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

Understanding Borrowers’ Claims Against Lenders

It should not come as a surprise to you that when asked to pay on a defaulted debt, borrowers and guarantors often look for ways to escape liability by alleging that the lending bank acted improperly and committed egregious acts which caused the borrowers’ defaults.  Typically in these situations defaulting borrowers make claims such as breach of fiduciary duty, breach of contract, breach of the implied covenant of good faith and fair dealing, consumer fraud, tortious interference, conversion, and disposition of collateral in a commercially unreasonable manner.

The Appellate Court of Illinois, in a recent decision, addressed these claims as brought against MB Financial Bank and its senior vice president in her individual capacity.  The court clearly addressed the standards for each of these claims.  I thought it would be helpful to summarize the legal standards for these claims to assist you in avoiding the traps that some lenders have fallen into in the rare cases when borrowers’ claims prevailed.

First, a brief factual background that led up to the action against MB.

In 2011, Booklet Binding, Inc. (“Booklet”) entered into a typical ABL facility with MB’s predecessor bank with additional collateral provided by Booklet’s affiliate KP Industrial Properties, LLC (“KP”). Several months after closing its loan Booklet experienced financial issues and fell into a significant overadvance position and overdrew its checking accounts.  Thereafter the bank and borrowers entered into a series of amendments to the loan documents in an attempt to provide an opportunity for the borrowers to rehabilitate and get back on track financially, including retaining a turnaround consultant and brining in an investor.  The overadvances continued and the borrowers’ financial condition worsened.

By August of 2013, the bank’s workout group was involved and advised the borrowers that the bank would not extend any further financing nor clear any checks (including payroll checks) unless there were sufficient funds in the bank accounts.  When the principals of the company offered to use personal funds to cover payroll, the workout officer told them that any funds they personally deposited into the payroll account would be used to setoff obligations owed to the bank.  She then froze all accounts and denied them online access to the borrowers’ accounts.  Even then, the bank offered to extend additional financing to the borrowers if the owners agreed to guaranty the proposed new overadvances and have the guaranties secured.

Booklet ultimately effected an assignment for the benefit of creditors and the assignee assigned “any and all claims [and] causes of action” that Booklet and KP might have against the bank to the former owners. After liquidating the collateral and collecting the accounts receivable, the bank was paid in full.

A year later, the former owners brought an action against the bank and its workout officer claiming that the bank prematurely declared a default under the loan agreement and mishandled collateral that Booklet and KP had pledged to secure the loan.  Two years later the bank moved for summary judgment, which motion was granted and the former owners appealed.  The appellate court in a reasoned decision addressed each of the former owners’ claims and affirmed the court below ruling in favor of the bank.  On its decision in favor MB, the appellate court clearly described each of the claims brought against the bank.  They are summarized below.

Breach of Fiduciary Duty:  To prevail on a claim of breach of fiduciary duty, a plaintiff must show (1) the existence of a fiduciary duty on the part of the defendants, (2) the defendants’ breach of that duty, and (3) damages proximately resulting from that breach.  A fiduciary relationship exists where one party reposes trust and confidence in another, who thereby gains a resulting influence and a superiority over the subservient party but as a general rule a fiduciary relationship does not exist between a debtor and creditor.  The court noted that the loan agreement specifically stated that “no fiduciary relationship exists…”

Breach of Contract:  To prevail on a breach of contract action, a plaintiff must establish the following: (1) the existence of a valid and enforceable contract, (2) performance by the plaintiff, (3) breach of the contract by the defendant, and (4) damages or injury to the plaintiff as a result of the breach. In this case, the court noted that the parties’ dispute centered on whether the bank breached its contracts with Booklet by prematurely declaring a default under the loan agreement.  The court concluded that there was no issue of fact that the bank had not breached the agreement when it declared a default after the borrowers failed to cure the overadvances.

