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, 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

PACA: If It Looks Like a Duck and Walks Like a Duck, It Still Needs to Be a True Sale to Avoid Liability

The strong arm effect of The Perishable Agricultural Commodities Act (PACA) continues to strike at lenders who refuse to take “no” for an answer.

In March 2018, we dedicated two Wurst Case Scenario posts to a significant PACA decision (Tanimura) from the Ninth Circuit Court of Appeals where the Court reversed its prior position and joined the Second, Fourth and Fifth Circuits in protecting true sale factors from exposure when a PACA beneficiary goes unpaid. In that case, the Ninth Circuit said:

…. 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.”)…

In January 2020, we focused on a case affecting Produce Pay, Inc., a “multi-service finance company,” that asserted a PACA claim against a bankrupt distributor, claiming it was a purchaser that was entitled to assert PACA trust claims against a nonpaying/bankrupt purchaser of produce. The bankruptcy court in that case determined that Produce Pay purchased produce from growers but with full recourse. Thus, it was not entitled to the protection of the PACA trust.

On Oct. 13, 2020, the United States District Court for the Central District of California issued a decision – again concerning Produce Pay. This time Produce Pay claimed not to be a factor but instead a consignor and that the risk of nonpayment fell on Produce Pay’s consignment agent (Izguerra), who assumed the risk of nonpayment. The Court noted:

While it is true that the opinion in Tanimura focuses on whether a factoring agreement is a sale in order to determine whether the proceeds remained in the trust, this Court must decide whether a transaction is a sale to determine whether Plaintiff is entitled to PACA protection. Therefore, this Court applies the transfer-of-risk test adopted by the Ninth Circuit in Tanimura.

The transfer-of-risk test established in Tanimura provides:

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 considering whether to apply the transfer-of-risk test, the Court, looking to the Second Circuit’s seminal decision on the subject, considered: (a) whether Produce Pay has a right to recover any deficiency from Izguerra if the assets assigned do not satisfy the debt; (b) whether Produce Pay’s right to the assets assigned is affected should Izguerra pay the debt from independent funds; (c) whether Izguerra has a right to any funds recovered from the sale of assets above that necessary to satisfy the debt; and (d) whether the debt is reduced by the assignment itself.

The Court noted that according to the agreement, Izguerra bears all the risk should its purchaser fail to pay. Accordingly, the Court held that:

the transaction is a secured loan and not a true sale, contradicting the Complaint and making Produce Pay ineligible for protection under PACA.

Produce Pay loses again. These are expensive lessons. Notwithstanding, there are reasonable opportunities to provide financing to the PACA industry. But be warned not to be cavalier in extending financing, and be sure to make and rely upon sound business and legal practices or run the risk of sustaining losses.

Personal Guaranties: The Document of Last Resort

Lenders take guaranties but hope to never need them. Sometimes, lenders take them knowing that the guarantor is judgment-proof, but hope that the guaranty will serve as a deterrent against otherwise improper acts. Guaranty agreements have grown in verbiage over the years and typically include all types of conditions and waivers. Once the lender determines to pursue a guarantor, it is common for the guarantor to look for reasons that the guaranty should not be enforced. Thus, the waivers are important and enable lenders to prevail on motions for summary judgment and avoid an expensive trial. But that is a topic for another day.

But what if the lender does not have a written guaranty?  Is it out of luck? The Michigan Court of Appeals issued a decision on Oct. 29, 2020, that sheds some light on this. But first, let us consider some underlying requirements.

Readers of Wurst Case Scenario are familiar with the term statute of frauds. Most, if not all, jurisdictions have enacted statutes of frauds that require certain agreements to be in writing. For example, the California statute of frauds (California Civil Code 1624) provides:

(a) The following contracts are invalid, unless they, or some note or memorandum thereof, are in writing and subscribed by the party to be charged or by the party’s agent: …

(2) A special promise to answer for the debt, default, or miscarriage of another, except in the cases provided for in Section 2794 .

