United States: Commercial Restructuring & Bankruptcy Alert - February, 2010

Contents

• Second Circuit Joins Ninth Circuit in Allowing Post-petition Attorneys' Fees on Undersecured Claims
• California Court of Appeal Weighs In on Corporate Directors' Fiduciary Duties to Creditors
• The Seventh Circuit's Recent Opinion in Boyer v. Crown Stock Distribution, Inc. – Lessons from a Failed Leveraged Asset Sale
• California Update—New Cases
• The Metavante Ruling – In a Case of First Impression, U.S. Bankruptcy Court Limits ISDA Counterparty Rights Upon a Bankruptcy Event of Default
• Tax Refunds from NOL Carrybacks Create a Window of Opportunity for Lenders

Second Circuit Joins Ninth Circuit in Allowing Post-petition Attorneys' Fees on Undersecured Claims
By Molly J. Baier

Recent Ninth and Second Circuit opinions allowing unsecured creditors to claim post-petition attorneys' fees signal a break from past practices. The Supreme Court opened the door for a shift in the 2007 Travelers opinion, and last year two circuits found the right fact-patterns to allow such fees.

For many years, the First, Eighth and Ninth Circuits categorically prohibited unsecured creditors from collecting attorneys' fees for work performed post-petition, even where there was an attorneys' fees provision in the contract with the debtor. The Ninth Circuit's view, announced 19 years ago in In re Fobian, 951 F.2d 1149 (9th Cir. 1991), was that attorneys' fees incurred litigating issues peculiar to federal bankruptcy law—i.e., questions beyond basic contract enforcement—would not be awarded absent bad faith or harassment by the losing party. Fobian reached this result without citing any supporting authority in the Bankruptcy Code.

Three years ago, in Travelers Casualty & Surety Company of America v. Pacific Gas & Electric Company, 549 U.S. 443, 127 S.Ct. 1199, 167 L. Ed. 2d 178 (2007), the Supreme Court concluded that it was unfair to disallow post-petition attorneys' fees incurred by a surety holding a contingent claim for the legal costs of litigating and negotiating the treatment of its claim under the bankruptcy plan of reorganization. While the Supreme Court signaled its displeasure with Fobian's lack of a solid rationale for disallowing the fees, it stopped short of allowing the fees. Rather, citing the possibility that there might have been other reasons to disallow the fees—reasons that were not briefed to the lower courts—the Supreme Court remanded the case for further proceedings. The issue was left open for courts to rethink their positions.

In June 2009, the Ninth Circuit faced a similar issue in In re SNTL Corp. 571 F.3d 826 (9th Cir. 2009). Having heard the message in Travelers, the Ninth Circuit seized the opportunity, asking: "May an unsecured creditor include attorneys' fees incurred postpetition but arising from a prepetition contract as part of its unsecured claim?" This time the court answered this question "yes"—such fees fall within the Bankruptcy Code's broad definition of "claim." The Ninth Circuit reached this result by noting that neither section 502 nor section 506 of the Bankruptcy Code provided any support for the disallowance of such a claim:

Id. at 841-842. (Section 502(b) provides for the disallowance of all or a portion of certain other types of claims, such as claims for unmatured interest.) The Ninth Circuit noted that section 506 deals with the treatment of secured claims, and said that section 502 was the better place to look for authority regarding an unsecured claim.

In November 2009, the Second Circuit joined the chorus, holding in another surety bond case, Ogle v. Fidelity & Deposit Company of Maryland, 586 F.3d 143 (2nd Cir. 2009), that an unsecured creditor is entitled to recover post-petition attorneys' fees that were authorized by an otherwise enforceable pre-petition contract of indemnity, but were contingent on post-petition events. The Second Circuit noted that: (1) none of the section 502(b)(2)-(9) exceptions applies; and (2) section 506(b) does not implicate unsecured claims for post-petition attorneys' fees, and therefore interposes no bar to recovery.

The shift in thinking, however, raises unusual questions. For example, what does this mean for unsecured creditors who, in reliance on the previous interpretation of the law, elected not to include a claim for attorneys' fees in a proof of claim filed before SNTL? If the claims-bar date has not passed, the creditor may amend its claim to assert a right to the fees. Even if the claims-bar date has passed, a creditor may, under certain circumstances, be permitted to amend a previously filed claim—generally, if it can show a "nexus" between the originally filed claim and the amendment; for example, where the creditor seeks to cure a defect in the previous claim or plead a new theory of recovery. But the farther a case has progressed, the less likely it is that courts will accept amendments. If a plan has been confirmed, the creditor must establish compelling circumstances; and if the plan funds have already been disbursed, it may be impossible altogether. An unsecured creditor who has foregone assertion of a significant claim for attorneys' fees—especially if the case is currently pending in either the Second or the Ninth Circuits—may wish to consult with counsel regarding circumstances of its particular case.