Good Faith and Fair Dealing:  Every contract has an implied covenant of good faith and fair dealing.  Breach of the duty of good faith and fair dealing arises only when one party is “vested with contractual discretion” and exercises that discretion “arbitrarily, capriciously, or in a manner inconsistent with the reasonable expectation of the parties.” However, the duty of good faith and fair dealing is an implied covenant, and it cannot be used to overrule or modify the express terms of a contract. Nor may the implied covenant of good faith and fair dealing be used to read into a contract an obligation that does not exist.  The principals claimed that the bank breached its covenant of good faith and fair dealing when it declined to complete work-in-process.  However, the court held that no provision, express or implied, in the loan agreement required the bank to do Booklet’s work and the covenant of good faith and fair dealing could not be used to read into a contract an obligation that does not exist

Consumer Fraud:  In order to establish a violation of the Consumer Fraud Act, a plaintiff must demonstrate: (1) a deceptive act or practice by the defendant, (2) the defendant’s intent that the plaintiff rely on the deception, (3) the occurrence of the deception in the course of conduct involving trade or commerce, and (4) actual damage to the plaintiff, (5) proximately caused by the deception.  The court summarily dismissed the principals’ claim that the bank acted improperly in denying the borrowers online access.

Tortious Interference:  To recover for tortious interference with prospective economic advantage, a plaintiff must establish the following elements: (1) a reasonable expectancy of entering into a valid business relationship, (2) the defendant’s knowledge of the expectancy, (3) an intentional and unjustified interference by the defendant that induced or caused a breach or termination of the expectancy, and (4) damage to the plaintiff resulting from the defendant’s interference.  A plaintiff states a cause of action only if he alleges a business expectancy with a specific third party as well as action by the defendant directed towards that third party.

Conversion:  To prevail on a claim for conversion, a plaintiff must demonstrate: (1) unauthorized and wrongful control, dominion, or ownership by the defendant over the plaintiff’s property; (2) the plaintiff’s right in the property; (3) the plaintiff’s absolute and unconditional right to the immediate possession of the property; and (4) a demand for possession of the property

Commercial Reasonableness: UCC Article 9 provides that, “[a]fter default, a secured party may sell *** or otherwise dispose of any or all of the collateral ***. Every aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.” Commercial reasonableness is determined on a case-by-case basis unless the manner of the sale falls under one of the “safe harbor” exceptions in section 9-627 of the UCC. Relevant here, section 9-627(c) provides as follows:

(c) Approval by court or on behalf of creditors. A collection, enforcement, disposition, or acceptance is commercially reasonable if it has been approved: (1) in a judicial proceeding; (2) by a bona fide creditors’ committee; (3) by a representative of creditors; or (4) by an assignee for the benefit of creditors.

Where collateral is disposed of pursuant to the safe-harbor provisions in section 9-627(c), the transaction is commercially reasonable as a matter of law.

This case is a good example of what a borrower may toss at a lender when the relationship breaks down.  The undisputed facts demonstrated that the bank had acted within its rights and had not abused its position to the disadvantage of the borrowers.

Keep in mind that bad facts engender bad results and that each of these claims has been successful in actions against lenders who crossed the line of proper conduct, at least in the eyes of the court that ruled against them.

Finally, this action was brought as a retaliatory measure after the bank had been paid in full.  Although the claims were not successful the record is unclear whether the bank was able to recover what must have been significant legal costs in defending itself.  Watch for future articles on these pages which will discuss ways to mitigate excessive legal costs in situations like this.


KOSOWSKI and PATREVITO v. ALBERTS and MB FINANCIAL BANK, N.A., successor in interest to Cole Taylor Bank, 2017 IL App (1st) 170622-U, December 22, 2017

Commercially Reasonable Disposition of Collateral

The Supreme Court of Nevada issued a decision of interest on November 22, 2017, while most of us were preparing for a Thanksgiving weekend.  Although the Court specifically held that the issues before it were not subject to the UCC, it applied UCC standards making a decision of interest to us.

It appears that parties to this case were previously before the Court resulting in a prior decision that the homeowners association (HOA) had a lien on a homeowner’s home for unpaid monthly assessments which lien was split into super-priority and sub-priority pieces and upon foreclosure the super-priority piece extinguished the first deed of trust.  In that earlier case the Court held that that inadequacy of price alone “is not enough to set aside a sale; there must also be a showing of fraud, unfairness, or oppression.”

