Is Your Inventory Lien Enforceable?

Inventory lenders beware. A 1994 amendment to the Bankruptcy Code may turn the priority scheme on its head.

Section 546(h) of the Bankruptcy Code permits a debtor to return goods which were shipped pre-petition by a supplier to a debtor in exchange for a credit of the purchase price, as long as certain conditions are met.

This provision is troublesome in many respects. First, a debtor is entitled to make a post-petition preferential transfer to a pre-petition creditor, so that the creditor will receive payment in full on a claim which might otherwise have been paid pennies on the dollar.

Second, the statute is silent on the rights of an inventory-secured creditor vis-a-vis the goods to be returned. Can the debtor return the goods only subject to the lien, or only if the debtor can demonstrate that the lender has an adequate equity cushion or is otherwise adequately protected? Unfortunately, there are no reported decisions which address the rights of the secured creditor in this circumstance.

A debtor has a strong incentive to take advantage of the benefits of Section 546(h): The debtor can transfer its slow-moving or excess inventory at full cost.

An inventory lender must closely monitor a debtor's conduct in the early stages of a bankruptcy proceeding to assure itself that 546(h) is not utilized to the lender's disadvantage. For more information please contact Jay Welford at (313) 961-8380.

Cross-Stream Guaranty Found To Be Fraudulent Conveyance

Intercorporate guarantees are common practice for most commercial lenders. Intercorporate guarantees fall into three types: Up-stream guarantees (the subsidiary guaranties the parent's debt); down-stream guarantees (the parent guaranties the subsidiary's debt); and cross-stream (the brother corporation guaranties the sister's debt). A recent decision from the 7th Circuit Court of Appeals serves as a reminder of the potential pitfall of this common practice.

Relying on case law, the trustee in In re Image Worldwide, Ltd. sought to avoid a cross-stream guaranty as a fraudulent transfer in violation of the Uniform Fraudulent Transfer Act. Worldwide guaranteed the repayment of its affiliate's loan balance to the Bank. Because the Bank stipulated that the transaction rendered Worldwide insolvent, the only issue was whether Worldwide, as a guarantor, received reasonably equivalent value for its guaranty.

The Bankruptcy Court determined that a loan for the benefit of an affiliate is not regarded as fair consideration to the sister corporation. The Seventh Circuit rejected this narrow interpretation and stated that in analyzing whether the debtor received reasonably equivalent value, courts should look to whether the guarantor received indirect benefits from the guaranty. The Court also noted that reasonably equivalent value for the purposes of the fraudulent transfers law is something more than consideration to support the contract. While the Bank's agreement to forbear from further collection activities was probably sufficient consideration for the guaranty, that did not mean that the guarantor corporation received reasonably equivalent value.

Image Worldwide should serve as a reminder to lenders that intercorporate guarantees are often subject to attack, but also that indirect benefits to a guarantor may be considered in determining reasonably equivalent value. In particular, in the context of cross-stream guarantys, the court may find reasonably equivalent value when the transaction strengthens the viability of the corporate group. For more information please contact Tom Coughlin at (313) 961-8380.

The Right To Conduct Discovery Regarding Garnishee Disclosures -- A Trap For The Unwary

When a creditor is collecting a judgment, it will often file writs of garnishment against any party the creditor has reason to believe is holding property of its debtor. After this third party (the "Garnishee Defendant") receives a writ of garnishment, it is required to file a Garnishee Disclosure which details any property of the debtor the Garnishee Defendant has in its possession. Frequently, the debtor also owes the Garnishee Defendant money and a dispute will arise as to who is entitled to the debtor's property. Michigan Court Rule 3.101(L) specifically provides that a creditor "may serve the garnishee with written interrogatories or notice the deposition of the garnishee." Michigan Court Rule 3.101(M) also states that the "facts stated in the disclosure must be accepted as true unless the Plaintiff has served interrogatories or noticed a deposition within the time allowed by subrule (l)."

This right to conduct discovery can actually act as a trap for the unwary and prevent a creditor from collecting everything it is entitled to. For example, in Alyas v Illinois Employers Insurance of Wausau, the Michigan Court of Appeals held that a Garnishee Defendant insurance company's statement that there was no liability owed under an insurance policy must be accepted as a true statement because the creditor did not file any discovery within fourteen days of receipt of the Garnishee Disclosure. In Local 58 v. Einsten Electric, the Eastern District of Michigan followed Alyas noting that a plaintiff who does not file timely discovery cannot attack the accuracy of a Garnishee Disclosure. Alyas and Local 58 may be cited by parties to defend a Garnishee Defendant's completely inaccurate disclosure and to prevent a plaintiff from later challenging the truth of the Garnishee Disclosure.

