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Technology Notes

Sometimes Your Collateral is Source Code, which is Actually Nothing

Posted in Collection, Technology Notes

We are well out of the .com bubble, but tech companies still form and fail.  For the lenders brave enough to lend to the tech companies developing software, the collateral is often the source code which is the nuts and bolts of an application or “app”.  While the source code is actually a written text written in some development code, it exists in the abstract and it thus an intangible in that sense.  However, unlike most collateral intangibles, this type often requires the original developer to make the source code worth anything more than a line item on a security agreement.

leyser-soze

Consider for a moment the case of Aereo, Inc., which filed bankruptcy is late 2014.  It was a company which developed a web based app which allowed users to watch TV on mobile devices or over an internet connection at home.  Basically, Aereo, Inc. received the cable/TV signal from the normal sources, e.g., cable and antenna, and then converted the signal to be routed through the internet to the subscribers.

In the course of developing this technology, Aereo raised about $250 million in equity from inventors.  So, presumably someone believed in the product.  (Admittedly, there was no secured debt).  Additionally, Aereo listed its assets as worth $20 million when it filed bankruptcy in November 2014.

So why did Aereo end up in bankruptcy? Basically all the old guard TV networks sued Aereo for providing their content to Aereo subscribers.  Much could be written about the underlying litigation in which Aereo essentially claimed it did nothing wrong by re-broadcasting the network’s programming verbatim.  However, this post is to discuss the value of the underlying source code of the app.

Putting the lawsuit aside, the technology was worth $250 million to someone.  However, in a recent decision by the bankruptcy court hearing the case the bankruptcy court approved a sale of the source code for $125,000.00.

Obviously, the sale price of what was essentially the heart and soul of Aereo seems low when considering the equity investment.  One of the main reasons is the lawsuit by the networks.  However, I would also propose that the ultimate sale price was also driven by the fact that the value of the source code is also driven by the individual developer’s involvement.  If the programmers leave, then the value drops a precipitously. Why would that be?

The simple answer is that source code is not a straight forward fait accompli, but rather it is usually a patchwork of fixes, updates, modifications and short term solutions.  It’s basically as if you are selling the rights to the sewer system of Rome – its complex, it’s been modified as the generations have progressed, and the original guy who designed it is gone.

So, if you are the secured creditor, how do you monetize the source code collateral to recover on the debt?  The short answer is that you likely won’t.  Most lenders discount the various types of collateral based on their collectability after default.  In the case of source code, the recent Aereo sale should be of some indication of the value of source code without the developers.  Understanding that the Aereo lawsuits played an impact in the sale, a lender should not ignore the total loss in value because the source code did not come with its original developers.

The take home message is this – the true value of source code is often with the developers and not with the intangible code.

In re Aereo, Inc. case no. 14-13200-shl, pending in the United States Bankruptcy Court for the Southern District of New York, Manhattan Division.

Tough Times for Lenders

The Only Thing Worse Than a Claim in Bankruptcy is Claim Subordination

Posted in Collection, Guaranty Issues, Remedies, Tough Times for Lenders, Workout Issues

Claim subordination is the opposite of alchemy.  In most bankruptcy cases, creditors might look for ways to improve their treatment.  Claim subordination in the bankruptcy code provides a mechanism to force a creditor to receive worse treatment (relative to other non-subordinated claims which is, admittedly, not that great of treatment).

alchemy_lab

In bankruptcy, there are a few ways for a claim to be subordinated.  A claim could be subordinated because you did something bad.  A claim could be functionally subordinated by having debt determined to be equity.  Or, among others, a claim could arise as a result of a transaction involving the sale of stock of the bankrupt debtor or its affiliate.  It is the last one that has come up recently in a Fifth Circuit opinion in a way I thought was interesting because it deals with guaranties.

 I. The Underlying Case

The underlying bankruptcy case involves the debtor American Housing Foundation (“AHF”) which, prior to entering bankruptcy, operated to promote and develop low income housing and obtain Low Income Housing Tax Credits (known as “LIHTC”).  Each actual housing project was operated out of a specific single purpose entity (“SPE”) which was controlled by AHF.

In the course of its operations, AHF would form limited partnerships with AHF as general partner.  AHF would then solicit and obtain investors to put money into the LPs in exchange for limited partnership interests.  That money invested into the LP was then supposed to be put into a specific SPE (which actually held the asset) as unsecured debt to cover pre-financing costs.

Other than the opportunity to receive a distribution from the LP, inventors would also be able to claim a LIHTC.  But to sweeten the deal even more, AHF provided a guaranty of the money invested into the LP to each investor.  Some the guaranty agreements even provided for interest.

