Reversal of Fortune

Revlon Lenders required to return unintended payoff to Citibank

In February 2021, WurstCaseScenario discussed the $894 million mistake made when Citibank erroneously paid off a Revlon syndicated loan including paying some $500 million to disgruntled syndicate members in full. While many of the syndicate lenders returned the erroneous payments to Citibank, a large group of lenders who felt mistreated in the syndicate retained the payments. Citibank brought an action seeking restitution by requiring the lenders to return the payments. The U.S. District Court for the Southern District of New York (SDNY), relying on precedent from the New York Court of Appeals in its 1991 Banque Worms case, ruled that they could keep the payments. Citibank appealed. On Sept. 8, 2022, the Court of Appeals for the Second Circuit reversed the SDNY ruling that Citibank was entitled to be repaid about $500 million from the co-lenders.

To recap, Citibank, in its capacity as agent, intended to wire $7.8 million in interest to Revlon’s lenders. However, user error and failed safeguards allowed Citibank to wire $894 million of its own money to the Revlon lenders. The payments totaled the exact amount owed to each lender. Once Citibank realized the error, they sent notices to each lender demanding the funds be returned. After the notices, some lenders returned funds, but $501 million remained unpaid. The SDNY determined that Citibank could not recover the $501 million because the “discharge-for-value” defense applied.

The discharge-for-value rule allows a creditor to escape restitution where they have mistakenly received funds that discharged a debt owed to them so long as they were unaware of the transferor’s error.

In reversing the SDNY, the Second Circuit ruled that the elements of the “discharge-for-value” defense had not been met. According to the Court, the lenders had constructive notice and “were not entitled to the money at the time of Citibank’s accidental payment, as required by the Banque Worms ruling.”

The Second Circuit determined the “discharge-for-value” defense is not applicable because the lenders were on notice of mistake. The Court stated that a “reasonably prudent investor would have made reasonable inquiry, and reasonable inquiry would have revealed that the payment was made in error.”

The Circuit Court discussed that New York courts and the Restatement of Restitution and Unjust Enrichment (a scholarly treatise covering numerous legal topics and regularly relied upon by judges and litigators in considering questions of first impression) require inquiry in such situations. Relating to the erroneous $894 million payment, the Court identified four red flags that existed and created a duty for the lenders to inquire about the payment error:

    1. The credit agreement required prior written notice of prepayment. No prior notice was provided.
    2. Revlon’s distressed financial condition should have caused doubts as to the almost $1 billion payoff.
    3. The loan was trading with a 70-80% discount and therefore it would be improbable that Revlon could or would pay off debt at full value.
    4. Four days prior, Revlon had an elaborate scheme to avoid acceleration, and it would be illogical if they were planning to retire the debt.

The Court determined these red flags should have caused the Revlon lenders to inquire of Citibank about the payment, and that inquiry would have exposed the error. The Court stated the SDNY misunderstood the inquiry notice test.

Additionally, the Court said Banque Worms does not apply because the debt was not payable on Aug. 11, 2020. According to the Court, a debt is payable if 1) demand is made or 2) the debt has matured. On Aug. 11, 2020, demand had not been made and the Revlon debt’s maturity was in three years.

This is not the first time the Second Circuit was faced with an agent’s error. You must recall the error made when the agent inadvertently terminated the Unsecured Creditor’s Committee (UCC) financing statements securing a $1.5 billion loan to General Motors. In GM, there were two facilities with the same agent. When the first was paid off, the agent unwittingly released all UCCs instead of just the one that secured the synthetic lease that had been paid. Delaware UCC law applied, so the Second Circuit certified Delaware law questions to the Delaware Supreme Court, and held the agent liable for its error saying that “…no creditor could ever be sure that a UCC-3 filing is truly effective, even where the secured party itself authorized the filing.” The big winners here were GM’s creditors who were able to benefit from some unexpected, unencumbered assets.

But the Revlon/Citibank case did not concern the erroneous filing of a UCC-3 – it was about an error by paying off the syndicated lenders. The lenders knew or should have known that they were not about to receive payments; to the contrary, they knew that their loans were seriously impaired. They knew that Revlon was at risk of having to file for bankruptcy protection – something it ultimately did in June 2022, nearly two years later.

