral is not the lender’s customer, it can be more complicated and difficult to make sure all legal requirements are met. Additionally, the lender has less leverage on the third party to ensure all requirements to perfect a security interest are met. When the third-party collateral is an investment account held at a financial institution other than the lending bank, the matter is further complicated by the need to involve a second financial institution, with its own customer relationship to protect, in the process.

In the Berkshire Bank case, the lender had drafted a security agreement saying that the creation of a security interest in the investment account required the lender to obtain control over the investment account. Control over such an account is usually established by an agreement between the lender, the owner of the investment account and the institution holding the account, giving the lender certain rights of control over the account while the loan remains outstanding. Berkshire Bank requested the Merrill Lynch (where the investment account was located) sign such an agreement, but Merrill Lynch never did.

When the borrower defaulted, the lender sued the borrower and her brother, seeking to establish its rights to obtain recourse against the investment account. The lower court ruled that Berkshire Bank had not satisfied the requirements of its own security agreement by failing to establish control over the investment account, resulting in the loss of the investment account as collateral. The Vermont Supreme Court affirmed, holding that lenders must follow to requirements of their own security documents, and that loss of rights to collateral (and the resulting benefit to the third party who pledges the collateral for a loan) is no justification for ignoring the requirements of the lender’s own loan documents.

The lesson from this decision and others before it is that large institutions like banks will always be held to the letter of their own agreements and the law in Vermont.

This requires extra vigilance and care in the proper completion and execution of all required loan documents, and in drafting loan and collateral documents that minimize the risks of post-closing gaps in documentation. Extra care and diligence is also required in connection with any loan that involves third party collateral, especially an investment account held at a different institution.