California Court of Appeal Weighs In on Corporate Directors' Fiduciary Duties to Creditors
By Mike C. Buckley

Since the Delaware Chancellery Court's decision in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corporation, Civ. A. No. 12150, 1991 WL 277613 (Del. Ch. Dec. 30, 1991), courts have struggled with the issue of whether officers and directors of an insolvent or almost insolvent corporation owe fiduciary duties to anyone other than the shareholders—for example, creditors. In Credit Lyonnais, the Delaware Chancellery Court articulated a broad rule that officers and directors owe fiduciary duties to creditors as soon as the corporation becomes insolvent. More recently, the Delaware Supreme Court in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) explained the boundaries of Credit Lyonnais and held that creditors themselves cannot bring a direct claim against the officers and directors for breach of fiduciary duty. Rather, those claims belong to the corporation and need to be brought derivatively.

Delaware law on this topic is nationally important because the fiduciary duties of the officers and directors of a corporation are determined by the law of the jurisdiction in which the corporation is incorporated, regardless of where the officers and directors live or acted, or where the corporation has its headquarters or its assets. Because Delaware is by far the most common situs for incorporation in the United States, its law is significant.

Now, other large commercial jurisdictions are facing the same questions. California, because of its size, also has a large number of corporate citizens. Until recently, California law on the duties of officers and directors of an insolvent corporation was not clear. However, in Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020 (Cal. Ct. App. 2009), the Court of Appeal, California's intermediate appellate court, explained in detail the California law on this topic.

Berg was a creditor of Pluris, Inc., a failed California corporation. Pluris' board of directors resolved to assign all of the company's assets to an assignee for the benefit of creditors so that the assignee could liquidate the company's available property and prorate the proceeds among the company's creditors. Berg argued that the assignment approach was far less desirable than a bankruptcy or some other form of liquidation because Berg believed Pluris had substantial operating loss carry-forward tax credits that could be utilized by another corporation to reduce or eliminate its income tax exposure. According to Berg, the tax credits could be sold for a lot of money if the Pluris directors had only tried to do so. When the directors took the assignment for benefit of creditors approach, destroying any value in the tax credits, Berg sued them for breach of fiduciary duty, asserting that Pluris was insolvent or "in the zone of insolvency" (a term taken from the Delaware cases), and the Pluris directors had violated their fiduciary duty to creditors by failing to take action to realize value from Pluris' valuable tax attribute assets.

Berg's third amended complaint was rejected by the trial court, which sustained a demurrer (a California procedure parallel to Federal Rule 12(b)(6)) to it and dismissed the Berg suit. The rejected amended complaint alleged that the Pluris directors had breached their fiduciary duties to creditors by selecting a course of action that was "easiest for them by ignoring alternatives specifically brought to their attention, including Berg's proposed reorganization[,] and [by] failing to make any reasonable inquiry and other possible approaches that would or might have yielded greater assets for the creditors"; and by failing "to explore BERG's articulated plan to maximize the value of PLURIS' [net operating losses for] the benefit [of] creditors."

On appeal, the court unambiguously held that the directors of a California corporation like Pluris owe only the fiduciary duties that are set out in the California Corporations Code, specifically section 309(a). That section provides that "[a] director shall perform the duties of a director...in good faith, in a manner such director believes to be in the best interest of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances." Section 309(c) expressly exculpates corporate officers and directors from breach of duty liability so long as they adhere to the standards set forth in the section.

The court reasoned that because there is no analogous statutory authority in California, establishing a corporate directors' fiduciary duty to corporate creditors whenever a corporation is insolvent or "in the zone of insolvency" (a term used in the Delaware cases), no such duty exists. The court said "[a]ccordingly, based on this established doctrine, we conclude that under the current state of California law, there is no broad, paramount fiduciary duty of due care or loyalty that directors of an insolvent corporation owe the corporation's creditors solely because of a state of insolvency, whether derived from Credit Lyonnais or otherwise. And we decline to create any such duty...."

The court discussed what practitioners have frequently observed since Credit Lyonnais, that duties owed to shareholders and creditors inevitably conflict. That conflict dilutes the statutory and common law duties that directors unambiguously owe to the corporation and its shareholders, and, despite the conflict, there are no practical standards by which directors might balance the possibly conflicting duties owed each constituency. The court also observed that a director's ability to objectively and concretely determine when a state of insolvency exists is limited, and that the potential turning on and turning off of a duty to creditors based upon day-to-day or even month-to-month operating results is highly impractical.