The apparent lesson here is that while some mistakes cannot be corrected, others can.  However, the better lesson is to exercise care whether in releasing UCCs, making payments or taking any action affecting your rights.

Is What You Hold As Sacred Included in Your Sacred Rights?

One of the most critical provisions of a syndicated loan facility is what is commonly referred to as sacred rights. Sacred rights provisions typically require 100% of the co-lenders’ consent before certain changes may be made to the syndicated loan agreements. There are certain things the agent can do in its discretion, others that require a majority of the co-lenders, and others that require consent by a supermajority of the co-lenders. But sacred rights are those rights in which even the smallest lender in the syndication has veto rights.

Sacred rights typically include reductions in interest rates, extending payment and maturity dates, releases of collateral and other significant business terms. A recent trend affecting syndicated loans is what has become known as uptiering. Some recent notorious uptiering cases include Serta Simmons (LCM XXII Ltd. V Serta Simmons Bedding LLC) and TriMark (Audax Credit Opportunities Offshore Ltd. V TMK Hawk Parent Corp.). In a very recent decision from the Delaware Bankruptcy Court (Bayside Capital Inc. and Cerberus Capital Management, L.P. v. TPC Group Inc. (2022 WL 2498751, DE Bankr. July 7, 2022)), the Court focuses on yet another syndicated facility where some minority noteholders found their senior security interests subordinated to new loans made by a supermajority of their co-lenders.

The judge in the TPC case began his decision by saying:

There has been a flurry of litigation in recent years over transactions that seem to take advantage of technical constructions of loan documents in ways that some view as breaking with commercial norms….

He then describes uptiering:

In its most aggressive form, such a transaction is one in which the debtor and a majority (but not all) holders of a syndicated debt issuance agree to enter into a new loan that is supported by a superior lien in the same collateral that secured the original debt…. While such a transaction would typically require an amendment to the original credit agreement or indenture, those documents are typically drafted to permit a majority (or, in some cases, a supermajority) of the holders to amend the agreement without the consent of the minority.

Although this did not occur in the Delaware case, he pointed out that often

the debtor [then] repurchases the participating lenders’ share in the prior (now junior) loan – effectively leaving behind the minority holders in a tranche of debt that is now junior to that held by the majority lenders.

The underlying transaction closed in 2019 and involved TPC issuing $930 million in senior secured notes, about 10% of which were purchased by Bayside Capital and Cerberus. The notes were secured by a first lien on substantially all of the TPC’s assets and a second lien on inventory and receivables subject to the first liens in favor of an asset-based facility agented by Bank of America.

The loan agreement provided:

[TPC], the Guarantors and the Trustee … may amend or supplement this Indenture … and the Notes … with the consent of the Holders of at least a majority in the aggregate principal amount of the then outstanding Notes voting as a single class….

It also provided:

[any] amendment to, or waiver of, the provisions of this Indenture … that has the effect of releasing all or substantially all of the Collateral from the Liens securing the Notes … will require the consent of the holders of at least 66-2/3% in aggregate principal amount of the Notes….

The Court noted:

The “sacred right” at issue here… provides that without such consent “an amendment, supplement or waiver… may not…. make any change in the provisions in the Intercreditor Agreement or this Indenture dealing with the application of proceeds of Collateral that would adversely affect the Holders.

At the time of the later transaction that subordinated the interests of Bayside and Cerebus, the holders of the “new” notes also held a supermajority of the then-outstanding “old” note, thus giving them the authority to amend the “old” notes in any way that did not violate a holder’s sacred rights. The parties also entered into a new intercreditor agreement that operated to subordinate the “old” notes to the “new” notes with respect to the common collateral securing both sets of notes. The consents were executed by more than 67% of the holders of the “old” notes, which was expressly authorized under the initial agreements.

The result? The Court found that the subsequent transaction which subordinated otherwise senior debt was permitted within the terms of the documents entered into by the objecting parties.

