What Secured Lenders and Factors Need to Know About PACA and Other Hidden Liens

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Lien On Me: What Secured Lenders and Factors Need to Know About PACA and Other Hidden Liens

JULY 22, 2020 12:00 PM - 1 : 0 0 P M E T Disclaimer

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Howard Brod Brownstein (Moderator), The Brownstein Corporation (610) 828-1300 or [email protected] Howard is the President of The Brownstein Corporation near Philadelphia, a firm that provides investment banking, turnaround management and other services. He also regularly serves as an independent corporate board member for publicly-held and privately-owned companies, as well as large nonprofits. Howard is an NACD Board Leadership Fellow as well as a Fellow of the American Bar Foundation. He is the author of over 90 articles and textbook chapters, and regularly guest-teaches at leading business and law schools.

Jonathan S. Bodner, Bodner Law PLLC (516) 444-3923 or [email protected] Jonathan Bodner is the Founder of Bodner Law PLLC in Great Neck, NY, and provides local, regional and national businesses, as well as individuals, with legal excellence, results and value in a wide array of transactions, litigation and bankruptcy matters throughout Long Island, the boroughs of New York City and New Jersey.

Jeffrey A. Wurst, Armstrong Teasdale LLP (212) 209-4443 or [email protected] Jeffrey Wurst is a Partner at Armstrong Teasdale LLP in New York City, and has more than 30 years of experience and is well recognized for handling significant commercial finance and bankruptcy matters. He is an esteemed fellow of the American College of Commercial Finance Lawyers and is a panelist on the American Arbitration Association’s National Roster of Arbitrators.

▪ A wide array of liens arise under federal and state law that may have the effect of priming a secured lender

▪ However, there are steps lenders can take to protect themselves from becoming subordinated to these types of liens

▪ Many of these liens may be found by diligent lender searches and other due diligence

▪ IRS Tax Liens Arise under federal law Prime a bank, but a lender can run searches every ninety (90) days

▪ Real Estate Tax Liens Arise under state law Prime a mortgage, but can be monitored

▪ Warehouse Liens Arise under state law Inventory in the warehouse A lender can obtain a landlord’s waiver

▪ Construction & Material Men’s Liens Arise under state law Can prime a lender “Notice of Lending”

▪ Liens on Meat and Poultry – Packers & Stockyards Act Arise under federal law (and some by state law) Bond requirement Letter of Credit

▪ Other liens

▪ Notice of Lending

▪ State law money transmitter statutes Floating trust on proceeds of sales of ‘store value cards’

In addition to these liens, Lenders should be cognizant of a special lien that may arise when lending to any company that touches or will touch fruits and vegetables

The Perishable Agricultural Commodities Act of 1930, as Amended

▪ Over eighty (80) years ago, Congress concluded that sellers of certain perishable farm products were suffering from severely unfair treatment at the hands of their buyers

▪ Fruits and vegetables were grown on farms and sold in large quantities to buyers, often hundreds or thousands of miles away

▪ Upon delivery by rail, buyers were able to reject the goods on the basis that they were non-conforming or deteriorated in the course of transit

▪ Sellers could even falsely claim deterioration if a market declined between the placement of the order and delivery of the goods

▪ Farmers had limited recourse – they could not simply take back their goods upon a buyer’s non-acceptance or a dispute

▪ In 1930, Congress, seeking to protect farmers, passed legislation to regulate commerce by passing PACA

▪ PACA initially regulated transactions by requiring licensing of buyers and permitting United States Department of Agriculture (“USDA”) intervention when buyers failed to meet payment obligations

▪ Initial remedies for unpaid sellers were to seek suspension or revocation of buyers’ licenses or reparation awards, which could inure to a judgment

In the early 1980s,Congress expanded PACA’s protections as:

(i) produce sellers often did not have time to verify the creditworthiness of buyers due to the need to market and sell produce speedily;

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(ii) purchasers were using credit extended by secured lenders to purchase produce, which created security interests for the lenders in the produce and proceeds thereof; often this resulted in sellers being left unpaid upon buyers’ insolvencies or bankruptcies

▪ In 1984, Congress determined these types of financing arrangements were “against public policy” and a burden on commerce and amended PACA to increase the protections