To make a long story short, AHF acquired property too quickly and exhausted capital needed for operations of existing projects.  This apparently caused AHF to use some new cash to fund operations, pay dividends and fraudulently divert some of the cash to the principal of AHF.   This proved untenable and AHF was put into an involuntary bankruptcy case.  As is usually the case, after the bankruptcy filing everyone got sued.

 II. Guaranty Subordination

Templeton was an investor in several of the LIHTC LPs.  As was typical, Templeton received LP interest in exchange for his investment and also received a guaranty from AHF.

While the notion of a guaranty of an investment might not seem too far off mark, the careful lender will recall that a guaranty is a contract for the repayment of debt. In contrast, an equity investment is not debt.  The Fifth Circuit touches on this issue in its opinion.  However, what is ultimately the legal reason for subordinating the guaranty obligation is section 510(b) of the Bankruptcy Code.

I would commend to you the actual text of 510(b), but the Fifth Circuit summarizes the section as such:

“Accordingly, this provision makes clear that claims arising from equity investments in a debtor’s affiliate should be treated the same as equity investments in the debtor itself–i.e., both are subordinated to the claims of general creditors.”

So, because Templeton’s “guaranty” from AHF arose from the sale of the LP interest, any recovery on account of the guaranty was automatically subordinated to the other creditors of AHF for the purposes of distribution.  In this case, Templeton is projected to receive nothing if subordinated as opposed to ~40% as a general unsecured creditor.

III. Things to Consider

Regardless of whether a guaranty of an equity investment is enforceable as such (notwithstanding the lack of actual debt), the guaranty will be subject to mandatory subordination if the guarantor files bankruptcy and the equity company is an affiliate of the guarantor.

This particular type of subordination puts the claim below general unsecured creditors, which puts any chance of recovery in the “very unlikely” category.

By the same token, if you are a lender and your collateral is a lien in such guaranty, then you face the same prospect of subordination as the borrower.

Finally, the opinion discusses other issues of some note, which did not make it into this post because of length.  The opinion discusses preference ordinary course defense, and valuation for the purposes of fraudulent transfers.

Templeton v O’Cheskey (In the Matter of: American Housing Foundation), case no. 14-10563, in the United States Court of Appeals for the Fifth Circuit.  Opinion revised June 8, 2015.

Opinion is here.

Good Times for Lenders

A Lender’s First Line of Defense May be the Debtor’s Own Chapter 11 Plan

Posted in Good Times for Lenders, Lender Liability, Venue

On occasion I have thought that a chapter 11 bankruptcy case is somewhat analogous to a trip on a plane in a few ways. Among other analogous events, consider checking a bag and then forgetting to pick it up on the conveyor belt after the flight lands. It would be easy enough to do – as the bag is riding in the cargo hold, perhaps it was simply forgotten.  If that has ever happened to you, it likely you went back to pick up the bag from the airport.  On the other hand, in a chapter 11 bankruptcy case, if the debtor-in-possession doesn’t pick up all of its assets when it exits bankruptcy, it will lose them forever.

luggage

To understand how a cause of action could just go away after plan confirmation, it is helpful to understand the legal distinction between the original entity which filed bankruptcy and the debtor-in-possession, or DIP.

I. The Bankruptcy Estate is Something Separate

When any bankruptcy case is filed, an estate (not unlike a trust) is immediately created and all of the assets of the entity are immediately and automatically transferred to the estate pursuant to the bankruptcy code.

  • When the bankruptcy case is filed as a chapter 7 liquidation, a 3rd party is appointed to manage and liquidate that estate for the benefit of the creditors.
  • In a chapter 11 reorganization bankruptcy case, the estate is usually managed by the filing entity- the DIP, which is given possession of the estate to administer for the benefit of the creditors.

As a practical matter, a typical chapter 11 bankruptcy case looks like business as usual by the debtors prior management, but legally, the debtor is acting as a trustee over the bankruptcy estate which was created upon filing.

The distinct, but parallel, existence of the estate from the DIP is important when considering the effect of confirming a chapter 11 plan.  When a chapter 11 plan is confirmed, one of the effects is to re-vest assets into the debtor who will then operate under the plan going forward.

The rub is: anything that is not transferred out of the estate to the debtor does not belong to the debtor.  This is where the cause of action issue comes up.

 II. Take it or Leave It

A cause of action (or perhaps an affirmative defense) is an asset of the debtor before filing bankruptcy and it remains so during bankruptcy.  As an asset of the estate, it must be transferred under the plan to the debtor in order for the debtor to use it after confirmation of the plan.

Among others, the Fifth Circuit has held that if a cause of action is not specifically and unequivocally reserved and transferred to the debtor post plan confirmation, it will not belong to the debtor post confirmation.

More simply, if the confirmed plan does not sufficiently identity a cause of action which will leave the estate and be given back to the debtor after plan confirmation, that cause of action functionally disappears.  So, if the DIP doesn’t take the cause of action, it leaves it.

