March 2014 The RMA Journal70

LEGALISSUES

March 2014 The RMA Journal | Copyright 2014 by RMA70

March 2014 The RMA Journal 71

AGGRESSIVELY Protect Your Collateral

When Borrowers Attempt Asset Transfers

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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.

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 act to protect its collateral. Indeed, there is a real risk that the lender could be deemed to have waived certain important rights if it waits too long.

BY MICHAEL D. FIELDING

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To begin, the lender should promptly communicate with the debtor and find out exactly what was transferred. It’s important to get copies of all documents related to the transaction (such as corporate resolutions, assignments, etc.). While the company is no longer the legal owner of the property, the transfer did not invalidate the lien, which secures the underlying debt obligation.

Accordingly, it’s important to accelerate the debt and start the process of foreclosing on the collateral. The lender should 1) consider freezing or setting off any monies in a deposit account if such funds are available, 2) demand full payment from any guarantor, and 3) determine if the transfer was not properly authorized under the company’s governing organization documents and applicable state law.

As discussed in more detail below, a lender should strongly consider filing a lawsuit claiming that the col-lateral was fraudulently transferred to the debtor. The

lender should also seek to have a court issue in-junctive relief to protect the property during the pendency of the litiga-tion.

Of course, there may be many reasons why a lender will not want to initiate full-blown legal

action. In those circumstances, doing nothing is not an optimal course of action. Instead, a lender can offer to forebear from instituting legal action provided the parties agree to amend their existing relationship. This could include modifying the loan terms, getting additional assets pledged as collateral, receiving a waiver of any potential causes of action (such as lender liability claims), or obtain-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-

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 im-mediately 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.

A party that knowingly violates the automatic stay may be liable for actual and punitive damages as well as attorney’s fees and costs. More plainly put, while the debtor’s actions may have been egregious, they do not allow the lender to immediately swoop in and attempt to seize the collateral. Rather, the lender must proceed through the bankruptcy process to ultimately recover it and/or be compensated by the debtor. Fortunately, the lender has several potential tools to be used in bankruptcy.

Seek dismissal of the bankruptcy as a bad-faith filing. A debtor will be deemed to have filed his bankruptcy peti-tion in bad faith when, considering the facts as a whole, it strongly appears that the debtor is inappropriately at-tempting to avail himself of the bankruptcy laws. Once a bankruptcy is determined to have been filed in bad faith, the judge can dismiss the case and thereby leave the parties with their normal state-law rights and remedies. Indeed, judges do not appreciate debtors perceived as abusing the judicial process.

So how does one establish that a bad filing has occurred? The lender needs to quickly create a record of the debtor’s bad-faith conduct, which can be done in several ways. Gather key documents that demonstrate the issues the debtor is facing. A party can question the debtor, under oath, at the 341 meeting of creditors that occurs a few weeks after the bankruptcy is filed. A party can also con-duct a Rule 2004 examination, which is akin to a subpoena where a party must produce documents and testify under oath regarding matters relating to the debtor. Additionally, other parties adversely affected by the bankruptcy filing may be willing to share key facts or documents.

A bad-faith filing is determined based on the unique circumstances of each case. Important factors may include

While the debtor’s actions may have been egregious, they do not allow the lender to immediately swoop in and attempt to seize the collateral.

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the debtor’s wrongful conduct prior to the bankruptcy fil-ing, the timing of the debtor’s actions in relation to other ongoing events (such as a bankruptcy filing on the eve of a foreclosure sale of a key asset or just before adverse legal action is taken), or the debtor’s inability to viably reorganize.

Object to the debtor’s use of cash collateral and demand adequate protection. The pre-petition transfer of assets from the company to the debtor does not cut off the lender’s lien. Following the transfer, that lien still attaches to proceeds of that asset. The lender should formally inform both the bankruptcy court and the debtor that the lender does not consent to the debtor’s use of that cash collateral. The lender must demand that the debtor provide adequate protection in exchange for its use of the cash collateral in which the lender has a lien.

Courts do not require a debtor to unilaterally provide adequate protection to secured lenders. Rather, that is something that must be affirmatively sought, and fre-quently adequate protection will be given back only to the date when the lender first files a motion seeking it. Seek relief from the automatic stay to foreclose on your collateral. The Bankruptcy Code provides that relief from the auto-matic stay may be granted either for cause or for situations where the debtor does not have equity in the collateral and it is not necessary for an effective reorganization.1

Cause for relief from the automatic stay will depend directly on the specific facts of the case. However, ar-guments supporting a bad-faith filing or the existence of a fraudulent conveyance will go hand in hand with a stay-relief motion. Even if a judge does not dismiss a bankruptcy filing as being in bad faith, she may still grant relief from the automatic stay to enable the lender to foreclose on its collateral. This real possibility provides negotiating leverage to the lender if it is willing to reach a compromise.

Attack the transfer as a fraudulent conveyance. Virtually every state has adopted either the Uniform Fraudulent Transfer Act or the Uniform Fraudulent

Conveyance Act. These state statutes typically provide a lender with two potential claims by which it may recover wrongfully transferred property.

First, a creditor may claim that the company/borrower made a constructively fraudulent transfer to the debtor. To do this, the creditor must show that the company was insolvent when the transfer was made and that either the company did not receive reasonably equivalent value in exchange or the transfer left the company with insufficient assets to pay bills.

