Using Supergeneric Collateral Descriptions

Return with us now to those thrilling days of yesteryear.  Err, that is prior to July 1, 2001, when the “old” Article 9 of the UCC reigned.  Under “old” Article 9 (Section 9-203) a security interest was enforceable when it attached but it did not attach until “…the debtor has signed a security agreement which contains a description of the collateral…,” value has been given and the debtor has rights in the collateral.

“New” Article 9 (also Section 9-203) treats this in a similar manner.  Again the security interest becomes enforceable when it attaches and is enforceable only when value has been given,  the debtor has rights in the collateral and the power to transfer such rights and “the debtor has authenticated a security agreement that provides a description of the collateral….”

Note that the collateral description requirements for the security agreement resembled the requirements for the collateral description in the financing statement.

“Old” 9-110 provided that the collateral description of personal property in a financing statement was sufficient if it reasonably identified the collateral even if the description was not specific.  The Official Uniform Comment to that section specifically did away with prior holdings “that descriptions are insufficient unless they are of the most exact and detailed nature…”  Clearly the intent was to assure that the collateral description was clear while not making descriptions unduly burdensome.

“New” Article 9 broke this out differently.  A financing statement sufficiently indicates collateral it covers if the statement provides “(1) a description of the collateral pursuant to section 9–108 [relating to sufficiency of description]; or (2) an indication that the financing statement covers all assets or all personal property.”  9–504(1)–(2)  Remember the financing statement perfects the security interest but the security agreement is part of the attachment of the security interest.

Those of us who practiced under “old” Article 9 recall filing financing statements with pages of addenda describing the collateral.  It was not uncommon for the filing officer to misplace the attachments when saving the financing statements to microfiche. Some careless drafters included in the collateral description a statement such as “see attachments”.  Thus, when the attachments were lost problems arose.  The “all assets” description on financing statements cured this nightmare.

“New” Article 9, however, provides that a description of personal property in the security agreement is considered sufficient whether or not it is specific, if “it reasonably identifies what is described.”  9–108(a) Examples of reasonable identification include identification by specific listing, category, quantity, or any other method which makes the identity of the collateral objectively determinable. 9–108(b)(1)–(6) Super generic phrases such as “all assets” or “all personal property” are not sufficient to describe collateral in a security agreement.  9–108(c), comment 2.

In order to assure that the collateral description is sufficient I advise my clients to start with the UCC definition of “general intangible” which means “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction. The term includes payment intangibles and software.”  Count them – thirteen collateral types that are sufficiently described.

In a recent decision from the Bankruptcy Court for the Eastern District of Pennsylvania, Judge Chan followed this logic in considering whether M&T Bank held a valid lien on a debtor’s liquor license.

Initially Judge Chan considered whether a liquor license is property or a personal privilege under Pennsylvania law.  In doing so, she cited a 1986 (e.g. “old” Article 9) decision from the Third Circuit Court of Appeals, which held that:

although a liquor license is not property subject to attachment under Pennsylvania law, it is property that may be subject to a federal tax lien.

However, Judge Chan noted that in 1987 the Pennsylvania Legislature amended its laws adding a section stating that:

[t]he license shall constitute a privilege between the board and the licensee. As between the licensee and third parties, the license shall constitute property.

Accordingly, she ruled that the liquor license was property under Pennsylvania law.

Next, she needed to consider whether the collateral description contained in the security agreement sufficiently covered the liquor license.  She noted that

[t]he Security Agreement describe[d] the collateral as general intangibles limited to Liquor License …. Therefore, M & T’s security interest did attach to the Liquor License because the Security Agreement met all three requirements to make it enforceable against the Debtor and third parties.

The Bankruptcy Trustee (challenging M&T’s security interest), relying on a 1975 ruling of the Pennsylvania Supreme Court, argued that the collateral description contained in the UCC-1 Financing Statement did not sufficiently describe the collateral.    The Court, however, noted that:

M & T’s UCC–1 indicates that “the financing statement covers the following collateral: All assets of the debtor, whether now existing or hereafter acquired or arising, wherever located.

The Court went on to state:

Since the revised Article 9 superseded the former Article 9 under which [the 1976 case] was decided and M & T’s UCC–1 was filed after Article 9 was revised, it is clear that [the 1976] does not control the disposition of this case and M & T properly perfected its lien in the Liquor License by using a super generic description to describe its collateral.

