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Ninth Circuit Decides Issue of First Impression, Protects Insider Guarantor from Preference Liability

May 21, 2015

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In a case of first impression for any district or appellate court, the Court of Appeals for the Ninth Circuit (the “Court”) held that “when an insider guarantor has a bona fide basis to waive his indemnification rights against the debtor in bankruptcy and takes no subsequent actions that would negate the economic impact of that waiver, he is absolved of any preference liability to which he might otherwise have been subjected.” As discussed below, the case provides a list of factors for courts to consider in determining whether an indemnification waiver should be considered valid for purposes of exempting an insider guarantor’s preference liability.

In Stahl v. Simon (In re Adamson Apparel, Inc.), the Court decided whether a personal guarantor of corporate debt may be liable for preferences where that guarantor is an insider of the debtor but validly waived his rights to indemnification against the debtor. The debtor Adamson Apparel, Inc. (the “Company”) was the borrower under a multi-million dollar loan. The Company’s President and CEO Arnold H. Simon (“Simon”) personally guaranteed the Company’s obligations under the loan. At the same time, Simon waived his rights against the Company for indemnification, for reimbursement of any amounts Simon paid against the loan.

Prior to filing bankruptcy, the Company executed a large sale of its merchandise to a third party for approximately $5 million. The Company instructed the merchandise purchaser to transfer the purchase price directly to the Company’s lender, in partial satisfaction of the debt. A few months thereafter, Simon personally paid the balance of the loan, equal to approximately $3.5 million.

Six months after Simon paid off the loan, the Company filed for Chapter 11 bankruptcy, and the Committee of Unsecured Creditors (“Committee”) filed a lawsuit against Simon claiming he was liable for preferential payments. The Committee’s lawsuit theorized that the $5 million debt payment by the Company (via the merchandise sale) amounted to a preference in favor of Simon, because it reduced Simon’s debt under the loan by the same amount.

The key question was whether Simon was a “creditor” of the Company. Bankruptcy Code Section 547(b) sets the parameters of preference liability, and those parameters state that a preference exists only if, among other things, the debtor transfers property “to or for the benefit of a creditor.” Bankruptcy Code Section 101(10) defines “creditor” as an “entity that has a claim against the debtor that arose at the time of or before the order for relief,” and a “claim” includes a contingent right to payment. The plaintiff carries the burden of proof to establish that the defendant is, in fact, a creditor.

Under Levitt v. Ingersoll Rand Fin. Corp. (In re Deprizio), 874 F.2d 1186 (7th Cir. 1989) and Section 547(b), insider guarantors may be liable for transfers made by the debtor on the guaranteed debt up to one year before the petition date.   In the wake of Deprizio, an increasing number of guarantors executed indemnification waivers like the one executed by Simon. The bankruptcy courts have been split on whether such waivers are valid. One line of bankruptcy cases concludes that such waivers are valid and excuse the guarantor from preference liability. E.g., O’Neil v. Orix Credit Alliance, Inc. (In re Ne. Contracting Co.), 187 B.R. 420 (Bankr. D. Conn. 1995). However, another line of bankruptcy cases, most notably In re Telesphere Commc’ns, Inc., 229 B.R. 173 (Bankr. N.D. Ill. 1993), concludes that such waivers are invalid, because they lack economic impact—

if the principal debtor pays the note, the insider guarantor would escape preference liability, but if the principal debtor does not pay the note, the insider could still obtain a claim against the debtor, simply by purchasing the lender’s note rather than paying on the guarantee. . . . The attempted waiver of subordination rights was thus held to be a sham provision, unenforceable as a matter of public policy.

Telesphere, 229 B.R. at 176 n.3.

At a bench trial before the bankruptcy court, Simon argued that he had fully waived his indemnification rights against the Company and did not file a proof of claim against the Company, and therefore he was not a “creditor” of the Company and not subject to preference liability. The bankruptcy court agreed and entered judgment in favor of Simon. The district court affirmed the bankruptcy court’s judgment, and the lawsuit was then appealed up to the Ninth Circuit, which reviewed the bankruptcy court’s findings of fact for clear error and its conclusions of law de novo.

After concluding that the bankruptcy court did not make clear error in finding that Simon fully waived his indemnification rights, the Court addressed Telesphere’s concern regarding “sham” waivers. The Court stated that, rather than negating a waiver because it hypothetically could be a sham, “courts should instead examine the totality of the facts before them for evidence of ‘sham’ conduct.” In this case, the Court considered four factors to be relevant to the examination:

  1. Available Collateral—The loan in question was secured by a lien on the Company inventory and accounts receivable and, therefore, the loan could have been satisfied by those assets, without Simon’s guarantee.
  2. No Act as Creditor—Simon never filed a proof of claim against the Company and did not purchase the loan from the lender.
  3. No Unilateral Right to Purchase Loan—Simon did not have a unilateral right to purchase the loan.
  4. Other Guaranteed Debts—The plaintiff presented no evidence that the loan in question was the only Company debt that Simon guaranteed. If the loan was the only Company debt that Simon guaranteed, then perhaps Simon would have an incentive to satisfy this lender’s debt instead the Company’s other debts. But plaintiff presented no such evidence to support its burden.

All of these facts led the Court to conclude that Simon’s indemnification waiver was valid and not a sham, and therefore Simon was not a “creditor” of the Company under the Bankruptcy Code.

As the only appellate or district court decision to decide the issue, Adamson presents the strongest case to date that, in the event a borrower files bankruptcy, any insider guarantors who have truly waived their indemnification rights will not be liable for preferences related to the borrower’s pre-petition payoff of the debt.

