Third-Party Beneficiary Rights to Legal Fees? Not So Fast!

I am confident my readers will understand that one of the things near and dear to my heart is having lawyers get paid for their work. Those of us at the lenders’ bar often take solace in knowing that borrowers are obligated to pay our fees; and when they do not, the institutions we represent have both the wherewithal and desire to work with us in getting paid.

But not always.

We understand that at times the scope of the transaction exceeds initial expectations and fees may run up. We lawyers remain sensitive to that and work with our clients and their borrowers to reach a reasonable resolution when this occurs. But when a deal does not result in a closing, things may get difficult.

The United States District Court for the Southern District of New York recently issued a decision concerning a law firm’s attempt to recover over $800,000 in legal fees owed in connection with its representation of the agent lender in a deal that resulted in an executed loan agreement that did not fund.

The $167 million loan was intended to fund the development and construction of an 18,000-seat arena on the Virginia Beach waterfront. The City retained the right to approve the financing, and when it declined to grant its approval, the deal fell through.

The developer sued the City, which resulted in a finding that the City had not breached its agreement with the developer. The law firm brought its action against the borrower-developer and not its client, the lender.

The loan agreement provided that the borrower would pay all reasonable fees, charges and disbursements of counsel for the agent. The law firm, however, was not a party to the loan agreement and the law firm argued that it was an intended third-party beneficiary. The developer moved to dismiss the complaint claiming that the law firm did not have standing to sue because it was neither a party to the loan agreement nor an intended beneficiary.

The Court wrote:

Under New York law, non-parties can sue for breach only if they are an intended beneficiary of the contract. Those who qualify as mere incidental beneficiaries have no standing to sue on the contract.

The Court then focused on whether the contract provided that the law firm was intended to be a third-party beneficiary. The contract specifically stated:

… Nothing in this Agreement, expressed or implied, shall be construed to confer upon any Person … any legal or equitable right, remedy or claim under or by reason of this Agreement.

The Court noted that the contract did not specifically include the law firm or even counsel to the agent.

So, the question becomes: Is there anything in the contract that “expressly contemplates” that [the law firm] can bring a claim against [the developer] for payment of the fees it incurred in representing [the lender]? The answer is no. There is no such provision. There is no indication anywhere in the Credit Agreement that [the law firm] was either to receive payment directly from [the developer] or that it had any right to sue … for payment.

In fact, the Court stated:

the contract specifically indicates that [the lender] was to receive payment from the “Borrower” … for its counsel fees.

The Court went on:

The New York Court of Appeals has “sanctioned a third party’s right to enforce a contract in two situations: when the third party is the only one who could recover for the breach of contract or when it is otherwise clear from the language of the contract that there was “an intent to permit enforcement by the third party.”

The contract provided that the lender would receive payment, which excluded the law firm from directly suing to collect.

In dismissing the law firm’s complaint, the Court added:

This dismissal is of course without prejudice to [lender]’s ability to sue to recover any attorney’s fees that it pays to [law firm].

However, it would appear that if the lender was willing to sue to pursue its legal costs it would have at least authorized the firm to bring the action in the lender’s name. It is understandable that the lender might not have wanted to sue in its own name to recover legal fees – especially when a transaction does not close. That left the law firm out of pocket for a significant fee.

So, what is the takeaway?

Lawyers write the agreements. Protect yourself and make yourself a third-party beneficiary.

But consider that this case was very rare in that the loan agreements were executed but the deal still did not fund. Most deals that fail collapse before execution of the loan agreements. That certainly takes away a significant element – the executed loan agreements. Commitment letters – even nonbinding term sheet/proposal letters, provide for the lender recovering its legal costs and fees. Consider this a plea to add the lawyers as third-party beneficiaries to the proposal/commitment letters.

One can only imagine what might have occurred in the relationship between lender and its lawyers to leave the law firm strung out.

Caveat attornatus. (Lawyers beware.)

