AGGRESSIVELY Protect Your Collateral When Borrowers Attempt Asset Transfers

LEGALISSUES

Be prepared to file lawsuits, objections, and other legal motions when small business borrowers transfer collateral to themselves and file for bankruptcy protection. But also be prepared to compromise.

BY MICHAEL D. FIELDING From time to time, debt-laden owners of small businesses attempt to game the system thusly: They transfer their company’s assets to themselves, file for either Chapter 11 or 13 bankruptcy protection, and try to restructure the debt owed to the lender who has a lien on the company’s assets. The owner/debtor justifies this approach by saying that he assumes the company’s debt obligation as part of the assignment of assets. But from the lender’s perspective, the transfer of assets violates existing loan provisions and leaves the company with no collateral to foreclose upon to satisfy the debt. In situations such as this, what actions can a secured lender take to protect its interests?

Don’t wait for the bankruptcy filing to initiate action. To be certain, the debtor is not looking to protect the lender’s best interests and will leverage his position as much as he can for his own benefit. A lender must aggressively hink s tock act to protect its collateral. Indeed, there is a real risk that the lender could be deemed / T tock S i to have waived certain important rights if it waits too long.

March 2014 The RMA Journal 71 fers the asset to the debtor and the bankruptcy is filed, that asset becomes property of the transferee’s bankruptcy estate and is protected by an automatic stay. The stay immediately goes into effect when a bankruptcy is filed. It prohibits all efforts to recover either pre-petition debts or property of the estate outside of the bankruptcy process. To begin, the lender should promptly communicate A party that knowingly violates the automatic stay with the debtor and find out exactly what was transferred. may be liable for actual and punitive damages as well It’s important to get copies of all documents related to the as attorney’s fees and costs. More plainly put, while the transaction (such as corporate resolutions, assignments, debtor’s actions may have been egregious, they do not etc.). While the company is no longer the legal owner of allow the lender to immediately swoop in and attempt the property, the transfer did not invalidate the lien, which to seize the collateral. Rather, the lender must proceed secures the underlying debt obligation. through the bankruptcy process to ultimately recover it Accordingly, it’s important to accelerate the debt and and/or be compensated by the debtor. Fortunately, the start the process of foreclosing on the collateral. The lender lender has several potential tools to be used in bankruptcy. should 1) consider freezing or setting off any monies in a deposit account if such funds are available, 2) demand Seek dismissal of the bankruptcy as a bad-faith filing. full payment from any guarantor, and 3) determine if the A debtor will be deemed to have filed his bankruptcy peti- transfer was not properly authorized under the company’s tion in bad faith when, considering the facts as a whole, governing organization documents and applicable state law. it strongly appears that the debtor is inappropriately at- As discussed in more detail below, a lender should tempting to avail himself of the bankruptcy laws. Once a strongly consider filing a lawsuit claiming that the col- bankruptcy is determined to have been filed in bad faith, lateral was fraudulently transferred to the debtor. The the judge can dismiss the case and thereby leave the parties lender should also seek with their normal state-law rights and remedies. Indeed, While the debtor’s actions to have a court issue in- judges do not appreciate debtors perceived as abusing junctive relief to protect the judicial process. may have been egregious, the property during the So how does one establish that a bad filing has occurred? they do not allow the pendency of the litiga- The lender needs to quickly create a record of the debtor’s lender to immediately tion. bad-faith conduct, which can be done in several ways. Of course, there may Gather key documents that demonstrate the issues the swoop in and attempt be many reasons why a debtor is facing. A party can question the debtor, under to seize the collateral. lender will not want to oath, at the 341 meeting of creditors that occurs a few initiate full-blown legal weeks after the bankruptcy is filed. A party can also con- action. In those circumstances, doing nothing is not an duct a Rule 2004 examination, which is akin to a subpoena optimal course of action. Instead, a lender can offer to where a party must produce documents and testify under forebear from instituting legal action provided the parties oath regarding matters relating to the debtor. Additionally, agree to amend their existing relationship. This could other parties adversely affected by the bankruptcy filing include modifying the loan terms, getting additional assets may be willing to share key facts or documents. pledged as collateral, receiving a waiver of any potential A bad-faith filing is determined based on the unique causes of action (such as lender liability claims), or obtain- circumstances of each case. Important factors may include ing additional guarantors.

