Bank’s Money Used to Fund Bankruptcy Retainer

For those of you who have lived through one or more economic downsides you may have found yourself in a situation where a borrower diverted proceeds of your collateral (“copped cash”) to pay a lawyer’s retainer to bring a Chapter 11 case.  Shocking, isn’t it?

Years ago (prior to electronic bankruptcy filings) I received an early morning call from a client  telling me that his borrower had just called to say he filed a Chapter 11 and that his lawyer was on his way to Court to present an emergency motion for use of cash collateral.

I had already been on the failed workout (with an alleged defrauder) so I had at hand sufficient documents to object (with the hope of mitigating any damage) including verification reports of receivables where account debtors had faxed (remember those?) copies of cleared checks that had not been turned over to the lender in violation of the dominion provisions of the loan agreements.  When I arrived at court and obtained a copy of the petition schedules and saw how much had been paid as a retainer to the debtor’s attorney I  could not resist including the diversion in my argument.  The celebrated Judge Conrad Duberstein looked at me and said, “Jeff, this goes on all the time.  It’s not worth protesting.”  Connie’s was not a legal conclusion.  He was a practical judge and  pursuing the claim would not be cost effective – even it were to ultimately succeed.

Chasing proceeds of diverted collateral is not a simple task.  Innocent recipients have strong defenses and proving a lack of innocence is often difficult at best.

In a recent case that comes out of the Bankruptcy Court in West Palm Beach, Florida, Armstrong Bank’s attempt to recover from its borrower’s attorney utterly failed.  The bank’s claims, although possibly deserved, were not presented in a way that would warrant the relief it desired – to have the lawyer disgorge some $200,000 that had been paid to him as a retainer. The court did, however, imply the correct way the bank should have proceeded.

Assuming, as I suspect, the borrower “copped cash” by diverting account debtors’ payments and deposited them into its deposit accounts, it may have been possible to trace the proceeds, and if they were not intermingled with other funds (possible), a case may have been made out for disgorgement.  The bank never alleged any claims along this line.  Instead the bank brought some creative claims such as conversion, tortious interference with contract, unjust enrichment, equitable subordination.

The Court noted:

[E]xcept in extremely unusual circumstances, the secured creditor retains no interest at all in funds paid to debtor’s counsel as a pre-petition retainer. U.C.C. section 9-332, uniformly enacted in the states, provides that a transferee of money, or funds from a deposit account, takes free of any security interest “unless the transferee acts in collusion with the debtor in violating the rights of the secured party.” E.g., Fla. Stat. § 679.332.

UCC 332(b) provides:

A transferee of funds from a deposit account takes the funds free of a security interest in the deposit account unless the transferee acts in collusion with the debtor in violating the rights of the secured party.

Certainly when a lender makes an advance that is deposited into a deposit account it no longer has rights to the funds – unless it exercises rights it has under a deposit account control agreement prior to the funds being transferred out of the account.  In order to prove collusion the bank would have first needed to demonstrate that the funds in the account were proceeds of its collateral.

The Court stated:

Even if counsel knows that the debtor is in default of its loan obligations and that the secured creditor claims a lien on the funds used to pay a retainer, which is invariably the case, requesting a pre-petition retainer for services to be rendered in a chapter 11 case does not by itself constitute collusion as contemplated in the statute. It is not surprising, then, that almost no secured creditor claims that its pre-bankruptcy security interest continues to attach to the retainer paid to debtor’s counsel and that there are almost no reported decisions on the issue.

UCC 9-315(b)  states:

(2) if the proceeds are not goods, to the extent that the secured party identifies the proceeds by a method of tracing, including application of equitable principles, that is permitted under law other than this article with respect to commingled property of the type involved.

Assuming the bank was able to prove that the funds were proceeds it would then need to demonstrate that the lawyer and the debtor colluded in violating the bank’s rights.  Again difficult at best.  Did the lawyer advise the borrower to divert proceeds?  I am not saying that does not happen.  In fact I have often suspected (OK – strongly suspected) that had occurred.  If proven, the lawyer has much more to worry about than disgorging a retainer.

The Court explained (without justifying) why a borrower would use a bank’s collateral to fund its retainer.

To proceed in a chapter 11 case, a corporate debtor must be represented by counsel. Without counsel, the case soon will be dismissed. . It is the norm that a corporate chapter 11 debtor pays a retainer to its bankruptcy counsel prior to filing the petition. Experienced bankruptcy lawyers rarely undertake representation of a debtor-in-possession without a retainer. Indeed, the Court might doubt the competence of a bankruptcy lawyer who accepts an engagement to represent a chapter 11 debtor without a retainer or similar assurance of payment. To do so would put counsel completely at risk for counsel’s fee based on the success or failure of the case as a whole. So, a corporate chapter 11 debtor is required to have counsel and that counsel almost always must be paid a retainer

Finally the Court noted that bank’s do not pursue such claims although in rare situations they might:

More than 5,700 new chapter 11 cases were filed last year. There are more than 400 chapter 11 cases pending in this district alone. Why, then, is it so difficult to find a reported decision where a secured creditor claimed that funds used to pay a retainer to debtor’s counsel remained subject to its pre-bankruptcy security interest? The answer is that, except in extremely unusual circumstances, the secured creditor retains no interest at all in funds paid to debtor’s counsel as a pre-petition retainer.

The lessons: When a debtor is in workout a significant benefit from insisting that the debtor retain a trusted (yet independent) consultant is that the consultant may be able to protect against having collateral proceeds diverted to fund a retainer.  That does not mean that a recalcitrant borrower won’t take the rent money and pay it to its lawyer.  It should also be noted that if the collateral supports the advance, an advance to a debtor to fund its bankruptcy lawyer’s retainer may be worthwhile.  It certainly provides an opportunity for the lender and borrower to cooperate in structuring DIP financing or use of cash collateral.  Just because a borrower needs to seek bankruptcy protection does not mean that the relationship must be hostile.

With interest rates on the rise, unemployment down,and wages up, and the stock market in a flux we may very well start to see an increase in middle market bankruptcy filings.  Let’s keep a level head and act in the bank’s best interest, even when it means finding a middle ground with a borrower you no longer trust.

Armstrong Bank v Shraiberg, Landau & Page, P.A. and Tuscany Energy, LLC. 2018 WL 549642

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