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.

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

The Trust Indenture Act of 1939, 15 U.S.C. §§ 77aaa-77bbbb (the “Act”) basically provides that holders of notes subject to the Act shall not have their right to receive payment of principal, premium and interest impaired without the holders consent.  In the recent opinion in Marblegate Asset Management v. Education Management Corp., civil case in New York (the “Case”), the Court held (arguably in dicta), that the Act will allow a small minority of noteholders to block an out of court restructuring because the proposed intercompany sale via foreclosure (of substantially all assets) prevented the noteholders from receiving any real recovery from the maker.

chicken-game

In the Case, the Plaintiffs are dissenting unsecured noteholders subject to an indenture agreement (the “Indenture”) made by the operating subsidiaries (the “EDMC Subs”) of Education Management Corp. (“EDMC”).  The Plaintiffs hold ~$20MM of the ~$1.553BB in secured and unsecured debt owed by the EDMC Subs and guaranteed by EDMC.

Importantly, EMDC and the EDMC Subs operate one of the largest for-profit college systems in the United States.  As such, EDMC derived 78.6% of its net revenue from federal student aid programs under the Higher Education Act and overseen by the Department of Education.  One of the many regulatory requirements imposed on EDMC to permit it to receive the federal funds is that EDMC and the EDMC Subs may not file bankruptcy.  Thus, for practical purposes, if EMDC wants to continue to operate and receive funds it cannot file bankruptcy to restructure.

In 2014, EDMC began to suffer significant financial problems and its EBITA dropped from $662MM to $276MM in one year.  To address the situation, EMDC proposed an out-of-court restructuring that could proceed along one of two paths.

  • First Path: everyone agrees to an intercompany sale and creditors receive new notes and equity in the NewCo entity to be owned by EDMC and EDMC guarantee would be released.
  • Second Path: not everyone agrees and the secured creditors foreclose on substantially all of the assets of the EDMC Subs, release EDMC guarantee as to all creditors (permitted because of Indenture terms) and then re-sell the assets to NewCo owned by EDMC.  The consenting creditors would get new notes and equity in/from NewCo.  The non-consenting creditors would get nothing.

At the deadline for consent/non-consent to the first option 99% of the secured creditors consented and 90% of the unsecured consented.  Thus, the secured creditors indicated they would proceed with the second path.

Faced with the practical reality of receiving nothing because of the transfer of the assets from the EDMC Subs to NewCo, the Plaintiffs brought suit to enjoin the intercompany sale.  (The Court noted that even if the borrower/maker had no assets following the intercompany sale, there was potentially causes of action such as fraudulent transfer which might serve as recovery, even if speculative).

At the heart of the Case is whether the Act provides note holders with only the procedural right to pursue their note claim or the actual right to not have their payment impaired.  The Court held that the notes subject to the Act receive the actual right to not have their payment impaired by the maker (without their consent), and thus EDMC’s restructuring proposal (and related agreements) would violate the protection afforded the Plaintiffs under the Act.  Stated simply, the Court stated that depriving the maker/borrower of any meaningful means to pay the Plaintiffs (ie, the assets) violated the terms of the Act which require that repayment not be impaired by the maker/borrower.

In reviewing the legislative history, the Court indicates that the Act protects dissenting note holders (even this small minority of them) from this type of restructure by the borrower and encourages bankruptcy filing instead if the borrower seeks to restructure.

Notably, the Act does not prevent the secured creditor from simply foreclosing and being done with it.  So, as a practical matter, bankruptcy may be the only avenue for debtors seeking to restructure with multiple creditor constituencies who are subject to the protections of the Act if agreement is not immediately forthcoming.  However, the game of chicken remains the same.  Ultimately, if there is no money except from operations, if operations shut down the unsecured creditors face a difficult road to any meaningful recovery.

Marblegate Asset Management, et. al., v. Education Management Corp., et al., Cause 1:14-cv-08584, pending in the United States District Court for the Southern District of New York.

The SCOTUS has recently decided to hear an appeal to consider whether junior mortgage liens, which are out of the money, on chapter 7 debtor’s homes may be voided simply because there is no equity in the home to attach to the junior lien at the time of the bankruptcy filing.  The effect of a win by the debtor would be to permit bankrupt individuals to wipe out junior mortgages in chapter 7 when the senior lender’s lien debt is greater than the value of the home.

home underwater

In bankruptcy, a secured creditor’s claim is considered to be bifurcated for the purposes treatment under a plan (see chapter 11 or 13 usually).  More simply, when the secured claim exceeds the value of the collateral, the secured claim equals the collateral value and the portion of the debt above the collateral value is considered to be unsecured.