In recent years, in their mission to maximize their funds employed, lenders are often fearful of being excluded from a syndication by making waves in reviewing the syndicated loan documents. While lenders understand that they must perform their own due diligence and document review, they are reluctant to request changes, especially in the agency provisions. Because it is rare that a borrower will pay for a syndicate member’s due diligence costs (especially its legal costs), co-lenders often retain counsel at a low flat-fee rate to perform a review to confirm that the terms of the loan agreements conform with those of the underwriting. Banks often tell their lawyers to stand down when suggesting changes to agency provisions fearing that any requested change will cause the agent to exclude the bank from the syndicate.

Co-lenders are advised to keep a careful eye out for sacred rights provisions that do not include prohibitions against subordinating the lien priorities of the co-lenders. The lesson for not doing so could be costly.

A Tale of Two Participations

It was the best of times. Or was it the worst of times? Depends on which side you are on.

This article will address two decisions concerning loan participations. The decisions were issued on the same day but by different courts (the Third Circuit of Appeals and the Bankruptcy Court for the Eastern District of New York). The facts are not so different, yet the decisions are.

The first case concerns a motion brought by two individuals (the Movants) seeking to compel the bankruptcy trustee (the Trustee) to abandon property that they claimed was not property of the bankrupt estate. The Debtor was a provider of merchant cash advances and purportedly sold participations in its advances to third parties including the Movants. The Movants argued that certain accounts (the Account Funds) were established for their benefit in accordance with the terms of a so-called Syndication Participation Agreement (the Agreement). The Trustee opposed the motion on the grounds that the Agreement was not a true participation agreement but rather a disguised loan, or alternatively a security, and as a result, the Movants did not have a legal or equitable right to the Account Funds.

The Court stated:

In a traditional participation agreement the Account Funds would constitute the proceeds of loans originated by the Debtor but in which the [Movants] owned a fractional share. This is so because a true loan participation would have resulted in a sale to the [Movants] of a fractional interest in specific loans originated by the Debtor. However, the Court finds the [Movants] did not in fact purchase a participating interest in the underlying loans. Rather the[y] acquired a right as set forth in the Agreement to share not directly in the underlying loans but rather in the economic gain or loss of the Debtor.

In determining that the Agreement was not a true participation, it expressed two alternatives to its nature – either a loan or a security. However, inasmuch as neither of these alternatives would exclude the Account Funds from being property of the estate, the Court ruled that they were not subject to abandonment.

The Agreement provided that the Debtor was to make merchant cash advances with some unknown proportion of principal coming from the Movants. The Movants were to be repaid proportionately based on funds they provided to the Debtor and based on the Debtor’s estimates of and adjustments to payment amounts from its merchants. The Agreement indicates that the Movants were to provide funds to the Debtor, and that the Debtor was to determine how to advance the Movants money with “sole discretion” in credit underwriting and origination decisions. The Movants did not introduce any evidence from which the purported participations could be traced to specific merchant advances or to the Account Funds. The Court said:

When it comes to analyzing the true nature of a financial arrangement this Court may look past form and into substance, disregarding what the parties may call the transaction and inquiring into its true economic realities. . . .

Courts have articulated four factors . . . for finding a true loan participation, asking whether: (1) money is advanced by participant to a lead lender; (2) a participant’s right to repayment only arises when a lead lender is paid; (3) only the lead lender can seek legal recourse against the borrower; and (4) the document evidences the parties’ true intentions. . . . For purposes of a[n]. . . equitable interest analysis, a loan participation is one in which a lead lender originates a loan and then sells an equitable right to payment from that loan while retaining legal title.

The Court identified two factual predicates to finding true participations: either (1) the purported participation is entered into to facilitate a specific credit transaction, or (2) the purported participation is entered into to facilitate general lending operations, but loan proceeds are segregated and traceable to the underlying loans. The Court noted that in cases where courts have found a true participation to exist, the facts reflect that there is a known and specific borrower and loan in which the participation is sold.

The true loan participation test is commonly a test for determining whether a credit investment is in fact a disguised loan. A financial arrangement that passes the true loan participation test might be found to be a disguised loan if the weight of the following factors is answered in the affirmative: (1) whether there is a guarantee of repayment by the lead lender to a participant; (2) whether the participation lasts for a shorter or longer term than the underlying obligation; (3) whether there are different payment arrangements between the borrower and the lead lender and the lead lender and the participant; and (4) whether there is a discrepancy between the interest rate due on the underlying note and the interest rate specified in the participation. The Court stated:

The first factor is the most significant as it would evidence payment to the investor based solely on the credit risk of the lead lender rather than of the borrowers in whose credit transactions the investor is purportedly participating.