The court articulated the standard of duty owed by corporate directors to creditors as the application of the trust fund doctrine, which merely prohibits director self-dealing and the preferential treatment of certain creditors over others, and, accordingly, is relevant solely to cases where directors have diverted, dissipated or unduly risked the insolvent corporation's assets.

The court also rejected the idea that the trust fund doctrine might apply to situations in which the corporation was "in the zone of or the vicinity of insolvency." The court expressly held that there is no fiduciary duty under California law owed to creditors even under the trust fund doctrine simply because they were in the zone or vicinity of insolvency, but only when the corporation was insolvent.

Accordingly, the court affirmed the decision of the trial court dismissing Berg's suit.

Berg is a pretty straightforward decision sticking tightly to the statutory construct of the California Corporations Code. Implicit in the decision is the idea that almost all of California's law of corporations is statutory and should be read literally. There is, of course, much to be said for a bright line rule à la Berg.

But despite its literalness, there are interesting questions resulting from Berg. For example, might the existence of the California bright line rule, as opposed to the much more amorphous approach taken in Delaware, cause some corporations to be reincorporated under California law for the comfort of their directors? Would the Berg outcome have been different if Pluris had been a Delaware corporation reincorporated under California law after the directors realized the corporation was, in fact, insolvent? Would it matter if Berg's allegation, which would be taken as true for a 12(b)(6) type motion, was that the sole reason for reincorporating was to insulate the directors against the fiduciary duty they owe creditors under Delaware law?

Most states have essentially no law on this topic. Will solvent corporations engaged in relatively high-risk business enterprises and incorporated in Delaware be reincorporated in California so that directors may take the benefit of the Berg decision should the business someday fail? Is such reincorporation in itself a breach of fiduciary duty to the creditors regardless of the solvency of the company, if the motive of the directors is clearly self-protection?

Finally, does the sharp difference of opinion on this topic between the largest economy in the United States and the most-used incorporation situs in the country, and the absence of much law in many states, auger for a national corporations' code along the lines of the Uniform Commercial Code? Perhaps in some respect, the Berg decision creates more questions than it answers.

The Seventh Circuit's Recent Opinion in Boyer v. Crown Stock Distribution, Inc. – Lessons from a Failed Leveraged Asset Sale
By Stephen T. Bobo

The Seventh Circuit Court of Appeals recently upheld the avoidance of a leveraged buyout transaction in Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787 (7th Cir. 2009), and its opinion presents some interesting twists on fraudulent conveyance issues. The case involved the purchase of all of the assets, but not the stock, of Crown Unlimited Machine, Inc. ("Old Crown"), which was a designer and manufacturer of machinery for cutting and bending tubes. The $6 million purchase price was paid with a combination of $3.1 million in cash and a $2.9 million promissory note. The cash was funded by a bank loan obtained by the purchaser that was secured by a senior lien on all the assets being acquired. The promissory note given to Old Crown was secured by a subordinate lien on the assets, and the note terms provided that the purchaser would have to pay a reduced amount of only $100,000 per year unless future sales exceeded a specified threshold.

The purchaser was a newly formed company ("New Crown") that took the name of the seller after the closing. The principal of New Crown had worked for Old Crown for a while prior to the sale, and he contributed only $500 of his own money toward capitalizing New Crown. There were several more significant features of the transaction. Just prior to the closing, Old Crown distributed more than $590,000 of its available cash to its shareholders in the form of a dividend. Trade creditors and other unsecured creditors were not informed either of the sale or that they were dealing with a different entity after the closing. Creditors had no way of discovering the sale on their own since New Crown had adopted Old Crown's corporate name and continued operating the same business with the assets it acquired.

Following the closing, New Crown's business struggled, and it filed bankruptcy about 3-1/2 years later. In New Crown's bankruptcy proceeding, its assets were sold for $3.7 million to a newly formed entity (of which the principal of New Crown became the president). Although the sale proceeds were sufficient to repay New Crown's bank loan, not much was available to distribute to unsecured creditors. The bankruptcy trustee initiated litigation to avoid the purchase transaction and recover the purchase price paid to Old Crown and the dividend received by Old Crown's shareholders, utilizing the four-year reach-back period available under the Indiana Uniform Fraudulent Transfer Act and section 544 of the Bankruptcy Code.