Thus the Court concluded that Pennsylvania law clearly allows third parties to create security interests in Liquor Licenses and that M & T followed all the requirements to create and perfect a lien on the Liquor License and is entitled to proceeds from its sale in the amount of its secured claim.

The lesson?  Collateral descriptions in security agreements reasonably describe the collateral but the collateral description in a UCC-1 financing statement may be supergeneric.  Just as the UCC says!

 

In Re B & M Hospitality LLC, 2018 WL 1635228, Bankr. E. D. PA. April 3, 2018.

 

Should We Be Preparing For an Influx of Workouts?

This issue of WurstCaseScenario takes a different direction from our typical case study and, perhaps, delves into prognostication.

Ask anyone and he or she will tell you that this economic boom won’t last forever.  But when will it come to an end?  Or has it already ended?

This boom economy is now in its ninety-third month.  It is amongst the longest recorded expansion periods in our history.

Corporate Debt is at the highest levels since the 2008 recession.  Defaulted loans remain very low.  This is probably a result of historically low interest rates.  But interest rates are now on the rise.  The Fed raised interest three times in 2017 and is on track to raise interest three or four times this year.

The Dow Jones Average hit its all-time high on January 26 at 26,616.71.  Its low for this year occurred on March 23rd when it closed at 23,533.20.  Yesterday, it closed at 24,024.13.

This past Monday, Caterpillar commented that its first quarter profits “will be the high-water mark for the year” and stock prices immediately tumbled followed by some modest upticks as the week progressed.

Logic says that a recession is on the horizon, but when will it come and what can we do to get prepared?

In December, 2006, we were in a similar situation.  The economy was strong.  Turnaround professionals were like the Maytag Repairman.  There was no downturn in sight.  That was the last time I ventured into predicting the economy (note:  I am not an economist and never took a course in economics.  Everything I learned about economics I learned from Father Guido Sarducci’s Five Minute University).   At the request of Dow Jones, I published an article in its Daily Bankruptcy Review Small-Cap addressing the softness in the turnaround industry, concluding with encouragement to turnaround practitioners: “Get ready. It is coming. Your skills will be needed — at least we turnaround professionals hope they will.”  You all know what followed a few months later.

I suspect that we are in a similar time.  From my experience, just prior to upticks in loan defaults, fraudulent activity starts to occur.  Remember, desperate people do desperate things.  Increased interest rates are picking away at your borrower’s available cash and as their cash dries up some may find themselves getting desperate.

What can you do?

First, increase your fraud radar!  Be a bit more suspicious (without showing it) and be sure to verify, especially the unusual transactions and adjustments.

Watch out for increased aging of receivables, drops in sales, increased concentration, decreases in inventory purchases, etc.  Each of these on its own is probably not a problem, but when they come in combinations you do need to take a closer look.

The earlier you catch a problem the less likely it is that you will get hurt and more likely that you can save your borrower.

Encourage your borrowers to discuss their business challenges with you.  They need to see you as someone who can assist them when times get difficult.  You have more experience with companies entering or in financial distress.  With your assistance, the borrower will be in a better position to effect a turnaround before it gets too deep into trouble.

Be sure that once you have identified a problem and you need (and are willing) to make adjustments to the way you lend to that borrower, that you do so under a Forbearance Agreement that provides protections to you should the relationship deteriorate as you travel down the workout trail.

Next issue of WurstCaseScenario will return to discussions about court decisions and how they affect you.  I thought that this was the right time to sensitize you to what many see coming down the horizon so to better assure that you are ready for it.

THE PACA FACTOR: SOME RELIEF FOR PACA PHOBIA? (The Exciting Conclusion)

This is Part 2 of a two part article.  If you have not yet read Part One, I suggest that you click the prior article on the right. 

In Part 1 we discussed the decision issued in February, 2017  by the Ninth Circuit Court of Appeals when it ruled that the assignment of PACA receivables to a Factor was not subject to disgorgement when the factored client went bankrupt and the  produce growers did not get paid for their product.  In making its ruling the Ninth Circuit followed a prior precedent of that court that did not require an analysis of whether the assignment to the Factor was a true sale.  The case was later accepted to be heard by Ninth Circuit en banc.