The Court also considered whether the Agreement was actually a note or a security but declined to reach a conclusion. It was sufficient to conclude that it was not a participation and, thus, the Account Funds remained property of the estate and not subject to abandonment.

By contrast, the Third Circuit case concerned an intercreditor agreement between the secured lender in a lender finance transaction and a claimed participant in loans made by the secured lender. It is interesting that the parties and the courts (including the lower court and the court in the borrower-finance company’s bankruptcy proceedings) never focused on whether the participation agreement was a true participation or a disguised loan. Instead, they focused on various theories to either support or undermine the workings of the intercreditor agreement. The court below and the Third Circuit each ruled in favor of the participant solely on the terms and conditions of the intercreditor agreement. However, had the secured lender challenged the true participation and succeeded on that theory, the outcome would likely have been different. If the participation was not true, the participation agreement would have been deemed a disguised loan (as described by the first case discussed) and the participant would have been deemed an unsecured creditor, leaving the proceeds held by the secured lender available to reduce the indebtedness owed by its borrower.

The take-away is when dealing with participations, understand what rights you are receiving and what risks you are taking. The Movants invested over a million dollars but did not obtain an undivided interested in the Debtor’s merchant cash advances and, as a result, their investments remained property of the Debtor’s estate. Instead of being a participant, it was a lender to the Debtor or a beneficiary of a security. Similarly, the secured lender by not scrutinizing the participant’s interest, may have missed its opportunity to prevail in the intercreditor dispute. True sale issues need to remain a focus in these types of transactions.

In re: SRS Capital Funds, Inc. et al, 2022WL1110557 (Bankr. EDNY 2022)
CoFund II LLC v. Hitachi Capital America Corp., 2022WL1101576 (3d Cir. 2022)

Another MCA: This Time Enjoined

Readers of WurstCaseScenario tell me that they never tire of MCA stories. This case is from one of the most well-respected Federal District Court Judges, Jed Rakoff (the judge in the Madoff cases, for example), and has the potential of getting ugly. Read on.

This action was brought as a putative class action but has not yet been certified. The claims allege fraudulent and usurious loans and abusive collection tactics employed by merchant cash advance (MCA) defendants GoFund Advance, LLC, Funding 123, LLC, Merchant Capital LLC and Alpha Recovery Partners, LLC and certain individuals. The plaintiffs are two small businesses, a North Carolina urgent care facility and a Texas construction contractor, that entered into MCA agreements with the defendants.

Judge Rakoff described MCAs as:

financial products, often marketed to small businesses through allegedly high-pressure sales operations resembling “boiler rooms,” that purport to purchase at a discount a portion of a business’s future receivables.

This decision determines the plaintiffs’ motion to convert a temporary restraining order granted at the start of the action to a preliminary injunction. The Court summarized the legal standard:

A party seeking a preliminary injunction must ordinarily establish (1) irreparable harm; (2) either (a) a likelihood of success on the merits, or (b) sufficiently serious questions going to the merits of its claims to make them fair ground for litigation, plus a balance of the hardships tipping decidedly in favor of the moving party; and (3) that a preliminary injunction is in the public interest.

It is important to note that in order to secure the preliminary injunction, the party only needs to demonstrate likelihood of success on one claim against each defendant. Here, the plaintiffs’ claims were for breach of contract and for RICO. The Court concluded that the plaintiffs demonstrated their likelihood of success on their breach of contract claims but not on their RICO claims.

Plaintiffs’ primary argument at this stage was that, assuming that the MCA agreements were valid as MCA transactions rather than as loans, the defendants breached them by failing to timely pay the purportedly agreed-upon purchase price, having withheld some $400,000 of the $1 million purchase price. Under the agreement, the defendants were to advance $1 million as a “purchase price” in exchange for the purported purchase of all of the plaintiffs’ receipts until the plaintiffs had repaid $1.499 million through daily ACH withdrawals of $60,000. On its face, the repayment should have been completed in approximately 25 days. However, the defendants initially provided the plaintiffs with only $400,000, after supposedly subtracting $100,000 in fees. After the plaintiffs had made approximately $785,000 in payments to the defendants (a little more than two weeks), the defendants deposited an additional $400,000, supposedly reflecting a deduction of another $100,000 in fees.

