Bankruptcy Court holds that senior lender with security interest in debtors’ pre-petition inventory and accounts receivable, and holding replacement liens in the same type of property post-petition, is entitled to proceeds from post-petition sale of inventory acquired pre-petition and reimbursement for post-petition real estate taxes the lender advanced for the debtors over the claims of a post-petition secured lender. In re Isaacson Steel, Inc., 2013 BNH 010 (September 19, 2013)
On June 22, 2011, the debtors Isaacson Steel, Inc. (“ISI”) and Isaacson Structural Steel, Inc. (“ISSI,” together with ISI, the “Debtors”) voluntarily filed for Chapter 11 bankruptcy. As of the petition date, Passumpsic Savings Bank (the “Secured Lender”) held valid and perfected pre-petition security interests in the Debtors’ inventory and accounts receivable. To allow the Debtors to use the Secured Lender’s cash collateral and provide the Secured Lender with adequate protection from its diminution in value, the bankruptcy court granted the Secured Lender valid and perfected replacement liens in all post-petition inventory and accounts receivable of the Debtors.
Later in 2011, the Debtors entered into a secured lending agreement with the New Hampshire Business Finance Authority (the “Post-petition Lender”), which the court approved. The Debtors granted the Post-petition Lender “[a] first priority security interest in accounts receivable and inventory acquired . . . on or after October 1, 2011” and in proceeds generated from them. The agreement also provided that the Post-petition Lender’s liens were valid and perfected, and entitled to priority over competing liens, including those held by the Secured Lender. It did specifically disclaim the Post-petition Lender’s interest in all “cash collateral” that reflected the Debtors’ obligations to the Secured Lender.
On February 29, 2012, the Debtors sold substantially all of their property and the Secured Lender, following the court’s order, started to liquidate its security interests in the Debtors’ assets. The dispute arose regarding certain cash and other assets that remained in the Debtors’ estate after they wound down operations. On October 22, 2012, the Post-petition Lender, Turner (another creditor) and the Debtors entered into a stipulation settlement (the “Stipulation”) as to the distribution of the Debtors’ cash (the proceeds of winding down the operations of the Debtors), which established four funds of cash reserves that were disputed by the parties. While acknowledging the difficulty of tracing the cash and allocating expenses, the Stipulation divided the cash reserves between the Post-petition Lender and Turner and was approved by the bankruptcy court over the Secured Lender’s objections. The Secured Lender sought to enforce its liens on the cash reserves, and the parties submitted testimony for the court.
The court framed the dispute as competing claims over the four cash reserve funds by the Secured Lender and the parties to the Stipulation (chiefly the Post-petition Lender). It noted that the Bankruptcy Code required all entities claiming an interest in property to bear the burden of proof. It first analyzed whether the Secured Lender or the Post-petition Lender had met their individual burdens to show their interest in the funds, then ascertained each fund and their respective sources, and finally evaluated the Secured Lender’s and Post-petition Lender’s claims to the amounts. The primary dispute in the case surrounded the third and fourth funds.
The third fund consisted of proceeds from the sale of inventory purchased by the Debtors for a contract that was cancelled pre-petition. Specifically, those proceeds were from a sale of steel inventory that ISSI had acquired for fulfilling a pre-petition contract with Hilton, and after the contract was cancelled, ISSI sold the inventory post-petition and deposited the disputed proceeds into the fund. The Secured Lender argued that the inventory (and therefore the proceeds from its sale) constituted its cash collateral because the Hilton contract was entered into pre-petition. The Post-petition Lender argued that unless the Secured Lender could demonstrate that it had a valid security interest attached to the inventory when it was purchased, then the proceeds of the sale should be distributed according to the Stipulation.
The court noted that one form of adequate protection allowed for creation of replacement liens for pre-petition lienholders on accounts or inventory acquired post-petition to avoid the difficulties of tracing the proceeds of the collateral and so long as it avoids a windfall to the lienholder. Here, the court found that the inventory was purchased pre-petition and because the Secured Lender held a valid senior secured lien on all inventory of the Debtors, it was the Secured Lender’s collateral as of the petition date. After petition, the Secured Lender held a replacement lien on proceeds of its collateral, and because the proceeds from the sale (which comprised the third fund) were traceable to the inventory, they constituted proceeds from sale of the Secured Lender’s pre-petition collateral and not additional windfall to the Secured Lender. Therefore, the court held that the Hilton inventory proceeds constituted adequate protection subject to Secured Lender’s replacement lien and ordered them distributed to the Secured Lender.
