Header graphic for print

Lenders 360

Technology Notes

eSign & Commercial Finance: A License to Trash the Original Note?

Posted in Compliance, Regulatory, Technology Notes, Training

Are “electronic document” provisions appearing in your commercial loan documents?  This is the second in a series examining two provisions recently reviewed by me in commercial real estate transactions.   Unfortunately, the two provisions have serious problems: for UCC Article 3 notes, making a copy of it will not clothe the copy with Article 3 protections.

Copy & Trash the Original Note: No No & No

Electronic documents are not a passing fad:  the growing use of eSign tells me that the bank examination “report card” in 2016 or 2017 will include the use of electronic documents by banks.  This topic is not going away.  We will see more of these provisions, even in commercial loan documents.

In my last post, I summarized two laws that support these provisions (federal e-Sign law and the UETA [the form suggested for use by the states]).  As a general proposition, these laws are designed to preserve existing legal principals.  Like “paper” documents, electronic documents must comply with applicable state laws.

Following these laws into real world becomes very interesting:  the nuances of these laws create a couple of important traps for the unwary.  Let’s take a familiar office task, and then look at two provisions from several commercial mortgage loan documents.

A FAMILIAR TASK

Here is the scenario: after closing, you take the original (blue ink) real estate note and then,

  • scan it;
  • rename it;
  • forward it to a hard drive; and then
  • deposit the original (blue ink) real estate note in the trash can (or shredder)

Now, let’s look at the provisions.

TWO PROVISIONS

Example #1 (emphasis added):

Borrower hereby acknowledges the receipt of a copy of the Agreement and all other Loan Documents.  Bank may, on behalf of Borrower, create a microfilm or optical disk or other electronic image of the Agreement and any or all of the Loan Documents.  Bank may store the electronic image of such Agreement and Loan Documents in its electronic form and then destroy the paper original as part of Bank’s normal business practices, with the electronic image deemed to be an original.

Example #2 (emphasis added):

Borrower hereby acknowledges and agrees that Lender may create electronic images and destroy paper originals of any imaged documents received or generated by Lender in connection with the Loan.  Any such images maintained by Lender as part of its normal business processes shall be given the same legal effect as the paper original(s) thereof.  Borrower hereby agrees that Lender may convert any instrument into a “transferable record” under the Uniform Electronic Transactions Act (California Civil Code Section 1633.1, et seq.) (the “UETA”), and that the image of such instrument in Lender’s possession shall constitute an “authoritative copy” under the UETA.

In these examples, the following terms are problematic:  the image will be –

  • deemed an “original” (of the paper original document)
  • recognized as a “transferable record” (under eSign and UETA)
  • recognized as an “authoritative copy” (of the transferable record) (under eSign and UETA)

CORRECT: AN ORIGINAL

As a general proposition (and when using the term “original” in a broad sense), the image will be treated as an “original” and as an electronic record under Sections 12 and 13 UETA.  Of course, this assumes that the image was created and preserved in accordance with an electronic records plan.  In a future post, we’ll touch on key topics for a plan.

Note, however, there are special rules for particular types of electronic records.

WRONG: A TRANSFERABLE RECORD? AN AUTHORITATIVE COPY?

Of course, there are tangible differences between “paper” documents and “electronic” documents. The differences require different approaches in order to achieve the same results.  These differences, however, mean that making a copy of an original (paper) note will not create a “transferable record” and an “authoritative copy” of the note.  Once a paper note is created, it is the only “original” note.  There can be only a single such note.  We can’t create another one in the future.

The reason for this outcome is that UCC Article 3 does not work well when the note is an electronic record. The Article 3 holder in due course provisions (no notice of alterations or of an unauthorized signature) are good examples of this disconnect.  Consequently,  UETA and eSign each implement a parallel approach for UCC Article 3 notes, using a form of electronic record called a “transferable record”  (eSign Sec. 7021; UETA Sec. 16).  A transferable record is a unique type of “electronic record,” with unique rules and characteristics.