III. The Recent Case

The recent Rossco Holdings v. McConnell case in the Fifth Circuit provides a good excuse to write about the topic.  The opinion was entered last week.  In the case, post-confirmation chapter 11 debtors sued their alleged attorneys for malpractice in connection with the bankruptcy case.

The attorney/defendants moved to dismiss the lawsuit asserting that the confirmed plans of the plaintiffs did not transfer the causes of action from the DIPs to the debtors after confirmation. Therefore, the plaintiffs would have no right to bring the lawsuit.

The Fifth Circuit agreed and affirmed the dismissal of the lawsuit because the plaintiff/debtors did not specifically enough transfer the claims back into the debtor from the estate and therefore they no longer existed.

IV. Things to Consider

 The first thing to consider if you are a lender, is that if you are being sued by a post-confirmation debtor you should review the plan to see if the plan properly transferred the claim from the estate into the post-confirmation debtor.

Additionally, the opinion also denies a couple of the plaintiffs’ arguments simply because they were raised too late in the proceedings – particularly with regard to choice of law.  In short, the plaintiffs attempted too late to argue that 9th circuit law (which is more favorable for the plaintiff than 5th circuit law) applied and thus waived the argument.

In summary: All of the assets of the pre-bankruptcy debtor are along for the ride once in bankruptcy.  However, if a cause of action is not properly transferred by the DIP to the debtor upon exit, that cause of action will not belong to the post-confirmation debtor.

The opinion is here.

Tough Times for Lenders

PWC Escapes MF Global, Inc. Class Action Suit Claiming In Pari Delicto

Posted in Collection, Remedies, Tough Times for Lenders, Workout Issues

I have been told that in a traffic jam ambulance drivers are taught to move to the first opening available in traffic and figure out where to go after that.  Sometimes legal strategy takes that same philosophy.  In a recent 2nd Circuit Case, PriceWaterhouseCoopers, LLP (“PwC”) asserted in pari delicto to avoid immediate liability in a MF Global, Inc. (“MF Global”) related lawsuit.  What happens next, I assume has already been figured out by their very capable lawyers.

PP 68 PONTIAC AMBULANCE

It is helpful to know what the legal doctrine of in pari delicto means, if you do not already know.  The doctrine is “an affirmative defense which mandates that the courts will not intercede to resolve a dispute between two wrongdoers.”  In essence, if two wrongdoers come to court, the court will not resolve who is at fault.  More simply, if a party asserts they are not liable on a theory of in pari delicto, they are necessarily claiming to be a wrongdoer.

Following the collapse of MF Global a lot of people got sued.  Among the people who were sued were the D&Os of MF Global and PwC on behalf of MF Global.  PwC is alleged to have conducted audits of MF Global during the time in which MF Global is alleged to have “raided” (not my word) the commodities customers’ accounts in an attempt to keep MF Global afloat.   Stated in a broad stroke, the plaintiffs assert that PwC should have caught the alleged violations of the various securities laws, but did not.  The damages were asserted to be in the billions of dollars.

Here is where another legal concept comes into play – a derivative lawsuit:

In simple terms, a derivative lawsuit is where a third party brings a lawsuit on behalf of the primary party against a second party.

In this case, the aggrieved commodities customers filed a derivative lawsuit on behalf of MF Global against PwC claiming that PwC has violated securities laws when it raided the accounts.  Among PwC’s responses (of which, I presume there were many), PwC asserted the  affirmative defense of in pari delicto because the true party was MF Global (because it was a derivative lawsuit), and thus they were both wrongdoers.

Personally, I think it takes a lot of confidence on the part of PwC’s attorneys to assert the affirmative defense of in pari delicto in this, or any case.  In doing so, the client is being advised to assert that is a wrongdoer.

The case itself has been up and down the system.  However, it’s the recent ruling on May 22, 2015 which affirmed that PwC would not be liable to the commodities customers because PwC had prevailed on its affirmative defense of in pari delicto.  (The 2nd Cir. affirmed that there could be no professional negligence claim because PwC never worked for the plaintiffs).

What to take away from this decision and fact pattern for a lender?

  • Consider the true sources of recovery. If you are banking on a third party liability policy, then it might not be there.
  • Sometimes accountants might not act properly, and if they do, the lender might not be able to recover from them.

As a legal matter, this dispute is likely not over any time soon.  By essentially asserting wrongdoing, PwC has prevented liability from the derivative claimants, but has not addressed the potential for liability from other claimants.  Nevertheless, the tactic worked and now PwC is on to the next fight, having avoided liability at the first. In effect, PwC has gone for the first opening in heavy traffic and will figure out where to go after that.

