WurstCaseScenario

Is an account debtor that is a unit of a state government that received notification under UCC 9-406 to make payment to a factor obligated to honor such notification? 9-109 of the UCC addresses the Scope of Article 9. It provides: “[t]his chapter does not apply to … [a]ny transfer by a government or governmental unit.” A Florida appellate court just addressed that issue. Read on to see how it turned out.

The most basic principle in commercial finance law is the right to place account debtors on notice and to rely on the effectiveness of such notice. Account debtors that fail to abide by the notification remain obligated to the assignee of the account- the secured party.

In the Florida case the debtor provided roadside assistance to the Florida Department of Transportation. The factor provided the Department with notification that the debtor’s accounts had been assigned to the factor and that all future payments should be made to the factor. The notification stated that payment to any other party would not discharge the Department’s obligations on the accounts.

9-406 provides in part:

“[A]n account debtor on an account, chattel paper, or a payment intangible may discharge its obligation by paying the assignor until, but not after, the account debtor receives a notification, authenticated by the assignor or the assignee, that the amount due or to become due has been assigned and that payment is to be made to the assignee. After receipt of the notification, the account debtor may discharge its obligation by paying the assignee and may not discharge the obligation by paying the assignor.”

Although it received the notices, the Department nonetheless continued to pay the debtor and refused to pay the factor. The Department claimed that governmental account debtors were outside the reach of 9-406. It noted that 9-109(4)(n) provided: “[t]his chapter does not apply to … [a]ny transfer by a government or governmental unit.”

The Department argued that because its payments on the accounts receivable involved transfers of money by a governmental unit, the so-called government-transfer exception in 9-109(4)(n) prevented 9-406 from regulating how it may discharge its contractual obligation for the services rendered to it by the debtor.

The court noted that if the provisions of 9-406 could be read to “apply to” a “transfer” by a governmental unit where the governmental unit was merely an account debtor making a payment to the assignee of an account receivable rather than the assignor of that account, then the Department’s argument would be correct. But, the court explained that the plain language of section 9-109 excluded this construction.

The court went on to consider whether an account debtor’s payments on accounts receivable in accord with 9-406 are transfers to which Article 9 is being applied. Put differently, the question was whether an account debtor’s payments on accounts receivable are objects of 9-406.

The court determined that the statutory text showed that the transfer to which the statute applies—the transfer that is the object of the statute—is a transfer of accounts, chattel paper, or payment intangibles and not a transfer of money as payment to satisfy an account debtor’s obligation on one of those items.

The court concluded that the government-transfer exception created by section 9-109(4)(n) “by its own terms, is not implicated by the mere fact that the government happens to be an account debtor required to make a payment on an account, chattel paper, or payment intangible that has been assigned.”

The court went on to note that it would have reached a different conclusion had the government sold such assets:

“Article 9 generally applies to such sales, and the sale of an account, chattel paper, or payment intangible by a governmental body would be a transfer of that asset, which would be a transfer by a governmental unit within the meaning of [9-109(4)(n)]. That circumstance, however, is not what the facts of this case present. Here, the accounts receivable were sold [to the factor], and the Department, as the governmental account debtor, was owed notice of the sale under the statute for the purpose of sending the same payments it always owed. The text of [9-406] shows that its object—the thing it applies to—is the assignment of accounts, chattel paper, and payment intangibles. In this case, that occurred through a sale of accounts receivable by a nongovernmental entity, not the payment on those accounts by a governmental one.”

Conclusion — factor wins and the Department was subject to a double pay.

Assignees of state government receivables can take comfort in this ruling as it protects the integrity of their 9-406 (and 9-607) notifications to state government divisions.

CAVEAT: Do not confuse this ruling concerning notification to a state government with notification to a federal governmental unit which is covered by the Federal Assignment of Claims Act which, although can achieve the same result, is a bit more technical and cumbersome in effecting notification.

Imagine this. Your institution, along with four others, purchased participation interests in a loan to a hotel secured by liens on all of the hotel’s real and personal property. So far you are thinking, “So what?”

Now imagine that the loan goes into default and the borrower surrenders its collateral to the lead. Nothing yet, huh?