Know your boundaries and beware of the automatic stay. No matter how many contracts or loan covenants were broken, the harsh reality is that, after the company trans-

72 March 2014 The RMA Journal the debtor’s wrongful conduct prior to the bankruptcy fil- Conveyance Act. These state statutes typically provide a ing, the timing of the debtor’s actions in relation to other lender with two potential claims by which it may recover ongoing events (such as a bankruptcy filing on the eve wrongfully transferred property. of a foreclosure sale of a key asset or just before adverse First, a creditor may claim that the company/borrower legal action is taken), or the debtor’s inability to viably made a constructively fraudulent transfer to the debtor. reorganize. To do this, the creditor must show that the company was insolvent when the transfer was made and that either the Object to the debtor’s use of cash collateral and demand company did not receive reasonably equivalent value in adequate protection. exchange or the transfer left the company with insufficient The pre-petition transfer of assets from the company to assets to pay bills. the debtor does not cut off the lender’s lien. Following the Alternatively, the creditor may argue that the company/ transfer, that lien still attaches to proceeds of that asset. borrower (which is controlled by the debtor) acted with The lender should formally inform both the bankruptcy actual intent to hinder, delay, or defraud its creditors. court and the debtor that the lender does not consent to Because no one ever the debtor’s use of that cash collateral. The lender must explicitly states their A court must consider the demand that the debtor provide adequate protection in real intent to defraud exchange for its use of the cash collateral in which the their creditors, most totality of the circumstances lender has a lien. statutes identify several in determining whether a Courts do not require a debtor to unilaterally provide badges of fraud that are transfer was fraudulent. adequate protection to secured lenders. Rather, that is deemed indicative of an something that must be affirmatively sought, and fre- actually fraudulent transfer. These include items such as 1) quently adequate protection will be given back only to whether the transfer was to an insider, such as an owner the date when the lender first files a motion seeking it. of a closely held company; 2) concealment of the transfer; 3) an impending lawsuit or other legal action at the time Seek relief from the automatic stay to foreclose on your of the conveyance; 4) the percentage of assets transferred; collateral. 5) the consideration that was received in exchange for the The Bankruptcy Code provides that relief from the auto- transfer; 6) solvency; and 7) the timing of the transfer matic stay may be granted either for cause or for situations compared to other ongoing events.2 In short, a court must where the debtor does not have equity in the collateral consider the totality of the circumstances in determining and it is not necessary for an effective reorganization.1 whether a transfer was fraudulent. Cause for relief from the automatic stay will depend Many states impose a constructive trust on property that directly on the specific facts of the case. However, ar- was fraudulently transferred to a debtor. A constructive guments supporting a bad-faith filing or the existence trust is an equitable remedy recognizing that, although of a fraudulent conveyance will go hand in hand with the debtor may hold legal title to the property, he is not a stay-relief motion. Even if a judge does not dismiss the equitable owner of the asset. In order to impose a a bankruptcy filing as being in bad faith, she may still constructive trust, courts require the creditor to specifi- grant relief from the automatic stay to enable the lender cally trace the asset. If a court imposes a constructive trust, to foreclose on its collateral. This real possibility provides the property will be deemed to be outside the debtor’s negotiating leverage to the lender if it is willing to reach bankruptcy estate and therefore not subject to the au- a compromise. tomatic stay.

Attack the transfer as a fraudulent conveyance. Object to the debtor’s exemptions. Virtually every state has adopted either the Uniform At times, there will be particular assets that are highly Fraudulent Transfer Act or the Uniform Fraudulent important to the debtor’s ongoing business operations.

March 2014 The RMA Journal 73 In an effort to both keep those assets and pay as little as materially false written document regarding the debtor’s possible on the lien supporting those assets, the debtor financial condition that was used with the intent to deceive will cause the company to transfer the property to him, to obtain money or property; 3) fraud or defalcation while then file bankruptcy and declare those assets as being acting in a fiduciary capacity; or 4) willful and malicious exempt—in other words, as assets the debtor will ulti- injury by the debtor to the property of another (such as mately be able to keep regardless of the outcome of the conversion).3 bankruptcy. To have these debts excepted from discharge, the credi- To add further salt to a lender’s wounds, a Chapter 13 tor must file an adversary proceeding (in other words, a debtor may even claim the property as being exempt, but lawsuit filed in the bankruptcy court against the debtor) not identify the lender’s lien as attaching to it, with the seeking a judicial determination that the debt is non- hope that the plan will be approved. dischargeable. Generally, the deadline for objecting to the A creditor must be vigilant in these circumstances. The discharge of these debts will be approximately 80 to 100 deadline for objecting to a debtor’s exemptions typically days after the bankruptcy petition date. falls somewhere between the 50th and 70th day following the bankruptcy filing. The notice-of-bankruptcy filing Object to the debtor’s proposed plan. issued by the court will have the exact date. A lender The debtor’s proposed bankruptcy plan will likely seek to should promptly obtain and examine the debtor’s bank- repay some minimum amount of the lender’s debt over ruptcy schedules to see which property is being claimed an extended period of time at a rate that is below market. as exempt. Additionally, the continued imposition of the automatic The creditor should also examine any proposed plan to stay followed by the discharge injunction may effectively ascertain how the debtor intends to deal with the lender’s strip the lender of its lien that secures the company’s debt lien. If the debtor is attempting to exempt some asset obligations. improperly, the lender needs to file an objection promptly In these situations it is absolutely essential that a lender with the bankruptcy court. vigorously object to any proposed plan that is not acceptable. Indeed, if a creditor knows of a plan provision—even Seek a denial of the debtor’s discharge for specific debts. The Bankruptcy Code provides that the debtor may not discharge certain types of debts through bankruptcy. These include 1) money or property obtained by false pretenses or actual fraud; 2) money or property obtained with a