Bearing Fund, LP., et al. v. PriceWaterhouseCoopers, LLP (In re MF Global Holdings Ltd. Investment Litigation), case no. 14-1249-cv, In the United States Court of Appeals for the Second Circuit, opinion issued May 22, 2015.

The Order is here.

Tough Times for Lenders

Make Whole Provisions: the Need to Aggressively Walk Back Aggressive Collection Provisions

Posted in Collection, Tough Times for Lenders, Workout Issues

Unexpected things happen in bankruptcy.   Some debts can be restructured, some debts can be reduced and some debts the debtor is just stuck with.  In contrast, outside of the bankruptcy ecosystem, economic interests are treated normally.  Because of the difference, a creditor’s activities for recovery in bankruptcy will, at times, seem at odds with their economic interests if viewed through the lens of a normal collection matter.

Credit:Paramount Pictures

Credit:Paramount Pictures

A currently pending adversary proceeding in the Energy Futures bankruptcy case is a good example of a creditor taking a somewhat counter-intuitive path to seek recovery.

As you may know, the bankruptcy case of Energy Future Holdings Corp. (“EFH”) is currently pending in Delaware.  As the name implies, EFH is an energy company.  The adversary I cite revolves around an affiliate of EFH who issued about $2 billion in notes under an indenture which contained a “make whole” provision.

As you may know, a “make whole” provision in a loan agreement basically provides that a borrower will need to pay some or all of the anticipated interest recovery to the creditor if the borrower pays the debt early.

In this case, the “make whole” provision was part of a large indenture issued by an affiliate of EFT on 2.18 billion in notes. For the purposes of the current litigation, a few of the provision are relevant:

  • First: Under the indenture, it was a default to file bankruptcy.
  • Second: Upon default by filing bankruptcy, the debt would automatically accelerate.
  • Third: Under any non-bankruptcy default, the acceleration would be permissive.
  • Fourth: If the borrower defaulted (other than filing bankruptcy), and tried to pay the debt back it would trigger the make whole provision, which amounts to approximate $13 million per month in interest costs.

So what happened?  The affiliate filed bankruptcy.  The bankrupt borrower asserted that the “make whole” provision was not triggered.  Realizing that this would be an issue, the indenture trustee attempted to deaccelerate the loan and assert the full “make whole” provision post-bankruptcy.

Based on the indenture, the bankruptcy court determined that the filing of the bankruptcy automatically accelerated the loan, which made the “make whole” provision inapplicable.

What is a creditor to do when faced with the consequences of an automatically triggered acceleration when, unexpectedly, it is not in the economic interest of the creditor?  Simple; try to deaccelerate the debt to be able to then trigger the “make whole” provision.  Well, not so simple.

As you may know, most bankruptcy courts have held that accelerating a debt post-bankruptcy is a violation of the automatic stay.  As it turns out, the opposite is also true.  In the recent order, the Bankruptcy Court held that attempting deaccelerate the loan was also a violation of the automatic stay.

As a result, the creditor (an indenture trustee) is now locked in an epic legal struggle to seek authority to deaccelerate a loan, which accelerated by the terms of the indenture upon the bankruptcy filing.  In contest is hundreds of millions of dollars under the “make whole” provision.

According to the Bankruptcy Court, there is nothing wrong with the “make whole” provision and it would normally be enforceable under state law.  The only issue is that the terms which caused the automatic acceleration preclude the “make whole” provisions and unwinding that automatic trigger would violate the automatic stay of the bankruptcy code.

Whereas most creditors would assume that the acceleration of debt and the collection options afforded by that act would be the logical next step in collection, the indenture trustee in the lawsuit must now fight to walk back those heavily negotiated provisions in the hopes of collecting on the debt is thought it bargained for under the indenture.

The take home message is be careful what you wish for, you just might get it.  In this case, the indenture called for an automatic acceleration of the debt upon bankruptcy filing. However, the effect of that acceleration precluded the make whole provision. In this case, it will cost the creditors hundreds of millions of dollars.

Delaware Trust Co. as Indenture Trustee v. Entergy Future Intermediate Holding Company, LLC and EFIH Finance, Inc. (In re Energy Future Holdings Corp.), Adversary No. 14-50363(CSS), pending in the United States Bankruptcy Court for the District of Delaware

 

(Apologies for the delay is writing.  Things are getting  little busy.)

Tough Times for Lenders

A Short Post on Oil and Gas Bankruptcies

Posted in Market Trends, Tough Times for Lenders

It was not too long ago that a lender would consider an oil & gas company as a fairly safe credit.  However, the times are changing.

oil and gas donkey

 

It is no secret that the current lower gas prices are due to upstream excess production, either domestically (in the US) or in the mid-east.  This has led to much discussion about the financial future of many upstream exploration and production (“E&P”) companies in the near term as well as to the down-stream companies later in time.