The fourth fund was a $60,000 escrow set aside for the Debtors’ real estate tax obligations during the bankruptcy. Because the Secured Lender held first mortgages on the Debtors’ real estate, it paid the Debtors’ accrued real estate taxes of $53,438 from the proceeds of foreclosure. The Debtors collectively had placed $60,000 into escrow, but the financial advisor for the Debtors could not trace the escrow’s amounts to particular sources.
The court noted that Section 503 of the Bankruptcy Code allows for claims for administrative expenses paid by any entity to preserve a Debtor’s estate so long the taxes were incurred post-petition. The court agreed that the Secured Lender was entitled to an administrative claim for all post-petition taxes it advanced on behalf of the Debtors and because the escrow was earmarked for payment of post-petition real estate taxes, it ordered $53,438 of the fund distributed to the Secured Lender to satisfy its administrative claim. For the remainder, the court allocated based on the use and benefit that each Debtor received from the real property between the petition date and date of sale. It found that ISI received approximately 12.33% of the use and ISSI, 87.67%. Because ISI’s ending cash was subject to the Secured Lender’s lien and sale order and ISSI’s assets were subject to the Stipulation, the court ordered the ISI portion of the remainder distributed to the Secured Lender and the ISSI portion distributed according to the Stipulation.
Court for District of Massachusetts holds that an episcopal church (debtor) is an eligible entity to file a Chapter 11 bankruptcy petition by virtue of its status as a corporation, rather than a nominee trust of the national church that default interest rates of nearly double the contract rates were unenforceable penalties resulting in denial of bank’s claim for pre-petition and post-petition interest. OneUnited Bank v. Charles Street African Methodist Episcopal Church of Boston, 501 B.R. 1 (Sep. 30, 2013).
OneUnited Bank (the “Bank”) brought a foreclosure action against debtor Charles Street African Methodist Episcopal Church of Boston (the “Debtor”) after the Debtor failed to make payments on its two outstanding loans. The Debtor responded by filing a Chapter 11 bankruptcy petition. The Bank sought to dismiss this petition on grounds of the Debtor’s ineligibility and bad faith under U.S.C. § 1112(b)(1) . The Bank also filed a proof of claim against the Debtor for payments outstanding and interest accruing under the default interest rates of the loans, to which the Debtor objected.
The Debtor is a Massachusetts non-profit corporation that is a part of the African Methodist Episcopal Church (the “National Church”), a national umbrella organization connected to its regional affiliates through national conferences. The National Church is governed by its organizing document, the Book of Discipline, which states that all regional churches that own property hold that property in trust for a national non-profit entity affiliated with the National Church. The Book of Discipline also requires all regional churches to seek approval from the national conference before encumbering or transferring any property.
The Debtor desired to build a community center for its members and sought financing from the Bank, and secured its loans with mortgages on its property. The Debtor obtained all necessary approvals for its mortgages from the national conference. The Debtor received one loan in the principal amount of $1.115 million at a fixed interest rate of 7.875% to mature in five years and a second loan in the principal amount of $3.652 million at a floating “prime” rate between 7% and 14% to mature in 18 months. Both loans contained default interest rates of the greater of 18% or the “prime” rate plus 5%. The Debtor defaulted on both loan obligations and the Bank moved to foreclose against the Debtor’s mortgaged property. In response, the Debtor filed a Chapter 11 bankruptcy petition, and the Bank sought to dismiss this petition and file a proof of claim.
The District Court affirmed the Bankruptcy Court’s denial of the Bank’s motion to dismiss. The court concluded that the Debtor was a corporation duly constituted under Massachusetts law and thereby an eligible debtor under Chapter 11. In reaching its conclusion, the court found that the Debtor was not a nominee trust as asserted by the Bank because the Debtor controlled its own operations outside the instruction of the National Church. The Debtor had members and employees and conducted various business and charitable activities. Holding property in trust for the National Church and requiring approval to encumber or transfer that property did not negate the Debtor’s independent existence and activities. The Debtor’s push to build a community center further emphasized that it was not merely an agent of the National Church.