Winston & Strawn LLP v Mid-Atlantic Arena, LLC, ESG Enterprises, Inc., SDNY July 19, 2021, 2021 WL 3037478

The Emerging Use of Arbitration in Bankruptcy Matters

Readers of this blog (as well as my other published articles) should be familiar with my advocacy for use of arbitration in resolving commercial finance disputes. Certainly, in matters involving disputes between secured creditors (e.g., intercreditor disputes), I have long expressed my view that things like these should be resolved privately, not through a public forum. This is a great benefit of arbitration. I am also inclined to privately resolving disputes between lenders and borrowers through arbitration. In those rare instances when a lender may have crossed the line and is subject to liability, isn’t it better to keep that dispute under the cover of a confidential arbitration?

Over the past 30 years, the use of mediation has become common in bankruptcy disputes. But the question has long been raised whether arbitration clauses would be enforced in the context of a bankruptcy case. That issue was addressed in a recent decision from the Bankruptcy Court for the District of Maryland. While this decision may not be the first to address this question and enforce a prepetition arbitration private provision, the scholarship of this decision certainly makes it ripe to present.

The Maryland Bankruptcy Court wrote:

The filing of a chapter 11 bankruptcy case generally stops all matters affecting the debtor’s financial affairs and consolidates the resolution of those matters in one forum, the bankruptcy court. That collective process is intended to, among other things, allow a debtor to catch its financial breath and develop a cohesive reorganization plan; provide consistency and certainty in the resolution of matters potentially affecting the debtor’s reorganization; and ensure fair and equal treatment of the debtor’s creditors. …A frequent question…. is how these basic principles apply to an arbitration clause in a prepetition contract between the debtor and just one creditor.

Prior to the filing of his personal bankruptcy case, the debtor entered into a litigation funding agreement whereby the lender extended financing to fund the cost of the lawsuit in exchange for a percentage of the debtor’s interest in a whistleblower litigation. When the lender and borrower found themselves in a dispute, the lender invoked the arbitration clause contained in its agreement and the debtor filed a Chapter 11 case. The lender moved for relief from the automatic stay to allow the arbitration to proceed. The debtor objected.

The lender argued that the Bankruptcy Court was required to enforce the prepetition arbitration agreement, while the debtor argued that enforcement would conflict with the objectives of the Bankruptcy Code.

The [Federal Arbitration Act] and the [Bankruptcy] Code both are grounded in important policy considerations concerning efficiency and fairness. The FAA focuses on these notions in the context of, among other things, private contracts affecting commerce, creating a strong presumption in favor of the parties’ threshold agreement to arbitrate disputes. …The Code …  is not party- or contract-specific but seeks to balance the rights of many parties with many different contracts, rights, and interests involving a single debtor.

The Court turned to whether the dispute was a core proceeding:

If a claim is a constitutionally core proceeding, the bankruptcy court has the discretion to retain the proceeding and not enforce the terms of the parties’ arbitration agreement. …[T]his discretion arises from the inherent conflict in allowing an arbitrator to resolve proceedings that are grounded in the Code itself or that are integral to the debtor’s reorganization efforts…. A bankruptcy court’s discretion is far more limited with respect to nonconstitutionally core or non-core proceedings.

Some circuit courts have ruled that a bankruptcy court has no discretion to refuse arbitration of non-core claims. The Court quoted a New York case for the steps to follow in evaluating requests to compel arbitration:

[F]irst, it must determine whether the parties agree to arbitrate; second, it must determine the scope of that agreement; third, if federal statutory claims are asserted, it must consider whether Congress intended those claims to be nonarbitrable; and fourth, if the court concludes that some, but not all, of the claims in the case are arbitrable, it must then decide whether to stay the balance of the proceedings pending arbitration.

In doing its analysis, the Court determined that this was a hybrid case involving constitutionally core and non-core proceedings with the state law contract claims being subject to the prepetition arbitration agreement. The Court further noted that those claims could be separated from the bankruptcy and fair debt collection claims – “even if that may not be the most procedurally efficient approach….” In light of legal precedent in the Fourth Circuit Court of Appeals, the Bankruptcy Judge felt compelled to bifurcate the claims and allow the contract and nonbankruptcy claims to proceed to arbitration.