This, then, is the time to explain how circuit courts establish precedent.  First, remember that the circuit courts of appeal hear appeals from the District Courts (the trial courts) in their circuits.  The District Court is where the facts are determined (either by a jury or by the judge, if there is no jury).  The District Court will always determine the law.  On appeal, absent a serious error, the findings of fact will remain untouched but the legal conclusions are reviewed de novo (anew).

When circuit courts of appeal reach different legal conclusions, those cases often find their way to the United States Supreme Court (the next and last stop in the appeal process).  40 judges sit on the Ninth Circuit.  Each case is heard by a panel of 3 judges.  Typically, the panels are assigned for each day of argument.  Thus, a judge is sitting on a panel with 2 different judges for each daily calendar.  Those decisions are either unanimous or by a majority, sometimes with a dissenting opinion.

Just as judges on a panel can disagree on what the law is or should be, panels of judges may make rulings that conflict with the rulings of other panels.  In those instances it becomes common for the entire circuit court[1] to hear another round of the appeal.  That is called en banc.

The Circuit Court that made the ruling in the appeal discussed in Part 1, expressed some concerns regarding the holdings in the prior case that it relied upon as precedent, which precedent was not in line with those of other circuit courts that had addressed the same issue.

Specifically, the Ninth Circuit relying on the prior precedent did not first engage in a true sale examination before considering the commercial reasonableness of the factoring agreement.  The Court described the situation as:

The central dispute in this case developed after [Client]’s business failed, and Growers did not receive full payment from [Client] for their produce.  Growers sued [Factor] alleging: (1) that the Factoring Agreement was merely a secured lending arrangement structured to look like a sale; (2) that the accounts receivable and proceeds, therefore, remained trust property under PACA; (3) that because the accounts receivable remained trust property, [Client] breached the PACA trust and [Factor] was complicit in the breach; and (4) that under PACA the PACA-trust beneficiaries, including Growers, held an interest superior to that of any secured lender. Hence, [Factor] was liable to Growers to repay the value of the accounts receivable.

As might be expected the parties to the appeal presented many questions to the en banc panel to consider.  However the Court determined to answer only one:  “whether, in the context of determining the assets included in a PACA trust, a court needs to conduct a threshold true sale inquiry before it determines whether a transaction transferring PACA trust assets was a commercially reasonable sale.”  The Court reversed the three judge circuit panel and the District Court below and joined the Second, Fourth and Fifth Circuits in adopting a threshold true sale test to determine whether assets transferred in transactions that are labeled “sales” remain assets of a PACA trust.

The Ninth Circuit joined the reasoning of the Second Circuit quoting it as follows:

 …due to the need to sell perishable commodities quickly, sellers of perishable commodities are often placed in the position of being unsecured creditors of companies whose creditworthiness the seller is unable to verify. Due to a large number of defaults by the purchasers, and the sellers’ status as unsecured creditors, the sellers recover, if at all, only after banks and other lenders who have obtained security interests in the defaulting purchaser’s inventories, proceeds, and receivables.

… Congress intended to shield agricultural growers from risk in enacting PACA “to protect the public interest.” … PACA’s purpose is not to give a one-sided boon to growers, but instead, to benefit all parties and society by ensuring that growers are protected; lenders know their risk; and agricultural commerce is encouraged to benefit society.

But the Court did not stop there.  It went on to confirm that a factor who purchases accounts from growers (whether directly or through a distributor or broker) in true sales is free from a claim of trust fund diversion.

…. a PACA trustee’s true sale of accounts receivable for a commercially reasonable discount from the accounts’ face value is not a dissipation of trust assets and, therefore, is not a breach of the PACA trustee’s duties. (“The assets of the trust would thus have been converted into cash and the receivables would no longer have been trust assets.”… “[A] ‘bonafide purchaser’ of trust assets receives the assets free of claims by trust beneficiaries” and noting that the determinative issue on appeal is whether the “factoring agreement” was a loan secured by accounts receivable or a true sale of accounts receivable); (“[N]othing in PACA or the regulations prohibits PACA trustees from attempting to turn receivables into cash by factoring. To the contrary a commercially reasonable sale of accounts for fair value is entirely consistent with the trustee’s primary duty.”)…

I leave it to my readers to determine whether this story has a happy ending.  The good news is certainly that a true sale factor can be comfortable in factoring PACA receivables provided it is factoring on a true sale basis.