When you are a creditor seeking to collect a judgment, you should promptly file interrogatories requesting further information about any ambiguous Garnishee Disclosures. Moreover, if you have any other reason to believe that the Garnishee Disclosure is incomplete or otherwise inaccurate, you must file interrogatories in order to ensure that you don't waive any rights to pursue a Garnishee Defendant who has not fully disclosed debtor's property in its possession. Finally, if you are a creditor who is responding to a writ of garnishment it is worth the time to carefully include specific statements of fact in the disclosure. If no discovery is filed by the creditor seeking to collect its judgment, these disclosed facts will be accepted as true in any subsequent proceeding, possibly preventing unnecessary litigation costs. For more information please contact Jane Quasarano at (313) 961-8380.

Avoiding Disputes over Insurance Loss Payments with Insurance Premium Financiers

It is not uncommon for a company to finance the premiums for its property and liability insurance policies through a premium finance company. To secure these loans, such specialty lenders generally take an assignment of the unearned premium payable upon early termination of the insurance policies. To maintain sufficient collateral throughout the loan, premium finance companies usually require the borrower to make an initial down payment on the premium so that the premium rebate, taking into account debt amortization, will always be larger than the loan balance.

During our due diligence on behalf of a lender in the origination of a secured loan, we uncovered a more aggressive premium financing arrangement. The proposed borrower had obtained 100% financing from the premium finance company. To improve its collateral position the finance company also took an assignment of "all loss payments which will reduce the unearned premium which become payable under the insurance policies".

Under its loan facility, our client would have a perfected security interest under the UCC in both the borrower's personal property and the insurance proceeds payable by reason of loss to such goods. However, we could not assure our client that its security interest would have priority over the premium finance company's lien. The lien of a premium finance company is generally governed by state law other than the UCC.

If you are a secured lender, we recommend the following: First, ask your borrower whether it independently finances its insurance premiums and, if it does, review the documentation signed by your borrower. Second, if the premium finance company claims a security interest in insurance claim proceeds, require the finance company to subordinate the priority of its lien on insurance loss payments payable with respect to your collateral. For more information please contact Victor F. Ptasznik at (313) 961-8380.

Does The New Value Exception Still Exist

The Bankruptcy Code maintains a delicate balance between a debtor's right to reorganize and the rights of creditors to be paid. The Code sets forth the "pecking order" of priority regarding how claims are to be paid. Secured claims are paid first, claims incurred during the course of the bankruptcy are paid next, pre-petition priority claims such as taxes, wages and consumer deposits are then paid before the claims of unsecured creditors are paid. At the bottom of the priority are the equity holders. This doctrine is known as the "absolute priority rule."

However, in many bankruptcy cases, the absolute priority rule creates an anomalous result. If, under a plan, all of the unsecured creditors are not paid 100% of what they are owed, then the class of creditors subordinate to them (i.e., stockholders) cannot retain their shareholder interest. Thus, the court is called upon to confirm a plan of reorganization that provides for a payment of less than one hundred cents on the dollar to the unsecured creditor class, but then mandates that the equity holders' equity interest is wiped out. If this occurs, then who owns the reorganized company?

To correct this anomaly, the courts have created a doctrine known as the "new value exception" to the absolute priority rule, which states that if the equity holders contribute new value in the form of cash or other property to help fund a plan of reorganization, the equity holders can either retain their equity interest or can exchange the new value for the issuance of new equity in the reorganized company.

In a recent decision, In re Coltex Loop Central Three Partner L.P., the Second Circuit took the position that existing equity holders cannot take advantage of the new value exception. The Coltex case was a single asset bankruptcy case where the secured creditor (which held a huge deficiency claim after a valuation of its collateral), objected to a plan which provided that the current equity holders would put in "new value" in exchange for the retention of their equity interest. The court concluded that the equity holders were not obtaining their new equity only as a result of their prior position as equity holder. That is, because the equity holders had not exposed the property to the marketplace to attract other equity holders, it was not the amount of the new value given, but rather the old equity owners' maintenance of control of the debtor company which gave them the opportunity to provide the new equity.

Coltex has been appealed to the United States Supreme Court where a determination is expected. We will update you in a future newsletter as to its outcome. For more information please contact Jay Welford at (313) 961-8380.

The Enforceability Prefiling Stay Waivers: It's a toss up

A prefiling stay waiver is a debtor's agreement with a creditor not to contest that creditor's motion for relief from the automatic stay should a bankruptcy be filed. In practical terms, it means that once a debtor files for bankruptcy the creditor who has a prefiling stay waiver can attempt to obtain payment of the debt owed to him while other creditors are frozen by the automatic stay. Historically, prefiling stay waivers were not enforceable. More recently courts have treated prefiling stay waivers as private contracts that are enforceable in bankruptcy. However, the current trend is for the courts to examine each case on its facts and then make an ad hoc determination, based on a series of factors, whether a prefiling stay waiver is enforceable. The existence of a signed prefiling stay waiver is only one such factor.¹

While the case by case, multi-factor approach allows courts the discretion to grant relief from the stay when justice so requires, it also injects uncertainty into the lending process. If prefiling stay waivers are routinely upheld, lenders have an incentive to enter workout arrangements with debtors because they can be assured that in the event of bankruptcy, the lender will still be able to obtain the full value of its collateral.