Then the lead and the participants enter into a management agreement with a hotel management company. Still looks ok?

The lead on the eve of failure sells all of its right, title and interest to Bank2 via a quitclaim deed and then surrenders its assets to a trustee. Got your interest now? It gets more interesting.

Bank2 then brings an action against the trustee and the 5 participants seeking a declaratory judgment that Bank2 owns the entire fee interest in and to the hotel and its personality. To make matters worse, Bank2 acknowledges that it knew about the participations yet insists that its purchase was for the entire interest.

The question arises whether the participants merely had an interest in the payment intangible – the flow of funds and any funds to be derived from the liquidation of the collateral. Once the borrower surrendered the collateral to the lead, and the lead sold the collateral, did the participants retain an interest in the proceeds received by the lead or its trustee? Did they retain their undivided interest in the fee transferred to Bank2? Did Bank2 buy its interest free and clear of or subject to the interests of the participants?

These are the underlying facts and issues addressed in the March 2, 2017 decision of the Supreme Court of Iowa. Central Bank etc. v Thomas C. Hogan, as Trustee et al, 2017 WL 836824.

Central Bank (Bank2 in our intro) claimed that the participations were not true sales but instead merely a loan. The Court disagreed finding that the participation agreement contained the requisite indicia of a true sale.

It is also noteworthy that the lead sold its right, title and interest and not the entirety of the fee interest. Clearly the lead lender believed that it was buying the entirety and possibly paid a steep price for a roughly 55% undivided interest when it may have thought it was getting a bargain.

In November 2015, the FDIC published its Advisory on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations. That is a MUST READ for those of you trading in participations.

A significant case concerning the rights of participants and lenders has been pending in the Bankruptcy Court for the Eastern District of New York (in re Oak Rock Financial LLC). Oak Rock was a lender that borrowed funds from a syndicate of lenders and also sold participation interests to others. This litigious matter has already put down some significant decisions but the big question remains: were the participations subject to or free of the liens of the loan syndicate? You can expect to see more on these cyber pages once a decision comes down.

I am seeing more participation activity than I have seen in years. For quite a while it appeared that participations had given way to syndications – and after some ugly situations a decade or two ago, perhaps they should. Notwithstanding, lenders continue to sell and investors continue to buy participation interests.

If you want to learn more about participations I (and some really smart lawyer friends) will be presenting a webinar on the subject on Tuesday, March 21 at 1 pm ET. Register at Webinar (If you miss the live presentation it will be available on demand) or you can attend in person if you write to me at [email protected]

I am attending the 2017 LendIt conference in New York along with some 5,000 other attendees made up of consumer and small business lenders, traditional banks that are partnering with or are considering partnering with FinTech lenders, marketplace investors and others.

This online FinTech lending world has grown exponentially as has the attendance at this still reasonably young conference which is presented annually in each of the US, Europe and Asia.

Last year there was a good deal of banter in the halls of the conference with concerns of how a new administration in Washington would treat online lending and what regulation would come along with the new regime. This year, however, many of the lenders are even giddy over what they envision to be a laissez faire Trump Administration, at least as far as regulation of small business and online consumer lending goes.

Where state and federal regulators have long been the watchdog when it came to consumer lending in general they were hands off when it came to commercial lending, including most small business lending. Since last year we have seen states accelerate their regulatory arms into the small business lending world as online practices have gained the attention of states’ attorneys general and legislatures.

Typically small business loans are supported by personal guaranties, not only by the business owner, but often by his or her spouse who may have little or no knowledge of the business and who may not have the sophistication assumed to be had by business operators. As guarantors and their spouses have fallen victim to predatory lending practices where interest rates might exceed one hundred percent per year, and guarantors and their families have lost their homes and their life savings, there has been an outcry from state agencies to step into roles that the Feds might otherwise have assumed. That is not to say that interest rates will reflect the lender’s risk in making the loan, however, at some point an interest rate may just be too much.

We are seeing more and more situations where new players in the lending world have gotten so aggressive in their lending practices that regulation, whether by the Consumer Financial Protection Bureau or other Federal or state regulators, is likely to change the landscape of commercial lending. California, New York, Illinois and other states are moving ahead at least with closer scrutiny of online small business lenders and it must be expected that more and more states will be stepping up their roles as well.