An electronic record, when recognized as a “transferable record,” gives the holder of the “authoritative copy” the same status as a UCC holder in due course.

Unfortunately, the two provisions overlook the requirement that consent to create a transferable record can be made by the maker of the electronic document only at the creation of the electronic document, and only when utilizing technology that creates a unique token.

These two concepts mean that making a copy of an original note does NOT create a transferable record nor does it create an authoritative copy of the note.

DO NOT TRASH THE BLUE INK NOTE.

TWO PROBLEMS

Only at Creation.  Under UETA and eSign, the parties to the actual electronic record, as part of and during the process of executing the eNote, must expressly agree that the electronic record is a “transferable record.”  In contrast, consenting in a paper note to create (at a future date) an electronic record by imaging the paper note does not comply with UETA and eSign, because the person who signs a paper note is not (at that time) signing and creating an electronic record.  In other words, the person imaging the paper note at the copier is not executing the eNote.  The person at the copier is not the same person described in UETA and in eSign as the “issuer of the electronic record.”

UETA Sec. 16, Comment No. 2 (pp 51-52) directly addresses this “at the time of creation” concept:

The definition of transferable record as “an electronic record that…the issuer of the electronic record expressly has agreed is a transferable record” indicates that the electronic record itself will likely set forth the issuer’s agreement, though it may be argued that a contemporaneous electronic or written record might set forth the issuer’s agreement. However, conversion of a paper note issued as such would not be possible because the issuer would not be the issuer, in such a case, of an electronic record. The purpose of such a restriction is to assure that transferable records can only be created at the time of issuance by the obligor. The possibility that a paper note might be converted to an electronic record and then intentionally destroyed, and the effect of such action, was not intended to be covered by Section 16.

Unique Token.  UETA Sec. 16, Comment No. 1 (p. 48)  addresses the unique challenges and requirements involved in adapting paper note rules to electronic forms:

“Paper negotiable instruments and documents are unique in the fact that a tangible token – a piece of paper – actually embodies intangible rights and obligations. The extreme difficulty of creating a unique electronic token which embodies the singular attributes of a paper negotiable document or instrument dictates that the rules relating to negotiable documents and instruments not be simply amended to allow the use of an electronic record for the requisite paper writing.”

Consequently, creating a transferable record (with these unique tokens) cannot be established by merely scanning a document at your typical scanner.

Finally, since the imaged copy will not produce a “transferable record,” there is no “authoritative copy” of such record.  In other words, there is no “original, sole and only” electronic note.

In the next post: a few comments on the “normal business plans” portion of these provisions.

If you have any information or a story to add, please comment below.

 

Good Times for Lenders

eSign & Commercial Finance: On the Bank Report Card in 2016

Posted in Good Times for Lenders, Regulatory, Technology Innovation, Technology Notes, Value Alignment (Client Interests)

Last year, a new topic started to appear in commercial mortgage loan documents: provisions covering the use of electronic documents (aka “electronic records” or “eDocs”).  Unfortunately, two provisions examined by me were not completely correct.  (And until recently, I made the same mistakes.)

These provisions, however imperfect, support my bet that starting in 2016, the implementation  and use of electronic documents will be part of every bank examination, will be included in every bank’s “report card,” and will be of growing importance within leading commercial lending platforms.

To sum it up: 2016 (or 2017 at the latest) will be the year of the commercial, electronic loan document.  With electronic commerce cemented into the fabric of our personal lives, eSign and electronic documents will finally arrive in commercial lending.

In order to understand “electronic” provisions and to (almost) accept my bold prediction, we need to grasp –

  • The fundamental business drivers or motivations behind the federal eSign law and state versions of UETA
  • The scope and terms of both laws
  • The limits or boundaries where electronic documents and paper documents are different

(Disclaimer: this is a short summary and NOT a book.  Maybe in the future I’ll jump into related topics of federal preemption, the various differences between UETA and eSign, consumer law issues, MISMO SMART documents, MISMO data standards, notary laws, etc.)

