At the point in time when the economic structure of loan becomes financially unsupportable for the borrower, a lender is faced with a few options.  The lender could simply default the loan and begin collection activity.  Alternatively, the lender could seek to re-work the deal in some way to provide some breathing room for the borrower.  No good deed goes un-punished, so it’s good to understand the impact of the two most common types of borrower accommodations – the loan modification and the forbearance agreement.

First; the basics.  The core purpose of a loan modification is to adjust the terms of a loan because the borrower would have been in default under the prior terms.  The notion being that the loan relationship is going to continue.  The core purpose of a forbearance agreement is to prevail over the prior loan terms and legal rights for a period of time because the borrower needs relief from those rights in order to accomplish something of value to the lender.  The notion being that forbearance is not a long term fix.

That is not to say that there isn’t significant cross over for both types.  A loan modification may reduce payments and shorten maturity with the expectation of a re-fi.  Alternatively, a forbearance agreement may contemplate installment payments and an extended payout after maturity.  In between the two types of agreements there are a lot of different ways to structure the deals and choosing the right one is as much strategy as tactics.

Below is a breakdown of how different deal specifics typically are reflected in a loan modification vs. a forbearance agreement.


Loan Modification Forbearance Considerations
While a default may have existed just prior to the modification, after a modification the prior default is withdrawn. The prior default will typically still exist. With an existing and recognized default, the lender will not need to re-default the loan at a later time.  This will reduce the time to collection activity in relation to the loan document terms.


Loan Modification Forbearance Considerations
Regardless of whether the loan was previously accelerated, the modification will withdraw the acceleration. The loan will typically remain accelerated. Acceleration permits the lender to collect the whole debt immediately.  This and the default may be an issue if the borrower files bankruptcy.  In most jurisdictions, a bankruptcy court will require a lender to obtain relief from the automatic stay in order to accelerate the loan after the borrower files bankruptcy.


Loan Modification Forbearance Considerations
Maturity may be modified as part of the loan modification.  Although a loan modification can effect any terms of the original loan document, such as covenants, or economic / payment terms also. Maturity will have already occurred because of the default and acceleration.  A new maturity will not usually be provided because the loan typically remains in default under forbearance and throughout the forbearance period. Lack of a new maturity date under a forbearance provides the lender with a quicker reaction time for collection work.  On the other hand, modifying the maturity gives a borrower more flexibility under the loan terms to attempt to pay back the loan.

Statute of Limitations

Loan Modification Forbearance Considerations
As long as the maturity (and acceleration) remains in the future, most direct collection causes of action will not have their statute of limitations start running. Once the loan is mature and accelerated the statute of limitations for collections begins to run. It’s important to stay on top of your statute of limitations after acceleration and maturity.  If those deadlines are not extended, time will be on the side of the borrower (and guarantors).

Rights of Lender

Loan Modification Forbearance Considerations
A loan modification typically has similar terms to the original loan documents, but not always.  This is a good time to clean up any outstanding items. After default, the collection options are all open to the lender.  However, forbearance agreements will usually curb those to some extent during the forbearance period. Because loan modifications usually track closing with what a bank rep is used to dealing with, it takes less oversight to monitor.  On the other hand, forbearance is a whole new deal which might not integrate into the lender’s system or process well.

Notices of Future Default

Loan Modification Forbearance Considerations
Lender will need to comply with the terms of the modification. Lender will need to comply with the terms of the forbearance.  The difference is that the default under the loan agreement has already occurred and a forbearance agreement usually has a much tighter default provision; often with no cure period. With the notice periods in a loan modification applicable, the time to declare a default will cause a delay in moving forward.  Any cure time will add to this.  On the other hand, a forbearance will not require a default under the loan (and its provisions), but rather whatever the lender requires under the forbearance agreement.

Lender Booking

Loan Modification Forbearance Considerations
Bank accounting is beyond the scope here, but a modification may be shown as a differently from a non-performing loan. Bank accounting is beyond the scope here, but forbearance is likely still a non-performing loan. Consult your compliance folks on this.