The Court acknowledges that, if the arbitrator resolves the Contract Claims or the Non-Bankruptcy Claims prior to this Court addressing the Bankruptcy Claims, the parties could face conflicting results, or one forum may be bound by the other’s decision under the doctrine of claim or issue preclusion. The Court is not prepared to rule on such matters at this time, but will by separate order issue a temporary stay of proceedings on the Debtor’s Complaint to monitor how these matters progress and to guard against undue delay or gamesmanship. The Court dislikes the element of uncertainty introduced by this approach but, absent clear authority under the Code or case law giving this Court more discretion to refuse arbitration in the context of non-constitutionally core or non-core claims, the Court finds this approach warranted and most appropriate under the circumstances.

The takeaway in this developing area of the law is, that while bankruptcy claims must be resolved in the Bankruptcy Court, nonbankruptcy claims that are the subject of an arbitration agreement may be compelled to be resolved by an arbitration tribunal. I will continue to keep an eye on this doctrine and continue to advocate the use of arbitration for the resolution of commercial finance disputes.

 

In re: John McDonnell McPherson v Camac Fund, L.P., Bankr. MD, June 1, 2021, 2021 WL 2232351

(Where) to Sue or Not to Sue? That Is the Question!

Two decisions issued a day apart, one from California and the other from Michigan, highlight the importance of bringing your action in a court where you can obtain jurisdiction over your defendant.

It’s My Seat, a ticketing vendor and concert promoter operating and organized in California, brought an action in the California state court system against Hartford Capital, a New York-based merchant cash advance company. Hartford removed the action to the Central District of California under diversity (actions between parties of different jurisdictions) and moved to dismiss the action for lack of personal jurisdiction.

The facts of the case involve It’s My Seat having sought a low-rate business loan by filing a loan application online. Hartford’s representative contacted It’s My Seat and promised that if It’s My Seat first took a $250,000, 30-day “bridge loan” with an interest rate of 15%, that it would then provide a $750,000 term loan with interest at 8.99%. The bridge loan provided for daily ACH payments in the amount of $3,600. The Hartford representative assured that the term loan would be made but did not document that assurance in any way. It’s My Seat signed and notarized the bridge loan documents and Hartford advanced the bridge loan, but for a previously undisclosed $22,000 “funding fee.” When It’s My Seat protested the funding fee, Hartford’s representative promised to credit the amount. It’s My Seat made the daily payments for the required 30-day period, but the $750,000 line of credit was not issued. The Hartford representative claimed that he was “doing everything I can to get this pushed through.” It’s My Seat continued to make the $3,600 daily payments for 70 days (40 more than originally required) having to obtain third-party emergency loans in order to do so. Ultimately, Hartford refused to provide the term loan on the basis that the third-party loans violated the bridge loan agreements, and It’s My Seat brought the action against Hartford and its representatives.

The court dismissed the action against Hartford and one representative because the complaint was not timely served. The other representative, Stein, moved to dismiss for lack of personal jurisdiction. The question of personal jurisdiction turned on whether Stein’s relevant contacts with It’s My Seat subjected Stein to specific personal jurisdiction.

Where a defendant’s contacts are “not so pervasive as to subject him to general jurisdiction,” the Ninth Circuit applies a three-part specific jurisdiction test: “(1) The nonresident defendant must do some act or consummate some transaction with the forum or perform some act by which he purposefully avails himself of the privilege of conducting activities in the forum, thereby invoking the benefits and protections of its laws. (2) The claim must be one which arises out of or results from the defendant’s forum-related activities. (3) Exercise of jurisdiction must be reasonable.” (citations omitted)

Stein admitted that he called It’s My Seat in California to solicit and conduct business in the form of the bridge and term loans. The court determined that Stein’s contacts with California are therefore integral and essential parts of the claims made in the case and that It’s My Seat made a prima facie showing of the first two prongs. The burden then shifted to Stein to set forth a compelling reason why the exercise of jurisdiction would not be reasonable.