For the visually unimpaired, these pictures sum up both eSign and UETA, and the business drivers that propelled their passage into law:

The Paper World: Content Inside Unwieldy Containers (paper documents)

The Paper World:
Content Inside Unwieldy Containers
(paper documents)

The Electronic World: Same Content Inside a Speedy Container (electronic documents)

The Electronic World:
Same Content Inside a Speedy Container
(electronic documents)

 

 

 

 

 

 

 

The differences between paper documents and electronic documents simply are the wheels on the bag.  The content in the bag generally remains unchanged.  But the bag with wheels moves much, much faster (and with less effort on everyone’s part).

DRIVERS

The drive to ditch paper documents for electronic documents is based upon the benefits of increased efficiency, speed to market, quality control, etc.   (It is a sibling to the technology mantra of “fewer people, doing more work, in less space.”)  In the early 2000s, Ernst & Young studied the operations of ten commercial mortgage lenders.  The survey painted commercial mortgage lenders as information companies, with paper processes and systems screaming for a technology solution.   The report concluded:  “[C]ommercial mortgage lending processes are inefficient . . . . This environment is eroding profitability, which has already been hammered  by competition and volatility in the capital markets.  A renewed focus on technology enabled process improvement will improve a lender’s competitiveness, ease the strain on both the organization and operations, and enhance profitability.”

This drive for efficiency continues today, as seen in a 2012 white paper by the FDIC for community banks, on the topic of “bank efficiency and economics of scale.”

FEDERAL AND STATE LAWS

eSign and UETA are the statutes creating and governing electronic documents.  They  authorize the use of electronic records and signatures in transactions (including commercial real estate transactions) using an “overlay” approach that generally preserves existing legal principals:

  • They do NOT eliminate the need to comply with the underlying substantive laws governing transactions, including state laws governing real estate transactions
  • The laws of each state remain determinative; the state-by-state patchwork approach remains in place.  (Link to prefatory notes in UETA.)   (The Law of Electronic Signatures has a summary of the state-by-state approach taken on the adoption of UETA.)

Deferring to state law, of course, is the same approach taken in the “paper” world. Like “paper” documents, electronic documents and records must comply with the substantive law of each state.

By taking this approach, the impact of electronic documents even extends to an industry that is as old as dirt: the real estate industry. The drafters of UETA could not identify a reason to exclude real estate from UETA. The prefatory notes to UETA (on p.2) state the following:

“. . . real estate transactions were considered potentially troublesome because of the need to file a deed or other instrument for protection against third parties. Since the efficacy of a real estate purchase contract, or even a deed, between the parties is not affected by any sort of filing, the question was raised why these transactions should not be validated by this Act if done via an electronic medium. No sound reason was found. . . . exclusion of all real estate transactions would be particularly unwarranted in the event that a State chose to convert to an electronic recording system, as many have for Article 9 financing statement filings under the Uniform Commercial Code.”

This approach drives the concepts underlying both eSign(Section 7001(a)) and UETA (Section 7):

  • If a law requires a record to be in writing, an electronic record satisfies the law
    • Electronic means “relating to technology having electrical, digital, magnetic, optical, electromagnetic, or similar capabilities
    • Electronic record means “contract or other record created, generated, sent, communicated, received, or stored by electronic means”
    • Record means “information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form”
    • Information means “data, text, images, sounds, codes, computer programs, software, databases, or the like”
    • The record must remain accurate (properly stored) and accessible
  • If a law requires a signature, an electronic signature satisfies that law
    • Electronic signature means “an electronic sound, symbol, or process attached to or logically associated with a record and executed or adopted by a person with the intent to sign the record
  • A record or signature may not be denied enforceability solely because it is in electronic form

DIFFERENCES

There are exceptions, however, to this “additive” approach.  For example, some aspects of UCC Article 3 (which governs promissory notes) do not work well when the note is an electronic record.  (For example, lost paper notes.) Consequently,  UETA and eSign each implement a parallel approach for UCC Article 3 notes, using a form of electronic record called a “transferable record.”  This is a unique type of “electronic record,” with unique rules and characteristics (eSign Section. 7021; UETA Section 16).