Borrower Reporting

Loan Modification Forbearance Considerations
A modification will usually avoid a default for a borrower, which will have a significantly more positive impact on the borrower vs a forbearance. A forbearance will have a significantly more negative impact of the borrower because the default and acceleration will be subsisting.  Additionally, even in simple capital structures, loans by other lenders will often “cross default” resulting in a domino effect when the first of several loans to various lenders is put into formal default.

If the borrower has a chance of a refi at a different institution or program a default may preclude the refi.  So, a lender should consider its gain vs. its collateral.

Also, if the borrower is under several different loan agreements with different lenders, the defaulting lender should be aware of the potential domino effect and resulting spiral downward.

The decision to enter into a loan modification or a forbearance is both a strategic and tactical one.  I have outlined just a few considerations for making a determination.  In practice the process is extremely deal specific and, frankly, a risk opportunity.

Beyond the scope of this article is the impact each can have in bankruptcy, collection litigation and lender liability.  All of which should be considered.

As always, remember – no good deed goes unpunished.

When making a secured loan, the process of making sure your collateral is actually – legally – your collateral can be more difficult than expected or later determined. The steps are fairly simple, but the analysis and execution can be lacking for a number of technical reasons which can render your first priority lien a junior lien or gone all together if you are not careful.

Lord, P., Miller, C., Ferrell, W., Arnett, W., Banks, E., Offerman, N., Berry, C., … Warner Home Video (Firm),. (2014). The Lego movie

There are numerous opportunities to mess up collateralizing things for a secured loan.  This blog post will discuss personal property which has its own rules (as opposed to real property).

First, the down side.  If a lien is not properly attached or perfected the lender runs the risk of either being subject to a later lien or all together unsecured if the borrower files bankruptcy.  It’s a big deal.

There are two basic steps to create a lien.  The first step is “attachment” the second step is “perfection”.  Both are equally important but for different technical reasons.  However, the underlying purpose of the exercise is also two-fold.  1 – Agree on what is being pledged and, 2 – let everyone else know.

I. Attachment

When taking a pledge of collateral, the first deal a lender makes is with the borrower.  This agreement is contained (usually) within the security agreement.  This is the document, signed by the borrower, which identifies specifically what things are being pledged (hypothecated, etc.) as collateral.

The security agreement should either: specifically identify what is being pledged, or should enumerate the class of collateral by their defined terms in the applicable uniform commercial code.

The security agreement is the specifics of the agreement to pledge collateral by the borrower to the lender.  (By the way, be sure the borrower actually is the owner of the collateral.  One cannot pledge what one does not own).

There are many traps for the unwary in this process.  The type of collateral pledged may be one of several defined collateral classes depending on how it is being used. Thus, taking a lien on equipment will not give a lender a lien if that equipment is being used as inventory.

Once a lender has properly attached the collateral the lender has a lien on the collateral as between the borrower and lender.  BUT not third parties.

II. Perfection

When taking a pledge of collateral, the second deal a lender makes is with everyone else.  In short, once the lien is attached the lender needs to let everyone else know about the lien, otherwise it’s meaningless to third parties.

Different types of collateral require different types of perfection.  The typical perfection method is filing a form with the secretary of state called a UCC1 form. Other methods are used for specific types of collateral, but that is beyond the scope of this article.

The secretary of state’s filing system provides a public forum which provides legal constructive notice of the filing.  This means that if a UCC1 is filed everyone is on proper notice even if they never look at the filing.

The state of incorporation will determine which secretary of state needs to receive the lenders UCC1.  After that, the next task is the technical compliance with the requirements of filing.  More specifically, the lender needs to put the world on notice as to what the lender’s lien attaches to.  If this is done successfully, then all third parties will be subordinate to the lien of the first lender.

To accomplish this, the lender needs to properly name the borrower by its formal legal name (no DBAs) and give reasonable notice of the collateral pledged.

A failure on either of these can cause a lender to loose priority or the lien all together.  The formal legal name is easier to mess up than you think.  With regard to the collateral, here is where determining exactly the character of collateral becomes important as well.  If your security agreement says “equipment” but your UCC1 says “inventory” then there has not been proper perfection.