Section 2794 provides:

A promise to answer for the obligation of another, in any of the following cases, is deemed an original obligation of the promisor, and need not be in writing: …  Where the promise is upon a consideration beneficial to the promisor, whether moving from either party to the antecedent obligation, or from another person;

Similarly, by way of example, the New York statute of frauds (New York General Obligation Law §5-701) provides:

a. Every agreement, promise or undertaking is void, unless it or some note or memorandum thereof be in writing, and subscribed by the party to be charged therewith, or by his lawful agent, if such agreement, promise or undertaking: …

2. Is a special promise to answer for the debt, default or miscarriage of another person;

That statute goes on to say:

3. There is sufficient evidence that a contract has been made if:

(a) There is evidence of electronic communication (including, without limitation, the recording of a telephone call … sufficient to indicate that in such communication a contract was made between the parties….

The Michigan case involves enforcement of an oral guaranty for a business loan made under California law, although the lawsuit was brought in Michigan where the guarantor resides. There is no explanation why the lender did not obtain a written guaranty. There is no explanation why neither the original written business loan agreements, nor the amended documents entered into 10 years later, failed to even reference the guaranty.

Instead, the lender relied on the transcript of a pre-loan closing telephone conversation between the lender’s representative and the guarantor. Fortunately for the lender, the guarantor admitted the accuracy of the transcript.

Q. You personally guaranty [sic] to pay [lender] upon demand all that you owe on the business line account. As guarantor, you authorize [lender] without notice or prior consent to change any of the terms of the amount of your company’s business line account. In addition, you agree to pay attorney’s fees and other expenses incurred in enforcing this guaranty.

A. Uh-huh.

Q. This guaranty benefits the [lender] and its successors and assigns. Finally, you agree this audiotaped application may be used as evidence of your agreement to the terms of this guaranty.

A. Uh-huh.

Q. Do you understand and agree to these terms?

A. Yes.

During the conversation, the guarantor also agreed that the agreement would be subject to California law.

The Michigan Court of Appeals, applying California law, ruled in favor of the lender saying: “An oral guaranty is …enforceable if the guarantor gained a business or personal advantage from the transaction,” and, “Here it is clear that [guarantor’s] leading and main objective was not to become a surety or guarantor but to simply serve his own personal interests connected to keeping his business afloat.”

But how would other states address an oral guaranty? Likely, in a similar way. As indicated, New York has a similar statute of frauds, and other similar exceptions. However, my search for even a single case in New York where an oral guaranty was enforced came up empty. However, there are cases that discuss what would be needed to enforce an oral guaranty. One New York case went so far as to say:

An oral guaranty would be enforceable (1) if it were supported by new consideration; (2) if it were beneficial to the promisor; and (3) if the promisor had agreed to be directly liable for the debt.

That court, however, declined to find that an oral guaranty existed.

The facts in the Michigan case may be unique but not out of reach. It is common (and perhaps even standard) to have recorded conversations when interviewing potential borrowers and guarantors during the application process. Having to rely on that recorded conversation may give rise to other problems. That said, the best practice is still to obtain a well-written guaranty executed by the guarantor.

No Fraudulent Conveyance Despite Transfer of Assets After Notice of Default to Guarantor

In a Sept. 29, 2020, decision, the Eleventh Circuit Court of Appeals issued a disturbing decision affirming dismissal of a bank’s action to bar a guarantor’s bankruptcy discharge despite the guarantor having transferred substantial assets to a limited liability company he set up for his wife and daughter. The transfer occurred after the default by the borrower.

The non-dischargability action was dismissed by the Bankruptcy Court for the Southern District of Alabama, and was later affirmed by the United States District Court. The bank then appealed to the Eleventh Circuit (the appellate court just below the United States Supreme Court), which covers the states of Georgia, Alabama and Florida.

The guarantor guaranteed two business loans made in 2006 to fund a real estate development project. In 2008, he reaffirmed his guaranty when the loans were increased. A year later, the development project was in financial trouble and the bank sent the guarantor a warning of potential default. Less than two weeks after receiving the warning letter, the guarantor conveyed parcels of real property to a newly formed limited liability company whose members were the guarantor, his wife and daughter. He later conveyed his membership interest to his wife and daughter, fully divesting himself of any interest. This transfer was part of a series of conveyances of personal assets including real property, cash and business interests made to family members over the next five years. In 2010, the bank brought an action against the guarantor resulting in a money judgment in the amount of $9.1 million. The guarantor continued to transfer assets through 2014.

