Credit Bid Rights at 363 Sales: Have the Ground Rules Changed?

Regina Stango Kelbon

The following is a summary of a paper prepared for the Pennsylvania Bar Institute.

Regina Stango KelbonThe decisions by the Bankruptcy Court for the District of Delaware in In re Fisker Auto. Holdings, Inc., and the Bankruptcy Court for the Eastern District of Virginia in Free Lance-Star Publ’g Co., have sparked discussions as to the circumstances justifying the curtailment of a secured creditor’s credit bid rights in a sale conducted pursuant to Section 363 of the Bankruptcy Code.

The In re Fisker Auto. Holdings, Inc. case represents the first major case in a post RadLAX world limiting a secured creditor’s credit bidding rights under section 363(k) of the Bankruptcy Code. Following the court’s lead in Fisker, the Bankruptcy Court for the Eastern District of Virginia in In re Free Lance-Star Publ’g Co. limited a secured creditor’s right to credit bid because the secured creditor did not hold valid liens on all of the assets being sold, and because the secured party engaged in a loan-to-own strategy and inequitable conduct that the court found resulted in the depression of the sale price for the debtors’ assets.

While the Fisker and Free Lance decisions have provoked discussions regarding limitations on a secured creditor’s credit bid rights, a careful review of these cases highlight that they arise out of unique fact patterns and, therefore, may be of limited utility in attempting to limit a secured creditor’s credit bid rights. In each of the cases, 1) there were unencumbered assets that were being sold as part of the auction process; 2) the secured creditor had purchased the claims at a deep discount with a stated intention to implement a loan-to-own strategy; and 3) each auction was proposed on a very fast track designed to depress market participation and the value of the debtor’s assets. As such, secured creditors seeking to embark on loan-to-own strategies need to assess the applicability of these decisions and proceed cautiously to avoid any unwanted limitation on credit bidding rights in a Section 363 sale context.

Lenders’ risk: Who really owns the collateral?

Nikolaus J. Caro

F8E56703A48C584BA41E613723A92DB7Unlike real estate transactions where a lender can obtain title insurance, secured lenders are often relying upon the representations and warranties in their loan agreement and the borrower’s audited financial statements, if and when determining whether the collateral securing their loans is owned by the borrower or another pledgor.  After default, a lender may find itself in a precarious position whereby it is unable to foreclose on the collateral because it is not owned by its borrower and it does not have a pledge from the person that actually does own the property.  According to the Third Circuit, however, certain oversights may not affect the lender’s position as a secured creditor.   In In re WL Homes 534 Fed. Appx. 165 (3d Cir. 2013), the court dealt with the issue of whether or not a deposit account owned by a wholly-owned subsidiary of the debtor was properly pledged despite the fact that the owner of the deposit account did not sign a pledge agreement.

In 2007, WL Homes LLC (“WL Homes”) and Wachovia Bank (“Wachovia”) entered into a transaction pursuant to which Wachovia extended a $20 million revolving line of credit to WL Homes secured by among other things various deposit accounts, including a $10,000,000 deposit account opened at Wachovia after the loan closed and owned by and in the name of JLH Insurance Corp., a wholly-owned subsidiary of WL Homes (“JLH”).  JLH was formed as a pure captive insurance company—it’s sole purpose was to pay claims brought against WL Homes by insuring the risk of WL Homes.   The purpose of the deposit account was to meet a requirement under Arizona law dealing with captive insurance companies.  Although the JLH account was owned by and in the name of JLH, WL Homes transferred all of the funds into that account.  The two entities had separate books and records and organic documents, but there was significant overlap in their board compositions, and the President of JLH was also the CFO of WL Homes and had negotiated the loan documents with Wachovia in such capacity.  The WL Homes balance sheet treated the deposit account as an asset of WL Homes.

In early 2009, WL Homes filed for Chapter 11 bankruptcy, which was subsequently converted to Chapter 7, in the Bankruptcy Court for the District of Delaware.  Promptly thereafter, Wachovia filed an action with the court seeking a declaratory judgment that it had an enforceable security interest in the pledged JLH deposit account.  The Bankruptcy Court granted Wachovia’s motion for summary judgment, finding that (i) Wachovia had use and control over the deposit account and (ii) JLH had consented to the pledge of the deposit account as collateral.  After the District Court for the District of Delaware ruled that Wachovia did not in fact have use and control over the account, but nonetheless affirmed the outcome in the Bankruptcy Court on the grounds that JLH had consented to the pledge, the case was appealed to the Third Circuit.