Practically speaking, the move towards a multi-factor approach does not mean that lenders should abandon the practice of obtaining prefiling stay waivers from debtors. A properly executed waiver may still be important factor in obtaining relief from the automatic stay. Lenders should focus attention on all factors used by courts in determining if a waiver is enforceable and should consult legal counsel familiar with the automatic stay provisions of the Bankruptcy Court before entering a workout with a debtor. For more information please contact Dan Serlin at (313) 961-8380.

Revised UCC Article 9 On Its Way

The Y2K problem is only one hurdle which the secured credit industry will be facing in the new millennium. In July, 1998, the National Commission on Uniform Laws adopted a complete revision of Article 9 of the Uniform Commercial Code. Article 9 governs various aspects of secured transactions, including the respective priorities among secured creditors, the methodology for perfecting a security interest in a borrower's assets and the procedures which enable a secured creditor to take control of the collateral upon default. It is anticipated that by January, 2001, many if not all of the fifty states will have adopted revised Article 9. Among the highlights are the elimination of the requirement of a borrower's signature on a financing statement (a letter authorizing the lender to sign the financing statement is sufficient), a revision of the rules regarding where the UCC financing statement must be filed and the adequacy of the description of collateral to be contained on the financing statement and in the security agreement. These revisions may potentially cause greater upheaval in the "space odyssey year" than most anticipate. In future issues, we will provide further background on the proposed Article 9. For more information please contact Jay Welford at (313) 961-8380.

Secured Creditor Surcharged For Agreeing To Debtor's Continued Operation

If an Eighth Circuit decision remains good law, creditors may lose some of their collateral in a debtor's property by allowing the debtor to continue in operation. Early this summer, in Hartford Underwriters Insurance Company v. Magna Bank, N.A. (In re Hen House Interstate, Inc.), a three-judge panel affirmed the bankruptcy court's order granting a surcharge on the collateral of Magna Bank ("Magna") for the payment of workers' compensation insurance premiums.

Magna was owed about $4.1 million at the inception of the Chapter 11 case and had a security interest in all of the debtor's assets. The debtor and Magna agreed to terms for a financing and cash collateral order permitting the payment of "all ordinary and necessary expenses of operation . . . which are allowed in the Budget." The Budget included workers' compensation premiums. The order also prohibited the surcharge of Magna's collateral pursuant to §506(c) without Magna's written consent, and no consent could be implied.

Reorganization efforts failed, and the debtor liquidated most of its assets. Hartford, who had continued to provide workers' compensation insurance despite the fact that the debtor had failed to pay over $50,000 in premiums, sought allowance and payment of its claim.

The Eighth Circuit determined that this case presented the same circumstances as its prior case, U.S. v. Boatmen's First National Bank of Kansas City ("Boatmen's"): Magna consented to the continued operation of the debtor's business.

Magna countered that Boatmen's was clearly distinguishable because the creditor in that case had agreed to subordinate its security interest to administrative expense claims. In doing so, the secured creditor in Boatmen's had consented to be surcharged. Furthermore, the Boatmen's bankruptcy court had found a direct benefit to the secured creditor. The Eight Circuit was not persuaded. It found that the decision in Boatmen's turned solely on the fact that the creditor consented to the continuation of the business. Magna's consent to the debtor staying in business was consent to payment of these premiums and therefore Magna's collateral was subject to surcharge.

The danger in the Eighth Circuit's opinion is that it creates a disincentive for creditors to agree to a debtor continuing in business. Lenders will be less willing to agree to debtors continuing in business and will instead opt for liquidation. For more information please contact Steve LaPlante at (313) 961-8380.

Regulator Advises Banks on PC Banking

On August 24, 1998 the Office of the Comptroller of the Currency ("OCC") advised banks on ways to identify and control risks arising out of banks' use of personal computer ("PC") banking. The Bulletin also laid out the OCC's expectations of bank management and boards of directors when the bank operates a PC banking system, and suggested that all banks that provide or are planning to provide PC banking should follow the guidelines.

Among the advice contained in the Bulletin, the OCC recommends that banks adopt thoroughly-tested security controls, including data access controls, encryption, and virus protection. Further, banks should monitor changes in consumer and banking laws, and should take adequate measures to comply with them. In addition, the OCC recommended that banks consult with legal counsel to ensure that they have enforceable contracts with their PC banking customers, particularly if electronic contracting is being used to sign customers up for the service. For more information, contact Holli Targan at 313-961-8380.