The court then cited the factors in determining reasonableness:

(1) the extent of the defendants’ purposeful injection into the forum state’s affairs; (2) the burden on the defendant of defending in the forum; (3) the extent of conflict with the sovereignty of the defendant’s state; (4) the forum state’s interest in adjudicating the dispute; (5) the most efficient judicial resolution of the controversy; (6) the importance of the forum to the plaintiff’s interest in convenient and effective relief; and (7) the existence of an alternative forum. (citations omitted)

The California court then weighed each of the factors and concluded that Stein failed to make a compelling case that the exercise of jurisdiction in California would not be reasonable and declined to dismiss the action as against Stein.

The Michigan case concerned a dispute between two lenders and their priority in the collateral of a mutual borrower organized and operating in Ohio. The underlying claim is one of great interest although not decided in the case. Plaintiff and its predecessor provided financing to borrower under a revenue purchase agreement and perfected an all-asset Uniform Commercial Code (UCC) filing on Dec. 12, 2019. Defendant provided one or more merchant cash advances and perfected an all-asset UCC filing on Jan. 23, 2020. Defendant also secured ACH payments from the borrower’s bank account.

Plaintiff brought an action in Michigan state court against Defendant for (1) declaratory judgment as to priority in collateral, (2) tortious interference with a contractual relationship, (3) tortious interference with future business expectations, (4) conversion, and (5) temporary, preliminary and permanent injunctive and declaratory relief. Defendant removed the case to the Federal District Court in Eastern Michigan under diversity and moved to dismiss the complaint for lack of personal jurisdiction.

Michigan law recognizes two bases for personal jurisdiction over a corporation: (1) general, and (2) specific (called limited personal jurisdiction). A court has general jurisdiction over a corporation where the defendant’s contacts within the forum are so continuous and systematic as to render it essentially at home in the forum state. As to specific jurisdiction, the inquiry focuses on the relationship among the defendant, the forum and the litigation. For a court to exercise specific jurisdiction, the defendant’s suit-related conduct must create a substantial connection with the forum state. The plaintiff has the burden of proof to establish that a defendant’s contacts are sufficient to subject it to jurisdiction.

Plaintiff argued that the Michigan Court had general jurisdiction over Defendant because Defendant solicited business from Michigan residents through its website and established “long-term lending relationships with Michigan residents” as evidenced by UCC filings in favor of Defendant, and litigation within Michigan courts. The Court found that evidence to be insufficient to establish general jurisdiction over Defendant as it failed to demonstrate continuous and systematic contacts.

Plaintiff further argued that Defendant had utilized its website to solicit business from Michigan residents and establishes general jurisdiction. The Court found no authority to support that proposition and indicated that case law states the opposite. The Court held:

Plaintiff has offered no evidence to support a finding that this is “an exceptional case,” or any authority to support the proposition that Defendant[]’s contacts are sufficient to establish it was “at home” in Michigan. There is no evidence that Defendant [] has physical locations, employees, or officers in Michigan. There is no evidence that Defendant [] has bank accounts or conducts daily corporate activities in Michigan. While Plaintiff offers proof that Defendant has filed multiple UCC debtor financing statements and has brought one case within Michigan courts, this evidence merely confirms that Defendant [] has done some in-state business in Michigan. This is insufficient for purposes of establishing general jurisdiction.

The Court then focused on whether “specific jurisdiction” would apply. Under specific jurisdiction, a plaintiff may sue a defendant “only on claims that arise out of the defendant’s activities in the forum state.” The Court cited the standard for specific jurisdiction as determined by the Sixth Circuit Court of Appeals:

First, the defendant must purposefully avail himself of the privilege of acting in the forum state or causing a consequence in the forum state. Second, the cause of action must arise from the defendant’s activities there. Finally, the acts of the defendant or consequences caused by the defendant must have a substantial enough connection with the forum state to make the exercise of jurisdiction over the defendant reasonable.