TWO PROVISIONS

In my next post, we’ll apply use these principals to these two provisions:

Example #1:
Borrower hereby acknowledges the receipt of a copy of the Agreement and all other Loan Documents. Bank may, on behalf of Borrower, create a microfilm or optical disk or other electronic image of the Agreement and any or all of the Loan Documents. Bank may store the electronic image of such Agreement and Loan Documents in its electronic form and then destroy the paper original as part of Bank’s normal business practices, with the electronic image deemed to be an original.

Example #2:
Borrower hereby acknowledges and agrees that Lender may create electronic images and destroy paper originals of any imaged documents received or generated by Lender in connection with the Loan. Any such images maintained by Lender as part of its normal business processes shall be given the same legal effect as the paper original(s) thereof. Borrower hereby agrees that Lender may convert any instrument into a “transferable record” under the Uniform Electronic Transactions Act (California Civil Code Section 1633.1, et seq.) (the “UETA”), and that the image of such instrument in Lender’s possession shall constitute an “authoritative copy” under the UETA.

Of course, the provisions are cryptic in nature.  Unfortunately, there is a major problem in both examples.  It is a problem based upon a misunderstanding of UETA. Until recently, I shared the same misunderstanding (even thought I’ve written and spoken on eSign and UETA, and have been active in MISMO since 2005).  More on all of this to come.

Tough Times for Lenders

The Lender Holds the Bag When the Appraisal is Wrong

Posted in Tough Times for Lenders, Workout Issues

The Bankruptcy Code permits a bankruptcy trustee to “surcharge” a lender’s collateral when the cost will benefit the lender and there is also benefit to the bankruptcy estate.  The friction arises when the collateral is worth less than the lender’s secured claim plus the surcharged expenses.  In short, who is left holding the bag when the collateral is worth less than the trustee’s expenses and the secured debt?  In some ways it’s a question of necessity, but as a practical matter it’s a question on appraisals.

credit: Imagine Television, The Hurwitz Company, 20th Century Fox Television / heckyeahreactionsgifs

I. The Surcharge

The bankruptcy code allows bankruptcy trustees to recover the reasonably necessary costs of preserving a lender’s collateral from the collateral under certain circumstances.  Specifically, section 506(c) states:

“The trustee may recover from the property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim, including the payment of all ad valorem property taxes with respect to the property.”

In the recent 5th circuit case, the court has stated that “to recover under this provision, the trustee bears the burden of proving the following: ‘(1) the expenditure was necessary, (2) the amounts expended were reasonable, and (3) the creditor benefited from the expense.’”

The underlying theory for all of this is that the estate should be reimbursed when it incurs expenses which the secured creditor would have incurred anyway while the estate moves to monetize value from the collateral as time moves on.  The idea being, if the collateral is worth less than the debt, than the trustee would simply abandon the asset to the secured creditor because it would be of no value to the bankruptcy estate.

The whole analysis revolves around the value of the asset.  Because; if the asset is worth less than the debt, there is no benefit to the estate to realize on by a sale and thus no reason to incur expense.

So, what happens if the appraisal is simply wrong and the asset is worth far less than the secured debt? Does the bankruptcy trustee get to surcharge the asset with a lien for expenses even though there is no hope of recovery for the bankruptcy estate from the asset?

In the Fifth Circuit, yes.

II. The Case

In the case of Southwest Securities, FSB v. Segner (In the Matter of Domistyle, Inc.), case 14-41463, pending in the United States Court of Appeals for the Fifth Circuit, the court found that the estate could surcharge the asset.

In short, the appraisal on real property collateral of the lender came back as millions more than the debt.  The lender did not challenge the appraisal.