The court further concluded that the Debtor’s objection to the Bank’s proof of claim was meritorious, and affirmed the Bankruptcy Court’s denial of pre-petition and post-petition interest to the Bank. In reaching its conclusion, the court noted that the default interest rates were more than double the contract rates of the loans and nearly 10% higher than the prime rate at the time of contracting. In order to justify these heightened rates, the Bank’s default interest rates would have to have been a reasonable forecast of the Bank’s anticipated damages. Instead, the Debtor successfully demonstrated that the default interest rates were not a reasonable forecast of the Bank’s estimated damages. The court noted that the Bank applied the same default rates for both loans, despite differences in principal amounts, interest rates and maturity dates. The court also found that the default rates ranged from the prime rate plus 5% to prime plus 10% but would never fall lower than 18%. This arbitrary imposition and volatility did not reflect the Bank’s potential damages in a default. The court concluded, therefore, that these default rates were not related to the Bank’s potential damages and that the Bank did little to reasonably estimate its potential damages in the event of a default. In fact, the court found that these rates not only failed to reasonably forecast the Bank’s damages, but were grossly disproportionate to a reasonable estimate of damages. Thus, the court held that the Bank was penalizing the Debtor and that the default interest rates were unenforceable penalties.
Unambiguous language in a guaranty agreement will control during a dispute and overcome defenses and counterclaims of fraudulent inducement, ambiguity, undue influence and breach of good faith dealing. HSBC Realty Credit Corporation (USA) v. O’Neill, 2014 WL 486529 (1st Cir. Feb. 7, 2014).
HSBC (the “Lender”) brought an action against O’Neill (the “Guarantor”) as the guarantor of the Lender’s loan to a company, Brandywine Partners, LLC (the “Borrower”), of which the Guarantor was a principal. The Lender extended a loan to the Borrower of $15.9 million, which was personally guaranteed by the Guarantor up to a cap of $8.1 million. The guaranty stated that the Guarantor was the primary obligor of the loan to the Borrower and that the Lender need not enforce or exhaust its rights or remedies against the Borrower or its collateral before enforcing its guaranty against the Guarantor. The loan agreement also limited the loan-to-yield ratio to 60% of the Borrower’s property value.
The Guarantor responded to the Lender’s enforcement of the guaranty with an array of defenses and counterclaims, including fraudulent inducement, ambiguity, good faith dealing and undue influence, among several others. The District Court rejected the Guarantor’s defenses and granted the Lender’s judgment on the pleadings. The Guarantor appealed the District Court’s decision.
The Court of Appeals concluded that the Guarantor’s claims were baseless given the unambiguous language and clear provisions of the personal guaranty. The Guarantor first claimed fraudulent inducement based on the loan-to-yield ratio enforced by the Lender against the Borrower, arguing that the Lender had knowledge that the property value was not sufficient to meet this ratio while the Guarantor had no such knowledge. The court, however, found that the Guarantor explicitly confirmed in the guaranty agreement that he was familiar with the Borrower’s property value and that the Guarantor acknowledged that the Lender made no representations inducing him to sign the guaranty.
The court continued by finding that the Lender had not represented that it would enforce its rights against the Borrower’s property before enforcing them against the Guarantor. The court reached this conclusion because the guaranty stated that the Lender may enforce its rights first against the property, but not that it must. Additionally, the guaranty specifically granted the Lender the ability to enforce its rights against the Guarantor before exhausting its other remedies. The court found that these unambiguous terms in the guaranty controlled and held that it is unreasonable as a matter of law to rely on alleged misrepresentations that contradict the explicit terms of an agreement.
The court also rejected the Guarantor’s claim that the guaranty cap provision was ambiguous. The clear language of the guaranty precluded any reasonable differences in interpretation of whether the guaranty cap applied only to the last $8.1 million of the loan, as the Guarantor asserted. The court concluded that contract provisions must be read consistently with their actual language, and there were no terms in the guaranty indicating that it applied only to the last $8.1 million of the loan.
Additionally, the court found that the Guarantor’s unfair or deceptive practices claim failed because the underlying fraud claim was insufficient and the Guarantor’s claim could not stand without the fraud claim. The court also found no merit in the Guarantor’s claim of a breach of good faith dealing because the Guarantor was not a party to the original loan agreement and therefore could not bring a claim asserting bad faith against the Lender.
The court also dismissed the Guarantor’s undue influence and contract of adhesion claims because the Guarantor had held himself forward as a sophisticated party. The Guarantor acknowledged his property interest and that he conducted an independent review of financial records and property value as part of the guaranty. The court concluded that these acknowledgements provided evidence of his sophistication as a party.
Finally, the court rejected the Guarantor’s argument that limited guaranties are generally meant to cover the last portion of the loan. The court found that even were this unsupported claim true, the unambiguous language of the guaranty once again controlled. The guaranty expressly provided that the Lender had no obligation to enforce the loan agreement against the collateral before the Guarantor, so the Lender was entitled to enforce its claim against the Guarantor.
Having rejected the Guarantor’s arguments, the Court of Appeals affirmed the judgment of the District Court.