In ruling in favor of Wachovia under California Law, the Third Circuit first opined that the debtor need not fully own the property that it pledges in a secured transaction, but it may only pledge the rights that it actually has in that property—a security interest attaches to the debtor’s rights, which need not amount to full ownership.  Furthermore, the court opined that consent of the owner of the property is one way in which the debtor may obtain rights in such property, and thus the defining issue became whether or not JLH had consented to the pledge of its deposit account; in order to consent, it first had to have knowledge of the pledge.

In applying certain principles of the law of agency, including the “doctrine of imputed knowledge”, the court held that an agent’s knowledge, in this case the President of JLH, will be imputed to the principal, JLH, if knowledge of the fact is material to the duties to the principal.  Such knowledge must be acquired in the scope of the agent’s duties to the principal, and only knowledge that is actually material to such duties will be imputed.  Furthermore, even knowledge obtained in a different capacity can be imputed if such knowledge is present in the mind of the agent while acting for the principal.  In applying these principles to the facts, the court held that JLH had sufficient knowledge because its President was the CFO of WL Homes and he had sufficient knowledge when acting in his capacity as an agent of JLH.  Because it had sufficient knowledge, JLH was deemed to have consented to the pledge, thus giving WL Homes rights in the deposit account and resulting in an enforceable security interest in favor of Wachovia.

The cases cited by the Third Circuit were situations where a lender would be hard pressed to know which company or individual owned a particular piece of equipment.  In those cases, courts would impute the consent of the owner, who generally owned the borrower and signed the documents, to granting a lien as well.  This case extends the concept because here the account was not in the name of the borrower and the lender had knowledge of that fact.

Despite the fact that the lender overcame what could have been a deleterious mishap, it nonetheless could have saved itself from the risk of being an unsecured creditor, as well as the high cost of litigation, had the parties set up the account at closing and properly identified the source of all collateral being pledged.  In addition to properly identifying the owner or rights-holder of all collateral, ensuring that an express consent is acquired or adding such party as a signatory to the loan documents helps mitigate the likelihood that the debtor will challenge the enforceability of a lender’s security interest.

“Loss Payee” v. “Lender Loss Payee”: How the Difference of One Word Can Prevent a Secured Lender’s Recovery on Insurance Proceeds

Jason I. Miller

8FB7E8F1756E711AD4F5ACD73289F034As a secured lender, you take a security interest in your borrower’s inventory and/or equipment and then perfect under applicable law.  To further protect the value of the collateral supporting your loan, you confirm your borrower has adequate insurance and obtain an endorsement as “loss payee” on the policy.  What happens when the collateral is stolen or destroyed and your borrower misrepresents to the insurance company that there are no liens on the collateral?  The above facts are virtually identical to those in Westfield Ins. Co. v. Talmer Bancorp, 2013 WL 5812027 (6th Cir. 2013), a case where the Sixth Circuit  ruled that because the secured party was listed as “Loss Payee” rather than “Lender Loss Payee,” the secured party was barred from recovering any insurance proceeds.  This case highlights the small but very important distinction between “Loss Payee” and “Lender Loss Payee” endorsements.  While the terms differ by a single word, the designations make a critical difference in determining whether a secured party can recover insurance proceeds under the borrower’s insurance policy after a loss.  A secured party receives far greater protection when its rights are endorsed as “Lender’s Loss Payee”.

In the Westfield case, Milan 2000 Furnishings, Ltd. (“Milan”) obtained a business-property insurance policy from Westfield Insurance Co. (“Westfield”). Peoples State Bank (“Peoples”) obtained a lien on Milan’s real property and a security interest in Milan’s inventory and required Milan to obtain insurance on the collateral. Milan obtained the policy and named Peoples as a loss payee under the policy.