The plaintiffs were required to provide the defendants with 24 hours prior notice if any of the daily $60,000 ACH withdrawals would result in insufficient funds. The failure to provide notice was identified in the contract as an event of default. Several of the plaintiffs’ remittances resulted in ACH payments being returned for insufficient funds, but the plaintiffs did not notify the defendants as required.

The plaintiffs argued that the defendants breached the MCA agreement by initially depositing $400,000 of the $1 million, by withdrawing excessive fees and withholding until later the second $400,000 payment. The defendants were unable to demonstrate where in the MCA agreements they were entitled to the fees or where they were entitled to withhold portions of the purchase price. The Court then concluded that the plaintiffs were likely to prove that the defendants breached the contract by failing to send the full purchase price, minus applicable and appropriately disclosed fees.

The Court also accepted the plaintiffs’ argument that their own breach (tripping ACH payments) occurred as a result of the defendants’ failure to fully fund the purchase price and that the breach in ACH payment occurred after the defendants’ default.

Indeed, the payment may not have failed had the account been fully funded from the outset.

The defendants alleged a litany of harms that supposedly resulted from their default in payment. They argued that their default was clearly hastened because the defendants failed to timely deposit the cash advance in the plaintiffs’ account. Thus, the Court concluded:

Therefore, [the defendants are] likely to succeed in proving contract damages and, by extension, in prevailing on its breach of contract claim.

The Court went on to find that the plaintiffs had not demonstrated likelihood of success on each element of their RICO claim and, as a result, denied the preliminary injunction on that claim.

Next, the Court considered the other requirements to issue a preliminary injunction – irreparable harm and the public interest.

The papers establish that defendants’ issuance of UCC lien letters has frozen its bank and health insurance accounts, effectively locking up the urgent care center’s finances. If the urgent care center is unable to collect insurance reimbursements, and thus cannot make payroll or purchase medical supplies, there is a material risk of the business’s collapse. That would constitute an irreparable harm for which later payment of money damages would be inadequate.

The urgent care center’s inability to continue as a going concern would also disserve the public interest, because it would eliminate a source of medical care to the people of Fayetteville, N.C. To withdraw medical resources from any community would seriously harm the public interest at any time, but the implications are particularly serious in light of the continuing COVID-19 pandemic . . .

The Court granted the preliminary injunction and ordered:

During the pendency of this case, [defendants are] enjoined from continuing to debit unauthorized monetary amounts from bank accounts belonging to [plaintiffs] and from freezing bank accounts, health insurance accounts, assets and receivables belonging to [plaintiffs]. [Defendant] is further enjoined to withdraw and retract any UCC Lien Letters sent to third parties and to direct any other person or entity acting on its behalf to do the same.

So, what does this all mean? Yes, it is a victory for the plaintiffs and those who have been affected by the conduct of irreputable MCA providers. But that is not the end of the road. Plaintiffs still have a great burden ahead. Likelihood of success on the merits is not success on the merits. That will only come after trial. New York State Courts have, in numerous decisions to date, upheld MCA agreements. These facts may differ from the state court cases, and keep in mind that this federal judge is likely to look at this case with a fresh set of eyes.


Even if the case proceeds to trial, the next burden for the plaintiffs will be to succeed in getting certified as a class. That will not be easy. The defendants will likely be looking to settle this short of trial. A significant difference between this case and the New York State Court cases is the amount at issue. The New York State Court cases tended to revolve around small claims (under $50,000). Here the parties have more at risk. Are the plaintiffs looking to win a cause? If yes, then the class certification is important. If not, and the defendants are willing to walk away, then the plaintiffs will have won but without a precedent. If the defendants intend to stand their ground, then the issues will get flushed out and this will be a case to watch as it goes to trial and on to appeals that will certainly get the attention of the MCA industry.

We will be watching and reporting issues of significance.