Plaintiff alleged that the second prong was met because Defendant’s “actions had consequences in Michigan resulting in harm to [Plaintiff], a Michigan resident.” However, the Court noted that both the U.S. Supreme Court and Michigan courts have rejected this theory of specific jurisdiction.

When assessing specific jurisdiction, “[t]he proper question is not where the plaintiff experienced a particular injury or effect but whether the defendant’s conduct connects him to the forum in a meaningful way.”

*****

…it is clear that Defendant[]’s conduct—entering into a contract with a company in Ohio to purchase revenue and withdrawing funds from that company’s bank account in Ohio—may not form the basis for Defendant to be sued in a Michigan court. …. Plaintiff does not allege that any of Defendant[]’s challenged conduct took place in Michigan.

The dismissal of the action does not bar Plaintiff from pursuing its claims in a proper jurisdiction; it certainly does not appear that any statute of limitations is at risk. However, the cost and time incurred takes its toll on Plaintiff.

Each of the California and Michigan cases rests on nonphysical presence of the parties—email and websites.  The Michigan case concerned a loan made into Ohio, while the contacts in the California case concerned a loan made into California. That is not to say that had the Michigan plaintiff brought its case in Ohio that an Ohio court would have ruled differently.

The takeaway is to make a careful analysis when bringing an action against a party of a different jurisdiction, and assure that jurisdiction is proper in the venue where the action is brought.

One final thought: Commercial lenders and factors have long expressed concerns about egregious conduct engaged in by certain merchant cash advance providers. Each of these cases highlights questionable conduct that commercial lenders and factors will want to monitor.

It’s My Seat, Inc. v Hartford Capital LLC, et al. (CD CA, 3/30/21) 2021 WL 1200042
Franklin Capital Funding, LLC v Ace Funding Source, LLC (ED MI, 3/31/21) 2021 WL 1224917

Think Before You Click: A $500 million mistake!

A major objective of this blog is to keep lenders apprised of significant judicial decisions that impact their business lives so they can learn from them, correct bad habits and improve their best practices. In writing WurstCaseScenario we seek to help lenders avoid making mistakes. Today, we focus on a critical decision from the Southern District of New York (“SDNY”), In re Citibank August 11, 2020 Wire Transfer, 20-cv-6539 (SDNY, February 16, 2021), concerning a costly mistake that could and should have been avoided.

Readers of these pages should remember the debacle that resulted from another bank inadvertently terminating the Uniform Commercial Code (UCC) financing statements perfecting the security interests of the syndicate of lenders in the General Motors case.

As an aside, we may want to keep in mind that the facts underlying this decision all occurred during the COVID-19 pandemic.

In 2016, Revlon took out a seven-year, $1.8 billion syndicated loan with Citibank as agent. Amongst its duties, the bank was to receive payments from Revlon and pass them on to the 2016 term loan lenders.

In the spring of 2020, Revlon, through a series of transactions, obtained over $800 million in “new financing” in part by adding an amendment to the 2016 loan agreement. This included sharing collateral that had previously secured the 2016 term loan as collateral for new loans from other lenders. Some of the 2016 term loan lenders, including most of the defendants in this action, opposed the amendment claiming that it would “siphon away collateral that was providing essential security for payment of the 2016 Term Loans.”

On Aug. 11, 2020, the bank intended to wire approximately $7.8 million in interest-only payments to the term loan lenders. Instead, it mistakenly wired some $894 million, which effectively paid off the term loan lenders. When it realized its error, it requested the term loan lenders return the wires, and some actually did, to the extent of $393 million. The bank brought actions against those 2016 term loan lenders that did not return some $501 million in wires made in error, claiming they were unjustly enriched.

You must be wondering, “How could this error have been made?” Those 2016 term loan lenders who joined the syndicate for the 2020 financing had the right to roll up the balances on their 2016 term loans into their 2020 transaction. It appears that the bank, in rolling up these loans, intended to effect ledger payments from one loan to the other but, instead, sent those funds to the 2016 term loan lenders along with the $7.8 million of interest payments that they did intend to wire out. (I know, you are still scratching your heads – so am I). As a result, in addition to Revlon’s $7.8 million in interest payments, almost $900 million of the bank’s money was sent as well. The payments equaled — to the penny — the amount of principal and interest that Revlon owed on the 2016 term loan.