The Bankruptcy Court's Decision Was a Split Decision

In the proceedings before the Bankruptcy Court, New Crown was found to have paid the $6 million purchase price without receiving reasonably equivalent value in return. Consequently, New Crown had begun its operations with assets that were unreasonably small in relation to the business. The Bankruptcy Court believed that the assets acquired by New Crown had been worth no more than $4 million as of the closing, and that New Crown had been so depleted by the debt it had taken on that it had been on "life support" from its inception. Therefore, the Bankruptcy Court ruled that the buyout transaction should be avoided, with the result that Old Crown could neither enforce its $2.9 million promissory note nor retain the $3.1 million in cash received at closing and the two interest payments of $100,000 received on the promissory note.

However, the Bankruptcy Court refused to allow the trustee to recover the $590,000 dividend that Old Crown paid to its shareholders shortly before the closing. It ruled that the dividend was legitimate because it had been paid from cash that belonged to Old Crown rather than to New Crown. The court rejected the trustee's argument that the purchase of Old Crown's assets had been a leveraged buyout and refused to collapse the transactions and re-characterize them as a sale by the shareholders of Old Crown, so that the dividend would be seen as an asset of the New Crown's bankruptcy estate. Thereafter, both sides appealed. Old Crown and its shareholders sought to overturn the judgment avoiding the sale of assets, and the trustee sought to reverse the holding that the $590,000 dividend payment could not be recovered.

The Seventh Circuit Sides with the Trustee

On appeal, the Seventh Circuit took a fresh look at the situation and sided with the trustee. It had no difficulty finding that the transaction should be avoided as a fraudulent conveyance despite the reluctance of some other courts and various commentators to characterize leveraged buyout transactions as fraudulent conveyances. The defendants argued that this transaction was neither a conventional leveraged buyout nor a fraudulent conveyance because it was an asset sale, not a sale of the company's stock, and also because New Crown had "limped along for three and a half years before collapsing into the arms of the bankruptcy court."

The Seventh Circuit rejected the defendants' first point as being of "no conceivable significance," because leveraged buyouts can take the form of asset acquisitions, citing to OODC, LLC v. U.S. Bank National Association (In re OODC, LLC), 321 B.R. 128 (Bankr. D. Del. 2005), and In re Aluminum Mills Corporation v. Citicorp North America, Inc. (In re Aluminum Mills Corporation), 132 B.R. 869 (Bankr. N.D. Ill. 1991). According to the Seventh Circuit's view of the situation, although the transaction was nominally a purchase of Old Crown's assets, it was actually a transfer of the ownership of the company because Old Crown distributed the money it received in the sale to its shareholders and thereafter existed only as a shell. In addition, New Crown concealed the transactions from its creditors, which "would be normal if the stock of a corporation were sold, rather than its assets; but in a sale of its assets, the seller's creditors would expect to be notified that they would henceforth be dealing with a different firm."

On the defendant's second argument, the court pointed out that although New Crown had been able to survive for several years, it lacked adequate capital and this was sufficient for fraudulent transfer purposes. Because all of New Crown's assets were encumbered (both by the bank and by the secured note owed to Old Crown), the sale reduced its ability to borrow on favorable terms as it had no collateral to offer to new lenders. The transaction also depleted most of the company's cash, since Old Crown had pulled out $590,000 as a shareholder dividend and New Crown had obligated itself to pay at least $595,000 in debt service on its loans, without receiving anything in return except its principal's $500 capital contribution. New Crown ran up additional debt on unfavorable terms. Seven months before it declared bankruptcy, it had $8.3 million in debt and its assets were worth only half that amount. As the Seventh Circuit characterized New Crown's situation, "It was naked to any financial storms that might assail it." Therefore, the Seventh Circuit affirmed the Bankruptcy Court's rulings that New Crown had not received "reasonably equivalent value" in the sale, and the transaction to New Crown was a fraudulent conveyance.

The court went on to take a fresh look at the shareholder dividend that Old Crown paid just prior to the sale. Even though the trustee had failed to present evidence concerning Old Crown's dividend policy, the court determined that the dividend was inherently suspect. It pointed out that family-owned companies rarely pay dividends, but instead channel distributions of profits as salary in order to avoid double taxation. There was evidence in the record showing that four of the Old Crown shareholders were officers and that the dividend represented 50 percent of Old Crown's profits for the prior year, which the court believed to be unreasonably high given the cash needs of the business. It concluded that these were sufficient indications that the dividend was part of the fraudulent transfer rather than a normal distribution of previously earned profits. This caused the burden to shift to the defendants to produce evidence that it was a bona fide dividend, which they failed to meet. Therefore, the court concluded that the dividend was part of the fraudulent conveyance and could also be avoided by the Trustee.

