The Good, the Bad and the Ugly

Factoring/Bankruptcy Automatic Stay/Sanctions

It is not uncommon for contemporary factors to believe that they are not subject to the bankruptcy automatic stay. In many cases they are not. However, that is not always the case.

Let’s consider old-line factoring (which has also been referred to as non-recourse factoring and full-service factoring) where the factor provides a full range of services including credit control, credit protection, collection, maintaining sales ledgers and providing financing. Old-line factoring was typically done on a maturity basis (Maturity Factoring), but over the years many variations came about including Collection Factoring.

In Maturity Factoring the factor purchases receivables and pays for them on the average maturity date which is typically 60 days after the invoice date (which is also the purchase date). If the account debtor were to file for bankruptcy or commit some other act of insolvency, the factor would, nonetheless, pay the purchase price to its factored client on the average maturity date.

Retailers were often late payers and, as a result, many factors started to purchase retail invoices on a collection basis (Collection Factoring) where the purchase price would not be paid until the invoice was actually paid. If there was an act of insolvency, the factor would then pay the purchase price (and not wait for collection which was certainly dubious). The factor (and not the factored client) would then be the customer’s unsecured creditor.

Now let’s add in the financing layer. The factored client typically cannot wait until the average maturity date or actual collection of the factored receivables and needs money sooner. In those cases, the old-line factors would make advances (loans) to the factored client which would be repaid from the proceeds when they became payable by the factor on the average maturity date or upon collection.

Thus, the factored client would have no obligation to the factor if it were to go into bankruptcy [other than for any monies that might become due to the factor by virtue of any chargebacks or other expenses, which I will defer discussing until another blog. For the purposes of this discussion. let’s assume that there were no chargebacks or other expenses they come into play.].

These scenarios do not necessarily apply to much of contemporary factoring where the factor retains full recourse to its factored client should the account debtor not pay for any reason including a bankruptcy or other insolvency event.

Now, we turn to the recent case at hand (remember, this is WurstCaseScenario) from the Ninth Circuit Bankruptcy Appellate Panel (BAP).

Jill Medley is a licensed real estate broker who entered into a number of agreements with Precision Business Consulting, LLC, whereby she assigned to Precision a portion of the commissions to be received upon the closing of homes in exchange for a 75% advance against the commission to be earned. Medley assigned replacement commissions to Precision should any deal not close and also allowed Precision to hold the deed to her home as additional collateral.

One such commission did not collect because the contract did not result in a closing, and Medley filed a petition for a personal Chapter 13. Precision filed a secured proof of claim asserting it was owed the amount of the advance plus interest at the default rate. Medley objected to the secured claim contending that the debt was properly a general unsecured claim. Precision claimed it was “a factoring company that purchases receivables . . . Factors don’t loan money.”

Precision then asserted a claim against another commission that became earned by Medley, and Medley objected claiming that her bankruptcy estate did not have an interest in the new commission. The Chapter 13 case was ultimately dismissed, and Medley retained the entire commission. She then filed a motion to hold Precision in contempt for violating the automatic stay and requested that the Bankruptcy Court impose civil contempt sanctions.

Medley argued that under the “transfer-of-risk” test, Precision was a secured creditor and not a purchaser of the commission. The bankruptcy court agreed, and Precision appealed.

On appeal, the BAP quoted Black’s Law Dictionary and stated:

“Factoring” is described as “[t]he buying of accounts receivable at a discount. The price is discounted because the factor (who buys them) assumes the risk of delay in collection and loss on the accounts receivable.”

The BAP recognized that the courts have applied this principle in various contexts (including in considering whether a transfer is usurious) based on the economic substance rather than its form.

“A loan … is the delivery of a sum of money to another under a contract to return at some future time an equivalent amount with or without an additional sum agreed upon for its use; and if such be the intent of the parties the transaction will be deemed a loan regardless of its form.”

The court considered these principles and whether the transaction was “a sale or a usurious loan. . . and the trier of fact should look to substance rather than form.” The BAP then went on to conclude:

. . . the bankruptcy court did not err when it found that the agreement was not a true sale, but rather a secured loan, and that the right to receive the commission was property of the bankruptcy estate protected by the automatic stay.