As a corollary to that, most folks outside of Texas are likely not aware that a significant portion of the oil patch is serviced by smaller vendors whom you would likely not know by name.  These are the early warning companies that are expected to fail prior to the larger E&P companies.

Despite financing vehicles and hedging (learned from the last downturn, I am told), some of the E&P companies are already filing bankruptcy or seemingly moving in that direction.

  • Recently, Quicksilver Resources, Inc. and affiliates filed chapter 11 in Delaware (case no. 15-10585).   Quicksilver was (and remains) a E&P company based in Fort Worth, Texas.  It lists over $1BB in liabilities as well as over $1BB in assets.  Click here for the press release.
  • Another E&P company, Sabine Oil & Gas Corp. announced last week that it had retained restructuring counsel as well as a financial advisory firm.  Sabine is the product of merger last year with Forest Oil and claims operations in the Eagle Ford Shale, East Texas, North Texas and offshore.  Its last filed 10-K listed closed to $1BB in assets.  Click here for investor info from the Sabine investor page.
  • And finally, another E&P company I will mention is Dune Energy, Inc. based in Houston who filed bankruptcy in early March 2015 in Austin (case no. 15-10336).  Dune claims operations in Texas and offshore.  Its bankruptcy schedules listed $144.2MM in debt against $229.5MM in assets.  Click here for the Form 8-K.

Of course, there are more E&P companies who have filed (or may).  A quick check of the docket for the Western District of Texas appears to show a few of the smaller service companies who have recently filed chapter 11 also.  Most people I speak with in my field believe that we will see more oil & gas restructuring by the end of the year.  While these companies did very well even during the recent recession, as the economy has gotten better and production has increased, these companies are facing serious financial trouble.

Tough Times for Lenders

7th Circuit Holds Construction Lender “Caused” M&M Liens when it Cut Off Funding, Can’t Seek Coverage Under Title Policy

Posted in Insurance & Environmental Risks, Tough Times for Lenders, Workout Issues

Knowing when to cut your losses and walk a deal is a difficult skill to master.  In the construction loan context it is particularly difficult because a half completed building lacks the intended value anticipated on the loan.  On the other hand, cutting off disbursements causes a whole other set of risks including mechanic and materialman’s liens (“M&M Liens”) which often prime the lender’s mortgage lien.  While different types of insurance may help, the 7th Circuit recently held that priming M&M Liens incurred after the lender had cut off funding following borrower’s default were caused by the lender and therefore excluded from the title insurance coverage.  The result was essentially a total loss to the lender of ~$61MM.

Credit: LucasFilm, Ltd. / Imigur

The Project

The project was a commercial construction project in Kansas City, MO.  Basically what happened was that BB Syndication Services (the “Lender”) lent money on a construction loan to build the commercial development to its borrower.  The total line of credit was ~$86MM.

In the project, First American Title (the “Title Company”), acted as disbursing agent and insured against encumbrances on the property.  The idea being that prior to making a disbursement, the Title Company would check for liens, and barring liens would disburse the next construction draw.  The title insurance policy contained a exclusion to coverage which excluded any liens that are “created ,suffered, assumed or agreed to” by the Lender.

The 7th Circuit mentions some notable, but stereotypical, background facts in the opinion illustrative of deal that is going to go south present in this project:

  • The project was “fast tracked” and many contracts were signed before the plans were finalized. The result was that the initially cost estimate was almost immediately rendered inaccurate.
  • The construction company immediately warned all the parties that the changes would increase the initial estimate of $118MM by an additional $30-$40MM.
  • Notwithstanding the revised cost estimate the Lender opted to proceed even though there were no additional funds from the Lender or sponsors.
  • When ~$5MM had been disbursed the projected cost overruns began to come to light.
  • Undaunted, the Lender continued making disbursements and paid out over $61MM.

After the original contractor was fired by the borrower the Lender saw that the project was falling apart.  The new construction company determined they would need an additional $37MM (see above).  The Lender then declared the default and ceased making disbursements.  Two things happened when the Lender cut off the funds:

  1. Over $17MM in M&M Liens were filed (which primed the Lender), and
  2. The Borrower filed bankruptcy

 A Lawsuit About a Lawsuit

Most insurance coverage litigation is usually a lawsuit about another lawsuit in which there was a loss.  This was no different.  The Borrower filed bankruptcy and the bankruptcy court ultimately allowed $17MM in M&M Liens which all primed the Lender’s mortgage lien.  Next, the bankruptcy court conducted a judicial auction of the property which yielded $10MM.  Obviously this was not enough to pay the (now) first lien M&M Liens.  In the end, the lender settled for payment of $150K on its $61MM debt.