All parties assumed the appraisal was correct and permitted the bankruptcy trustee (now liquidating trustee) to attempt to sell the property.

After a diligent marketing attempt it because obvious that the collateral was, in fact, worth millions less than the debt.  However, before figuring that out, the bankruptcy trustee had spent a significant amount of money on maintaining the property.

Thus, the question to the Fifth Circuit was: does a bankruptcy trustee get a super priority lien for expenses on the collateral when there was really no benefit at all to the bankruptcy estate in hindsight?

The answer in the Fifth Circuit is that a bankruptcy trustee can eat into the collateral value of expenses even when it becomes obvious that the collateral cannot be sold for any value to the bankruptcy estate.

III. Things to Consider

While the nuances of 506(c) deserve more attention than they are provided here, the headline message is that the lender needs to seek and assert an appraised value of collateral throughout a bankruptcy case.

If the lender in this case had shown early that there was no equity in the collateral, then it would not have to bear the burden of a new senior lien for expenses of maintaining the collateral while the secured creditor was held at bay.  Rather, in this case the lender simply did not contest the value.  (Which may mean that the lender’s appraised value also was higher than the debt).

While the opinion discusses the ins and outs of a surcharge under 506(c), the practical consideration is really how quickly and effectively can a lender assert an accurate collateral value to avoid the extra cost and expense of a bankruptcy surcharging against the collateral with no benefit at all to the bankruptcy estate.

Tough Times for Lenders

THE GOVERNMENT HAS WAYS TO FIND OUT WHO LENDERS HAVE DISCRIMINATED AGAINST EVEN IF THE LENDERS DON’T KNOW

Posted in Lender Liability, Tough Times for Lenders

Sometimes government regulators do funny things.  Sometimes their actions reflect that they are non-economic actors, sometimes its political, sometimes its bureaucracy and sometimes there is just no reason at all because no one knows who made the original decision. The recent Ally Bank borrower discrimination settlement in which no one knows who was actually discriminated against is a good example.

M. C. Escher: "ESCHER on ESCHER Exploring the Infinite", p. 66 Published in 1989 by HARRY N. ABRAMS, INC., New York Drawing Hands

M. C. Escher: “ESCHER on ESCHER Exploring the Infinite”, p. 66
Published in 1989 by HARRY N. ABRAMS, INC., New York
Drawing Hands

In 2013 the Department of Justice (“DOJ”) and the Consumer Financial Protection Bureau (“CFPB”) commenced actions against Ally Bank. The DOJ action was a civil action filed in Michigan, while the CFPB action was commenced as an administrative matter before the CFPB.

The crux of the allegations was that “…between April 1, 2011 and the present, Ally engaged in a pattern or practice of discrimination on the basis of race and national origin in violation of the ECOA based on the interest rate “dealer markup”—the difference between Ally’s buy rate and the contract rate—paid by African-American, Hispanic, an Asian/Pacific Islander borrowers who received automobile loans funded by Ally.”  DOJ Consent Order.  Ally did not admit to any wrongdoing.

Long story short, Ally simply agreed to pay $80 million in monetary damages, which were to be paid to the minorities who were allegedly discriminated against with the higher rates.  (This is in addition to $18 million in civil fines.)  The problem was, Ally was legally unable to know the races of any of its borrowers, so the DOJ and CFPB have no idea who gets the money.

To fix the problem, the DOJ and CFPB are using a complex methodology which, based on what I have read, seems to try to identify minorities by last name and location. The methodology, which is admitted to be less than totally accurate, is apparently the best option.

So, in case you missed that, the DOJ and CFPB are looking at last names to find minority borrowers to send money on account of borrower discrimination because the bank has no way of knowing who the minority borrowers are.

As I mentioned above, sometimes government regulators do funny things, like develop complex ways to isolate minority borrowers for compensation for discrimination when the lender has no way of knowing who are minorities they are alleged to have wronged.