The BAP went on to affirm the bankruptcy court’s rulings including its ruling sanctioning Precision for a willful violation of the automatic stay in the amount of the debtor’s attorneys’ fees and costs in connection with the violation of the automatic stay. It went on to comment that although the bankruptcy court had considered (but not imposed) punitive damages, it would have been an error if it had.

The takeaway is that factors who purchase receivables with recourse must exercise care when their factored clients file for bankruptcy. Keep in mind that unless it is clear that the factor has assumed the risk of loss that a court will likely be severe in addressing the factor’s self-help. That said, it has been my practice in such situations to seek and obtain a “comfort order” confirming that the proceeds of the purchased receivables are not property of the bankrupt estate and, pending such order, assure that all such proceeds are being held in a suspense account. Of course, if the factor will be providing DIP factoring or financing, the “comfort order” will be included within the DIP order.

Ice in Winter?

New York Court of Appeals Affirms a Secured Lender’s Right to Recover Against Account Debtors

There is nothing more critical to a secured lender than its right to recover on its collateral. Those of us engaged in commercial lending have slept under that security blanket since the beginning of time (well, since the creation of security interests). We have relied on Sections 9-406 and 9-607 (and their predecessor sections in the old Article 9 of the Uniform Commercial Code) and sent account debtors notifications to pay the lender or be at risk of paying twice.

In recent years, a number of court rulings have missed the point and miscomprehended the purpose of these sections and their importance as the lifeblood of asset-based lending and factoring. For example, the Fourth Circuit Court of Appeals ruled “the UCC provisions …. do not provide a private right of action….[1]” The Eleventh Circuit Court of Appeals held: “we conclude that § 9-406(a) creates neither an express nor an implied right of action for a secured party…”[2] Various state and federal trial courts have made similar rulings. In short, this is a critical issue that threatens the basis of commercial financing.

Keep in mind that when the Fourth and Eleventh Circuits (and other federal courts) made their rulings, they were interpreting state law because the Uniform Commercial Code (UCC) is law adopted by each state (in some cases with non-uniform provisions) and is not the law of the nation. Thus, when state courts interpret the UCC, those decisions, once affirmed by that state’s highest court, will be binding upon relevant federal courts as well.

New York is certainly a significant jurisdiction for commercial finance law – perhaps the most significant. Thus, when a case involving a secured party’s right of action to recover on its accounts receivable collateral works its way through the complex legal system, it is one that is worthy of attention.

The Supreme Court of New York [3] ruled in a November 2020 decision: “to hold that an account debtor is obligated to pay the secured creditor and not the debtor would be tantamount to creating a duty owed by the account debtor to the secured creditor that was separate and distinct from the duty it owed to the debtor.” This led to the appeal discussed below.

First, the facts. Worthy Lending LLC provided a loan to Checkmate Communications LLC and Checkmate executed a Promissory Note and Security Agreement in favor of Worthy Lending. Worthy filed a UCC-1 financing statement and sent a notification to New Style Contractors, Inc. as follows:

Pursuant to Section 9–406 of the Uniform Commercial Code, payments of accounts made by New Style to Checkmate or to anyone other than Worthy Lending will not discharge any of New Style’s obligations with respect to such Accounts, and notwithstanding any such payments, New Style shall remain liable to Worthy Lending for the full amount of such Accounts.

Checkmate defaulted on the note and Worthy accelerated the debt, but Checkmate filed for bankruptcy. Worthy brought an action against New Style, the account debtor, alleging that New Style was obligated to pay Worthy, even if it had already paid Checkmate. New Style brought a motion to dismiss and the trial court dismissed the complaint stating that Section 9-607 of the UCC

does not determine whether an account debtor, bank, or other person obligated on collateral owes a duty to a secured party (UCC 9-607[e]). In other words, the section upon which [Worthy’s] cause of action is based does not determine whether [New Style] owes a duty to [Worthy]. (internal quotes omitted)

Worthy appealed to the Appellate Division (New York’s intermediate appellate court), which held:

. . . .[Worthy] did not have an independent cause of action against [New Style] pursuant to UCC 9-607. [Worthy] and [New Style] have no contractual or other relationship or duty to one another. [Worthy] seeks to impose upon [New Style] a separate obligation to repay [Worthy] the same amount it has already paid the nonparty [Checkmate] under their contract. Because there was a dispute between [Worthy], the secured creditor, and [Checkmate] as to who had the right to collect from [New Style], section 9-607(e) applied.