All of the Avoided Transfers Could Be Recovered Even Though They Exceeded Creditor Claims

The Seventh Circuit then turned its discussion to the basis of recovering the funds that the defendants had received under section 550 of the Bankruptcy Code. If the asset sale were collapsed and recharacterized as a sale of Old Crown by its shareholders, as is implicit in the court's characterization of the sale as a leveraged buyout, then the court viewed the Old Crown shareholders to have been the initial transferees of the funds. In that case, the dividend that Old Crown paid to the shareholders would be an adjustment to the purchase price. On the other hand, if the overall transaction was not collapsed, the initial transferee of the cash paid by New Crown was Old Crown, and its shareholders were subsequent transferees of the initial transferee of the funds. Since the shareholders gave no "value" in return for the payments, they were therefore not protected by section 550(b)(2) of the Bankruptcy Code, which precludes recovery from a subsequent transferee that took for value and in good faith, and without knowledge of the voidability of the transfer avoided.

The defendants contended that having to return any of the $3.3 million (plus the dividend) that they received would provide an unfair windfall for the trustee. New Crown had sold the assets for $3.7 million in its bankruptcy, and if Old Crown had to return all of the payments it received plus the dividend, then the debtor's estate would have received more than $7.6 million. This is far more than what was needed to pay total estate obligations of only about $5.3 million plus administrative expenses. The court made it clear that there would be no windfall because any excess funds after creditors are repaid in full would go back to the debtor and would be ultimately distributed according to state law; but as far as it could tell the only parties entitled to any residual would be the shareholders of Old Crown. Therefore, it affirmed the Bankruptcy Court's determination that the full purchase price could be recovered by the trustee. It reversed the determination that the $590,000 dividend could not be avoided, and pronounced that any funds remaining after satisfying creditor claims and costs of administration must be returned to the defendants.

Noteworthy Aspects of the Decision

The court's opinion is worthy of discussion in several respects. It had no difficulty characterizing the sale of assets as a leveraged buyout and applying fraudulent conveyance concepts to the transaction. However, its analysis of the basis for treating a sale of assets as tantamount to a sale of ownership of a company is unsatisfying. The court's treatment of the dividend that Old Crown paid to its shareholders is more unusual. The limited facts set forth in the opinion indicate that the $590,000 was some, but apparently not all, of the company's cash, and that New Crown had permitted the dividend payment prior to closing with the amount of the dividend determined by the performance of the business during the period leading up to the closing. The court also indicated that the dividend represented half of Old Crown's profits for the prior year, a level that "was unreasonably high given the cash needs of the business." But the opinion fails to explain the basis for this conclusion. Although the court points out that the trustee failed to present any evidence concerning Old Crown's dividend policy, it also concluded that the form of the payment was suspect because such companies rarely pay dividends, but typically are motivated by tax considerations to distribute earnings as salary. Although the opinion does not articulate what evidence was in the record on this point, the Court relied on these several indications alone to conclude that the trustee had met his burden of showing that dividend was an integral part of the fraudulent transfer rather than a normal distribution of a portion of previously earned profits, or as the opinion describes it, "the withdrawal of an asset vital to the acquiring firm."

Unfortunately, the opinion is murky in terms of explaining whether and how the court determined what amount of Old Crown's funds constituted the ordinary working capital needs of the business and what portion was earnings above that level. Therefore, it is difficult to ascertain its basis for declaring that the distribution of half of the prior-year's profits by way of a dividend to shareholders was unreasonable. The language of the opinion implies that if Old Crown had paid the $590,000 as additional salary or bonus payments to its officers instead of as dividends, those payments would have had a better chance of avoiding recovery. But this is unlikely to be a meaningful distinction since the form of payments should not dictate whether they were fraudulent conveyances, and it seems doubtful that such a difference in form would not have changed the outcome here. Consequently, it is difficult to determine how the court defined when such payments would be insulated from avoidance in context of a leveraged sale of a company's assets.

It is also unusual that the dividend was recovered from the Old Crown shareholders solely to help ensure that the creditors of New Crown were paid. After all, 3-1/2 years had passed between the transaction and the bankruptcy, and the opinion does not indicate that any creditors of Old Crown remained unpaid. It also did not appear that the trustee needed to recover the dividend in order to ensure that all New Crown creditors were paid in full and that all administrative expenses were satisfied. The creditor claims totaled $5.3 million, whereas the proceeds of the bankruptcy sale plus the avoided amount paid by New Crown to Old Crown totaled $7 million, without considering the dividend payment.