Customer Privacy Becomes the Hot Button Voluntary Action Regarding Online Privacy of Customer Information is Encouraged

Little has captured the attention of the banking regulators lately as much as electronic banking. And consumers' concerns about the information gathered by banks when using the electronic channel has prompted the regulators to advise banks on how to handle such information. The Federal Trade Commission and the Consumer Electronic Payments Task Force (comprised of federal banking agencies) both recently issued reports highlighting consumer privacy interests, and recommended voluntary industry action and self regulation.

In addition, a group made up of bank trade associations has developed "U.S. Banking Industry Privacy Principles" to encourage their members to voluntarily adopt privacy policies. Also, the FDIC recently sent a letter to bank Chief Executive Officers, which advised banks to take specific action to protect consumer information obtained electronically. These steps include notice to consumers about information practices before any personal information is collected, giving consumers a choice about how information collected about them may be used by the financial institution, and taking measures to protect against unauthorized access to consumer information.

The hope is that banks' voluntary efforts to address privacy concerns will head off formal regulation of how banks must handle consumer information obtained electronically. For more information, contact Holli Targan at (313) 961-8380.

Firm News

Thomas E. Coughlin was appointed as an Adjunct Professor at Wayne State Law School to teach creditor's rights during the Fall term of 1998. Mr. Coughlin was recently added to the list of Who's Who in American Lawyers, and will attend the National Conference of Bankruptcy Judges in Dallas later this month.

Stephen LaPlante recently taught bankruptcy trial advocacy at a seminar sponsored by the Federal Bar Association and the Detroit Bar Association

Victor F. Ptasznik, who is a member of the American Bar Association Commercial Financial Services Committee, will act as the Michigan law contributor to a state-by-state survey of law relevant to commercial lenders. The survey will be published and periodically updated on the Committee's website. Vic also coordinates the firm's role as Michigan Compendium Counsel for the Commercial Finance Association.

Larry Rochkind spoke on "Winning Techniques for the Insolvency Accountant as an Expert Witness" at the Business Valuations & Asset Recovery Conference in mid-September. Larry also is scheduled to participate at the Commercial Lending Institute on "Alternative Remedies for the Financially Distressed Debtor and Other Insolvency Issues" on November 4.

Holli Targan has written the Legal Issues chapter of The 1999 Guide to Smart Cards and Stored Value, published by Faulkner and Gray. The book is a handbook for businesses engaged in stored value projects in retailing, vending and the Internet.

Holli also presented a seminar on the legal issues surrounding banks' involvement in on-line securities brokerage activities at the 1998 Home Banking Forum.

Jay Welford, who is Co-Chair of the Legislative Committee of the Bankruptcy & Insolvency Section of the Commercial Law League of America, recently met with members of the House and Senate Conference Committee, which was reconciling two bankruptcy bills: S.1301, which was passed by the Senate; and H.R. 3150, which was passed by the House. Jay also met with the Deputy Economic Advisor to the President to review provisions of the pending legislation which the President had threatened to veto if not revised as a result of the Conference Committee's actions.

Jay has also been elected as an executive officer of the Bankruptcy & Insolvency Section and will ascend to its Chairmanship in a few years.

¹The factors used in determining if a given prefiling stay waiver is enforceable are: (1) the existence of a valid prefiling stay waiver; (2) the sophistication of the party making the waiver; (3) the time between the signing of the waiver and the bankuptcy filing; (4) the consideration given for the waiver; (5) the feasibility of the Debtor's plan; and (6) the effect that enforcement will have on junior lienors and unsecured creditors.

Members of the Financial Services Law practice group include: Gail Anderson, Lise Barerra, Robert Bolton, Tom Coughlin, Steve LaPlante, Ralph Margulis, Alicia McGinnis, Vic Ptaznik, Jane Quasarano, Larry Rochkind, Linda Scheuerman, Dan Serlin, Holli Targan, Jay Welford and Wendy Zabriskie.

The Firm periodically publishes this Newsletter and others on current developments in financial services law, real estate and property management law, environmental law, insurance law, real estate capital law, employment relations law and employee benefits law. If you would like to be added to our mailing list to receive this Newsletter or any of the others which we publish, please return the enclosed response card.

For more information on any of the topics covered by this Newsletter, or if you have any questions or comments, please feel free to contact the Editors, Holli Targan or Dan Serlin at (313) 961-8380. This Newsletter is provided as an information service to our clients and friends as a summary of current financial services law. These articles are not meant as legal opinions and readers are cautioned not to act on information provided without seeking specific legal advice with respect to their unique circumstances.

Copyright ©1998 by Jaffe, Raitt, Heuer & Weiss, Professional Corporation. The contents of this Newsletter may not be reproduced, transmitted or distributed without the express written consent of Jaffe, Raitt, Heuer & Weiss, Professional Corporation.