In fairness, there may have been some smoking gun piece of evidence that the DOJ found which never made it to the light of day.  But, absent that, it seems at least possible that lenders could get sued by the DOJ and the CFPB for discrimination when even the lender doesn’t know who it is discriminating against.

DOJ consent order is here.

Read more here on The Detroit News.

A Loophole Big Enough to be a Wormhole

Posted in Uncategorized

Like most bank defendants, Key Bank was looking for the quickest way out of a $5 million fraudulent transfer lawsuit brought by a chapter 7 Trustee.  Rather than wait to win in the standard path of arguing facts, the bank relied on the broad and powerful “safe harbor” provision of the bankruptcy code which protects certain transfers from recovery.  In doing so, the bank utilized a technical, but effective, argument to avoid the need for trial and simply exit the case where it entered.

Intersteller

Credit: Paramount Pictures

I. The Underlying Loan

The basic transactional history of the case will sound fairly familiar to many readers; however, that is why it will be equally important in light of the outcome.  A loan in the amount of $11.2 million was made to an insider of the bankrupt debtor prior to bankruptcy.  While the bankrupt debtor had no obligation to repay the loan, the debtor did, in fact, pay back approximately $5 million to the lender.

Shortly after the note was signed and the loan was funded it was assigned to a REMIC as a CMBS governed by a Pooling and Servicing Agreement (“PSA”).  Key Bank’s servicing arm was the master servicer for another major bank as trustee (the “Trustee”) for the Loan.

 II. The Lawsuit

As I have said before, everyone gets sued in a large bankruptcy case – and this was no different.  The debtor in the lawsuit was an affiliate/insider of the original borrower under the loan.  Both entities were controlled by the same person.  For whatever reason, at some point the debtor began making payment for the borrower to Key totaling $5 million dollars.  At no point in time was the debtor obligated on the loan.

As alluded to above, the non-obligated affiliate filed bankruptcy and ultimately had a chapter 7 trustee appointed to administer the assets.

I will not go over (again) the elements of a fraudulent transfer, but in a non-bankruptcy context the chapter 7 trustee’s arrangement would usually be a win for the chapter 7 trustee / plaintiff.

When Key Bank was sued for recovery of the $5 million Key Bank filed a motion to dismiss. Key Bank asserted the safe harbor provisions of 11 U.S.C. 546(e) which essentially say that a purported fraudulent transfer payment cannot be recovered if it was made to a “financial institution” in connection with a “securities contract”.  Both of these terms are defined in the bankruptcy code very broadly

As discussed in the opinion, these terms are defined so broadly in the bankruptcy code that it makes it hard to place any liability of Key Bank or the Trustee.

III. The Holding

The bankruptcy court made a few notable rulings in this case.  The Court discussed Stern v. Marshal and the relation back doctrine.  Most importantly for this past, the Court made two findings concerning the safe harbor provisions of the bankruptcy code.

First, the Court held that the payments were made to a financial institution because there were first paid to Key Bank (ie, not the trust).  The Court so determined even though Key Bank agreed that it was a “mere conduit” of the funds.

Second, the Court held that payments were made in connection with a “securities contract” because the underlining notes referenced securitization and they were, in fact, securitized.

The result – the majority of the claims asserted against the defendants were dismissed.

 IV. The Take Away

In this case, the bankruptcy code provides a safe harbor which protects large lenders from recovery of (non-fraudulent) fraudulent transfer lawsuits.  The language of the safe harbor statute is so broad that it may provide a defense to almost any payments made on a CMBS loan.  While arguably not a loophole, it certainly provides the mechanism for lenders to short-cut a lawsuit to dismissal on the front end.