Alternatively, the creditor may argue that the company/borrower (which is controlled by the debtor) acted with actual intent to hinder, delay, or defraud its creditors. Because no one ever explicitly states their real intent to defraud their creditors, most statutes identify several badges of fraud that are deemed indicative of an actually fraudulent transfer. These include items such as 1) whether the transfer was to an insider, such as an owner of a closely held company; 2) concealment of the transfer; 3) an impending lawsuit or other legal action at the time of the conveyance; 4) the percentage of assets transferred; 5) the consideration that was received in exchange for the transfer; 6) solvency; and 7) the timing of the transfer compared to other ongoing events.2 In short, a court must consider the totality of the circumstances in determining whether a transfer was fraudulent.

Many states impose a constructive trust on property that was fraudulently transferred to a debtor. A constructive trust is an equitable remedy recognizing that, although the debtor may hold legal title to the property, he is not the equitable owner of the asset. In order to impose a constructive trust, courts require the creditor to specifi-cally trace the asset. If a court imposes a constructive trust, the property will be deemed to be outside the debtor’s bankruptcy estate and therefore not subject to the au-tomatic stay.

Object to the debtor’s exemptions. At times, there will be particular assets that are highly important to the debtor’s ongoing business operations.

A court must consider the totality of the circumstances in determining whether a transfer was fraudulent.

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In an effort to both keep those assets and pay as little as possible on the lien supporting those assets, the debtor will cause the company to transfer the property to him, then file bankruptcy and declare those assets as being exempt—in other words, as assets the debtor will ulti-mately be able to keep regardless of the outcome of the bankruptcy.

To add further salt to a lender’s wounds, a Chapter 13 debtor may even claim the property as being exempt, but not identify the lender’s lien as attaching to it, with the hope that the plan will be approved.

A creditor must be vigilant in these circumstances. The deadline for objecting to a debtor’s exemptions typically falls somewhere between the 50th and 70th day follow-ing the bankruptcy filing. The notice-of-bankruptcy filing issued by the court will have the exact date. A lender should promptly obtain and examine the debtor’s bank-ruptcy schedules to see which property is being claimed as exempt.

The creditor should also examine any proposed plan to ascertain how the debtor intends to deal with the lender’s lien. If the debtor is attempting to exempt some asset improperly, the lender needs to file an objection promptly with the bankruptcy court.

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

materially false written document regarding the debtor’s financial condition that was used with the intent to deceive to obtain money or property; 3) fraud or defalcation while acting in a fiduciary capacity; or 4) willful and malicious injury by the debtor to the property of another (such as conversion).3

To have these debts excepted from discharge, the credi-tor must file an adversary proceeding (in other words, a lawsuit filed in the bankruptcy court against the debtor) seeking a judicial determination that the debt is non-dischargeable. Generally, the deadline for objecting to the discharge of these debts will be approximately 80 to 100 days after the bankruptcy petition date.

Object to the debtor’s proposed plan. The debtor’s proposed bankruptcy plan will likely seek to repay some minimum amount of the lender’s debt over an extended period of time at a rate that is below market. Additionally, the continued imposition of the automatic stay followed by the discharge injunction may effectively strip the lender of its lien that secures the company’s debt obligations.

In these situations it is absolutely essential that a lender vigorously object to any proposed plan that is not accept-able. Indeed, if a creditor knows of a plan provision—even

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a plan provision that contravenes existing law—and the plan is approved and becomes final and non-appealable, then the creditor will be stuck with it.

For a plan to be confirmed under either Chapter 11 or Chapter 13, the Bankruptcy Code requires that the plan be confirmed in good faith and not by any “means forbidden by law.”4 A plan cannot be proposed in good faith if the debtor has proposed it with the intent of ef-fectively stripping the lender’s lien in contravention of existing law. Additionally, a plan cannot be proposed in good faith where the debtor caused important property of the company to be fraudulently transferred to the debtor in contemplation of a bankruptcy filing.

Be ready to appeal. Despite having highly competent counsel making power-ful legal arguments, there is no guarantee that a lender will prevail at the bankruptcy court level. The sad reality is that, from time to time, judges make mistakes or simply 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 District Court and, if needed, appeal once again to the Court of Appeals. This gives the lender a second and third bite at the apple and creates further uncertainty for the

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-tion is the name of the game in bankruptcy.

On the one hand, a lender faces the distinct risk that a judge will allow the debtor to retain the property and restructure the debt obligation owed. Indeed, bankruptcy exists to give debtors a second chance, and judges are not terribly concerned about how the restructuring may 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 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 dis-cussed here, but then be willing to compromise when the debtor offers an acceptable proposal. Indeed, judges are frequently quick to approve compromises between debtors and lenders provided such agreements are in compliance with applicable law.

ConclusionIt can be extremely frustrating to have one’s collateral wrongfully transferred from the borrower/company to its owner/debtor, who then immediately files bankruptcy and seeks to restructure the debt. Because every situation is unique, a lender cannot wholly rely on a laundry list of argu-ments. Rather, the lender must be very prompt and diligent in protecting its collateral. Failure to do so could result in a very unsavory restructuring of the debt obligation. v

••Michael 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. He can be reached at Michael.Fielding@huschblackwell.com.

Notes1. See 11 U.S.C. § 362(d).2. See Mo. Rev. Stat. § 428.024.2 (enumerating badges of fraud). 3. 11 U.S.C. § 523(a)(2), (4) and (6). 4. See 11 U.S.C. §§ 1129(a)(3) and 1325(a)(3).

The sad reality is that, from time to time, judges make mistakes or simply side with the debtor in the name of “equity.”

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Contributors

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

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

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.(His article can be found on page 61)

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

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)

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

JaMes hartZog is a senior commercial lending expert and product manager for Harland Financial Solutions. (His article can be found on page 38)

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 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)

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)