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Lenders 360

Bitcoin: Everyone is Talking Blockchain and its Not too Late to Get on the Band Wagon

Posted in Technology Innovation, Uncategorized

Bitcoin first came into public existence in 2008 with the first coins “mined” by a person/group named Satoshi Nakamoto.  As you are probably aware, Bitcoin is a method of transferring value electronically and without the need for any money issued by a sovereign entity.

The first thing to know about Bitcoin is that it is totally decentralized.  There is no master server and no bank vault with anything tangible in it.  Bitcoin exists only as complex mathematics on random computers around the world.  However, once you own a Bitcoin, you can spend is like money with anyone who will accept Bitcoin.

What is the Public Ledger

The driving factor for most Bitcoin believers is the lack of centralization or government oversight.  There is no actual coin and there is no government keeping track of who owns any particular coin.  However, this begs the question: How do does anyone know who actually owns a Bitcoin.

The answer is the Public Ledger.  To overly simply the Public Ledger, it’s a spreadsheet that exists on private computers all over the world known as nodes.  These nodes run on personal computers of people who download Bitcoin mining applications.  All of these random computers around the world share the Public Ledger and confirm not just ownership of a particular Bitcoin, but also the transfer of a Bitcoin from one wallet to another.

When a transaction of Bitcoin occurs the Public Ledgers are notified.  The transaction causes several things to occur.  Among them, the hashing on the blockchain is updated, there is a proof of work, and if all of the math checks out, then the Bitcoin is transferred to the recipient’s wallet.

What is a wallet?

A wallet is exactly what is sounds like.  It is a person’s repository of Bitcoin.  Wallets are held at recognized exchanges online.  Something like a deposit account, but with no rules and no FDIC.  Importantly, the wallet doesn’t actually hold anything.  Rather, the wallet is simply something a Bitcoin is assigned to in a Blockchain.  A bit like signing your name on a bike and then letting your kids play with it with the rest of the neighborhood kids.

What is Bitcoin Mining

So, to recap, there is no government regulation and the records of the transaction are on the Public Ledger that maintained by random people, including the local 14 year olds.  Why would anyone actually bother to keep the system working?  The answer is Bitcoin mining.

Bitcoin mining is the act of processing the transaction of a Bitcoin from one wallet to another.  For reasons discussed below, this takes a lot of computer power.  However, each time a transaction is processed a new block in the Blockchain is hashed and in return, the Bitcoin miner is awarded a fee in bitcoin for the work.  As more transactions are completed, these bit coin fees diminish.  These fees are the source all bit coin, including the “genesis” Bitcoins from 2008.

What is the Blockchain and Hashing

The short version is: the idea is simple but the execution is very complicated.  The Blockchain is the lineage of each Bitcoin from inception to the current owner as reflected on the Public Ledger.  Again, to over simplify, think of the Blockchain as stacking wooden blocks with a new block added everyone a new Bitcoin owner owns a particular Bitcoin.  The rub is proving ownership on a network of nodes, which is where the Hashing comes in.

You can think of the Hashing as the glue between the wooden blocks making up the Blockchain.  This where the complex math comes in and we circle back to the Bitcoin miners.

Each block gets a new Hash. If you looked at a Hash, it would look like a long string on random numbers and letters; but they act as a public encryption password for the owner of the Bitcoin.  You can (loosely) think of the Hash as a lock on a bike.

Every time a Bitcoin is transferred to another wallet the miners will process that transaction and add a new block to that Bitcoin, and that will give rise to a new Hash.  This new Hash can be though of as an additional lock on the bike.  So, if the new owner wants to access its Bitcoin it must know the prior bike lock combination and the new lock combination.  Meaning, every new transaction adds to the level of mathematical complication.

Here is why is gets harder and hard for computers to mine Bitcoin.  As Bitcoins are transferred over and over again Bitcoin miners are forced to compute more and more complex mathematics as they encrypt lock after lock. (Think bike locks on bike locks).

What is a Bitcoin?

Its very complicated mathematics.  In fact, its cryptology.  But more importantly – is Bitcoin “currency”?  Of course, currency and its production is regulated by a governing body.  Here the creation of Bitcoin is regulated by processing power of random computers to compute the complicated cryptology that I simplistically refer to as a bike lock.  Moreover, Bitcoin is mathematically designed to max out at 21 million Bitcoin.

A prevailing question is how to legally characterize Bitcoin: is Bitcoin a “currency”, a “commodity” or a “security” for the purposes of regulation by an actual government?