The bank (by its successor) ultimately sued the guarantor, his wife and daughter under the Alabama Uniform Fraudulent Transfer Act resulting in the guarantor filing for bankruptcy. The bank then commenced an adversary proceeding to declare the guarantor exempt from discharge due and allege the fraudulent conveyance. The guarantor answered the complaint and then moved for summary judgment dismissing the complaint by arguing that he did not defraud the bank in guarantying the loans, and because his conveyances did not injure the bank or its property.

The Bankruptcy Court found that the bank’s claim failed because the bank did “not contend that the underlying debt from the guaranties was obtained by fraud or was anything other than a standard contract debt” and because “[t]he underlying debt is the result of personal guaranties, not any willful and malicious injury by [guarantor].” Finally, the Bankruptcy Court found no basis for the bank to amend its complaint to add a claim under the Fraudulent Transfer Act, noting that the bank had “not provided any Alabama law that [a] debtor/transferor who fraudulently transfers property is liable to a creditor for the value of the transferred property.” On appeal, the District Court agreed with the Bankruptcy Court “for all the reasons articulated in [its] order,” and the bank appealed to the Eleventh Circuit.

The Eleventh Circuit stated that the bank

does not—and cannot—argue that [guarantor] or the entity whose debt he guarantied fraudulently obtained money or property from [the bank].  A state court awarded [the bank] a judgment on its ordinary breach of contract claim, and that judgment makes no findings of fraud. The only fraud that [the bank] alleges—[guarantor’s] conveyances of real and personal property—happened years after [guarantor] incurred the debt by signing the guaranties. The money that the bank loaned is obviously not traceable to those later conveyances.

It went on to distinguish the 2016 decision of the United States Supreme Court in Husky International Electronics, which held “[t]he term ‘actual fraud’ in § 523(a)(2)(A) encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.”

However, the Eleventh Circuit claimed that

…the Supreme Court [did not] eliminate[] the requirement that for a debt to be exempt from discharge …, the money or property giving rise to the debt must have been “obtained by” fraud, actual or otherwise. Instead, [it] merely recognized the possibility that fraudulent schemes lacking a misrepresentation—including fraudulent transfers of assets to avoid creditors—can satisfy the “obtained by” requirement in some circumstances.

Readers of WurstCaseScenario likely understand how difficult it is to prove intentin order to succeed in proving “actual fraud.” But a fraudulent conveyance does not need to be done with intent to defraud. It is the action that matters – not the reason for it.

Section 8-9A-4 of the Uniform Fraudulent Transfer Act, as adopted in Alabama, provides:

(a) A transfer made by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made, if the debtor made the transfer with actual intent to hinder, delay, or defraud any creditor of the debtor.

This type of fraudulent transfer does require proof of intent. Although, in its complaint, the bank used some of this language, it did not make any reference to this Alabama state law. Instead, it only referred to Section 523 of the Bankruptcy Code, the section that addresses exemptions to discharge. In addition, Section 8-9A-5 of the Uniform Fraudulent Transfer Act, as adopted in Alabama, provides for certain transfers that do not require proof of intent to defraud:

(a) A transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the debtor made the transfer without receiving a reasonably equivalent value in exchange for the transfer and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer.

(b) A transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the transfer was made to an insider for an antecedent debt and the debtor was insolvent at that time and the insider had reasonable cause to believe that the debtor was insolvent.

These claims were not included in the complaint although it would appear likely that they could have been proven.

Section 523 of the Bankruptcy Code, which the bank did specifically cite in its complaint, does not provide for fraudulent conveyances. Inasmuch as the bank did not ask to set aside the transfer under Alabama law, the Court did not have to address whether the transfer would be exempted from discharge. It merely needed to deny the relief under Section 523.

Had the Eleventh Circuit stopped there, it might not have been so bad. Instead, it went beyond the failure to prove intent under 523:

The only misconduct alleged by [the bank] pertains to [guarantor’s] fraudulent conveyances of assets. But those conveyances occurred years after [guarantor] became indebted to [the bank] for the [borrower’s] guaranties, and the conveyances are not traceable to that debt, which arose from an ordinary breach of contract.

That is what should concern lenders. This makes it unclear whether Alabama and the Eleventh Circuit will protect lenders against fraudulent transfers by its borrower and guarantors when a well-pled complaint is at issue, instead of the one in this case, which clearly failed to put forth the proper claims.

SE Property Holdings, LLC  v. Jerry DeWayne Gaddy, 11th Cir., September 29, 2020 (2020 WL 5793082)