Bad facts engender bad law. The egregious facts that are bringing about this change may be justified for the conduct of bad lenders. Unfortunately the end result will be that the good lenders will be subject to the same regulation, and the costs inherent with such regulation will result in higher costs to the borrower who will have less access to responsible lenders.

I hope to hear these issues addressed at LendIt. If not, it is time they make these issues a priority for future conferences.

Lenders’ Rights to Post- Confirmation Default Interest

Click HERE read my most recent article published by ABF Journal.

 

Lenders expect that their borrower will be responsible to pay the lender’s legal fees in all matters arising out of the loan made or to be made to the borrower.  However, under what is generally referred to as the American Rule, each party is obligated to pay its own legal costs unless there is an agreement for one party to pay the other party’s legal costs or if there is a statute that provides that the other party is to pay such expenses.

As a result, when they do not have an agreement to rely upon for reimbursement of legal costs, creative lawyers often attempt to recover under statutes such as the Racketeer Influenced and Corrupt Organizations Act (RICO) or similar statutes to shift the burden to pay (and better assure that they get paid) to deeper pockets.

Lenders have long included broad indemnity provisions in our loan documents making the borrower liable for the lender’s costs and expenses including its reasonable attorneys’ fees and costs.  But are those provisions broad enough to allow the lender to recover its legal costs in all situations?  Obviously not, or I would have nothing to write about today.

Courts have held that the written agreement must “evince an ‘unmistakably clear’ intention to waive the American Rule against prevailing parties’ recovery of attorneys’ fees…” (Wells Fargo Bank v Webster Business Credit).  The Wells Fargo-Webster case began with a claim asserted by Wells Fargo and others regarding the conduct of the administrative agent and later developed into a claim by Webster, as the administrative agent, to recover its attorneys’ fees and costs.

On appeal, the court held that the  contract

…. expressly contemplates third-party litigation against the lenders…without “clearly impl[ying]” that the parties intended the provision to provide for indemnification in litigation against each other …. This provision is fatal to defendant’s claim of inter-party indemnification for attorneys’ fees …..

I recently found myself confronting a community bank seeking to recover a substantial amount of attorney’s fees in connection with its efforts in a bankruptcy case.  At the time of the commencement of the bankruptcy case, and at all times thereafter, no default had been declared on the mortgage loan and no action was commenced.  The community bank appeared in connection with use of cash collateral and plan confirmation matters but did not assert any claim for attorneys’ fees until months after the debtor’s plan had been confirmed.

The attorney fee provision contained in the mortgage provided:

The Mortgagor will pay when due and payable all …, attorneys’ fees, … which have been incurred or which may hereafter be incurred by the Mortgagee in connection with the issuance of its commitment, the preparation and execution of loan documents and the funding of the loan to the Mortgagor secured hereby;

 Of course, the problem faced by the community bank was that the attorneys’ fees incurred during the bankruptcy were not for the issuance of any commitment, the preparation of documents or the funding of the loan which occurred years earlier.  In fact the attorney fee provision by its own terms would not have covered the community bank for its attorneys’ fees if it had to foreclose on the premises or sue the guarantor.

The provision did go on to provide that the borrower was obligated to

reimburse [lender] for ….., all claims, demands, liabilities, losses, damages, judgments, penalties, costs, and expenses (including, without limitation, attorneys’ fees) which may be imposed upon, asserted against, or incurred or paid by them by reason of, on account of or in connection with any bodily injury or property damage occurring in or upon or in the vicinity of the Mortgaged Property through any cause whatsoever or asserted against them on account of any act performed or omitted to be performed hereunder or on account of any transaction arising out of or in any way connected with the Mortgaged Property, or with the Mortgagee or any of the indebtedness evidenced by the Note, excepting for the gross negligence of the Mortgagee or its agents.

But it does not provide for attorneys’ fees incurred in negotiating a cash collateral order or even in foreclosing on the property.

The lesson here is to carefully review your attorney fee indemnification provisions contained in your agreements to assure that they are broad enough so that the legal fees you incur can be recovered from the other party.