Lesa, LLC v. Family Trust of Kimberley and Alfred Mandel, 2016 WL 6599912 (N.D. Cal. 2016)
The following is a follow-up case summary relating to an order dated November 2016, with respect to the same junior lenders and senior lender written about in the Fall 2016 ACIC Newsletter. In the Fall 2016 case summary, the United States District Court for the Northern District of California held that a standstill provision only barred actions to enforce a subordinated debt, but that the provision did not bar all legal actions outright, including actions alleging fraud. Here the Court addressed whether the defendant Junior Lenders’ specific cause of action for rescission of contract violated the standstill provision.
In 2012, Montage Capital LLC (“Montage”) lent $925,000 of senior debt (“Senior Debt”) to INSITEsource Corporation (“Insite”). Insite then raised over $500,000 (“Subordinated Debt”) from a number of investors (the “Junior Lenders”). The Junior Lenders entered into a subordination agreement in favor of Montage, under which a standstill provision provided that the Junior Lenders were not to (1) “demand or receive from [Insite]…all or any part of the Subordinated Debt, by way of payment, prepayment, setoff, lawsuit or otherwise”, or (2) exercise any remedy with respect to collateral or “commence, or cause to commence, prosecute or participate in any administrative, legal or equitable action against [Insite]”, in each case, until the Senior Debt was fully paid.
In the fall of 2014, certain Junior Lenders in the case attempted to seize control of Insite and its assets. These actions triggered a default under the Senior Debt loan and security agreement between Insite and Montage. In October 2014, Insite filed suit in San Francisco Superior Court to seek clarification as to its legal rights and return of its assets.
By February 2015, the Junior Lenders filed a cross-complaint against Montage, Insite and affiliates, alleging, among other things, fraud and negligent misrepresentation by Insite. In the April 2016 order, the Court held that the Junior Lenders could file their cross-complaint based upon fraud because the subordination agreement’s intention was to bar the enforcement of the Subordinated Debt, but not to bar all legal actions outright. In the April 2016 order, the Court left open the door to allow the Senior Lender to make the argument that the Junior Lenders’ cross-complaint itself was the functional equivalent of an action to collect the Subordinated Debt. Consequently, the Senior Lender amended its complaint and identified fifteen alleged breaches by Junior Lenders that demonstrate that the cross-complaint was the functional equivalent of an action to collect the Subordinated Debt that resulted in a breach of contract with respect to the Subordination Agreement.
The Junior Lenders, however, argued that the Subordination Agreement was meant to bar actions to enforce the Subordinated Debt, whereas an action for rescission for fraud in the inducement seeks to “extinguish the Subordinated Debt and to return the parties to where they were before the contracted was entered.” The Court agreed with the Junior Lenders. The Court ultimately rejected the Senior Lender’s argument that the cross-complaint was the functional equivalent of an action to collect on the Subordinated Debt, because it found that there is a legal distinction between an action to rescind a contract and an action to enforce a contract. An action to collect on the Subordinated Debt would be seeking to enforce the benefit of the bargain or expectation interest under a contract (i.e. the Subordination Agreement). However, in this case, an action to rescind the Subordinated Debt “seeks to repudiate its very existence.”
Accordingly, the Court found that the fifteen potential alleged breaches by Junior Lenders were “dependent on the Subordination Agreement prohibiting a creditor from seeking to rescind the Subordinated Debt in the first place…” (i.e. the alleged “breaches” are only a breach “if rescission is prohibited by the Subordination Agreement to begin with.”). The Court’s holding in this case essentially nullified the Subordination Agreement to the benefit of the Junior Lenders. The Court further observed that while an action to enforce the Subordinated Debt and an action to rescind the Subordinated Debt may have the same practical effect (as in this particular case), they are “still two different legal claims with different remedies.” With this decision, the Court is effectively putting the burden on senior creditors to specify in standstill provisions that an action for rescission of debt counts as a prohibited action by junior creditors under a subordination agreement.