If perfection is not proper then there is no way to keep a third party from taking over a first position lien (assuming they attach and perfect properly) and, worse, if the borrower files bankruptcy ANY failure to attached or perfect will be attacked by the trustee and likely render a lien worthless.

There are, frankly, a number of ways to mess up this technical process.  The mind frame to approach securing a loan is “this seems simple, but it’s actually quite complex”.  Oftentimes, a misstep isn’t discovered until years later when it’s too late to remedy.

There is a significant amount more to talk about on the topic, but I wanted to give a brief overview of attachment and perfection.  Email me if you have any good war stories on the topic; they tend to be very interesting.

In good times many lenders are willing to approve a loan which is secured only by accounts receivable.  The ability to value A/R seems more straightforward than it actually is when considering underwriting.  There are several legal and practical problems with collecting A/R which will reduce its ultimate value to a lender if the lender ends up needing to monetize the A/R following default.  This post will discuss A/R and collecting the A/R.

Let’s begin with the basics: what is an account receivable (“A/R”)?  It’s a common misconception that A/R is the payment.  A/R is actually the right to receive the payment.  When a payment is made, the A/R ceases to exist.

So, when a lender takes a blanket lien against A/R, the lender is really encumbering the right to receive payment from third parties in the future, not the cash in the bank account.

Misunderstanding this can cause problems in a few ways.  One of the most common issues I have seen is when the borrower reports A/R that is actually just revenue.

In a hypothetical scenario: the borrower sells equipment.  A buyer orders some equipment online and at the same time pays for it. Then borrower ships buyer the equipment.  Borrower generates an invoice to account for the payment and the transaction closes.

Oftentimes an unsophisticated borrower will assume that this transaction created an account receivable, when, in fact, it did not.  Further, the borrower will then turn around and report the transaction as an account receivable on a borrowing base report or loan application.  Doing so can cause issues with covenants and underwriting for the lender if the lender is not aware of the misstep.  Simply stated, there is no A/R in this hypothetical and therefore there is no collateral to collect on if things go south.

Another problem I commonly see is when a lender overvalues the A/R when considering underwriting or loan modifications.  A/R’s true value for a lender is the lender’s ability to monetize the outstanding A/R at the time of the default.  Three basic things work against the lender in the scenario when the lender needs to collect A/R.

First – the reason the lender is seeking to collect A/R is because the borrower is in default.  Usually a borrower is in default because business has been going poorly.  Poor economic performance usually also means that the A/R that exists has diminished over time because the borrower has been doing less business.

Second – the practicality of collecting A/R is difficult.  The lender is immediately at a disadvantage because the lender doesn’t have the books and records of the borrower to show who actually owes money on an outstanding A/R.  It’s great to look at a balance sheet and see $10MM in A/R, but it’s another thing all together to track down the specifics.  I have been in situations where the A/R records were all on a cloud server which was deleted.  Next, the lender will oftentimes need to pursue the A/R in its own name, one way or another.  It’s likely that the account debtor (the person who bought the equipment) would simply ignore a demand by the lender to pay up.  There a number of reasons for this.  Part of the problem is that if the lender needs to actually resort to bringing a lawsuit, all of the evidence of the A/R is really the borrower who may not be helpful on the witness stand.

Third – Finally, there is the unknown relationship between the borrower and the account debtor.  Most all of the account debtors have some excuse about why they did not pay the invoice.  Usually these excuses include: the equipment was no good, I have a credit that’s not reflected, I have a deal with the borrower where I don’t have to pay, I returned the item, or – in cases of fraud – I have never heard of the borrower.  (All of which I have heard).  The facts related to all of these excuses will likely be unknown to the Bank when it tries to monetize the A/R and, if the excuses are true, may result in an offset to the A/R.

There are clearly a number of hurdles to monetizing A/R.  From a preliminary perspective, the A/R that exists when a lender takes a lien against A/R will not be the A/R that might be available for collection at a later date.  The lender is simply betting that the borrower will continue to generate A/R at a rate acceptable even in a time of default at some unknown time in the future.

