WurstCaseScenario

Once upon a time (before the time of computer-based loan documents) asset-based lenders utilized a pre-printed 4-page Security Agreement (Accounts Receivable) and similar documents to immortalize their agreements with their borrowers.  These agreements were printed on a single 11×17 piece of paper with a cover page (titled Security Agreement (Accounts Receivable) and identification of the parties), 2 pages of terms and conditions (in 20 or so paragraphs) and page 4 – the critical last page after the fold, the Guaranty.

These pre-word processing agreements were rarely negotiated except for a rare change typed in the margin by iteration with an asterisk to note the place of the change.

Life was simple and, unlike today, lawyers were not making a living negotiating ABL loan agreements.

Page 4 remained the critical document, conveniently hidden on the last page and containing critical waivers that protected the lender should the borrower or its principal do the wrong thing.

As a practitioner in the twenty-first century I enjoy making a living when borrowers attempt to negotiate the most mundane terms of a Loan and Security Agreement.  I am skilled at finding a middle ground protecting my lending clients while accommodating a language issue raised by borrower’s counsel who is demonstrating his worth to his borrower client.

But when it comes to negotiating terms of a Guaranty, I am reminded of my mentor when I was cutting my teeth as an ABL lawyer, who said to a borrower trying to negotiate a guaranty: “Do you want to borrow my money? Are you going to pay it back? Then just sign the agreement.”

A recent decision out of the Superior Court of Pennsylvania, is indicative of the power of the personal guaranty.

Borrower obtained a loan from Lender, which was secured by a note giving Lender a lien and security interest in Borrower’s asset (i.e., the collateral for the loan). In pertinent part, the Lender’s note provided that Borrower would pay the outstanding balance and interest by a certain date or a default would occur under the note.

The Borrower’s principal gave a guaranty, which provided (in part):

For good and valuable consideration, Guarantor absolutely and unconditionally guarantees full and punctual payment and satisfaction of Guarantor’s Share of the Indebtedness of Borrower to Lender, and the performance and discharge of all Borrower’s obligations under the Note and the Related Documents. This is a guaranty of payment and performance and not of collection, so Lender can enforce this Guaranty against Guarantor even when Lender has not exhausted Lenders remedies against anyone else obligated to pay the Indebtedness or against any collateral securing the Indebtedness, this Guaranty or any other guaranty of the Indebtedness. Guarantor will make any payments to Lender or its order, on demand, in legal tender of the United States of America, in same-day funds, without set-off or deduction or counterclaim, and will otherwise perform Borrowers obligations under the Note and Related Documents.

The guaranty also specifically stated that the:

 Guarantor also waives any and all rights or defenses based on suretyship or impairment of collateral…. [and the guarantor also] waives and agrees not to assert or claim at any time any deductions to the amount guaranteed under this Guaranty for any claim of setoff, counterclaim, counter demand, recoupment or similar right, whether such claim, demand or right may be asserted by the Borrower, the Guarantor, or both

These very standard guaranty provisions should never be overlooked or negotiated away.

We will save you the gory details of this case other than to point out that the guarantors claimed that the guaranty and the related agreements were against public policy.  The Court ruled:

Public policy is more than a vague goal which may be used to circumvent the plain meaning of a statute. …

Public policy is to be ascertained by reference to the laws and legal precedents and not from general considerations of supposed public interest. As the term “public policy” is vague, there must be found definite indications in the law of the sovereignty to justify the invalidation of a contract as contrary to that policy. Only dominant public policy would justify such action. In the absence of a plain indication of that policy through long governmental practice or statutory enactments, or of violations of obvious ethical or moral standards, the Court should not assume to declare contracts contrary to public policy. The courts must be content to await legislative action.

It is only when a given policy is so obviously for or against the public health, safety, morals or welfare that there is a virtual unanimity of opinion in regard to it, that a court may constitute itself the voice of the community in so declaring. There must be a positive, well-defined, universal public sentiment, deeply integrated in the customs and beliefs of the people and in their conviction of what is just and right and in the interests of the public weal. Only in the clearest cases, therefore, may a court make an alleged public policy the basis of judicial decision.

The court declined to follow the guarantors’ suggestion recognizing that UCC section 3-605 explicitly permits a separate agreement of a party to waive the defense of impairment of collateral.