At this point is important to recall that the genesis of any Bitcoin is the mining process.  There is no sovereign currency that can simply be created by the acts of a citizen.  A citizen can earn a dollar, but cannot simply print a dollar.  In terms of being a security, the owner of a Bitcoin has not bought into anything other than the belief in the nodes and others belief in the Bitcoin.

Perhaps then the Bitcoin is a commodity?  However, for this or any cryptocurrency I would caution against using a legacy legal term to describe Bitcoin except for analogy.

Encryption is Key

I have glossed over a lot of the very complicated encryption that goes into Bitcoin.  Like anything complicated, it is difficult to include everything relevant in a blog post.

One thing I would like to mention is that the Bitcoin wallet has become less and less confidential.  Rather, even with Tor masking it is appearing that movement of Bitcoin can be more easily tracked by a sovereign entity, which strikes at the heart of the purpose of Bitcoin.

Tough Times for Lenders

Two Lawsuits Diverge and I take the Defendant Less Liable

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

To paraphrase Count Ciano, Success has many fathers and failure has many targets.  You may recall a while back I wrote about how a loan to old General Motors (worth $1.5 billion) was accidentally rendered un-secured.  When GM entered bankruptcy, the loan was ultimately determined to be unsecured and lenders (presumably) lost billions.  As you might expect, some people were sued as a result.  One of those folks was the attorneys for GM.  Recently the 7th Circuit entered an opinion in their lawsuit.

By way of brief recap, prior to bankruptcy, GM had (among others) two secured loans.  The first was for $300MM and the other for $1.5B.  About a year prior to bankruptcy, the $300MM was up for maturity and GM was preparing to refinance.

In the $300MM refi GM was represented by Mayer Brown, LLP, a large and well respected law firm.  On the other side, JP Morgan was the agent for the lender syndicate and was represented by another well respected large law firm.

It turns out that at the same time, JP Morgan was also the agent for the $1.5B secured loan.  Both loans were perfected by separate UCC1.  Mayer Brown prepared the documents for the refi transaction.  Unfortunately, on the closing check list and closing documents sent to JP Morgan’s attorneys, the documents contained a release of the $1.5B UCC1.

In what might be the understatement of the year, the 7th Circuit writes:

“The big mistake was that the closing papers for the [$300MM] deal accidentally also terminated the lender’s security interest in the collateral securing the [$1.5B] loan.”

Apparently, all the parties missed the error (save one lone Mayer Brown paralegal, who was ignored).  The important part here is that JP Morgan’s attorney’s affirmatively approved the checklist and loan documents – which included the $1.5B release documents.  JP Morgan’s attorneys even went to far as to tell Mayer Brown “Nice job on the documents”.  (Again, a lesson on your emails being an exhibit).

Despite the colossal oversight and high stakes litigation that followed, no one bothered to tell the syndicate lenders until years later. At which time several brought their own lawsuits.

Strangely, despite the “easy to see” claims against JP Morgan and counsel (7th Circuit’s words, not mine), the lenders sued Mayer Brown.  The arguments are essentially 3 fold:

  • Mayer Brown was an attorney for JP Morgan in other matters, and therefore was acting as an attorney for JP Morgan in this matter,
  • Mayer Brown drafted the documents and therefore owed a duty to JP Morgan, and
  • Mayer Brown had an duty because the purpose of the documents were for JP Morgan’s loan.

In the recently released opinion by the 7th Circuit, Oakland Police, et al. v. Mayer Brown, LLP, the Court affirmed that all three arguments are not supportable and the claims must be dismissed.

There is a lot going on in the background of this case which makes it interesting, but the opinion is a great cite for the transactional lawyers who paper up complex transaction.  Specifically, the Court holds:

“By preparing the first draft, an attorney does not undertake a professional duty to all other parties in the deal”

The lender’s strongest argument (in my humble opinion) was that it relied on Mayer Brown not to misrepresent the effect of the documents.  While everyone seems to agree that the error was simply a mistake, the ruling appears to insulate a non-mistake from liability in exchanging documents.  This puts added pressure on all sides to review (and re-review) all turns of draft to ensure nothing new suddenly appears.

That lack of a complete review of a huge stack of documents on the 8th turn is usually a cost saving endeavor.  However, one should be mindful of such an argument.  The opinion points out that the original inclusion of the wrong release was based on an older UCC search which was used as a “cost-saving” measure by a Mayer Brown paralegal.  (on a $300MM refi).