When viewed from a distance, the core of the Seventh Circuit's opinion relating to the dividend seems less about fraudulent conveyance issues and more focused on considerations of alter ego, or the liability of one entity for the indebtedness of another. The court mentions several times that the sale of assets and the change of entities had been concealed from the creditors. In the eyes of both the creditors and the court, New Crown and Old Crown were essentially the same company, and there were strong equitable reasons to collapse the transaction and make the dividend subject to the claims of creditors of New Crown. The opinion's language and analysis focused on fraudulent conveyance issues because that was the way the case reached the Seventh Circuit, but the result is best understood through an alter-ego lens instead.

Lessons for Structuring Similar Transactions

The takeaway lessons are several. First, a highly leveraged transaction such as the Crown one is susceptible to being unwound as a fraudulent conveyance whether structured as a stock sale or an asset sale. Even the facts that a portion of the purchase price was in the form of a soft note and the purchaser survived for 3-1/2 years before going into bankruptcy did not insulate the transaction from avoidance. Second, if the selling company has excess cash above working-capital needs that is to stay with the owners of the seller, the form and timing of the transfer of those funds to the owners should be carefully considered. An extraordinary distribution of a large portion of the seller's cash on the eve of a highly leveraged sale clearly troubled the Seventh Circuit here. However, a distribution of earnings that can be shown to have been in excess of the working-capital needs of the business (including a cushion above budgeted needs and funding projected growth) should not be inherently suspect. In the case of a subchapter S corporation or a limited liability company, making such a distribution through additional salary or performance bonus payments might bother a court somewhat less than an extraordinary dividend, although the basis for such a distinction seems unconvincing.

Perhaps the most important lesson to learn to avoid similar consequences is to not conceal the transaction from creditors. Although the Seventh Circuit did not explicitly analyze the issues from an alter ego perspective, it justified collapsing the dividend payment into the purchase transaction because the parties had clearly treated New Crown as the successor to Old Crown. Not only did the buyer take the identical corporate name, but it appears that New Crown also continued to operate essentially the same business from the same premises and with the same employees. New Crown continued to deal with Old Crown's customers and suppliers, but failed to notify them that they were dealing with a different entity. There was also partial continuity between the management of the seller and the purchaser. All of these are factors in whether a purchaser should be deemed a mere continuation of the seller and liable for its debts. Accordingly, there was a strong basis to hold Old Crown liable for the debts of New Crown, allowing for recovery of the dividend to the extent necessary to ensure that creditors were fully paid.

Although New Crown may have insisted that the transaction be made invisible to third parties in order to maximize the transfer of Old Crown's goodwill, this and the other circumstances created substantial risks to Old Crown's shareholders. Had existing and new creditors been advised of the transaction and the fact that they now were dealing with a separate entity, the defendants would have been in a stronger position to protect at least the dividend from recovery in the event of the purchaser's failure.

California Update - New Cases
By Molly J. Baier

No Windfall for the Borrower or the Purchaser at a Foreclosure or Sheriff's Sale

The recession is beginning to yield a spate of new caselaw in the area of real estate foreclosure. Three times in recent months, the California Court of Appeal has struck down attempts by non-lenders to reap a windfall at a lien foreclosure sale. In a fourth case, the court declined to expand the duties of a foreclosure trustee beyond those specified by contract or by statute.

No Funds for Borrower Until the Lenders are Paid in Full

First, in Wells Fargo Bank v. Neilsen, 178 Cal. App. 4th 602 (Cal. Ct. App. 2009), the California Court of Appeal for the First District held that the borrower was barred from receiving foreclosure sale funds ahead of any of the lenders. American Express had held the first deed of trust, Wells Fargo the second, and PHH Mortgage the third. American Express (AMEX) had agreed to subordinate its loan to PHH, but Wells Fargo was not a party to the subordination agreement between AMEX and PHH. When the loan went into default, AMEX foreclosed, and Wells Fargo purchased the property for $400,000 at the foreclosure sale – enough to pay AMEX and Wells Fargo in full and have a great deal left over.

Attempting to take advantage of the confusion caused by the fact that the subordination was only partial, the borrower contended that once the liens of AMEX and Wells Fargo were paid in full, he was entitled to the balance of the proceeds ahead of PHH. No dice, said the Trial Court. The Court of Appeal agreed.

Foreclosure Sale Purchaser Does Not Become Entitled to Fire Insurance Proceeds

Next, in Washington Mutual Bank v. Jacoby, No. B212347, 2009 WL 4047971 (Cal. Ct. App. Nov. 24, 2009), the California Court of Appeal for the Second District held that the purchaser at a sheriff's sale of fire-damaged property was not entitled to receive the benefit of fire insurance proceeds that the loss payee lender did not need in order to be paid in full.