Appellants signed separate agreements—the guaranties—explicitly waiving “any and all rights or defenses based on suretyship or impairment of collateral….. [Guarantors] have not argued they are not parties. Accordingly, after construing the plain language of the statute, as we must, …because [Guarantors] signed separate agreements providing for waiver, section 3605 does not permit [Guarantors] recourse. [citing UCC -3605(i)(2)].

[Guarantors] however, argue that their waiver—notwithstanding the language of section 3605—violates the … UCC’s anti-waiver provisions. ….[Guarantors], however, have not presented any argument addressing the present version of Article 9 and any pertinent anti-waiver provisions. Absent any such argument, it would be inappropriate for us to adopt the[ir] reasoning …

Bottom line is that the guaranties were upheld and the Lender was entitled to recovery.

Always keep in mind the value of a personal guaranty.  Whenever a borrower protests the terms of a guaranty I am reminded of the wisdom of my client-mentors when I was cutting my teeth as an ABL lawyer, “Do you want to borrow my money? Are you going to pay it back? Then just sign the agreement.”

In these times of extraordinary competition and the need to employ funds are you willing to ignore that sound advice?

 

 

1. Michael Hartley and S. Kent Hartley v. Stephen J. Hynes, Douglas J. Hynes, Leslie A. Hynes and Midlantic Erectors, Inc. (October 19, 2018) 2018 WL 5093975

Borrower made an assignment for the benefit of creditors and assignee briefly operated the business pending an auction.  Following the auction conducted by the assignee, Bank brought an action against Guarantor for a deficiency judgment as well as for actual fraud.  The fraud claim was dismissed after the Bank presented its case, but the deficiency judgment was granted.

Guarantor appealed arguing that (1) he did not owe a deficiency because the trial court improperly applied the law regarding the commercial reasonableness of the disposition of Borrower’s assets at the auction and because the disposition was not commercially reasonable, and (2) in the alternative, the trial court erred in calculating the amount owed in the deficiency judgment.

The Guarantor later argued that the assignor/auctioneer was acting as an agent of the Bank.

The Bank responded by pointing out that it had no duty to show the sale was commercially reasonable because it did not market or sell Borrower’s assets, the assignee handled the liquidation of Borrower, including the sale of assets. The Bank asserted in the alternative that even if it had to establish the question of commercial reasonableness, the evidence in the record established that the sale was commercially reasonable. The Bank also maintained that the trial court did not err in calculating the deficiency judgment.

The record demonstrated that the Borrower opted to enter into an assignment for the benefit of creditors to wind down the business and that the Bank suggested that Borrower retain the assignee. The Borrower’s board of directors and shareholders executed a trust agreement and an assignment for the benefit of creditors which specifically named the assignee.

The Borrower transferred its property to assignee “so that the property so transferred may be expeditiously sold or liquidated” with the proceeds distributed to creditors. Pursuant to the ABC, a trust was created and “its object shall be the orderly liquidation of assets and property of [Borrower] and the distribution of the proceeds of the liquidation to creditors of [Borrower.]” Assignee’s duties were to sell and dispose of secured creditors’ collateral, pay the unsecured creditors off with funds not subject to any valid liens, and “to do and perform any and all other acts necessary and proper for the orderly liquidation or other distribution *** and the distribution of the proceeds therefrom to the creditors of Borrower.

The trial court addressed Guarantor’s counsel, stating:

The problem you have, is that there just is inadequate testimony that had [assignee] acted in a different way, or the bank acted in a different way, there would have been a different result.

The appellate court, wrote:

[The UCC] provides that, “[a]fter default, a secured party may sell *** or otherwise dispose of any or all of the collateral ***.” Unless there is an agreement to the contrary, the debtor is liable for any deficiency that results from the sale ***. Absent such an agreement, the only defenses available to a debtor against a deficiency judgment are lack of reasonable notice of the sale and commercial unreasonableness of the sale.