74 March 2014 The RMA Journal debtor—which, in turn, provides some added leverage for negotiation.

Be prepared to compromise. Any seasoned practitioner will tell you there is never a guaranteed result in litigation. Given that reality, negotia- The sad reality is that, tion is the name of the game in bankruptcy. On the one hand, a lender faces the distinct risk that from time to time, judges a judge will allow the debtor to retain the property and restructure the debt obligation owed. Indeed, bankruptcy make mistakes or simply exists to give debtors a second chance, and judges are not terribly concerned about how the restructuring may side with the debtor in the impact a lender’s bottom line. On the other hand, reason- able and fair-minded judges may quickly recognize the debtor’s blatantly wrongful conduct and grant the creditor name of “equity.” the relief it seeks. Given there is always some inherent level of uncertainty, a lender may find it most advantageous to leverage its position as much as possible by seeking the relief discussed here, but then be willing to compromise when the a plan provision that contravenes existing law—and the debtor offers an acceptable proposal. Indeed, judges are plan is approved and becomes final and non-appealable, frequently quick to approve compromises between debtors then the creditor will be stuck with it. and lenders provided such agreements are in compliance For a plan to be confirmed under either Chapter 11 with applicable law. or Chapter 13, the Bankruptcy Code requires that the plan be confirmed in good faith and not by any “means Conclusion forbidden by law.”4 A plan cannot be proposed in good It can be extremely frustrating to have one’s collateral faith if the debtor has proposed it with the intent of ef- wrongfully transferred from the borrower/company to its fectively stripping the lender’s lien in contravention of owner/debtor, who then immediately files bankruptcy and existing law. Additionally, a plan cannot be proposed in seeks to restructure the debt. Because every situation is good faith where the debtor caused important property of unique, a lender cannot wholly rely on a laundry list of argu- the company to be fraudulently transferred to the debtor ments. Rather, the lender must be very prompt and diligent in contemplation of a bankruptcy filing. in protecting its collateral. Failure to do so could result in a very unsavory restructuring of the debt obligation. v Be ready to appeal. Despite having highly competent counsel making power- •• ful legal arguments, there is no guarantee that a lender Michael Fielding is a partner in the Kansas City office of Husch Blackwell LLP. He is will prevail at the bankruptcy court level. The sad reality board certified in business bankruptcy by the American Board of Certification. He can be is that, from time to time, judges make mistakes or simply reached at [email protected]. side with the debtor in the name of “equity.” While such rulings are painful, they are not the end of the road. A lender may appeal an adverse ruling to the Notes District Court and, if needed, appeal once again to the 1. See 11 U.S.C. § 362(d). 2. See Mo. Rev. Stat. § 428.024.2 (enumerating badges of fraud). Court of Appeals. This gives the lender a second and third 3. 11 U.S.C. § 523(a)(2), (4) and (6). bite at the apple and creates further uncertainty for the 4. See 11 U.S.C. §§ 1129(a)(3) and 1325(a)(3).

March 2014 The RMA Journal 75 Contributors

Ezra Becker is vice president of research and consulting in the Financial Services Business Unit of TransUnion. (His article can be found on page 44)

Dalton T. Sirmans is CEO, MainStreet Technologies, Atlanta, Georgia. MST provides software for analysis and mitigation of loan portfolio risk. (His article can be found on page 18) Michael D. Fielding is a partner in the Kansas City office of Husch Blackwell LLP. He is board certified in business bankruptcy by the American Board of Certification. (His article can be found on page 70)

Kathy Swift is senior vice president and client service officer, Capital Pacific Bank, Portland, Oregon. (Her article can be found on page 34)

Claude A. Hanley jr. is a partner at Capital Performance Group LLC in Washington, D.C. (His article can be found on page 28) Michael L. Weissman is counsel to the Chicago law firm of Levin Ginsburg. He has documented commercial and real estate transactions for banks and commercial finance lenders and has prosecuted civil and bankruptcy cases on behalf of financial institutions. He also is a member of The RMA Journal Editorial Advisory Board. James Hartzog is a senior commercial (His article can be found on page 61) lending expert and product manager for Harland Financial Solutions. (His article can be found on page 38)

Renato Zeko is an enterprise risk management specialist, New York Community Bancorp Inc., Westbury, New York. (His article can be found on page 22)

Vladimir Prupes is director of research and consulting in the Financial Services Business Unit of TransUnion. (His article can be found on page 44)

Mark Zoeller is president of Zoeller Credit Services, Coursegold, California. (His article can be found on page 56)

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