Faced with the loss, the Lender then turned and sued the Title Company on the title insurance policy.  The Title Company countered with their exclusion of liens “created, suffered, assumed or agreed to” by the Lender.

On appeal, the 7th Circuit held for the Title Company stating:

The liens at issue here related to outstanding work that remained unpaid when [Lender] cut off loan disbursements due to insufficient funds to complete the project.  As such, the liens arose directly from [Lender’s] action as the insured lender, so coverage seems squarely foreclosed by Exclusion 3(a).

The 7th Circuit dismissed the Lender’ argument that it had the contractual right to cease disbursements and was therefore not responsible for the M&M Liens.  The 7th Circuit reasoned that the right to cut off funding had nothing to do with the sub-contractor’s right to file M&M Lien claims.

Moreover, the 7th Circuit stated that the Lender could be seen to have caused the cost overrun itself because the Lender  knew well in advance that the project was out of balance.  The 7th Circuit goes so far as to state “Only the lender has the ability – and thus duty – to investigate and monitor the construction projects economic viability.  When liens arise from insufficient funds, the insured lender has ‘created’ them by failed to discover and prevent cost overruns…”

 What to Take Away from the Case

If anything, lenders should not rely on title insurance which contain the fairly common exclusion for M&M Liens that will arise following cut off of disbursements at issue in the case.  Circuits are split regarding this issue, but it remains a risk regardless of your location.  Obtaining performance bonds are likely a better option.

In addition to the legal holding about a title policy exclusion, another lesson is the cost of failing to walk away early from a project that is clearly not going to work.  The opinion mentions the Lender’s knowledge of the cost overruns over and over again.  Had the Lender walked at $5MM it would have almost certainly been made whole.  Knowing when to cut your losses is as much an art as it is a science and it cost the Lender over $61MM on this deal.

BB Syndication Services, Inc v. First American Title, case no. 13-2785, in the United States Court of Appeals for the Seventh Circuit.  Entered March 12, 2015.

Good Times for Lenders

You Never Know Where Your Last Email will be Published

Posted in Good Times for Lenders, Technology Notes

A good piece of advice I once received when I was younger was: “Don’t write an email you wouldn’t want copied to the cover of the New York Times”.  In the past, it would take days of depositions in a lawsuit to get a handle on what someone said or thought to prove a legal point.  Now, emails (combined with searching techniques) can provide a first person narrative usually by people who have no inclination their email conversations will be exhibits in an unexpected and un-filed lawsuit.  Sometimes, and entire lawsuit comes down to one email.  That was the case in a recent 5th Circuit opinion.

 

Credit: Unknown

Credit: Unknown

The Lawsuit

The lawsuit itself is fairly interesting if you follow the litigation surrounding the WaMu collapse and takeover by JPMorgan Chase Bank.  The lawsuit concerns a developer who was contracted by WaMu (pre-takeover) to acquire land, build a WaMu location and then rent it to WaMu for 20 years.  Prior to acquiring the land but while the developer was under contract, WaMu was taken over by the FDIC.

There has been significant litigation concerning the WaMu leases since the takeover and assignment to Chase which I don’t intend on getting into here.  In fact, the lawsuit is worthy of its own blog post for those of you interested in this “obscure but heavily litigated” matter (as the 5th Circuit put it).  Among one of the more interesting holdings is that the FDIC can be held liable for negligent misrepresentation because “it is reasonable to rely [on the statement] when the federal agency which oversees the banking industry…tells you that your banking lease may be lawfully rejected”.

The Email

In any event, the purpose of this post is to illustrate that a lawsuit and its appeal can boil down to one single email.

The email in question was sent by an executive of the developer to Chase requesting that the lease be rejected quickly so that the developer could cut its losses and be done with it.  The developer, having relied on the FDIC’s representation that the lease could be rejected, believed that rejection was the only outcome.

As it turns out, the FDIC was wrong.  In fact, the agreement between WaMu and the developer was assumed by Chase. When the developer figured it out, he sued Chase for damages for breach of contract (as opposed to being stuck with nothing when the FDIC repudiates a lease).

In the 5th Circuit opinion, the Court of Appeals quotes the email directly five times in support of its holding that there was not mutual termination, which was one of the two issues on appeal.  (The developer won the appeal).  There is no other evidence directly cited by the 5th Circuit to support its holding.

In short, the entire case has now been determined based primarily on one email an executive sent out in the ordinary course of his day.  There is no legalese in the cited portions of the email.  In fact, the executive didn’t use the proper legal terms for what he was requesting from Chase and the FDIC.   I haven’t spoken with the executive, but I think it’s a safe bet that he did not write the email thinking the 5th circuit’s opinion would one day turn on a few quick sentences.