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A Look At Committee v. JP Morgan

March 9, 2015

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By now, every secured lender and attorney that represents secured lenders should be familiar with the opinion from the Second Circuit Court of Appeals styled Official Committee of Unsecured Creditors of Motors Liquidation Company v. JP Morgan Chase Bank, N.A. (In Re Motors Liquidation Co.) Covered in articles with titles such as “JP Morgan Loses $1.5 Billion Feud with Creditors of GM Forerunner,”[1] the opinion sent a shock wave through the lending community. As our finance colleagues have rightly noted, this case is a stark reminder that best practices require transactional attorneys to “measure twice, cut once.”[2] However, the case also offers important lessons for workout and restructuring professionals, who are often in the position to correct documentation mistakes before a subsequent bankruptcy filing makes the mistakes devastatingly permanent.

Factual Background

To recap the Motors Liquidation/General Motors case, in September 2008, the lender and the borrower entered into a loan repayment and release, which included the termination of certain UCC-1 financing statements in favor of the lender. Both the lender and the borrower retained sophisticated counsel to document the transaction. The errant UCC-3 termination statement was drafted by borrower’s counsel, and it referenced three financing statements to be terminated. One of the referenced financing statements was included by mistake—the parties did not intend to terminate it. Critically, the unintentionally released collateral was “by far the most important” of the collateral securing a separate, $1.5 billion term loan by the lender. Nonetheless, the UCC-3 was filed without either party noticing the error. In March 2009, the term loan was further amended. In June 2009, the borrower filed for bankruptcy protection. Apparently, the lender again did not notice the UCC-3 during both the loan amendment process in March and the presumably extensive pre-bankruptcy negotiations over the terms of the use of cash collateral. Instead, after the commencement of the bankruptcy case, the lender noticed the error in the UCC-3 and brought the error to the attention of the committee of unsecured creditors with the goal of rendering the UCC-3 ineffective. Instead, the committee sought a determination by the bankruptcy court that the UCC-3 was, in fact, effective as filed.

Legal Issues

The Second Circuit, in a per curiam opinion reversing the bankruptcy court, held that the filed UCC-3 was effective to terminate the unintentionally added UCC-1, because lender and its counsel manifested lender’s “assent[] to” its filing.

Under UCC § 9-509(d)(1), a UCC-3 termination statement is effective only if “the secured party of record authorizes the filing.” The UCC-3 was governed by Delaware law and, as readers may remember, the Second Circuit previously asked the Delaware Supreme Court to answer what it means to “authorize” a UCC-3 filing. In response, the Delaware Supreme Court stated:

[F]or a termination statement to become effective under § 9?509 and thus to have the effect specified in § 9?513 of the Delaware UCC, it is enough that the secured party authorizes the filing to be made, which is all that § 9?510 requires.  The Delaware UCC contains no requirement that a secured party that authorizes a filing subjectively intends or otherwise understands the effect of the plain terms of its own filing.[3]

Thus, the Second Circuit was left to determine whether the lender “authorized” the filing of the UCC-3.

The lender argued that it did not authorize the filed UCC-3 because (i) it only authorized borrower to terminate the intended UCC-1s, (ii) it instructed its counsel and the borrower’s counsel only to act in furtherance of that purpose, and (iii) counsel exceeded its authority by filing the over-inclusive UCC-3.

The Court rejected lender’s arguments, instead distinguishing between “what [the lender] intended to accomplish” and “what actions [the lender] authorized to be taken on its behalf.” To determine what the lender authorized, the Court reviewed the exchange of documents and communications between counsel leading up to the filing of the UCC-3. Specifically, when borrower’s counsel provided drafts of the UCC-3 and closing checklist to the lender, the lender’s counsel responded: “Nice job on the documents. My only comment, unless I am missing something, is that all references to [the lender] should not include the reference ‘for the Investors.’” Further, when borrower’s counsel circulated the related escrow agreement for review, lender’s counsel stated that the agreement “was fine” and signed it. The Court concluded that these communications evidenced the lender’s knowledge, review, and assent to the UCC-3, and “[n]othing more is needed” to evidence lender’s authorization.

The Court noted that the mistake in the UCC-3 could be traced to miscommunication, or lack of communication, within borrower’s counsel’s firm. This fact, however, was irrelevant to the Court’s analysis, because outward display of intent prevailed over actual intent.

Lesson for Workout/Restructuring Professionals 

Although the bankruptcy of General Motors followed fairly quickly on the heels of the transaction that led to the errant release of liens in late 2008, the record shows at least two points at which alert workout/restructuring professionals could have caught the perfection issue: first, when the loan was subsequently amended in March 2009, and, second, during the negotiations over the use of cash collateral prior to the bankruptcy filing. Once it is clear that a borrower is preparing to file for bankruptcy, lenders should assume that their liens will be tested by sophisticated creditors’ committees/trustee professionals who have a fiduciary duty to find unencumbered assets for distribution to unsecured creditors. A full perfection review should be completed as early as possible so that the lender can work with its restructuring/workout professionals to address any gaps in its perfection prior to the commencement of the bankruptcy case.


 

[1]           Linda Sandler, JP Morgan Loses $1.5 Billion Feud with Creditors of GM Forerunner, Wash. Post, Jan. 21, 2015.

[2]           Brian Devling and Jeff Chavkin , A $1.5 Billion (Un)Secured Loan, Bank Bryan Cave (Feb. 2, 2015), http://www.bankbryancave.com/2015/02/a-1-5-billion-unsecured-loan/.

[3]           Official Comm. of Unsecured Creditors of Motors Liquidation Co., 2014 WL 5305937, at *5.

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