The court further stated:

An assignment for the benefit of creditors is a voluntary transfer by a debtor of [its] property to an assignee in trust for the purpose of applying the property or proceeds thereof to the payment of [its] debts and returning the surplus, if any, to the debtor. ***A debtor may choose to make an assignment for the benefit of creditors, which is an out-of-court remedy, rather than to petition for bankruptcy, because assignments are less costly and completed more quickly.*** The assignment is  ‘a unique trust arrangement in which the assignee (or trustee) holds property for the benefit of a special group of beneficiaries, the creditors.’ *** The assignee owes a fiduciary duty to the creditors. Absent some defect in the creation of the assignment itself, an assignment passes legal and equitable title to the debtor’s property from the debtor to the assignee. In such case, the assignment is valid without the consent of any of the debtor-assignor’s creditors

The appellate court affirmed the trial court’s rejection of Guarantor’s argument that the assignee was an agent for the Bank, finding that Borrower retained the assignee and that under the UCC a disposition by an assignee for the benefit of creditors is, by statute, commercially reasonable.

Even if the Bank was required to prove that the sale ***was commercially reasonable, section 9-627(c)(4) provides that a sale approved by an assignee for the benefit of creditors *** is commercially reasonably. “Every aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.” *** “commercially reasonable” means that the disposition is made: (1) in the usual manner on any recognized market; (2) at the price current in any recognized market at the time of the disposition; or (3) otherwise in conformity with reasonable commercial practices among dealers in the type of property that was the subject of the disposition. *** Whether a sale is commercially reasonable is a question of fact.

So what are our takeaways from this case?

• A lender will not be liable for commercially unreasonable disposition of collateral if it did not sell the assets.
• The assignee (or consultant) retained by the borrower (and approved by its board and officers) will not be deemed to be an agent of the lender.
• The assignee in an ABC owed a fiduciary duty to the creditors of the assignor.
• Notwithstanding, a sale by an assignee in ABC is commercially reasonable by statute.

The court noted that ABCs are less costly and completed more quickly.  This method of liquidating a company has had a significant renaissance in recent years for this very reason.  Where small and middle market Chapter 11 cases once dominated the Bankruptcy Court dockets they are now rare.  Small and middle market companies just cannot afford to go bankrupt.

This case is a good example of how ABCs are effectively taking the place of small and middle market liquidating Chapter 11s and the benefits of that process.

 

MB Financial Bank, as successor in interest to American Chartered Bank v. Clayton D. Jacobs and Dwyer Products Corp., Appellate Court of Illinois, August 23, 2018, 2018 IL App (1st) 171939-U

It is common for parties to include provisions that prohibit the assignment of a document or the rights thereunder.  Section 9-408 is entitled Restrictions on Assignment of Promissory Notes, Health-care Receivables, and Certain General Intangibles Ineffective.  In fact the Official Comments to 9-408 states:

This section makes ineffective any attempt to restrict the assignment of a …. promissory note, whether the restriction appears in the terms of the promissory note…….

9-408 states, in part:

… a term in a promissory note … which term prohibits, restricts, or requires the consent of the person obligated on the promissory …. the assignment or transfer of… the promissory note, … is ineffective to the extent that the term:

A recent decision from the Delaware Bankruptcy Court sheds light on why you may not take comfort in the protection described in the Official Comment.

The Delaware case involved the proof of claim filed by a purchaser of three notes. The Debtor objected to the claim on the grounds that the notes were not assignable.  The Note provided:

Neither this Note, the Loan Agreement ….. nor all other instruments executed or to be executed in connection therewith . are assignable by Lender without the Borrower’s written consent and any such attempted assignment without such consent shall be null and void.

The Court noted that claims trading has changed the face of bankruptcy and that the claims trading industry is “robust and fruitful” and added: that

Delaware courts, while ‘recognize[ing] the validity of clauses limiting a party’s ability to assign its rights, generally construe such provisions narrowly because of the importance of free assignability.’

However, the Court focused on the distinction between the power to assign and the right to assign.

Citing a prior decision the Court said:

When a provision restricts a party’s power to assign, it renders any assignment void.  . However, in order for a court to find that a contract’s clause prohibits the power to assign, there must be express language that any subsequent assignment will be void or invalid. Without such express language, the contract merely restricts the right to assign.

The Court concluded that by including the language contained in the Note – “attempted assignment without such consent shall be null and void” – denied the seller of the Note the power to assign, rendering the assignment void.

The buyer of the Note argued that the anti-assignment provision should not be effective because the debtor breached the terms of the note and its loan agreement.  The Court dismissed this argument.

The Court then engaged in an analysis of 9-408 that we believe to be flawed, and we will not discuss it here.

