WurstCaseScenario

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.

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.

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, 11^th Cir., September 29, 2020 (2020 WL 5793082)

CAN A BANKRUPTCY DEBTOR BE A PPP BORROWER?

As we remain glued to the national and local news about return-to-work procedures and the effects that the pandemic has had on the worldwide economy, we take a look at an interesting decision that just came down from the Bankruptcy Court for the Western District of Tennessee.

The individual debtor filed his voluntary petition in December 2019. An operating trustee was appointed who asserted that as trustee he stepped into the debtor’s shoes as the shareholder of the debtor’s businesses. Alpha Visions Learning Academy, Inc. (Alpha), one of the debtor’s businesses, is a childcare center with 20 employees and about 70 children attending. As a result of the COVID-19 pandemic, attendance dropped and the trustee applied to the Small Business Administration (SBA) for a loan under the Paycheck Protection Program (PPP).

The trustee brought a motion and complaint seeking entry of a temporary restraining order, preliminary injunction and permanent injunction directing the SBA to consider Alpha’s PPP application without consideration of the debtor-owner’s bankruptcy proceedings. In addition, Alpha sought a declaration that SBA violated the Administrative Procedures Act and 11 USC Section 525(a) in excluding applications from entities who are in bankruptcy or who have an owner in bankruptcy.

The trustee alleged that the SBA made approval of any PPP loan expressly contingent on the applicant or any owner of the applicant not being “presently involved in any bankruptcy,” even though this condition is not articulated in the CARES Act that enacts the PPP, or in the Small Business Act. The trustee relied upon Section 525(a) of the Bankruptcy Code, which provides in part:

a governmental unit may not deny…a grant to…a person that is or has been a debtor under [the Bankruptcy Code]…solely because such…debtor is or has been a debtor…has been insolvent before the commencement of the case…or during the case but before the debtor is granted or denied a discharge, or has not paid a debt that is dischargeable in the case under this title or that was discharged…

The trustee argued that Section 525 applied because the PPP is by nature a grant rather than a loan because the debt is to be forgiven.

The SBA responded that the Small Business Act precluded the injunctive relief sought by the trustee, which provides that the SBA:

May…sue and be sued in any court…but no attachment, injunction, garnishment, or other similar process…shall be issued against the [SBA].

The SBA relied on a case from the Sixth Circuit Court of Appeals in asserting that the Small Business Act:

…provides basically that parties may proceed against the SBA but only as Congress has provided. [When the SBA brought] an action against a private party, and where that private party brings a counterclaim that implicates the SBA’s rights, the SBA’s rights are unaffected unless it is made a party to that action pursuant to the consent statute.

The SBA argued that the bankruptcy court’s authority to adjudicate Alpha’s Section 525(a) claim did not extend to its PPP claim, which did not arise under the Bankruptcy Code. The SBA said that it did not consent to the entry of a final judgment on the PPP claims.

The bankruptcy court, however, found that the SBA violated the Bankruptcy Code’s anti-discrimination provision when it directed lenders to refuse to accept PPP applications from entities owned by bankruptcy debtors. The court stated:

Perhaps nothing illustrates the arbitrariness and caprice of the bankruptcy exclusion rule better than SBA’s explanation. In order to implement a Congressional program intended to protect American workers from unemployment and loss of health insurance, SBA arbitrarily eliminated all workers employed by debtors in bankruptcy and all workers employed by entities whose owners are debtors in bankruptcy… In attempting to expedite the PPP application process, SBA chose a path that was diametrically opposed to its prior practice and the stated intention of Congress to provide funds for payroll, mortgage interest, rent, and utilities to struggling businesses. As the Administrator herself explained “no creditworthiness assessment is required for PPP Loans,” yet the explanation offered by SBA in its Opposition to Alpha’s Motion and Complaint is that it excluded bankruptcy debtors in order “reasonably to assure repayment.”…“Given the obvious purpose of the PPP, it was arbitrary and capricious for Defendant to engraft a creditworthiness test where none belonged.”

The court joined two other courts that considered similar claims in finding that the PPP “loan” is in the nature of a “license, permit, charter, franchise, or similar grant” without which a debtor’s fresh start would be impeded.

As there is no question that the only reason that Alpha’s application was turned away by Community Bank was the ruling by SBA that entities owned by debtors in bankruptcy are ineligible for the PPP program, the court finds and concludes that the SBA’s bankruptcy exclusion violates section 525(a) of the Bankruptcy Code.

The court ruled that the SBA violated the Administrative Procedures Act, 5 USC § 706(C), when it exceeded its rulemaking authority by excluding entities owned by bankruptcy debtors from the PPP program; 706(B), when it arbitrarily and capriciously excluded entities owned by bankruptcy debtors from the PPP program; and Section 525(a), when it directed lenders to refuse to accept PPP applications from entities owned by bankruptcy debtors.

Various courts that have considered these issues have determined that the PPP is not a loan program:

It is a grant or support program. The target grant recipients are small businesses in financial distress. The PPP could only be offered by the government; private lenders do not give away money. PPP funds “are unobtainable from the private sector.” … They also are essential to Plaintiff’s fresh start. … Of all the benefits a government can grant, free money might be the best of all. Denying Plaintiff access to PPP funds solely because it is a debtor violates § 525(a).