Haymount Urgent Care PC; Robert A. Clinton, Jr.; et al v. Gofund Advance, LLC; Funding 123, LLC; Merchant Capital LLC; Alpha Recovery Partners, LLC; et al. 2022 WL 836743 (SDNY 3/21/2022)

Federal Court Usury Claim Against MCA Dismissed and Court Declined to Compel Arbitration

Readers will recognize a few recurring themes in WurstCaseScenario: Merchant Cash Advance (highlighting both abuse and where MCAs are responsible high-risk financing sources) and promoting the use of arbitration in commercial finance disputes. A recent decision from the New Jersey Federal Court brings these two topics together. Note that the law, when applied to a specific set of facts, may not result in a fair treatment, despite the fact that the law itself is fair. Here, the judge apparently regretted making a correct decision.

Gold Lion Steel LLC (Gold Lion) and its guarantors (the plaintiffs) brought an action alleging that Global Merchant Cash, Inc., d/b/a Wall Street Funding (Global Merchant), willfully entered into two usurious loan agreements in violation of the criminal usury statutes well as the New Jersey Consumer Fraud Act. Global Merchant moved to dismiss and compel arbitration.

The financing was structured as a merchant cash advance pursuant to which Gold Lion agreed to repay the loans within 180 days at a 143% interest rate (for the first of two financings) and within 164 days at a 164% interest rate for the second. The loans were to be repaid in fixed daily payments of $270.28.

The individuals gave “validity guaranties” whereby they guarantied against the breach of any “representation, warranty, and/or covenant” under the loan agreements. This apparently included any breach of a covenant to make payments. (Sounds more like a full unconditional guaranty, doesn’t it?)

The agreement also included a broad binding arbitration clause for the resolution of any disputes. It also included a choice of law provision where the parties agreed that New York law would apply and that the arbitration would be held in New York. Notwithstanding, the plaintiffs argued that New Jersey law should apply, and the court addressed that first:

[A] district court must apply the choice of law rules of the forum state to determine what law will govern each of the issues of a case. . . . . Under New Jersey’s choice-of-law rules, effect is given to contracting parties’ private choice of law clauses unless they conflict with New Jersey public policy.

The Court recognized that New Jersey and New York each has a strong public policy against usury but that the cases presented by the plaintiffs did not support overruling the parties’ choice of New York law. It also noted that New York’s anti-usury policy was so strong that it made usury violations criminal.

The Court then turned to the enforceability of the arbitration clause, finding:

. . . the [Federal Arbitration Act] requires courts to compel arbitration in accordance with the terms of an arbitration agreement, upon the motion of either party to the agreement, provided that there is no issue regarding its creation. . . . . To that end, courts must determine: (i) whether the parties have executed a valid agreement to arbitrate and, if so (ii) whether the dispute at issue falls within the scope of the agreement.

The Court reasoned that the parties agreed that the dispute fell within the scope of the agreement and went on to find that the parties had agreed to arbitrate the dispute in New York. However, citing significant case law, the New Jersey Federal Court determined that it could not compel parties to arbitration outside of its jurisdiction, in what it described as a “perplexing dilemma”:

When faced with this dilemma, courts in this Circuit have denied the motions to compel arbitration and either dismissed or transferred to the appropriate district.

While recognizing its decision to be “somewhat paradoxical,” it held that it was required to follow this practice and deny Global Merchant’s motion to compel and grant its motion to dismiss.

So what does this all mean?

First, it does not mean that the MCA won the war, albeit it won the battle. The plaintiffs had an expensive lesson and should have followed the jurisdiction provisions of the contract. That difference would mean that the New York court, had there been one, could have compelled arbitration in New York, as provided for in the agreement, or better (albeit unlikely), could have determined that the strong anti-usury public policy required it to rule that the agreement was not subject to arbitration and that the MCA was subject to penalties.

It should be noted that in the event the matter proceeds to arbitration and the arbitrator rules that the MCA agreement was not usurious (as many New York courts have ruled in similar situations), it is unlikely that a court would vacate such an award on public policy grounds.

So, here is the takeaway: in addition to the confidentiality assurances of the process, arbitration remains a strong tool to protect lenders – whether right or wrong.

Gold Lion Steel LLC v. Global Merchant Cash, Inc., 2022 WL 596997