The Court concluded that the anti-assignment clause denied the seller the power to assign and was legally binding.  Thus, the Court held that the transfer of the Note was void.

Had the agreement between the seller and the buyer provided that the buyer could  enforce  the seller’s rights in the Note, the outcome may have been different.  Instead, the debtor’s objection to the proof of claim filed by the buyer was allowed and, we assume, that the time for the seller to file a proof of claim had passed, resulting in a windfall to the debtor’s estate at the expense of the buyer of the notes.

The point is that when taking a note (or other included obligation) by assignment be sure to do sufficient due diligence to assure that the seller of the note has the power to assign.

 

In re Woodbridge Group of Companies, LLC, 2018 WL 3131127, June 20,2018

Return with us now to those thrilling days of yesteryear.  Err, that is prior to July 1, 2001, when the “old” Article 9 of the UCC reigned.  Under “old” Article 9 (Section 9-203) a security interest was enforceable when it attached but it did not attach until “…the debtor has signed a security agreement which contains a description of the collateral…,” value has been given and the debtor has rights in the collateral.

“New” Article 9 (also Section 9-203) treats this in a similar manner.  Again the security interest becomes enforceable when it attaches and is enforceable only when value has been given,  the debtor has rights in the collateral and the power to transfer such rights and “the debtor has authenticated a security agreement that provides a description of the collateral….”

Note that the collateral description requirements for the security agreement resembled the requirements for the collateral description in the financing statement.

“Old” 9-110 provided that the collateral description of personal property in a financing statement was sufficient if it reasonably identified the collateral even if the description was not specific.  The Official Uniform Comment to that section specifically did away with prior holdings “that descriptions are insufficient unless they are of the most exact and detailed nature…”  Clearly the intent was to assure that the collateral description was clear while not making descriptions unduly burdensome.

“New” Article 9 broke this out differently.  A financing statement sufficiently indicates collateral it covers if the statement provides “(1) a description of the collateral pursuant to section 9–108 [relating to sufficiency of description]; or (2) an indication that the financing statement covers all assets or all personal property.”  9–504(1)–(2)  Remember the financing statement perfects the security interest but the security agreement is part of the attachment of the security interest.

Those of us who practiced under “old” Article 9 recall filing financing statements with pages of addenda describing the collateral.  It was not uncommon for the filing officer to misplace the attachments when saving the financing statements to microfiche. Some careless drafters included in the collateral description a statement such as “see attachments”.  Thus, when the attachments were lost problems arose.  The “all assets” description on financing statements cured this nightmare.

“New” Article 9, however, provides that a description of personal property in the security agreement is considered sufficient whether or not it is specific, if “it reasonably identifies what is described.”  9–108(a) Examples of reasonable identification include identification by specific listing, category, quantity, or any other method which makes the identity of the collateral objectively determinable. 9–108(b)(1)–(6) Super generic phrases such as “all assets” or “all personal property” are not sufficient to describe collateral in a security agreement.  9–108(c), comment 2.

In order to assure that the collateral description is sufficient I advise my clients to start with the UCC definition of “general intangible” which means “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction. The term includes payment intangibles and software.”  Count them – thirteen collateral types that are sufficiently described.

In a recent decision from the Bankruptcy Court for the Eastern District of Pennsylvania, Judge Chan followed this logic in considering whether M&T Bank held a valid lien on a debtor’s liquor license.

Initially Judge Chan considered whether a liquor license is property or a personal privilege under Pennsylvania law.  In doing so, she cited a 1986 (e.g. “old” Article 9) decision from the Third Circuit Court of Appeals, which held that:

although a liquor license is not property subject to attachment under Pennsylvania law, it is property that may be subject to a federal tax lien.

However, Judge Chan noted that in 1987 the Pennsylvania Legislature amended its laws adding a section stating that:

[t]he license shall constitute a privilege between the board and the licensee. As between the licensee and third parties, the license shall constitute property.

Accordingly, she ruled that the liquor license was property under Pennsylvania law.

Next, she needed to consider whether the collateral description contained in the security agreement sufficiently covered the liquor license.  She noted that

[t]he Security Agreement describe[d] the collateral as general intangibles limited to Liquor License …. Therefore, M & T’s security interest did attach to the Liquor License because the Security Agreement met all three requirements to make it enforceable against the Debtor and third parties.