One last thought.  Despite the title Uniform Commercial Code we must keep in mind that the UCC is state law and that there are non-uniform provisions.  Consider the “law of the land” now in the Second, Fourth, Fifth and Ninth Circuits (as discussed in these articles) and the non-uniform UCC provisions in states such as Louisiana which provides:

…the parties’ characterization of a transaction as a sale of accounts…. shall be conclusive that the transaction is a true sale and is not a secured transaction …

I take it that as long as there are issues like these, lawyers like me can continue to earn a living.

 

S&H Packing & Sales Co., Inc. v Tanimura Distributing, Inc.  (Ninth Circuit en banc 2018)   2018 WL 1003855

 

 

 

[1] The Ninth Circuit hears cases en banc by a limited en banc court consisting of ten judges selected by lot and led by the Chief Judge.  Thus, a Ninth Circuit en banc court consists of eleven judges.

THE PACA FACTOR: SOME RELIEF FOR PACA PHOBIA?

Secured Lenders and Factors tend to go running for the hills when they hear the word PACA.

This is a two part article on a significant topic.  For those of you who read WurstCaseScenario on the publication date, Part 2 will be circulated tomorrow (by email, LinkedIn and at www.WurstCaseScenario.com).

The Perishable Agricultural Commodities Act was enacted in 1930 to prevent unfair business practices and to promote financial responsibility in the fresh fruit and produce industry.  The Great Depression arrived.  Droughts destroyed crops.   Bankruptcies were prominent. Farmers were hit on all ends and the food supply chain was at risk.

The purpose of PACA is to remedy this risk through the creation of a statutory trust.  PACA products received by a commission merchant, dealer, or broker and any receivables or proceeds from the sale of such products are to be held by the commission merchant, dealer, or broker in trust for the PACA beneficiaries until suppliers, sellers, or agents have received full payment.

In 1984 PACA was amended to prevent secured lenders from defeating the rights of PACA trust beneficiaries. The congressional focus upon the relative rights of these two groups is unmistakable.

PACA permits the comingling of trust assets and permits the PACA trustee to convert trust assets into proceeds.  Thus, the transferees of trust assets are liable only if they had some role in causing a breach or dissipation of the trust.  If the trustee transfers trust property to a third person without committing a breach of trust, the third person holds the interest so transferred or created free of the trust, and is under no liability to the beneficiary.

The Ninth Circuit Court of Appeals in a February 2017 decision provided some relief for factors.

The Second, Fourth and Fifth Circuit Courts of Appeal have been consistent in their standard that before assessing the commercial reasonableness of a factoring agreement, it is first necessary to examine the substance of the factoring agreement to ensure a true sale has occurred. In the absence of a true sale, superficial indicators and labels surrounding a factoring agreement should be of no consequence. The substance of the transaction matters. If the substance of a transaction reveals a secured lending arrangement rather than a true sale, the accounts receivable remain trust assets. Thus, unpaid trust beneficiaries hold an interest in accounts receivable and their proceeds superior to all unsecured and secured creditors such that the trust beneficiaries should prevail.

The Ninth Circuit, however, did not require a true sale analysis.  In its 2001 decision in Boulder Fruit the Ninth Circuit summarized the following scenario:

Farmer sells oranges on credit to Broker. Broker turns around and sells the oranges on credit to Supermarket, generating an account receivable from Supermarket. Broker then obtains a loan from Bank and grants Bank a security interest in the account receivable to secure the loan. Broker goes bankrupt. Under PACA, Broker is required to hold the receivable in trust for Farmer until Farmer was paid in full; use of the receivable as collateral was a breach of the trust. Therefore, Farmer’s rights in the Supermarket receivable are superior to Bank’s. In fact, as a trust asset, the Supermarket receivable is not even part of the bankruptcy estate.

The treatment of true sales and security interests, therefore, is clear. What remains unclear is the analysis to apply when the true nature of the transaction is ambiguous.  How should a court treat a transaction if the parties to a factoring agreement label the transaction a sale of accounts but provide substantial recourse for the factoring agent, such as requiring the distributor to “repurchase” non-performing accounts or permitting the factoring agent to withhold payments or otherwise recoup payments already made to the distributor? What if, such labels notwithstanding, the recourse and security provided include a security interest in the accounts receivable? Has a true sale actually occurred?

In the Ninth Circuit’s 2001 decision it did not focus on transfer of risk in finding that a commercially reasonable factoring agreement did not result in a breach of the trustee’s duties.  Keep in mind that once a circuit court makes a decision, it is generally bound by the precedent established.