In a chapter 13 bankruptcy case (an individual’s version of chapter 11), some secured claims may be stripped downie, the secured portion is reduced to the collateral value.  Similarly, in chapter 13, junior lien holders who’s debt is behind a senior lien debt which is greater than the collateral value may be stripped off (rendered unsecured entirely).

In chapter 7, there is no plan treatment, and thus the distinction between debt is trumped by the general rule that a lien rides through bankruptcy, and thus – regardless of the valuation of the collateral – the secured lender is entitled to its entire secured claim against the property.  The debt is generally not enforceable against the individual, through, after discharge.  The SCOTUS has ruled in the past that a chapter 7 debtor may not strip down a lien.

However – the code section that provides for the distinction between the secured vs. unsecured portion of the debt also states that the lien of a purported secured creditor is “void” if the underlying claim is not an allowed secured claim.

Here is the issue:

  • A couple of chapter 7 bankrupt debtors in Florida have claimed that a junior lien which is junior to an already underwater senior lien is not a “secured creditor” and thus has no allowed secured claim (ie, there is no secured portion of the claim).
  • Thus – they argue – the second lien on their residential mortgage is void under the law because it is not a secured claim.

The Bankruptcy Court agreed with this argument over the objection of Bank of America, who is the junior lien servicer/holder.

BofA, seeing that this might be a little bit of a nationwide issue, promptly appealed two of the rulings to the SCOTUS, which has not yet heard the appeals.

The effect on residential lenders will be a little different depending on their respective position in the lien stack:

  1. The issue to be determined is of some consequence to senior lien holders because, if the junior lien is voided in a chapter 7 on undersecured collateral, the senior lien holder may have a little more flexibility in deciding whether to negotiate or take back the home.
  2. For junior mortgage holders, the issue is of greater consequence.  While the junior lien may have been out of the money at the time the bankruptcy was filed, the house may appreciate in value before the senior lender forecloses or the borrower sells.

Once the SCOTUS rules on the pending appeals, the ruling will affect the treatment of junior chapter 7 mortgage holders nationwide.

(As a side note, I missed last week’s post because I was in trial.  I would also like to thank the folks at Apple, Inc. for the traffic viewing the last post.  Swing by anytime.)

Between 2005 and 2007, a major bank is California  made a paltry $1.4 billion in overdraft fees.  However, a California Federal Court found that those fees were a result of misleading practices and ordered that major bank  pay $203 million in restitution.  The award was recently affirmed by the Federal Appeals Court in the Ninth Circuit. 

Overdraft fees put clients in dire straights
Overdraft fees put clients in dire straights

At the heart of the issue in the case was the bank’s practice of posting debits at the end of the day “high-to-low”; meaning, the largest debit was posted first and sequentially less debits were posted after in order of decreasing amount.  The alternative methods identified by the Court would have been “low-to-high” and “chronological”.

  • In high-to-low posting, the funds in the account are depleted more quickly, the result being that the remaining smaller debits create a larger number of overdrafts.  Thus, the overdraft fees are “maximized”.
  • On the other hand, the low-to-high posting allows the smaller debits to be satisfied first, leaving a lower number of overdrafts and thus lower overdraft fees.

The plaintiffs sued the bank under California law for unfair, unlawful, or fraudulent business practices.  The bank countered claiming that Federal Law, namely, the National Bank Act preempted (trumped) the state law, and therefore the bank was free to post the debits however they wanted.

The trial court found that:

  1. The “decision to post debit-card transactions in high-to-low order was made for the sole purpose of maximizing the number of overdrafts assessed on its customers”,
  2. The bank hid and misrepresented the way debit transactions were posted in their disclosures,
  3. Federal Law did not preempt the state law and the Bank was liable for being both unfair and fraudulent in its posting high-to-low, and
  4. The plaintiffs (as a class) were entitled to $203 million in restitution, among other things.