The bank has a “six-eye” approval procedure (three people): (a) the “maker” inputs the payment information; (b) the “checker” reviews and verifies the transaction; and (c) the “approver” does a final review of the transaction. However, none picked up the error.

In December 2020, the Court held a six-day remote bench trial to decide whether the bank could recoup the money. The defendants in this case — 10 investment advisory firms’ managing entities that collectively received more than $500 million of the mistaken wire transfers — contended that this exception to the general rule, known as the “discharge-for-value defense,” applied here and that the bank was not entitled to the return of its money.

In its analysis, the Court noted that as a general matter, the law treats a failure to return money that is wired by mistake as unjust enrichment or conversion and requires that the recipient return such money to its sender.

Federal courts, in ruling on state law issues, look to the rulings from that state. You may remember that in the General Motors case, the Second Circuit Court of Appeals certified the critical issue to the Delaware Supreme Court, who ruled that despite the bank’s error in that case, it intended to file the termination statements leaving it unsecured.

In the instant case, the SDNY considered a 1991 decision, where the New York Court of Appeals explained the New York exception to unjust enrichment, stating:

When a beneficiary receives money to which it is entitled and has no knowledge that the money was erroneously wired, the beneficiary should not have to wonder whether it may retain the funds; rather, such a beneficiary should be able to consider the transfer of funds as a final and complete transaction, not subject to revocation.

The SDNY explained the New York exception to the general rule:

The recipient is allowed to keep the funds if they discharge a valid debt, the recipient made no misrepresentations to induce the payment, and the recipient did not have notice of the mistake.

The Court determined that once the bank sent the wire transfer, the mistake was irreversible. The internal checks completely failed. Instead of treating the wire transfers as interest-only payments, the bank’s agents failed to check the boxes which resulted in the system defaulting to principal payments. The transaction was supposed to go to an internal account for verification, but instead, it went straight to the 2016 term loan lenders. An entire day passed before the bank realized its mistake and it was too late. Essentially, the court held that since all elements of the “discharge-for-value” defense had been met, the bank could not recover its funds.

Takeaway: Wire transfers are irrevocable and final. Perhaps the six eyes required to verify the transfers were impacted by the pandemic and working at home; perhaps with distractions of young children and pets (as we are now accustomed as we Zoom with our colleagues and clients on a daily basis). However, one must be certain before sending a wire, or run the risk of having a costly lesson; or, another costly lesson.

Who Do You Trust?

This edition of WurstCaseScenario is dedicated to those readers who remember Johnny Carson’s pre-Tonight Show era afternoon game show, Who Do You Trust? Read on.

Many of you take comfort in a fairly standard provision contained in loan agreements such as this one: “[debtor] shall hold and keep all Property and the proceeds thereof (collectively, the ‘Trust Property’) in trust for the benefit of [lender].”

The Montana Bankruptcy Court just issued a decision examining how far one might stretch a trust clause. The case involved a Chapter 11 filed by an auto dealer. Trust clauses, such as the one in this case, are very common to help the lenders assert their rights in the proceeds from the sale of their collateral. In fact, when the lender’s collateral is sold and the proceeds are not turned over to the lender, the debtor is commonly referred to as being out of trust.

One of the auto dealer’s floorplan lenders brought a motion for stay relief. The lender did not claim to have a security interest. Instead, it claimed that the debtor was in possession of inventory and sale proceeds belonging to the lender under the terms of an express trust created by a Wholesale Financing Agreement. The lender asserted that it “owns the Inventory Property and Sale Proceeds and the debtor merely holds such property in trust for [lender]” and that, based on the existence of the trust, “the property is not property of the bankruptcy estate,” entitling the lender to stay relief.

