Authored by: David Simonds and Edward McNeilly (both of Hogan Lovells)
Secured Creditor Forced to Pay Debtor’s Attorney’s Fees When Receivable Sale Is Treated as Disguised Usurious Financing
In In re Shoot the Moon, LLC, 2021 WL 4144933 (Bankr. D. Mont.), the United States Bankruptcy Court for the District of Montana (the “Bankruptcy Court”) held that (i) prepetition cash advances made by a merchant cash advance company to a chapter 11 debtor were disguised loans, not true sale transactions, (ii) certain transfers made to the merchant cash advance company were avoidable preferential transfers and (iii) the debtor was entitled to recovery attorney’s fees as the prevailing party under the parties’ contract.
Key Background Facts
In the early 2000s, Kenneth Hatzenbeller and two other principal investors created a business known as Shoot the Moon. Over time, this enterprise grew to consist of nineteen LLCs formed pursuant to Idaho, Montana, and Washington law that owned and operated sixteen restaurants located throughout the three states. Among other forms of customer payment, the restaurants accepted credit cards, which generated a revenue stream for the Shoot the Moon entities from a payment processing company named Heartland Payment Systems, Inc. (“Heartland”).
The Shoot the Moon restaurants encountered financial pressures, including due to the 2007-2009 financial crisis. Shoot the Moon sought additional financing, including secured financing, from various entities. Once the Shoot the Moon entities exhausted these sources of capital, several Shoot the Moon Entities sought additional financing from merchant cash advance companies such as CapCall. Between October 2014 and September 2015, the Shoot the Moon entities and CapCall consummated eighteen transactions. The transactions were documented in so-called merchant agreements and UCC-1 financing statements were filed. In substance, Shoot the Moon received immediate cash in return for a portion of future receivables generated through restaurant operations, with the amounts promised by Shoot the Moon substantially exceeding the amount of cash CapCall paid.
In October 2015, all nineteen Shoot the Moon entities merged into Shoot the Moon, LLC (the “Debtor”), which filed a chapter 11 petition on the following day. A chapter 11 trustee was appointed (the “Trustee”) and, after a chapter 11 plan was confirmed, the Trustee was appointed trustee of the STM Liquidating Trust.
During the pendency of the chapter 11 case:
- the Trustee sold substantially all of the estate’s assets pursuant to section 363(b) of the Bankruptcy Code for a price that was substantially less that the amount of the claims of numerous secured creditors (including those with perfected security interests senior to CapCall).
- The Trustee moved to obtain turnover of certain funds being held by Heartland, consisting of restaurant customer credit card payments processed prepetition, but not transferred to any Shoot the Moon accounts before the petition date. The Trustee and CapCall subsequently stipulated to segregate these funds pending resolution of the parties’ disputes.
- CapCall filed a proof of claim asserting a claim for conversion of receivables that CapCall contended it owned. CapCall acknowledged that the claim was unsecured and that CapCall held no security interest in property of the debtor.
CapCall commenced an adversary proceeding seeking declaratory relief that it owned the remaining balance deposited in the segregated account, a judgment against the Trustee for converting postpetition receipts, and other miscellaneous fees, costs, and interest components. The Trustee counterclaimed, seeking declaratory relief about which state’s law applied to the transactions and that the transactions were disguised loans rather than sales. The Trustee also sought unencumbered title to the segregated account, avoidance and recovery of allegedly preferential transfers, and remedies stemming from CapCall’s allegedly usurious interest rates.
Classification of the Transactions as True Sales or Loans
Although the parties disagreed about which state’s law should apply – CapCall asserted New York law, the Trustee, Montana law – the Bankruptcy Court held that the choice of law analysis made no difference to the outcome. The Bankruptcy Court applied the following multi-part test to determine whether the transactions were true sales or loans:
- whether the buyer has a right of recourse against the seller;
- whether the seller continues to service the accounts and commingles receipts with its operating funds;
- whether there was an independent investigation by the buyer of the account debtor;
- whether the seller has a right to excess collections;
- whether the seller retains an option to repurchase accounts;
- whether the buyer can unilaterally alter the pricing terms;
- whether the seller has the absolute power to alter or compromise the terms of the underlying asset; and
- the language of the agreement and the conduct of the parties.