The bank appealed.  In the first appellate opinion in this case (entered in 2012), the Ninth Circuit held that Federal Law permitted the high-to-low posting of debit transactions, and preempted the state law claim that the high-to-low posting was unfair.

but

The Ninth Circuit held that the bank was liable under the fraudulent prong of the state Unfair Competition Law.   Specifically, the Ninth Circuit affirmed the trial court’s holding that the Bank’s failure to disclose the effect of the high-to-low posting combined with the bank’s “misleading statements” combined to make [the bank] liable under a fraud theory as a misleading statement. Further – this type of state law violation “is not preempted by the National Bank Act”.

Litigation continued until October 29, 2014, when the Ninth Circuit affirmed (in an unpublished opinion) the trial court’s award of $203 million in restitution and related injunction against the Bank for violation of California’s Unfair Competition Law which prohibits misleading statements.

Normally, I would wrap up with how this would affect lenders, but I think it’s self-evident.  However, it is worth summing up a couple of things to consider:

First, lenders might want to take a look at their motivations and disclosures regarding overdraft fees.

 Second, lenders should be aware that their activities may be perfectly legal under Federal Law, but nevertheless may subject to them to liability under state law.

At the moment, the ruling considers only California Law, but it’s a safe bet that bank clients around the country who are being charged fees for having no money will be looking at those overdraft fees.

Last week Regions Bank sued Comerica Bank seeking a declaration that Regions is not liable to Comerica in connection with their $53MM syndicate loan to a plant nursery that went very wrong.  Regions Bank v. Comerica Bank, civil action 3:14-cv-3607, pending in the United States District Court for the Northern District of Texas.

In short:

  • The two banks loaned $53MM (total) to the plant nursery based on allegedly massively fraudulent inventory numbers.
  • The nursery filed bankruptcy and basically everyone apparently got sued for the alleged fraud.
  • Comerica allegedly has been threatening Regions with a lawsuit for misrepresentation or fraud for talking them into the syndicate.
  • Rather than wait for the lawsuit, Regions filed its declaratory judgment action.
  • In the lawsuit, Regions asserts that Comerica contractually waived any reliance on facts or representations that Regions provided to Comerica.  Thus, argues Regions, Regions cannot be liable to Comerica on account of Comerica relying on any information Regions forwarded to Comerica about the borrower.

There are a number of issues related to the lawsuit that are worthy of analysis.  (There are also a number of one-liners about money not growing on trees).  However, as the case is only a week old it provides a good avenue to illustrate the two levels of reliance waivers in Texas.

Money Dino

What kind of waiver am I talking about?  Contracting parties can waive reliance on representations of the other which are not contained in the contract.  It seems straightforward – if the representation is not in the contract, then forget I said (or failed to say) anything prior to signing.  Why the two levels then?

  •  The Basic Waiver: The typical waiver of reliance in a contract will essentially say that the parties waive any reliance on non-contractual representations.  However, the SCOTX has pointed out that such a contractual provision, like any contractual provision, is subject to avoidance for fraud.  Essentially, even if you waive reliance on prior non-contract statements, if someone made a fraudulent misrepresentation that lead to the execution of the contract (without the representation), the contract risks being avoided for fraud.
  • The Super Wavier: On the other hand, the SCOTX recognizes that some parties may contractually agree to waive any reliance non-contractual representations, regardless of how fraudulent they might be, if the parties so intended. Thus, the super waiver.

So, which waiver is in your contract?  It depends on what the Court thinks you meant when you signed the contract (containing the waiver).  Any answer that begins with “it depends” is not a lot of comfort for lender clients and the SCOTX has been somewhat unclear about which is which.

The SCOTX has said that “The contract and circumstances surrounding [the contract’s] formation determine…[how expansive the waiver is]”.  Schlumberger v. Swanson, 959 S.W.2d 171.  The Court goes on to instruct that lower courts should consider the sophistication of the parties, course of dealings and representation by counsel and, importantly, did the parties intend to put a final end to a long running dispute to determine whether the waiver is basic or super.  (Both terms I made up for ease of reading this post so don’t Google them).

I have not parsed through the complaint in the Regions case and Comerica has not yet answered.  Also, I am not opining on the merits of either parties’ positions.  However, the case provides a good excuse to point out that even if two parties waive any reliance on prior representations, in Texas, that waiver may not be enough to waive claims of fraud.  Meaning, the Court may let the case proceed even if a waiver of reliance is contained in the contract regardless of whether the fraud claim is ultimately determined to be without merit.

Lenders should be cautious and deliberate when drafting these waivers of reliance to attempt to remove as much risk as possible that a court will later find that the borrower may sue the lender for fraud.