The take home lesson here is likely already known by everyone reading this.  You have no doubt heard this over and over again.  Don’t write an email you would not want to be public.  This post is to illustrate that even the most mundane of emails may win or lose a lawsuit you have no inclination will be filed.   In short, you never know when your last email will be the one pasted into a Federal Appeals Court opinion.

Central Southwest Texas Development, LLC v. JPMorgan Bank, NA, et al., case no. 12-51083, pending in the United States Appeals Court for the Fifth Circuit.  Opinion Entered March 2, 2015.

Tough Times for Lenders

The Plaintiffs Suing the Lender May Not Exist At the Time the Loan Documents Are Signed

Posted in Lender Liability, Tough Times for Lenders, Workout Issues

It is often surprising to me how often people are unaware of the fairly high risk of being sued in connection with a chapter 11 bankruptcy case when there is money in the case.  Many times, non-debtor parties’ falsely comfort themselves with the belief they will not be sued because existing management wouldn’t want to ruin a business relationship.  The reality is that in large chapter 11 cases, you are just as likely to be sued by the creditors committee as anyone else as a lender.

get sued

Bankruptcy, at its most basic, is the attempt to monetize and equitably (and constitutionally) distribute whatever assets exist of the bankrupt entity.  Outside of bankruptcy, the obvious assets are normally the tangible widgets.  Inside of bankruptcy, the causes of action also become value for trade.

To understand how a third party lender can be sued by an unknown entity on a cause of action which makes no business sense, a quick review of statutory committees is helpful.

Under the Bankruptcy Code a committee of unsecured creditors may be formed to represent the interests of the larger body of unsecured creditors.  Importantly, this committee will have its attorneys’ fees paid by the bankrupt debtor.  This committee, now funded and represented will go about to seek the best recovery for its constituents.  One source of recovery is lawsuits, which are typically unencumbered.

Of course, a committee that did not exist prior to the bankruptcy filing will not typically have standing to sue for pre-bankruptcy wrongs.  However, the Bankruptcy Code and Court’s provide a mechanism to assign those causes of action to the unsecured creditor’s committee as payment on their unsecured debt.

Meaning – if you are a lender you might get sued by a group of angry unsecured creditors after the bankruptcy is filed. The bankruptcy case of Energy Futures Holding (“EFH”) provides a good illustration.

How could that happen?  If a bankrupt debtor unjustifiably fails (or is unable) to pursue a cause of action, the unsecured creditors committee may petition the court to be permitted to pursue the cause of action.  That is what the unsecured creditors committee is currently doing in the EFH case.

In the EFH case, certain subsidiaries were obligated on the LBO debt of the holding company.  The subs didn’t receive the money and even had a provision in the loan documents which essentially said they were only obligated to the extent that the obligation wasn’t a fraudulent transfer in bankruptcy.  Nonetheless, they allegedly paid a disproportionate share of debt service which payment are alleged to be fraudulent transfers.

After the bankruptcy case was filed, the lenders included a provision in the post-petition financing agreement that the bankrupt debtors would not sue the lenders for the pre-bankruptcy payment by the subs (now debtors in bankruptcy).

After the order permitted in the post bankruptcy financing was entered, the unsecured creditors committee in the EFH case was created.  Just recently, the unsecured creditors committee has requested that it be permitted to pursue fraudulent transfer causes of action against the lenders because the Debtor has waived the ability to do so.  The total asserted liability is $8 billion.

At present, the EFH bankruptcy court has not ruled on the request by the unsecured creditors committee.  However, it would not be unusual for the Court to grant such a request.  The legal issues are somewhat technical, but the practical considerations are fairly straightforward – the $8 billion lawsuit is not going to be pursued for legal and business reasons by the bankrupt borrowers but regardless it remains a valuable asset for potential recovery for creditors.

The take home consideration for lenders is this: the lenders sought pre-bankruptcy loan language they thought would shield them from a lawsuit, the lenders sought and obtained a post-bankruptcy waiver of pursuit of the lawsuit by the borrowers – however, the lenders are now facing the prospect that the unsecured creditors committee (who did not exist until after the post-bankruptcy waiver) will sue the lenders for $8 billion.

The loan document language may be of some comfort to you.  However, as a lender, in bankruptcy it might not be the borrower who sues you.

In re Energy Future Holdings Corp., case no. 14-10979, pending in the United States Bankruptcy Court for the District of Delaware.

Motion of the EFH Official Committee for Entry of an Order Granting Derivative Standing and Authority to Prosecute and Settle Claims on Behalf of the Luminant Debtors’ Estates. [dkt 3605]

Tough Times for Lenders

JPMorgan Requests Rehearing Following Loss of Secured Status of $1.5 Billion Loan following “Clerical Error”

Posted in Lender Liability, Tough Times for Lenders

It’s an old saying that lessons are expensive and good lessons are really expensive.  A recent 2nd Circuit Case provides a good lesson on attention to detail and, unfortunately, it is also a really expensive lesson to JPMorgan and their attorneys.  In the 2nd Circuit’s recent opinion, the Court determined that a UCC3 (termination statement) which “accidently” was filed served to unsecure a $1.5 billion (“BB”) loan which could not be re-secured because of GM’s bankruptcy filing.