▪ The 1984 PACA Amendments provide that perishable agricultural commodities, received by a commission merchant, dealer or broker, and all inventories or products derived therefrom, shall be held in trust for the benefit of all unpaid suppliers of such commodities until full payment has been received

▪ The 1984 Amendments provide that the mere shipment of qualifying produce creates a statutory trust on all of the buyer’s inventory of food or other products derived from the commodities, plus any proceeds of sales, as soon as the buyer accepts the goods

▪ It is a “floating” trust, which means that the trust extends to all of the buyer’s produce related inventory, and the proceeds thereof, regardless of whether the seller was the source of the inventory

▪ The seller becomes the beneficiary, and fiduciary duties are imposed upon the purchaser as well as certain individuals that control the trust property

▪ As the 1984 Amendments are an extremely powerful sword, Congress enacted rigid requirements for sellers to qualify for trust protection

▪ PACA makes it illegal to engage in the produce-marketing industry without first obtaining and complying with USDA's licensing requirements

▪ PACA makes various types of unfair trading conduct illegal and provides administrative complaint procedures as an alternative method to enforce PACA laws

▪ PACA establishes the PACA Trust under the 1984 Amendments to maximize the likelihood that produce sellers will be repaid in full before other creditors

▪ Farmers

▪ Certain logistics providers

▪ Exporters

▪ Commission merchants

▪ Brokers and farmers’ agents

▪ Dealers / Wholesalers

▪ The goods must qualify – fresh or frozen fruits and veggies – Processed or canned goods do not qualify – Example: Nuts don’t qualify, but what about Coconuts? – Example: Flowers don’t qualify, but what about edible flowers? – Fleming Case – Court held that batter-dipped frozen French Fries qualify as the process merely preserves crispiness and color while under a heating lamp, and they have the same taste and texture as potatoes after the process

▪ The buyer must be commission merchant, dealer or broker – a ‘dealer’ means “any person engaged in the business of buying or selling in wholesale ... quantities ... any perishable agricultural commodity in interstate ... commerce....” 7 C.F.R. § 46.2(m)(2) – dealer includes “retailers” who buy or sell produce “when the invoice cost of all purchases of produce exceeds $230,000 during a calendar year” AND purchases of at least one (1) ton of produce in any day of the year – Example: Wholesalers and distributors – What about: Restaurants, hotels, casinos, cruises or airlines?

▪ Transaction occurring in interstate or foreign commerce − Example: Where the seller and purchaser are both in same state, the transaction can still qualify as occurring in interstate or foreign commerce if the fruits or vegetables were grown or shipped from a foreign state or country

▪ Notice − Seller must send a “Notice of Intent to Preserve Trust Benefits” within 30 days after the expiration of the payment term, or alternatively, include proscribed statutory language on the invoices

▪ Payment terms: ‘prompt’ [10 days] / cannot exceed 30 days – Example: Parties agree by e-mail or telephone to extend payment terms

▪ Those licensed under PACA

▪ Those purchasing “wholesale or jobbing quantities”

▪ Most parties in the supply chain

May Assert PACA Trust Rights Can Be Liable Under PACA

Farmers Domestic Yes No Foreign Yes No

Logistics Providers Truckers Yes Yes Shippers Sometimes Sometimes Rail No No Air No No

May Assert PACA Trust Rights Can Be Liable Under PACA

Exporters Yes Yes

Processors No Yes

Commission Merchants, Yes Yes Brokers and Farmers’ Agents

May Assert PACA Trust Rights Can Be Liable Under PACA Dealers Wholesalers / Distributors Yes Yes E-commerce Firms Yes Yes Retailers No Yes Supermarkets Restaurants Hotels and Casinos Cruise lines Airlines

Consumers No No

▪ Personal liability to principal / party controlling PACA trust ▪ Landlords, trade creditors and lenders that receive payments pursuant to agreement or seek to enforce rights upon a default may be impacted by PACA where produce is involved – Notably, third parties that receive PACA trust funds may be able to assert certain defenses arising under general trust law

• American Airlines - $24 billion in assets, $29 billion of liabilities

• MSR Resorts - 30 luxury hotels, $2.2 billion in assets, $1.9 billion of liabilities