Washington Mutual held the first deed of trust, and a judgment creditor held a junior lien on the property. The judgment creditor caused the sheriff to sell the property to pay the judgment lien. Jacoby purchased the property at the foreclosure sale. Washington Mutual, as loss payee, was nearly paid in full through the proceeds of the sheriff's sale, and needed only a small amount of the insurance proceeds to be made whole. Therefore, after paying itself in full, Washington Mutual interpled the balance of the insurance proceeds, uncertain as to whether to pay them to the sheriff, the purchaser or the borrower, or to return them to the insurer, State Farm. The sheriff and the borrower (who had been denied coverage based on his suspected involvement in the fire and had subsequently passed away) did not respond. The purchaser responded, arguing that he should receive the balance of the insurance proceeds because he had been unable to inspect the property to discover the interior fire damage. "Caveat emptor," said the Trial Court, ordering the money to be returned to State Farm. And furthermore, an insurance policy is a personal contract. Although the purchaser may have become the borrower's successor in interest with respect to the property, he did not automatically become successor on the insurance contract.

No Windfall for a Bottom-Fisher Where the Auctioneer Misspoke

Third, in Millennium Rock Mortgage, Inc. v. T.D. Service Company, 179 Cal. App. 4th 804 (Cal. Ct. App. 2009), modified, No. C059875, 2009 WL 4913568 (Cal. Ct. App. Dec. 22, 2009), the California Court of Appeal for the Fourth District refused to allow the foreclosure sale bidder to scoop up a property on which the lender was owed $382,000, for $51,000, where the auctioneer read off a script with a clerical error.

One day in June 2008, the auctioneer planned to auction two properties: one on 13th Avenue, with an opening bid of $51,447, and the other on Arcola Avenue, with an opening bid of $382,544. The auctioneer had two scripts, but because of a clerical error, the 13th Avenue script contained the Arcola Avenue address, which the trustee read aloud, accidentally opening the bidding at $51,447 instead of $382,544. Millennium Rock bid $51,500, and no other bids were submitted. Before issuing the trustee's deed, the trustee discovered the error. He informed the winning bidder that he intended to re-auction the property rather than issue a trustee's deed. The winning bidder sought an injunction.

The Trial Court granted a preliminary injunction, but the Court of Appeal reversed, saying gross inadequacy of price, coupled with even slight unfairness or irregularity, is a sufficient basis for setting aside a sale under a deed of trust. If the sale is allowed to stand, noted the Court of Appeal, it will deprive a blameless beneficiary of its entitlement to the full amount of its credit bid and result in a windfall to a purchaser who acquired the property for only one-seventh of the amount that should have been set as the opening bid. Since irregularity, gross inadequacy of price and unfairness were all abundantly present, the sale was voidable at the option of the trustee.

No Non-Statutory Duties for a Foreclosure Trustee

In one recent case, the foreclosed property owner did receive a windfall ahead of a lienholder. In Banc of America Leasing & Capital, LLC v. 3 Arch Trustee Services, Inc., No. G041480, 2009 WL 4727904 (Cal. Ct. App. Dec. 11, 2009), the Fourth District Court of Appeal held that the foreclosure trustee had no common law or equitable duty to seek out a judgment lien creditor and give it surplus proceeds from a trustee's sale. Rather, the trustee's duties were strictly limited to those provided for by contract or by statute.

The plaintiff in the case, a judgment lien creditor, recorded an abstract of judgment, but did not record a request to receive a copy of any notice of default that might be recorded. A notice of default and notice of sale had in fact already been recorded, and, one month after the abstract of judgment was recorded, the property was sold through California's well-established non-judicial foreclosure process. The sale generated $114,797.77 more than the amount needed to satisfy the deed of trust. Several months later, the foreclosure trustee turned the excess proceeds over to the judgment debtor. The judgment lien creditor sued the trustee, claiming the trustee had a duty to search the public records before distributing such proceeds to the judgment debtor.

The Court of Appeal disagreed, holding that the trustee's duties were strictly limited to what is described in the statutory scheme. Section 2924b of the California Civil Code sets forth a list of the parties to whom the trustee is obligated to give notice. Judgment lien creditors are not on the list. Rather, if a judgment lien creditor wishes to be notified of a foreclosure, the statute requires that it record a request for a copy of the notice of default and notice of sale. The judgment lien creditor was out of luck.

The moral of this story is: if you are a judgment creditor, when you record an abstract of judgment in the real property records of any county in which you hope to gain a recovery, always record a request for notice as well.