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A Quick Background

By now you have likely heard about the recent opinion out of the GM bankruptcy case (which is now called “Motors Liquidation”) regarding JPMorgan Chase Bank.  However, I will briefly recap for those of you who have not received the emails circulating around.

Before I get into the case, it is helpful to be familiar with two legal concepts.  They are the bankruptcy code’s strong arm provisions and perfection and termination of a personal property lien.

  • Strong Arm Provisions:  This is a legal concept that exists under the Bankruptcy Code.  While it is a little complex, the crux of the law is that if there is a defect in a secured creditor’s perfection at the time of the bankruptcy filing, the secured creditor will generally be deemed unsecured.  Thus, the bankrupt debtor (and often unsecured creditors) will scour the perfection documents of creditors to determine if any collateral can be un-secured and thereby made free and clear.
  • Perfection and Termination:  In order to ensure that a secured creditor maintains its secured position to the exclusion of third parties, the secured creditor must perfect its lien.  For personal property, this usually means filing a form UCC1 with the state secretary of state.  When the secured loan is paid off (or released for some other reason), the secured creditor will file a form UCC3, which terminates the UCC1.

A Tale of Two Loans

In the case, two loans to GM pre-bankruptcy are relevant.  One was a secured term in the amount of $1.5BB which was secured by substantially all of GM’s U.S. equipment.  The other loan was a loan (a “synthetic lease”) in the amount of $300MM, which had other security.  JPMorgan was the agent on both the loans.  Both of the loans’ secured interest was perfected by the filing of a UCC1.  The $300MM loan had two UCC1s filed and the $1.5BB loan had one UCC1 filed.

Apparently, what happened was GM informed JPMorgan it was going to pay off the $300MM secured obligation.   GM instructed its attorney, a Meyer Brown partner, to prepare the documents.  The Meyer Brown partner assigned an associate to prepare the closing checklist.  The associate assigned a paralegal to run the UCC search to determine which UCC1 to terminate.  Unfortunately, the paralegal was not aware of the $1.5BB loan.  So, when the Delaware UCC search came up with 3 hits, the paralegal did not know that the 3rd UCC1 secured the $1.5BB loan and only two secured the $300MM loan.

Apparently, no one noticed that all three UCC1 were listed on the closing checklist to be terminate.  Apparently, no one checked to be sure that they had the correct UCC1s after the checklist was created and approved by all parties, including the attorneys for JP Morgan.  Thereafter, the closing company dutifully filed all UCC3s thereby un-securing the $1.5BB loan.

GM filed bankruptcy without anyone catching the errant UCC3 filing.  JPMorgan (who now had bankruptcy counsel) quickly realized there was a problem in light of the strong arm provisions.  JPMorgan was promptly sued by the creditors to declare them unsecured.  In bankruptcy court, JPMorgan essentially said, “we never meant to release the $1.5BB so therefore the $1.5BB UCC3 was filed without authority and not effective.” (my language, not theirs).  The Bankruptcy court agreed.

However, the decision was appealed directly to the 2nd circuit.  After certifying a portion to the Delaware Supreme Court, the 2nd Circuit held that JPMorgan authorized the filing of the UCC3 document, even if it didn’t intend the content to release the lien.  Thus, the $1.5BB lien was released.

The Request for Rehearing

Unsurprisingly, JPMorgan has recently requested a re-hearing on the matter and seeks to have the entire 2nd Circuit hear why they should not lose their $1.5BB lien.

In their request, JPMorgan frames the issue as a “seismic shift in agency law…”.  As part of their argument, JPMorgan infers that the volume of document precluded holding JPMorgan and its attorneys responsible for authorizing the filing of the errant UCC3.  Additionally, JP Morgan maintains that up and down the chain of command, no one on the JPMorgan side had any authority to release the liens on the 1.5BB loan.

Whether or not this is a seismic shift in law or the work-a-day application of law to an extremely large amount of money is, for now, an ongoing dispute.

Regardless, the attorneys’ fees alone in this case will make this an extremely expensive lesson for everyone involved.  If the loan remains unsecured, the cost of the lesson will be staggering.

 Official Committee of Unsecured Creditors of Motors Liquidation Company v. JPMorgan Chase Bank, N.A. (In re Motors Liquidation Company, et al.), cause no. 13-2187 in the United States Court of Appeals for the Second Circuit.