• Fresh & Easy – 167 grocery stores

• Sbarro - approximately 800 restaurants worldwide

• Quiznos - over 2,000 restaurants worldwide

• A&P Supermarkets – approximately 300 supermarkets Valid PACA claims were paid ahead of secured and unsecured creditors at outset of the bankruptcy proceedings through a variety of motions, bankruptcy court orders and procedures

D.M. Rothman & Co. Inc. v. Korea Commercial Bank Facts: ▪ KCB extended a revolving line of credit to DM in the form of “overdraft privileges” ▪ DM made regular bank deposits from sales of produce and also drew on line of credit ▪ DM paid overdraft charges to KCB in connection with the overdraft line ▪ KCB honored DM checks to non-PACA third parties ▪ DM then ceased making payments to PACA creditors and had a negative KCB account balance ▪ KCB continued to accept deposits of PACA trust funds and honor checks to non-PACA parties ▪ KCB called the line of credit when DM had an outstanding balance of over $150,000 and appx. $900,000 of PACA debt

Issue: ▪ Whether KCB was liable to unpaid PACA trust beneficiaries as a third-party transferee of PACA trust funds in breach of the PACA trust for receiving deposits into an account with a negative balance, honoring checks to non-PACA parties, and charging overdraft fees

Holding: ▪ The Court held that (i) KCB was not liable for receipt of the funds as the mere receipt did not encumber or render the funds less “freely available” to satisfy PACA obligations, (ii) KCB would have been liable for permitting withdrawals only if it had notice of the breach, and (iii) KCB was entitled to receive “commercially reasonable” overdraft fees

In re Kornblum

▪ A PACA creditor sought to include proceeds from a sale of a debtor’s cooperative units in the Hunts Point Market as part of the PACA trust ▪ The units were acquired prior to time that the particular PACA creditor’s claim arose, but after the debtor began engaging in business as a produce dealer ▪ The Court held that PACA imposes a non-segregated floating trust which continues in existence until all PACA trust creditors are paid in full ▪ Thus, the PACA creditor was able to assert its claim against the units as PACA trust assets, even though the units were acquired prior to time that the particular PACA creditor’s claim arose ▪ Kornblum Rule: The party disputing a PACA trust claim has the burden to prove either: (i) no PACA trust existed at the time of the purchase of an asset, (ii) even if a trust existed at the time of the purchase, no PACA trust funds were used to purchase the asset, or (iii) there was a time when all PACA debts were subsequently satisfied (thereby terminating the trust)

Mosovitz & Sons of Florida, Inc.

▪ Disputes between a secured creditor and PACA creditors regarding priority rights to real property and a CD ▪ The court held that under In re Kornblum, the burden of proof is on the lender to disprove the existence of a PACA trust ▪ PACA creditors were granted summary judgment regarding the real property and the Court held that a genuine issue of material fact existed regarding the origin of the funds for CD

Hunts Point Tropicals

▪ Secured Lender Bank and PACA creditors both argued In re Kornblum’s three-part rule.

▪ The Court held that a material issue of fact existed as to the origins of the funds used to acquire the assets

▪ Notably, PACA creditors also argued alternatively that the assets became PACA trust property because the monthly debt service was paid with PACA trust monies [Tony Vitrano Co. v. Nat’l Produce Co., Inc.]

▪ Ultimately, the lien dispute was settled before the Court was required to determine these issues.

A&J v. CIT / The Auster Company

▪ Whether a secured lender can receive ordinary loan payments from PACA trust sales proceeds ▪ The Court held that secured lender can accept money under trust law principals and not be subject to disgorgement of the funds to PACA creditors, if the lender: (i) qualifies as a bona fide purchaser, (ii) took the funds for value, and (iii) did not have notice of the PACA trust ▪ Key Distinction: A secured lender foreclosing on collateral versus receiving and accepting cash loan repayments from a borrower pursuant to ordinary loan terms ▪ Once a secured lender takes steps to exercise its rights and enforce its collateral, it is no longer taking “for value”, but instead, essentially forcing the transfer of trust property in satisfaction of an antecedent debt

Top Banana LLC v. Doms Wholesale & Retail Ctr., Inc.