The Bankruptcy Trustee (challenging M&T’s security interest), relying on a 1975 ruling of the Pennsylvania Supreme Court, argued that the collateral description contained in the UCC-1 Financing Statement did not sufficiently describe the collateral.    The Court, however, noted that:

M & T’s UCC–1 indicates that “the financing statement covers the following collateral: All assets of the debtor, whether now existing or hereafter acquired or arising, wherever located.

The Court went on to state:

Since the revised Article 9 superseded the former Article 9 under which [the 1976 case] was decided and M & T’s UCC–1 was filed after Article 9 was revised, it is clear that [the 1976] does not control the disposition of this case and M & T properly perfected its lien in the Liquor License by using a super generic description to describe its collateral.

Thus the Court concluded that Pennsylvania law clearly allows third parties to create security interests in Liquor Licenses and that M & T followed all the requirements to create and perfect a lien on the Liquor License and is entitled to proceeds from its sale in the amount of its secured claim.

The lesson?  Collateral descriptions in security agreements reasonably describe the collateral but the collateral description in a UCC-1 financing statement may be supergeneric.  Just as the UCC says!

 

In Re B & M Hospitality LLC, 2018 WL 1635228, Bankr. E. D. PA. April 3, 2018.

 

This issue of WurstCaseScenario takes a different direction from our typical case study and, perhaps, delves into prognostication.

Ask anyone and he or she will tell you that this economic boom won’t last forever.  But when will it come to an end?  Or has it already ended?

This boom economy is now in its ninety-third month.  It is amongst the longest recorded expansion periods in our history.

Corporate Debt is at the highest levels since the 2008 recession.  Defaulted loans remain very low.  This is probably a result of historically low interest rates.  But interest rates are now on the rise.  The Fed raised interest three times in 2017 and is on track to raise interest three or four times this year.

The Dow Jones Average hit its all-time high on January 26 at 26,616.71.  Its low for this year occurred on March 23^rd when it closed at 23,533.20.  Yesterday, it closed at 24,024.13.

This past Monday, Caterpillar commented that its first quarter profits “will be the high-water mark for the year” and stock prices immediately tumbled followed by some modest upticks as the week progressed.

Logic says that a recession is on the horizon, but when will it come and what can we do to get prepared?

In December, 2006, we were in a similar situation.  The economy was strong.  Turnaround professionals were like the Maytag Repairman.  There was no downturn in sight.  That was the last time I ventured into predicting the economy (note:  I am not an economist and never took a course in economics.  Everything I learned about economics I learned from Father Guido Sarducci’s Five Minute University).   At the request of Dow Jones, I published an article in its Daily Bankruptcy Review Small-Cap addressing the softness in the turnaround industry, concluding with encouragement to turnaround practitioners: “Get ready. It is coming. Your skills will be needed — at least we turnaround professionals hope they will.”  You all know what followed a few months later.

I suspect that we are in a similar time.  From my experience, just prior to upticks in loan defaults, fraudulent activity starts to occur.  Remember, desperate people do desperate things.  Increased interest rates are picking away at your borrower’s available cash and as their cash dries up some may find themselves getting desperate.

What can you do?

First, increase your fraud radar!  Be a bit more suspicious (without showing it) and be sure to verify, especially the unusual transactions and adjustments.

Watch out for increased aging of receivables, drops in sales, increased concentration, decreases in inventory purchases, etc.  Each of these on its own is probably not a problem, but when they come in combinations you do need to take a closer look.

The earlier you catch a problem the less likely it is that you will get hurt and more likely that you can save your borrower.

Encourage your borrowers to discuss their business challenges with you.  They need to see you as someone who can assist them when times get difficult.  You have more experience with companies entering or in financial distress.  With your assistance, the borrower will be in a better position to effect a turnaround before it gets too deep into trouble.

Be sure that once you have identified a problem and you need (and are willing) to make adjustments to the way you lend to that borrower, that you do so under a Forbearance Agreement that provides protections to you should the relationship deteriorate as you travel down the workout trail.

Next issue of WurstCaseScenario will return to discussions about court decisions and how they affect you.  I thought that this was the right time to sensitize you to what many see coming down the horizon so to better assure that you are ready for it.