The Bankruptcy Court held that factors (1), (2) and (8) weighed heavily in favor of classifying the transactions as loans, as CapCall retained a right of recourse against the Shoot the Moon entities and several other parties, funds from the accounts receivable were comingled with Shoot the Moon’s operating funds (with CapCall’s approval) and the language of the parties’ agreements and their conduct revealed a debtor-creditor, not a seller-buyer, relationship. For those reasons, the Bankruptcy Court held that the transactions constituted loans, not true sales.
Montana Usury Claim
The Trustee also claimed that the economic terms of eleven agreements with a Shoot the Moon entity formed under Montana law exposed CapCall to a usury penalty under Montana law. CapCall disputed that Montana law applied, and urged application of New York law, which lacks a usury statute analogous to Montana’s.
In federal cases predicated on bankruptcy jurisdiction, courts in the Ninth Circuit apply the “federal” choice-of-law rules based on the Restatement (Second) of Conflict of Laws. Restatement section 187(2) broadly provides that a court will apply the parties’ contractual choice of law unless either:
(a) the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties choice, or
(b) application of the law of the chosen state would be  contrary to a fundamental policy of a state which  has a materially greater interest than the chosen state in the determination of the particular issue and  which . . . would be the state of the applicable law in the absence of an effective choice of law by the parties.
As the eleven agreements in question were, by their terms, governed by New York law, that choice of law controls unless a Restatement exception applies. The Bankruptcy Court found that the first exception did not apply. As CapCall is based and operates in New York, there was a reasonable basis for New York choice of law. However, the Bankruptcy Court found that the second exception did apply.
- First, applying New York law was inimical to the fundamental policy animating Montana’s usury law of protecting vulnerable borrowers. Applying New York law would circumvent Montana’s protections entirely.
- Second, Montana had a materially greater interest in determining this issue than New York, as the borrowers in these transactions were legal entities formed under and governed by Montana law, owned by individual Montana citizens, and operated by an individual Montana citizen working from a Montana office. The only relevant link to New York was CapCall’s place of business. Montana had a substantially greater interest than New York in preventing lenders from circumventing its usury laws in transactions involving Montana borrowers.
- Third, Montana law would control absent an effective choice of law as all relevant factors (place of contracting, performance, subject matter of the agreements, parties) were largely or wholly concentrated in Montana, thus giving Montana the most significant relationship to the transaction and the parties.
As Montana law applied, and the effective interest rates charged exceeding permissible limits under Montana law, the Trustee prevailed on his usury claim.
The Trustee also prevailed on his preference claim under section 547(b) of the Bankruptcy Code. As the transactions were loans, payments to CapCall within the 90 days prior to the bankruptcy filing were payments of the debtor’s property on account of antecedent debts. There was no dispute that the Shoot the Moon entities were insolvent. Finally, the transfers enabled CapCall to receive a greater amount than it would have done in a chapter 7 liquidation, where the funds transferred to CapCall would have become property of the Debtor’s estate subject to both CapCall’s security interests and security interests senior to CapCall’s security interests. As senior secured creditors were not repaid in full, CapCall would have had a worthless general unsecured claim in a chapter 7 proceeding.
Finally, the Bankruptcy Court awarded the Trustee attorney’s fees as the prevailing party under Montana law’s reciprocal fee statute, which makes unilateral fee provisions bilateral regarding “any action on the contract” and entitles the prevailing party in such action “to recover reasonable attorney’s fees from the losing party.” The eleven agreements subject to Montana law each provided an express right for CapCall to recover attorney’s fees associated with enforcement of its rights and remedies. The Bankruptcy Court held that all of the matters on which the Trustee prevailed constituted an “action on the contract,” and thus the Trustee was, as a matter of reciprocity, entitled to payment of its attorney’s fees.
This case illustrates the critical importance of ensuring that a securitization or receivables financing transaction intended to be a true sale truly passes muster under applicable law and that, as far as possible, any back-up security interest has priority over the security interests of other lenders. The reclassification of the merchant agreements as loans, not sales, and CapCall’s junior security position created disastrous results, as CapCall not only recovered no funds, but was exposed to millions of dollars in liability to the bankruptcy estate.