Subsequently, Milan submitted an insurance claim alleging that burglars had stolen inventory from its warehouse.  Westfield requested executed proof-of-loss (“POL”) statements for Milan for both the warehouse and the inventory.  Although Milan listed Peoples on the warehouse POL, it did not identify Peoples as a loss payee on the inventory.  In fact, Milan admitted to affirmatively indicating to Westfield that no party held a security interest in its inventory.  After conducting an investigation, Westfield issued a joint payment to Milan and Peoples to cover the property damage and a separate payment to solely Milan to cover the stolen inventory.

Bancorp, as successor-in-interest to Peoples, objected to Westfield’s failure to pay insurance proceeds to the bank to cover the lost inventory.  Westfield refused and sought a declaratory judgment that it did not owe Bancorp any insurance proceeds due to Milan’s fraud.  The District Court for the Eastern District of Michigan entered a consent judgment in favor of Westfield in the amount paid to Milan, and declared the insurance policy void.  On appeal, the Sixth Circuit affirmed that Bancorp, as a loss payee, was ineligible to share in insurance proceeds when the insurance policy was voided due to Milan’s fraudulent POL.  As the court explained, “Milan’s admitted fraud forecloses Bancorp’s right to recovery under Michigan law because, unlike mortgagees, the policy gives loss payees such as Peoples no independent right of recovery if the insured breaches the policy’s terms.  Instead, under the policy’s loss payable provisions, ‘the lienholder is simply an appointee to receive the insurance fund to the extent of its interest…’” In sum, Bancorp’s lesser status as a loss payee (as opposed to a lender loss payee) prevented it from recovering any insurance proceeds after the actions of the named insured voided the underlying policy.

The Westfield case and the antecedent cases cited by the Westfield court, illustrate the harsh results that can ensue when an insurance policy is voided and a secured creditor is listed as a “Loss Payee”, as opposed to “Lender’s Loss Payee”.  There are a number of reasons why insurance companies may have the right to void a borrower’s policy (e.g., fraud, failure to timely file a proof of loss and intentional destruction of personal or real property).  Despite the similarity between the two terms, a secured party who is a loss payee rather than a lender’s loss payee cannot enforce the insurance policy after the policy is voided due to any of the circumstances listed above.  Lenders should be mindful of the difference between the two endorsements and always insist on obtaining a Lender Loss Payable endorsement.  In addition, Lenders should carefully read the provisions of that endorsement as well as the enumerated circumstances that can give rise to the insurer’s ability to void the policy.

What’s “Commercially Reasonable” for Article 9 Foreclosure Sales?

Ramesh Dhanaraj

dhanarajr1 (2)Since the financial crisis, sales under Section 363 of the Bankruptcy Code have provided an increasingly popular way for secured creditors of distressed businesses to recover their loans.  However, despite the advantages of Section 363 sales, the significant expense and time required to conduct a Bankruptcy sale has caused secured creditors to pursue less comprehensive solutions.  One alternative for recouping value from a troubled loan is an Article 9 foreclosure sale under the Uniform Commercial Code (UCC).

Article 9 (Part 6) of the UCC provides certain statutory remedies to all secured lenders, whether or not such remedies are expressly provided by the security agreement entered into by the lender and the borrower in a lending transaction.  If a borrower defaults under its loan agreement, Article 9 entitles a secured lender to pursue certain rights and remedies with respect to the lender’s collateral (for which a lien may be perfected under Article 9) as set forth in the parties’ security agreement and in Article 9 itself.

However, unlike a Section 363 sale where a Bankruptcy Court approves the process and the sale of a debtor’s assets itself, the UCC provides foreclosing creditors with procedural guidelines for selling collateral assets under Article 9.  This leaves an opening for others to attack the sale process after it is completed.

