By: Dean A. Langdon
A hallmark of bankruptcy is the ability of a trustee to recover fraudulent transfers from third parties. Fraudulent transfers include transferring property without being paid for it, transferring property for less than its worth, and making payments to a third party who knows the payments are likely to harm other creditors. Bankruptcy trustees have the ability to recover fraudulent transfers under both bankruptcy and state laws. Many states have adopted the Uniform Fraudulent Transfer Act (“UFTA”) or Uniform Voidable Transfer Act (“UVTA”) which allow a trustee to examine transactions in the four years before a bankruptcy is filed.
If a debtor has a loan secured by its assets, payments to the secured lender are not fraudulent transfers because the law does not consider property encumbered by a lien as property of a debtor. So, if a company has granted a lien on its accounts receivable and uses funds collected to pay the lender with a lien on the accounts, no fraudulent transfer has taken place. But sometimes bankruptcy trustees attack the validity of a lender’s lien. If they succeed, it can result in an asset to be sold, transfers to be avoided, or both. The Sixth Circuit Court of Appeals recently decided a case where the bankruptcy trustee attempted to recover transfers to a secured lender by a) trying to invalidate the lien because of the lender’s bad faith, and b) proving that a renewal of the loan was a novation. Bash v. Textron Financial Corporation (In re Fair Finance Company), Case No. 20-3351, September 10, 2021. The trustee lost on those arguments in front of the District Court and fared no better on appeal.
Fair Finance Company factored receivables – it purchased accounts receivable at a discount and collected the full balance due. To purchase those accounts, Fair Finance obtained a $22 million revolving line of credit (“LOC”) from Textron and one other bank in 2002. The LOC was secured by a lien against all the assets of Fair Finance. About the same time, Fair Finance was purchased by owners who began running a Ponzi scheme and who were eventually convicted of doing so. In the meantime, Textron renewed and modified the LOC in 2004. The changes allowed the other bank to exit and reduced the amount of the LOC to $17.5 million. The evidence established that as early as 2003 Textron knew Fair Finance was a “house of cards,” took steps to protect Textron’s position, and did not reveal Fair Finance’s practices. In 2007, Textron was paid in full. The Ponzi scheme was revealed in 2009 and Fair Finance was forced into involuntary bankruptcy in 2010. Fair Finance’s trustee appealed the District Court’s initial dismissal of his claims and the Sixth Circuit reversed, finding there was a fact question about the novation argument. Bash v. Textron Fin. Corp. (In re Fair Fin. Corp.), 834 F.3d 651 (6th Cir. 2016). On remand, the District Court granted summary judgment on the invalid lien argument and a jury found there was no novation. The trustee appealed again.
NO INVALID LIEN
The Sixth Circuit’s most recent decision explores the intersection between the Uniform Commercial Code (UCC) and UFTA. The UFTA is clear that a transfer of property subject to a “valid lien” is not a fraudulent transfer and defines a valid lien as one that is effective against the holder of a subsequent judicial lien. That definition led the Sixth Circuit to the UCC rules for priority of liens, which in turn took them to the requirements for perfecting a lien. But the Sixth Circuit found that perfection of Textron’s lien established its priority – not its validity. And the trustee argued that Textron acted in bad faith in its dealings with Fair Finance, that the UCC requires good faith, and that Textron’s lack of good faith should invalidate its lien. The Sixth Circuit carefully examined the UCC and explained that the duty of good faith is in the “performance and enforcement” of contracts. So, while bad faith may result in a creditor losing the priority of its lien against other lienholders, it does not affect the validity of the lien itself. Establishing and perfecting a lien was distinguished from the performance and enforcement of a contract. Accordingly, the trustee did not prevail on the theory that Textron’s bad faith invalidated its lien.
The trustee also argued that the changes to the LOC in 2004 were a novation – a new agreement which replaced the old one (and could invalidate its lien). The district court held a trial on this issue and a jury determined there was no novation, so the trustee’s appeal argued that the jury was improperly instructed. The jury instruction defined a novation as an intentional and knowing extinguishment of an old obligation and replacing it with a new contract. The instruction also stated there was a presumption in favor of finding a renewal (instead of a novation) and that there must be “clear and definite” evidence the parties intended to extinguish an old debt and create a new one. The trustee argued that instructing the jury on the presumption of a renewal was error. The Sixth Circuit did not decide whether Ohio law presuming a renewal was still valid, but instead held that including an instruction on the presumption was harmless error. This is because the gist of the instruction properly stated the burden of showing an intent to create novation requires clear and definite evidence, and language regarding the presumption did not change that core requirement.
LESSONS TO BE LEARNED
Creditors with valid liens have strong protection against fraudulent transfer claims, as long as they have property perfected their lien and have not novated the underlying agreement. This case is a good explanation of how the UCC and UFTA intersect, and what lenders should (and should not) do to protect their lien rights.
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