This later appeal to set aside a foreclosure sale addressed the mortgagee’s claim that in Nevada a court is “[g]enerally” justified in setting aside a foreclosure sale when the sale price is less than 20 percent of the property’s fair market value.  The mortgagee argued that the HOA foreclosure sale should be set aside based on commercial unreasonableness or based solely on low sale price. The Nevada Supreme Court seized the opportunity to provide further clarification on these issues.

As to the commercial reasonableness standard, which derives from Article 9 of the Uniform Commercial Code, the court held that it has no applicability in the context of an HOA foreclosure involving the sale of real property. As to the 20–percent standard, it clarified its longstanding rule that inadequacy of price, however gross, is not in itself a sufficient ground for setting aside a trustee’s sale absent additional proof of some element of fraud, unfairness, or oppression as accounts for and brings about the inadequacy of price.

That does not mean, however, that sale price is wholly irrelevant. In this respect the Court adhered to its prior observation that where the inadequacy of the price is great, a court may grant relief based on slight evidence of fraud, unfairness, or oppression.  It held, however, that the appellant failed to establish any of these criteria.

Because a wide array of personal property may be used as collateral, Article 9 does not provide detailed requirements by which a creditor must dispose of the collateral, but instead provides generally that the creditor’s disposition of the collateral must be done in a commercially reasonable manner.  The Court recognized that Article 9’s procedures governing disposition are “deliberately flexible” because “[t]he drafters hoped that Article 9 dispositions would produce higher prices than those typically obtained in real estate foreclosures”.  However, the Court noted that the majority rule appears to be that the secured party has the burden of pleading and proving that any given disposition of collateral was commercially reasonable.

Under Nevada Law before an HOA can foreclose, it must mail, record, and post various notices at specific times and containing specific information.  In a condominium or planned community, the association’s lien must be foreclosed in like manner as a mortgage on real estate.  In a cooperative whose unit owners’ interests in the units are real estate, the association’s lien must be foreclosed in like manner as a mortgage on real estate; or where in a cooperative whose unit owners’ interests in the units are personal property, the association’s lien must be foreclosed in like manner as a security interest under Article 9. Although the court determined that the HOA needed to foreclose as if it held a mortgage, it applied a standard of commercial reasonableness under the UCC.  Thus, the price obtained would not determine reasonableness – the process which followed would.  And absent establishing fraud, oppression or unfairness, the sale was affirmed.

The take away for UCC practioners is that the process followed in liquidating collateral is paramount – not the price obtained.  The caveat, however, is that those who are in the business of loan to own need to follow the process if their ownership interest is to be affirmed.


Nationstar Mortgage, LLC v Saticoy Bay LLC Series 2227 Shadow Canyon. 2017 WL 5633293



How Good Is Your Collateral Description?

Those of you who remember the pre-2001 UCC will remember those long lists of collateral descriptions that usually appeared as attachments to the financing statements filed with the state and local filing offices. Remember that?  And do you remember how those attachments were often lost by the filing office?

The 2001 changes simplified this, not only by eliminating the local filing, but also by allowing the term “all  assets” or similar language to be used on the financing statement in order to do away with those extra pages of collateral descriptions.

Keep in mind, however, that while the UCC allows use of the term “all assets” on financing statements the security agreement must reasonably identify the collateral and supergeneric descriptions, while allowed for use in financing statements, are expressly deemed insufficient for the security agreement.

Use of the supergeneric description on a financing statement is strongly recommended.  A November 1, 2017, well-crafted decision from the Bankruptcy Court for the Eastern District of Kentucky highlights the risk of being specific when generic would have been better.

The issue at hand was in the context of disputed use of cash collateral between a Chapter 11 debtor, Lexington Hospitality Group, LLC, and its lender, PCG Credit Partners, LLC (PCG), and whether hotel room charges were personal property or proceeds of real property.

The Court determined that “room revenue” was personal property and not subject to the mortgage.  The Debtor conceded (and the Court agreed) that PCG was secured in the room revenue but argued that PCG’s position was not perfected in the room revenue.  The Court examined the UCC financing statement which was properly filed and noted that:

The Security Agreement grants a lien on “all right, title and interest” of the Debtor in the “Collateral.” [Security Agreement, Art. III.] “Collateral” in the Security Agreement is broadly defined to include all assets of the Debtor, including accounts, general intangibles and payment intangibles…

The Court addressed the collateral descriptions contained in the financing statement which included:

goods, inventory, accounts, deposits, contracts…tangible personal property…The Financing Statement thereafter becomes more specific…[but] [it] does not identify “general intangibles” or “payment intangibles” in its description of the Collateral

The Court ultimately concluded that the room revenues were “payment intangibles”.  The specific description contained in the financing statement neglected to include intangibles (or even  payment intangibles) although they were included in the granting clause contained in the security  agreement.