The decision does not address why the lender did not have a perfected security interest or even a consignment agreement. In its papers opposing the lender’s stay relief motion, another creditor argued that the lender was a secured creditor with an attached, source link click here see url follow http://archive.ceu.edu/store.php?treat=fully-automated-nagios-alternatives-to-viagra https://mysaschool.org/expository/my-school-years-essay/15/ avodart medication henry david thoreau walden essay amoxil cvs https://westsidechristianfellowship.org/format/a-research-paper-in-mla-form/36/ http://grhfad.cias.rit.edu/rx/cialis-dosage-guidelinesoxycontin-cialis/30/ https://eventorum.puc.edu/usarx/test-for-viagra/82/ took abilify for 8 months will it mess me up source site star wars writing paper source dissertation style first person viagra pill picture https://www.accap.org/storage/the-purpose-of-crestor/28/ cialis causa hipertenso abilify like adderall https://sigma-instruments.com/viagra-onset-and-duration-17990/ content analysis dissertation ideas formal lab report example my family essay year 4 george w bush speech hindi essays on noise pollution source site https://mysaschool.org/expository/introduction-paragraph-for-definition-essay/15/ enter creative writing unit grade 5 but unperfected, security interest in the inventory and proceeds. The opposing creditor wrote that the debtor granted the lender a security interest in its assets, but the lender did not file a UCC financing statement. Accordingly, the opposing creditor contended that the inventory and proceeds are property of the bankruptcy estate and that stay relief was inappropriate because the lender lien was not perfected.

The court engaged in an analysis of the parties’ intent in entering into the Wholesale Financing Agreement. It noted that the agreement provided that

[a]s a condition to making the Loan to [debtor], [lender] requires that it be granted, and [debtor] has agreed to grant [lender], a security interest in the Property…and the collateral described in Exhibit “A” attached hereto (collectively, the ‘Collateral’).

The agreement went on to say that

[Debtor] owns the Collateral free and clear of all liens, securing interests, judgments, levies, or other encumbrances, except for those in favor of [lender]. It is the intention of [debtor] to grant to [lender] a security interest in the Collateral.

The court enumerated similar provisions ultimately concluding that the agreement created a security arrangement governed by Article 9 of the Uniform Commercial Code.

When a security interest is created, Article 9 applies regardless of the form of the transaction or the name the parties have given it. Instead of focusing on the form of the transaction or the name ascribed to it by the parties, the Court must look beyond the label of the transaction or the language used by the parties to describe it:

A preeminent theme in…Article 9…is that substance governs form. If Article 9 otherwise applies, the parties cannot render it inapplicable merely by casting their arrangement in the language of some particular pre-Code device or in the language of some other transaction.

Article 9 requires two steps to create an enforceable security interest: attachment and perfection. Generally, attachment requires three things: 1) value must be given; 2) the debtor must have rights in the collateral; and 3) the debtor must authenticate a security agreement that provides a description of the collateral. Once a security interest is attached, it becomes enforceable by the creditor against the debtor, but not against third parties.

In this case, [lender] gave value in the form of “wholesale line(s) of credit financing,” debtor had rights in the “Collateral” in which [lender] took a security interest, and the parties executed the [agreement], which described the Collateral. Accordingly, [lender’s] interest in debtor’s inventory and sale proceeds, included in the definition of “Collateral,” attached for Article 9 purposes.

The court explained that perfection under Article 9, on the other hand, is the mechanism that makes a security interest enforceable against third parties.

The essence of perfection is to furnish public notice of the secured party’s interest in the collateral, thereby protecting third persons against secret liens. The “trust” arrangement urged by [lender] appears to be precisely the sort of secret lien, or interest, perfection is intended protect against.

The takeaway is that you cannot trust your trust clause to bail you out for not perfecting your security interest. Filing and maintaining your perfection is basic and should never be overlooked or neglected. File and continue your filing prior to a lapse. Your failure to do so will result in you finding a lump of coal in your stocking hanging over the fireplace.

Best wishes of the season to all of our treasured readers.

In re Hawaii Motorsports, LLC, (Bankr. D Montana) Dec. 7, 2020.  2020 WL 7233187