Free money? 

Alpha Visions Learning Academy, Inc., v. Jovita Carranza, in her Capacity as Administrator for the United States Small Business Administration, Defendant (Bankr. WDTN) 2020 WL 2893413

I have a distaste for lender against lender litigation.  That goes for any financial institution for that matter.  Perhaps it comes from the doctrine of not airing one’s dirty laundry.  I am reminded of this from a decision that came down this Monday (March 2, 2020, for those reading this in reprint) by the US District Court for the S.D. Indiana.  No one gains from these types of lawsuits. 

If the following story bores you (and it should not) please do read the penultimate statement at the end.

BMO Harris Bank was financing a construction project for its customer, North & Maple LLC, with Midwest Form Constructors, LLC as the general contractor.  Throughout most of the project BMO Harris funded advances to Midwest’s account at Salin Bank and Trust Company to be used for the completion of the construction project.  At some point North & Maple notified BMO Harris to no longer send loan advances to Midwest but instead, to send them to Atlas Funds Control, LLC, the agent for Midwest’s bonding company.

However, when BMO Harris received instructions to transfer funds to Atlas, BMO mistakenly wired the funds to Midwest’s account at Salin.  Salin accepted the wire transfer and credited the funds to Midwest’s bank account and then withdrew most of it as a setoff to credit an outstanding loan made by Salin to Midwest. 

BMO promptly issued a recall request advising Salin of the mistake and demanding that the wire be returned.  Salin did not and instead, completed the setoff transaction.  Salin did this even though it had full knowledge that Midwest was having financial problems.  BMO claimed that Salin knew, or should have known, that the transfer was mistakenly sent to Salin.

BMO Harris brought an action against Salin for unjust enrichment, conversion and replevin.  Salin moved for judgment dismissing the action relying on Article 4A of the Indiana Uniform Commercial Code (yes, the UCC has more than Article 9), arguing that was the exclusive source of rights for financial institutions participating in the federal wire transfer system.  The court began with an examination of the Article 4A definition of a fund transfer:

 [T]he series of transactions, beginning with the originator’s [North & Maple] payment order, made for the purpose of making payment to the beneficiary [Midwest] of the order. The term includes any payment order issued by the originator’s bank [BMO Harris] … intended to carry out the originator’s payment order. A funds transfer is completed by acceptance by the beneficiary’s bank [Salin] of a payment order for the benefit of the beneficiary of the originator’s [North & Maple] payment order.

Keep in mind that North & Maple’s payment order was for the funds to go to Atlas – not Midwest.  The Court went on to consider Section 211 of Article 4, which provides:

(a) A communication of the sender [also North & Maple] of a payment order canceling or amending the order may be transmitted to the receiving bank [Salin] orally, electronically, or in writing[.]

(b) Subject to subsection (a), a communication by the sender [North & Maple or BMO standing in its shoes] canceling or amending a payment order is effective to cancel or amend the order if notice of the communication is received at a time and in a manner affording the receiving bank a reasonable opportunity to act on the communication before the bank accepts the payment order.

(c) After a payment order has been accepted, cancellation or amendment of the order is not effective unless the receiving bank [Salin] agrees or a funds-transfer system rule allows cancellation or amendment without agreement of the bank.

The Court then turned to case law from other districts, focusing on a New York case:

“[P]arties whose conflict arises out of a funds transfer should look first and foremost to Article 4A for guidance in bringing and resolving their claims[.]” …. If a situation is unequivocally covered by particular provisions in Article 4A, then it is beyond debate that Article 4A governs exclusively. …. However, courts should not interpret this directive to mean that Article 4A has “completely eclipsed” the applicability of common law in the area of funds transfers. …. (Article 4A “does not establish a legislative intent to preclude any and all funds transfer actions not based on Article 4A”); ….(holding that Article 4A did not preempt common law claim when the UCC was “silent” as to the factual scenario alleged); …. Rather, preemption likely does not foreclose common law claims related to funds transfers when the disputed “conduct or factual scenario is not addressed squarely by the provisions of [Article 4A].”

The Court went on to conclude:

Article 4A does not squarely address BMO’s allegations and thus does not preempt the common law claims presented.

However, that did not end the case: it only denied the motion to dismiss.  BMO Harris still needs to prove its case – especially that Salin knew of Midwest’s financial distress and that BMO would no longer be sending wires to Midwest. 

Perhaps reasonable minds will prevail and the banks will recognize their risks and reach a settlement.

BMO erred and Salin took advantage of it.  There was a time when financial institutions would not seize upon an opportunity like this.  Disputes such as these reflect poorly on the industry and only help to fuel borrowers’ claims against lenders.

Here comes the penultimate statement.

How could they have avoided airing their dirty laundry?  Arbitration. With arbitration the same result could have come about but without the notoriety of having the decision made public.  Yes, one of the major benefits of arbitrating disputes is that the process may remain confidential.  Had these parties submitted their dispute to arbitration those of you thinking “How dumb” or “How greedy” would never have known of this. 

You will be reading more on these pages about using arbitration in commercial finance disputes.  Its time has come.

BMO Harris Bank N.A. v Salin Bank and Trust Company, 2020 WL 998657, (SD Indiana, March 2, 2020)