In its February 2017 decision it described the situation as follows:

…the Factoring Agreement involved many hallmarks of a secured lending arrangement, including: security interests in accounts and all other asset classes except inventory; UCC financing statements; subordination of other debts; and substantial recourse for [Factor] against [its client] in the event [Factor] was unable to collect from [Client]’s customers (for example, [Factor] was entitled to force [Client] to “repurchase” accounts that remained unpaid after 90 days, and [Factor] could enforce this right by withholding payments from [Client]).

[Client]’s business later failed, and Growers did not receive payment in full from [Client] for their produce.  Growers sued [Factor] alleging: (1) the Factoring Agreement was merely a secured lending arrangement structured to look like a sale but transferring no substantial risk of nonpayment on the accounts; (2) the accounts receivable and proceeds remained trust property under PACA; (3) because the accounts receivable remained trust property, [Client] breached the PACA trust and [Factor] was complicit in the breach; and (4) PACA-trust beneficiaries such as Growers held an interest superior to [Factor], and [Factor] was liable to Growers.

Relying on Boulder Fruit and describing the cited cases as a circuit split, the district court granted summary judgment.  The district court noted the Ninth Circuit in Boulder Fruit expressly addressed the commercial reasonableness of a factoring agreement but implicitly rejected a separate, transfer-of-risk test. Further, the court noted the factoring agreement in Boulder Fruit transferred even less risk than the Factoring Agreement in the present case—in Boulder Fruit, the factoring agent enjoyed unrestricted discretion to force the distributor to repurchase accounts. The court therefore held that, even if Boulder Fruit could accommodate the transfer-of-risk test, the facts of Boulder Fruit controlled and precluded relief for Growers. Finally, the court concluded that the Factoring Agreement was commercially reasonable because [Factor] paid to [Client] 80% of the face value of the accounts as an up-front payment and ultimately paid to [Client] an even greater percentage of the face value of the transferred accounts.

Further, because the Factoring Agreement in the present case transferred a small degree of risk of non-payment, at least when compared to the agreement at issue in Boulder Fruit, we agree that Boulder Fruit would preclude relief to the Growers even if it were possible for our panel to adopt the transfer-of-risk test.

Although the judge writing the majority opinion did not focus on who assumed the risk for non-payment, a concurring decision[1]did:

In contrast, the Fourth, Fifth, and Second Circuits considered it necessary to examine the rights and risks transferred between the parties to a factoring agreement. ….. As the Fourth Circuit stated, “[I]f the accounts receivable were not sold but rather were given as collateral for a loan, then the accounts receivable would have remained trust assets, subject to [the factoring agent’s] security interest.”

In this decision the Ninth Circuit provided a safe harbor for factors who had not assumed the risk of non-payment.  But in rendering its decision it recognized that “subsequent panels are bound by prior panel decisions…” and cautioned that “under the doctrine of stare decisis[2] a case is important only for what it decides—for the ‘what,’ not for the ‘why,’ and not for the ‘how.’

Although the February 2017 decision was the law in the Ninth Circuit it was not the “law of the land.” Other circuits have looked, not only on the commercial reasonable standard, but also at the transfer of risk.  The Second Circuit (New York, Connecticut and Vermont) has held that

Where the lender has purchased the accounts receivable, the borrower’s debt is extinguished and the lender’s risk with regard to the performance of the accounts is direct, that is, the lender and not the borrower bears the risk of non-performance by the account debtor. If the lender holds only a security interest, however, the lender’s risk is derivative or secondary, that is, the borrower remains liable for the

debt and bears the risk of non-payment by the account debtor, while the lender only bears the risk that the account debtor’s non-payment will leave the borrower unable to satisfy the loan.

In other words the same facts in a New York case, for example, would have given a different result.  The Fourth and Fifth Circuits appear to have aligned with the Second.

S&H Packing & Sales Co., Inc. v Tanimura Distributing, Inc. 868 F3d 1047 (2017 9th Cir)

[1] A concurring decision is in addition to the majority decision and is by one or more of the judges giving different or additional reasons for joining with the majority.
[2] Meaning: to stand by things decided.  This is the legal doctrine that the US Supreme Court explained  “promotes the evenhanded, predictable, and consistent development of “ the law

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