In reversing the lower courts, the New York Court of Appeals wrote:

The language of the statute, as well as the clear commentary on the relevant sections requires reversal. New York’s UCC 9–607 and 9–406 adhere to the standard UCC language. Section 9–607(a)(3), entitled “Collection and Enforcement by Secured Party,” provides as follows:

“If so agreed, and in any event after default, a secured party … may enforce the obligations of an account debtor or other person obligated on collateral and exercise the rights of the debtor with respect to the obligation of the account debtor or other person obligated on collateral to make payment or otherwise render performance to the debtor, and with respect to any property that secures the obligations of the account debtor or other person obligated on the collateral.”

The Court went on to explain that an account debtor who receives a secured creditor’s notification asserting its right to receive payment directly can pay the secured creditor and receive a complete discharge or, if in doubt, can seek proof from the secured creditor that it possesses a valid assignment and withhold payment in the interim. The Court of Appeals confirmed that Worthy Lending is the “secured party” with the authority to enforce the rights of its debtor (Checkmate) to collect on the obligations of the account debtor (New Style).

The lower courts held that subsection 9–607(e) bars Worthy from using the mechanism provided for in section 9–607, by providing that “[t]his section does not determine whether an account debtor, bank, or other person obligated on collateral owes a duty to a secured party.” However, the plain language of subsection (e) merely states that UCC 9–607 does not itself determine whether an account debtor owes a duty to a secured party.

The agreement between Worthy and Checkmate grants Worthy the right to direct Checkmate’s debtors to pay Worthy directly, and bars Checkmate from interfering with any such direction if given. Subsection (e) of 9–607 does not even imply, much less state, that parties cannot contractually assume duties concerning the right of a secured party to enforce the rights of a debtor as against account debtors. Indeed, section 9–607(a)(3) expressly provides that “in any event after default,” a secured party may obtain collateral directly from an account debtor, and the secured party and debtor may agree that the secured party may do so by agreement, without regard to default—which they did here.

Finally, the Court addressed the concerns of the Appellate Division and the Supreme Court that New Style may have paid Checkmate and will now need to pay double by paying Worthy:

That is the statutory consequence of failing to pay a secured party who has notified the account debtor to pay the secured party directly. (emphasis added)

Keep in mind that before Article 9 of the UCC was fully revised in 2001, the New York Court of Appeals had addressed this very same issue.[4] In the Worthy decision, the Court of Appeals quoted its 1995 “on point” decision, stating:

“. . . .after the account debtor receives notification that the right has been assigned and the assignee is to be paid, and it continues to pay the assignor, the account debtor is liable to the assignee.” If New Style continued to pay Checkmate after receiving direction from Worthy to pay Worthy instead of Checkmate, the burden of double payment as between Worthy and New Style falls on New Style.


So, what does this mean? It means that New York is a safe haven for a secured party to pursue account debtors and recover on its collateral.

Those other jurisdictions that have taken a contrary view will likely be influenced by the precedent of this case even though the precedent is only binding in the State of New York – especially those misguided Federal Courts of Appeal that previously had no guidance.

So do we really need to celebrate this as a victory when a court issued a ruling that we long took as a basic tenet of secured lending?

Sure, why not?

Worthy Lending LLC v New Style Contractors, Inc. 2022 WL 17095585 (NY Nov. 22, 2022)

[1] Forest Capital v Blackrock, Inc., 658 Fed.Appx 675, (4th Cir., 2016)

[2] Durham Commercial Capital Corp v Ocwen Loan Servicing, LLC, 777 Fed.Appx. 952 (11th Cir., 2019).

[3] Note that New York’s “Supreme Court” is its trial court, while the Supreme Court of every other state is its highest court of appeals. New York’s highest court is its Court of Appeals.

[4] General Motors Acceptance Corp. v. Clifton-Fine Cent. School Dist., 85 N.Y.2d 232 (N.Y., 1995).

Reversal of Fortune

Revlon Lenders required to return unintended payoff to Citibank

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

He then describes uptiering:

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

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

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

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

The loan agreement provided:

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

It also provided:

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

The Court noted:

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

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

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

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

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

A Tale of Two Participations

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

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

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

The Court stated:

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

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

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

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

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

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

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

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

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

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

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

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