It does not matter what the parties intended by the security agreement.  Keep in mind that the security agreement is a private writing between the lender and the borrower but the financing statement is a recorded document that puts the world on notice what collateral is encumbered.

Back in the “old days” we would cut and paste the language from the granting clause and attach it to the UCC-1 financing statement.  Since 2001 that became unnecessary when the use of supergeneric descriptions were authorized by the UCC.

Why anyone would not take advantage of using a supergeneric description is beyond me!

I suspect that PCG has learned a costly lesson.

Who Owns the Goods?

The April 4, 2016 WurstCaseScenario discussed issues raised in the Chapter 11 of The Sports Authority (“TSA”) and the risks of failing to properly perfect interests in consigned goods under Article 9 of the UCC.  The TSA estate benefitted from the errors of intended consignors when what was intended to be consigned inventory was actually property of the TSA estate.

Today we are looking at another issue in the TSA bankruptcy affecting the rights to goods but this time our attention turns from Article 9 to Article 2.

O2Cool manufactured and distributed consumer cooling products originated in China and sold goods to TSA F.O.B. origin.  TSA utilized a complicated supply, delivery and logistics chain.  O2Cool sent a number of Stop Shipment Notices pursuant to UCC 2-705 to Yusen Logistics (Hong Kong) Inc. (“YLHK”), which provided origin cargo management and customs house brokerage services for TSA as well as to OOCL (USA), Inc., an agent for the carrier, Orient Overseas Container Line Limited.

The UCC states that a seller may stop goods from being delivered to a buyer when the seller discovers that the buyer is insolvent and the goods are still in a carrier’s or bailee’s possession.  This right to stop shipment exists until the buyer receives the goods. “Receipt” occurs when the buyer or the buyer’s designated representative takes actual physical possession of the goods. Goods that are in a common carrier’s possession for delivery to the buyer have not been received by the buyer. A seller’s right to stop goods from being delivered persists until the goods reach their final place of delivery.

TSA’s Bankruptcy Court concluded that because the goods were not yet in the physical possession of TSA when O2Cool sent the Stop Shipment Notices, O2Cool had the right to stop shipment of the goods.

The court’s reasoning was that because O2Cool had delivered the goods to YLHK and the goods were still in transit, when O2Cool sent the Stop Shipment Notices a common carrier, and not the buyer, was in possession of the goods.  Thus, O2Cool’s right to stop shipment continued until the goods were in the physical possession of TSA and not when title passed.

The Court next turned to whether notice was given to the proper  party.

The UCC provides that a seller has the right to stop delivery of goods upon discovering that a buyer is insolvent, and that a seller may stop shipment by notifying the bailee so as to “enable the bailee by reasonable diligence to prevent delivery of the goods. The UCC defines a bailee as “a person that by a warehouse receipt, bill of lading, or other document of title acknowledges possession of goods and contracts to deliver them.”

In this case YLHK was not listed as a carrier on the bills of lading and after it received the Stop Shipment Notices, YLHK notified O2Cool that it was neither a carrier nor in possession of the goods.

Article 2 of the UCC states that “a carrier who has issued a non-negotiable bill of lading is not obliged to obey a notification to stop received from a person other than the consignor”.  Consignor is defined as “a person named in a bill of lading as the person from which the goods have been received for shipment”.  Here Orient Overseas issued non-negotiable bills of lading showing another company as “the person from which the goods have been received for shipment.” Thus, the Court concluded that OOCL was not required to obey O2Cool’s Stop Shipment Notices.

Result:  The Stop Shipment Notice was not effective and TSA owns the goods.  Victory for TSA and its secured lenders and a loss to O2Cool and its secured lenders.

Lesson: Secured transactions under Article 9 of the UCC often depend on the workings of other UCC sections such as Article 2.