Such an attack occurred in the recent case of Edgewater Growth Capital v HIG Capital in Delaware.  In Edgewater, a private equity fund, Edgewater Growth Capital (“Edgewater”), acquired a company called Pendum which was in the business of servicing automatic teller machines.  Pendum became highly leveraged due to the significant debt financing that was required to consummate the acquisition.  Soon after Edgewater’s acquisition, Pendum began experiencing serious financial difficulty and became in default under its credit agreement with its lenders.  After numerous amendments to Pendum’s credit agreement were allowed, HIG Capital, another investment fund, purchased a majority of Pendum’s senior debt at a discount.  When Pendum requested yet another amendment from its creditors, its ninth in only about a year and a half, HIG agreed to approve it only under the condition that Pendum’s Edgewater-appointed board members resign from the board.  Consequently, Edgewater’s board members resigned and were replaced with a new board consisting of experienced restructuring consultants.  HIG then negotiated an agreement with the new board under which Pendum’s assets would be sold under Article 9 (the “Foreclosure Sale Agreement”).  Under this Foreclosure Sale Agreement, Pendum’s new board would first be allowed 55 days to attempt to sell the company independently outside of the Article 9 foreclosure sale context.  If no buyer was found during this so called “market check”, it was agreed that HIG would immediately commence an Article 9 foreclosure sale of Pendum’s assets.  As part of the Foreclosure Sale Agreement, HIG agreed to fund both the costs of finding a buyer and the operations of Pendum during the market check.  It also provided the board with a fiduciary “out” which allowed the board to continue to seek potential buyers for the business even after the allotted time for the market check expired.

Pendum conducted an extensive effort to sell itself which included hiring an investment bank and contacting 67 potential bidders.  Despite its considerable efforts, Pendum’s board was unable to secure a buyer for the business during the allotted 55 days.  Shortly thereafter HIG moved forward with the foreclosure sale.  HIG contacted 60 potential bidders and provided public notice of the sale by running advertisements in the Wall Street Journal.  In the end, no outside buyers arose on the day of Pendum’s auction and an affiliate of HIG purchased the company’s assets.  Edgewater then brought suit against HIG in the Delaware Court of Chancery contending that HIG’s acquisition of Pendum was not commercially reasonable under the UCC and was a prohibited private sale.

Edgewater alleged, among other claims, that HIG failed to conduct Pendum’s foreclosure sale in a commercially reasonable manner because the Foreclosure Sale Agreement discouraged competition by allotting too short a time period for properly marketing and selling the company.  The Edgewater Court disagreed.  It found that “commercial reasonableness” for Article 9 sales must be analyzed through the lens of the type of collateral being sold.  The court reasoned that, in the case of a distressed business, the analysis should turn on whether the secured party sold the collateral in conformity with the practices of a seller of “distressed entities”.  It went on to point out that any commercially reasonable process must take into account the “stark reality of the company’s economic facts, not based on the assumption that the foreclosing party must prop up [a] failing entity for the lengthy period that a healthy going concern could use to test the market.”  Specific factors that supported HIG’s actions and the timing as being commercially reasonable were that HIG (i) financed the company’s operations and independent efforts to find a buyer prior to commencement of the foreclosure sale, (ii) provided the board with a fiduciary “out” to continue to seek potential buyers even after the market check deadline, and (iii) allowed for a robust sale process which ultimately provided 83 days for marketing a highly distressed company and included discussions with over 60 potential bidders.

Additionally, Edgewater claimed that HIG’s sale of Pendum’s assets was private, and thus improper under Article 9, since Pendum’s assets were marketed and sold under agreements privately negotiated by Pendum’s board and HIG.  The Edgewater Court clearly points out that under Article 9 a secured party may purchase its own collateral, but it must do so at a “public” disposition not a “private” disposition.  A public sale under the UCC is one in which the public has had a meaningful opportunity for competitive bidding.  The Court disagreed with Edgewater’s argument and found that HIG’s efforts to include Pendum’s board in the sales process, which HIG took even though it had no contractual obligation to do so, was a manifestly positive one.  In dismissing Edgewater’s contention, the court asserts that if it were to deem a sale “private” whenever a borrower negotiates contractual concessions from a foreclosing party in order to give the borrower a greater chance to find a more favorable buyer, it would only be creating counterproductive incentives for secured creditors to exercise their rights in a way that would be adverse to borrowers.

The takeaway from Edgewater is that in cases where secured creditors are faced with the so-called melting ice cube scenario, the extent to which a borrower’s business is deteriorating may be balanced against the robustness of the foreclosure sale process making an Article 9 sale an attractive option for creditors when time is of the essence.