New Legislation Effective January 1, 2010

With the start of the New Year, several statutory amendments of interest to lenders came into effect in California:

Impound Accounts on Residential Mortgages. California Civil Code Section 2954 has been amended to add two new exceptions to the law that prohibits a lender from requiring an impound account as a condition of a loan on a single family, owner-occupied dwelling. As of January 1, 2010, a lender may, in addition to the previously allowed situations, require an impound account:

• Where the loan is made in compliance with the requirements for higher-priced mortgage loans established in Regulation Z, whether or not the loan is a higher-priced mortgage loan; or
• Where the loan is refinanced or modified in connection with a lender's home ownership preservation program or a lender's participation in such a program sponsored by a federal, state or local government authority or a nonprofit organization.

Reverse Mortgages. California Civil Code Sections 1923.2 and 1923.5 have been amended to add restrictions on a reverse mortgage lender's participation in certain other financial or insurance activities, and on referring the prospective borrower to anyone for the purchase of other financial or insurance products; to make certain changes in the 16-point type notice required to be given to a potential borrower; and to add requirements for the delivery of a written checklist covering issues that might impact the borrower as a consequence of the loan.

Residential Real Property Foreclosure. California Civil Code Sections 2923.5, 2923.6, 2924.8, 2924f and 2943, and California Financial Code Section 17312, have been amended to make temporary changes to the handling of foreclosures relating to certain mortgages and deeds of trust. Changes include adding procedures for the handling of short pay agreements. The new provisions sunset January 1, 2014.

Judgment Liens. California Code of Civil Procedure Sections 697.510 and 697.670 have been amended to provide that, within six months prior to the expiration of a judgment lien recorded with the California Secretary of State, the judgment lien can be renewed in the same manner as a UCC financing statement.

A Preview of Legislation Effective January 1, 2011

Notice of Filing a Mechanics Lien. A bill passed by the legislature in 2009 amends California Civil Code Sections 3084 and 3146, effective January 1, 2011. While the effective date of this statute is still a year away, it bears mention at this time, as construction lenders and workout officers may wish to modify their loan documents and/or operations processes to take into account the effect of the new statute, or even seek an amendment to the legislation to help make it more effective.

Assembly Bill 457 amends Civil Code Section 3084 to require, as a condition of the enforceability of the mechanics lien, that notice of the lien be served on the owner or reputed owner of the property, by registered, certified or first-class mail. The amended statute further provides:

The end result is that the requirement of the statute can be met by serving one of four parties: the owner, the reputed owner, the construction lender or the original contractor. Since the choice of whether to serve the lender or the contractor lies with the mechanics lien claimant if the claimant "cannot" serve the owner or reputed owner, it will be impossible for a lender to know whether the provision has been complied with unless the potential recipients communicate with each other. Thus, a lender may wish to include in its loan documents a requirement that the borrower provide lender with a copy of any Notice of Mechanics Lien received, and cause the borrower's contractor to do the same.

By the same token, although there is no express duty to do so under the statute, the lender, to avoid potential criticism from the borrower, would be well advised to make it a standard practice to pass along to the borrower any Notice of Mechanics Lien that the lender receives.

While the final provision of the statute, subsection (d), states that failure to serve the mechanics lien, including the Notice of Mechanics Lien, "as prescribed by this section" will cause the mechanics lien to be unenforceable as a matter of law, the statute does not set forth a deadline, in relation to the recording of the lien with the County Recorder's office, by which the Notice must be served. This will make it difficult for an owner or lender who is burdened by the lien to reap much benefit from the final provision, as the claimant appears to be free to serve the notice at any time. While the entire provision is in the nature of an "extra bite at the apple" to defeat mechanics liens, to ensure that such a bite yields some substance, modifying the statute to clarify this point may be advisable. Without such clarification, it is an open invitation for a court to rule that the new provision—a new trap for unwary subcontractors that would defeat significant legal rights—is void for vagueness.

Another point that would benefit from clarification would be to specify the address at which the construction lender or general contractor should be served. Civil Code Section 3097, which addresses preliminary 20-day notices, contains detailed provisions for the specification of such addresses, but these provisions do not formally carry over to section 3084.

Summary of Recommendations. To address the issues and opportunities raised by Assembly Bill 457, construction lenders may wish to:

• Amend construction loan documents to require that any notices received by the borrower or its contractor pursuant to the new statute be passed along to the lender.
• Set up a process by which operations personnel who receive Notices of Mechanics Liens automatically forward such notices to the borrower at the address provided in the loan documents, with a copy to the account officer.
• Discuss through trade associations whether to seek a further amendment to the statute, to make it clearer and therefore more likely to be effective.

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This article is presented for informational purposes only and is not intended to constitute legal advice.