Krol v. Key Bank N.A., et al. (In re MCK Millennium Centre Parking, LLC), adversary no. 14-00392, pending in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division

Tough Times for Lenders

The Long Arm of the FDIC is Even Longer After Recent 5th Circuit Opinion Extends the Extender Statute

Posted in Remedies, Tough Times for Lenders

One of the many tools of the FDIC in resolving failed banks is the Extender Statute which, by its terms, replaces existing statutes of limitation under state law by a period of years.  In simple terms, the Extender Statute creates a longer statute of limitations for bringing a lawsuit on behalf of the now defunct bank.  The technical nature, and the amount in contest has led some defendants in FDIC lawsuits to argue that the Extender Statute of 12 U.S.C § 1821(d)(14) applies only to statutes of limitation, and not to statutes of repose.  This argument has recently been declined in the 5th Circuit and, in doing so the 5th Circuit has allowed lawsuits against RBS Securities, Deutsche Bank Securities and Goldman Sachs with damages of almost a billion dollars to proceed despite state law.

time for that later

In short, Guaranty Bank failed after investing about $840 million into residential mortgage backed securities offered by the defendants RBS Securities, Inc., Deutsche Bank Securities, Inc. and Goldman Sachs & Co.  After Guaranty Bank failed the FDIC was appointed receiver and sued all of the defendants on a number of securities claims, including claims under Texas securities laws.  In response, the defendants asserted that the claims were barred by statute of repose in Texas.

 I. The Extender Statute

Following the Savings and Loan scandal and failure of the 1980’s, the U.S. Congress passed the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”). FIRREA did a lot of things beyond the scope of this post.  However, one of the things FIRREA did was create the Extender Statute.

 “The FDIC Extender Statute works by hooking any claims that are live at the time of the FDIC’s appointment as receiver and pulling them forward to a new, federal, minimum limitations period…”

At a minimum, the Extender Statute gives the FDIC 3 years from the date it is appointed receiver over a failed bank to decide whether to sue anyone for bad acts related to the failed bank.

In the case cited above, Guaranty Bank in Texas had failed, the FDIC had taken over and within three years of appointment as receiver, the FDIC sued RBS Securities, Deutsche Bank Securities and Goldman Sachs & Co. on claims related to alleged bad mortgage backed securities investments.

The issues in the appeal is that under Texas Securities Law (Tex. Rev. Civ. State. Art. 581-33(H)(2)(b)) the claims brought by the FDIC were barred by a statute of repose which ran shortly after the appointment of the FDIC as receiver.

II. Statutes of Limitations v. Repose

While the FDIC Extender Statute refers to a “statute of limitation”, the Texas Securities Law is a statute of repose.  Ordinarily the distinction is important, but not in this case.

To paraphrase the 5th Circuit: A statute of limitations creates a deadline for suing in a civil case based on the accrual of claim – which is typically when the damage is discovered or should have been discovered.  On the other hand, a statute of repose creates a deadline for suing in a civil case based on the last bad act – without regard to damage.

In the case, everyone agrees that the Texas Securities Law is a statute of repose and everyone agrees that the FDIC Extender Statute only references statutes of limitation.

III. The Holding

In 36 pages of dense and technical reasoning, the 5th Circuit holds that the Federal Extender Statute applies to extend statutes of limitation and the statute of repose under state law, such as the Texas Securities Law.

The statutory construction analysis is worthy of an attorney’s only blog post.  I will do you the favor of omitting the analysis here.  However, it is sufficient to say the opinion is comprehensive in its analysis.

IV. Why it Matters

Why does it matter?  RBS Securities, Deutsche Bank Securities and Goldman Sachs were all sued by the FDIC based on a failed bank’s investments into their residential mortgage backed securities trusts outside of state law prohibited time period.

When quantifying risk, the monetary exposure is just as important as the burn time of the limitations period.  Concerning this securities issue, the FDIC as managed to extend the otherwise applicable five year statute of repose to a eight year state of limitation in a case with damages near $1 billion.

If you are a lender and your counter-party is an FDIC insured bank, the statute of limitations on risk might be significantly longer than anticipated if the counter-party bank fails.

FDIC v. RBS Securities, Inc., case no. 14-51055 (cons w/ 51066), In the United States Court of Appeals for the Fifth Circuit.

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.