As a side note, the Court also considers whether Mayer Brown became an “attorney of the transaction” similar to an attorney for a title company.  The Court found that was not the case, but it serves as a reminder that if the law firm holds money in “trust” as part of the transaction the law firm might inadvertently have became an “attorney of the transaction” and thus owe duties beyond its client.

In this case, for some reason, the lenders decided to sue a lawyer who didn’t represent them for malpractice without suing the actual attorneys representing them.  Surely something is going on in the background, but in this case, the alleged failure is on one party and the litigation target was on another.

Oakland Police & Fire Retirement Systems, et.al. v. Bayer Brown, LLP, cause no. 16-2983, In the United States Court of Appeals for the Seventh Circuit.  Decided June 28, 2017.

Beware the Sleeping Executory Contract

Posted in Remedies, Reps & Warranties, Workout Issues

Sometimes a buyer is upset because he received less than he paid for.  On the other hand, sometimes the buyer is upset because he received way more than he paid for.  In a recent Texas Supreme Court decision, the buyer of contracts out of bankruptcy realized too late that it had purchased tens of millions in liability under an undisclosed indemnity agreement which had been dormant for years.

Indemnity Cat

To understand what happened, it’s helpful to have a general understanding of two things.  First, what is an executory contract.  Second, how does a sale process work in bankruptcy.

An executory contract is any contract under which both sides still owe an obligation under the contract at the time of the bankruptcy filing of one of the parties.

In defining an executory contract, the US Supreme Court has stated:

“Congress intended the term to mean a contract on which performance is due to some extent on both sides.

The Fifth Circuit has said:

“an agreement is executory if at the time of the bankruptcy filing, the failure of either party to complete performance would constitute a material breach of the contract, thereby excusing the performance of the other party.”

The characterization of an executory contract is important because the bankruptcy code has special provisions on how they must be treated.  One of the features of an executory contract is that it can be treated as an asset which can be “sold” to a third party; even over the objection of the contract counter-party.

Importantly, to sell an executory contract, the purchaser must take the contract subject to all of its terms.  The process is referred to as the assumption/rejection process.  (because the executory contract can also be rejected, which is a way to jettison liability on a bad contract).

As an asset of the bankruptcy case, an executory contract can be sold (technically assigned) either on its own or as part of a larger purchase.   This can done in a couple of ways, but one of the safer ways to do it is in a chapter 11 plan.  That was the case in Noble Energy v. ConocoPhillips in the Texas Supreme Court.

Noble purchased a slew of oil and gas properties and rights from a bankrupt debtor.  Prior to bankruptcy, the Debtor had entered into a number of transactions with ConocoPhillips.  One of the transactions included an environmental indemnity agreement which broadly and forever required ConocoPhillips and the Debtor to indemnify each other for environmental claims made against oil and gas properties they traded.

Unfortunately for Noble, those indemnity agreements were never disclosed in any way in the bankruptcy case – not even in the applicable purchase agreement.  Fortunately for ConocoPhillips, when Noble purchased the assets from the Debtor:

The Plan provides that any executory contracts not specifically referenced were to be assumed and assigned to Noble unless rejected at closing.  Noble agreed to the Plan and the APA has language that basically said “the assets and contracts we are purchasing includes, but is not limited to x y & z.”

Here was the error for Noble (in my humble opinion).  Noble had no actual knowledge of the existing indemnity agreement.  However, it agreed to assume – with all the burdens – ALL executory contracts unless specifically rejected.  Noble did not know about the indemnity agreements, so it did not “specifically reject” the unknown contracts.

Now, fast forward 10 years and ConocoPhillips sues Noble for $63 million based on the dormant environmental indemnity provision.

In the case, the Texas Supreme Court holds (importantly for the bankruptcy folks), that the cross indemnity provision was legally an executory contract which could be “sold” in bankruptcy.  The Texas Supreme Court holds (importantly for the transactional folks) that the unlimited scope of the purchase caused the unknown and undisclosed indemnity agreement to be part of the asset purchase agreement and bankruptcy plan thereby binding Noble to the terms.  Interestingly the environmental claim arose prior to the bankruptcy case, but the claim for indemnity was not made until after the purchase by Noble was completed.

While there is some interesting points on bankruptcy law in the opinion, the larger lesson from this case is that the common desire in drafting APAs to capture as much as possible may backfire if the purchaser unknowingly captures an indemnity that is sleeping.

Noble Energy, Inc. v. ConocoPhillips Company, cause no. 15-0502, Supreme Court of Texas.  June 23, 2017.

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.