▪ Court held that a factoring agreement is not per se breach of a PACA Trust ▪ Test: Does the financing arrangement encumber or render the PACA trust Assets less “freely available” ▪ A commercially reasonable sale of accounts for fair value is consistent with a PACA trustee’s primary duty under PACA ▪ Courts analyzing these disputes look to the terms of the factoring agreement ▪ Example: “Pennies on the dollar to turn a buck” vs. commercially reasonable rates ▪ In Boulder Fruit, the Court found no indication of a breach of a PACA trust where the factoring company paid more for the A/R than it collected ▪ However, in Top Banana LLC, the PACA trustee surrendered control of over $1 million of A/R to factoring company, didn’t exercise diligence over factor’s collection efforts, and which ultimately yielded poor collection results

Nickey Gregory v. Agricap, LLC

▪ Dispute between PACA creditors and secured lender regarding whether A/R proceeds were part of a PACA trust

▪ Converted A/R it was holding as loan collateral to cash and paid itself

▪ Key Distinction: Lending arrangement (A/R as collateral for loan) vs. true / traditional factoring arrangement (purchase A/R for a reasonably discounted price) [loan vs. sale]

▪ The Document was titled “Factoring Agreement” referenced “buyer”, “seller”, “purchase”, “sale”, as well as warranties traditionally accompanying an asset sale vs. Preliminary Term Sheet defining transaction as “credit facility”, referred to parties as “Lender” and “Borrower”, referred to “interest”, “advances”, “collateral”, and purpose “to fund borrower’s working capital needs”

Nickey Gregory v. Agricap, LLC (continued)

▪ There was even a Security Agreement referencing loan and collateral, Subordination Agreement for other debts providing for a first priority security interest in collateral, personal guaranty by the principal, UCC-1 filed to secure “the prompt and full payment and performance of the Secured Obligations”

▪ Court also looked to who bore the risk of collecting the A/R under the agreement (in a factoring agreement, risk should be on factor)

▪ In this case, the risk of collection remained on borrower

▪ The Court characterized the transaction as a revolving line of credit secured by A/R and other assets, and therefore, Agricap was deemed to be a lender and collection agent (as opposed to a purchaser for value)

▪ Accordingly, PACA trust claimants were deemed to have priorityProduce Pay, Inc. v. Spieth Farms, LLC and S&H Packing & Sales Co., Inc. v. Tanimura Distributing.

Recent Cases:

Produce Pay, Inc. v. Spiech Farms, LLC (W.D. Mich. 2019)

Accounts receivable sale where buyer retained full recourse against seller denied buyer protection of “true sale”

S&H Packing & Sales Co., Inc. v. Tanimura Distributing, Inc. (9th Cir. en banc 2018)

Ninth Circuit joined the Second, Fourth and Fifth Circuits in adopting a threshold true sale test to determine whether assets transferred in transactions that are labeled “sales” remain assets of a PACA trust

Know whether goods could qualify under PACA [Flemming]

Require representations in loan documentation regarding origin of funds [Kornblum]

Require representations in loan documents regarding existence of PACA debt at time of loan issuance [Kornblum]

Require full satisfaction of any and all PACA debt prior to loan issuance [Kornblum]

Monitor accounts payable subsequent to loan issuance

Monitor changes in business

If factoring PACA trust fund A/R, make sure factoring agreement: ▪ Contains commercially reasonable terms and borrower is actively involved in the collection process to maximize recovery [Top Banana] ▪ True Sale vs. Loan [Nick Gregory]

Know if there are PACA issues before foreclosing on collateral [A&J]

If A/R is part of a secured loan collateral package, be careful if lender collects A/R [Nick Gregory]

Bonds, Letters of Credit, Tri-party Agreements, etc.

– Non-PACA funds to purchase and/or pay monthly service, installments and/or premiums

Post loan transition from canned to fresh tomatoes

Private Equity Firm’s Sweep Of Portfolio Company Violated NY Trust Fund Law

LIEN ON ME: WHAT SECURED LENDERS AND FACTORS NEED TO KNOW ABOUT PACA AND OTHER HIDDEN LIENS

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