When things go south, it’s the little things that can get you into trouble.  When the servicer on a commercial mortgage sent the notice of foreclosure to the address on the deed of trust, but not to the known updated address of the obligors the obligors counter-sued for breach and the case has been pending now for eight years.  In a recent 5th Circuit opinion, the Court found that failure to serve the proper address can be an independent cause of action which is not precluded by the obligors own breach to repay the loan.

Things you don’t notice on takeoff can have an effect at landing

Around the year 2000, the original lender made a commercial mortgage loan to a multifamily apartment complex (“Borrower”) for several million dollars.  The original lender assigned the loan to Fannie Mae, which then used a national bank as a servicer (the “Servicer”).  The property met certain criteria which allowed it to qualify for low income tax credits, which were passed on to the Borrower limited partners of the various trusts in the corporate structure of the Borrower.

In 2010 the Borrower defaulted on the loan by non-payment of the monthly payments.  Upon default the servicing automatically transferred to Fannie, who hired a law firm to perform a non-judicial foreclosure of the property.

The law firm requested from the Servicer the addresses for the various notice parties for the non-judicial foreclosure, which the Servier provided.  The notice addresses provided by the Servicer were the notices contained in the relevant deed of trust related to the loan.

However, the Servicer had, for years, treated the deed of trust addresses as outdated and sent all prior correspondence to the new updated addresses.  That information was not shared with the law firm, who proceeded to send the statutory foreclosure notices to the old deed of trust addresses.

Long story short, the borrower and guarantors did not get the notices of default, acceleration or foreclosure.

The law firm proceeded to foreclose upon the property, which Fannie Mae bid in at the sale.  This triggered, among other things, an IRS recapture of the tax credits in an amount of $1.2MM, which Fannie then had to pay out of pocket.

After the sale, the borrower and guarantors filed a lawsuit against the law firm, the Servicer and Fannie Mae for a number of claims including breach of contract for failure to send the notices to the correct addresses.

After some litigation, the law firm and Servicer were eventually dismissed following motions for summary judgment, leaving only Fannie Mae – the note holder.

The guarantor’s motion for summary judgment on breach of contract was initially granted by the trial court, but then denied on reconsideration.  The basis for reconsideration was Fannie Mae’s assertion that the guarantor’s cannot prove breach of contract by Fannie Mae because the guarantor’s cannot prove that the Borrower was not in breach (ie, for non-payment).  As you may know, one of the elements for asserting a breach of contact claim is that the plaintiff was not in breach, itself.  However, like all Texas rules, there are exceptions.

After the MSJ/reconsideration ruling, the guarantors appealed to the 5th Circuit, who issued the recent opinion.  The 5th Circuit agrees with the general prospect that a plaintiff cannot assert a breach of contract claim if the plaintiff has also breached.  Importantly, the 5th recognized an exception to that rule.  The 5th stated:

“We conclude that Fannie Mae’s agreement in the deed of trust to give notice of foreclosure was independent of the [Guarantors’] agreement under the note to pay monthly installments to satisfy the debt.  The obligation to give notice of foreclosure would not even arise unless and until the [Guarantors] were in default under the note.”

In so holding, the 5th Circuit holds that a breach of the payment requirement is legally different from a notice requirement in the deed of trust, which can independently give rise to a claim by the borrower and guarantor against a lender/noteholder.

There are probably a few lessons here for everyone.  Perhaps most importantly is the time frame.  The initial notice of default was sent in 2010.  The simple issue of sending notice has given rise to a lawsuit that has now been pending for years after the notices went out.  Moreover, the 5th Circuit didn’t resolve the matter, it simply remanded the issues back to the trial Court.

Legal issues aside in the ruling, it’s important to remember that missing even small legal prerequisites in a collection scenario (with desperate guarantors) can expose note holders to serious jeopardy for years.

5th Circuit opinion in Williams v. Wells Fargo, case no. 16-20507

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, v. Bayer Brown, LLP, cause no. 16-2983, In the United States Court of Appeals for the Seventh Circuit.  Decided June 28, 2017.

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.


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.

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).


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.

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.


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.

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

Credit:Paramount Pictures
Credit:Paramount Pictures

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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