FYI: Ill App Court Upholds Judgment in Full Against Guarantors Under "Carve-Out" Provision for Litigation Delay, Upholds Charging Orders Against Borrower's LLC/LLP Interests

The Illinois Appellate Court, First District, recently ruled that in filing an interlocutory appeal of an order appointing a receiver, the guarantors of a construction loan were liable for the full repayment amount under a "carve-out" provision that provided for full repayment liability if the guarantors took any action to "contest, delay or otherwise hinder" the lending bank's efforts to appoint a receiver or enforce the terms of the loan agreement.  

 

The Appellate Court also ruled that under the Illinois Limited Liability Company Act and Uniform Partnership Act, a court need only have jurisdiction over a judgment debtor to enter charging orders against the judgment debtor's transferable or distributional interests in limited liability companies and limited partnerships.

 

A copy of the opinion is available at: 

http://www.state.il.us/court/Opinions/AppellateCourt/2012/1stDistrict/1110749.pdf.

 

A real-estate developer ("Developer") purchased commercial property located in Chicago, Illinois (known here as "Block 37"), and financed the purchase with a construction loan from plaintiff bank ("Bank") for a total of about $205 million.  The loan was guaranteed by both the president of the real estate development company as well as its parent company (collectively, "Defendants").  

 

The guaranty provided that the Defendants' liability for the loan would be capped at just over $50 million, subject to a so-called "carve-out" provision that operated as an exception to the cap on liability.   Specifically, the carve out provision provided that the guaranty would become a full repayment guaranty if "the Borrowers contest, delay or otherwise hinder any action taken by . . . the Lenders in connection with the appointment of a receiver for the Premises or the foreclosure of the liens, mortgages or other security interests created by any of the Loan Documents."

 

The developer defaulted on the loan and Bank initiated a foreclosure action seeking in part to enforce the guaranty against Defendants.  Although the complaint originally sought judgment only on the guaranty for the amount of the liability cap, Bank subsequently amended the complaint to seek the full repayment amount of the loan from Defendants pursuant to the carve-out provision, arguing that Defendants had contested the foreclosure and the appointment of a receiver by filing an interlocutory appeal following the lower court's grant of Bank's emergency petition for the appointment of a receiver. 

 

In response, Defendants filed a motion to dismiss, arguing that the carve-out provision was an unenforceable penalty.   The lower court denied the motion.   Bank filed a motion for summary judgment, which the lower court granted.   The lower court entered judgment against Defendants for over $206 million pursuant to the guaranty and carve-out provision, certifying under Illinois Supreme court Rule 304(a) that there was no just reason to delay enforcement or appeal of the judgment. 

 

About a month after the entry of judgment, Defendants filed a motion to reconsider the Rule 304(a) certification, which the lower court denied.  Bank then served citations to discover assets on Defendants.  Several months after the grant of summary judgment and the entry of judgment against Defendants for the full repayment amount, Defendants appealed. 

 

Defendants also filed a motion for substitution of judge as of right, asserting that service of the citations to discover assets commenced a new supplementary proceeding under section 2-1402(a) of the Illinois Code of Civil Procedure, entitling Defendants to substitution of judge prior to a ruling on any substantial issue.  The lower court denied the motion for substitution of judge, ruling that the citation to discover assets was part of the same proceeding as a means to enforce the judgment.

 

Bank then filed a motion for a charging order to cause distributions from various limited liability companies ("LLCs") in which Defendants had an interest to be paid to Bank, and to bar Defendants from transferring or impairing their assets.  Bank also later filed a motion for rule to show cause why Defendants should not be held in contempt for dissipating almost $5 million in assets in violation of the citations. 

 

Finding Defendants in contempt of the citations, the lower court, following appeal and remand on the charging orders, ultimately imposed charging orders on Defendants' distributions on additional limited liability companies as well as on limited partnerships in which Defendants held an interest, for a total of 72 such entities.  The lower court also ordered the foreclosure of all the charging orders, and appointed a receiver for all the interests pursuant to section 30-20 of the Limited Liability Company Act.   Defendants appealed again.   

 

The Appellate Court affirmed the lower court's:  (1) grant of summary judgment; (2) judgment in Bank's favor pursuant to the carve-out provision; (3 ) orders imposing charging orders on Defendants' limited liability companies and limited partnerships; and, (4) order denying Defendants' motion for substitution of judge as of right.

 

As you may recall, the Limited Liability Company Act provides in part that "[o]n application by a judgment creditor of a member of a limited liability company or of a member's transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment."  805 ILCS 180/30-20. 

 

Similarly, the Uniform Limited Partnership Act provides in part that "[o]n application to a court of competent jurisdiction by any judgment creditor of a partner or transferee, the court may charge the transferable interest of the judgment debtor with payment of the unsatisfied amount of the judgment interest."   805 ILCS 215/703(a).

 

Before examining the enforceability of the carve-out provision in the guaranty agreement, the Appellate Court ruled on the timeliness of Defendants' notice of appeal and whether Defendants' post-trial motion for reconsideration tolled the time to appeal the judgment.  The court ultimately concluded that  Defendants had timely appealed, reasoning that because their nonspecific motion to reconsider the Rule 304(a) determination was for the purpose of modifying or vacating the underlying judgment, the motion to reconsider qualified as a proper post-trial motion.  See Kingbrook, Inc. v. Pupurs, 202 Ill. 2d 24, (2002)(noting that neither the Code nor Illinois supreme court rules require specificity in post-judgment motions in non-jury cases); 735 ILCS 5/2-2-1203(allowing parties in non-jury cases to file a post-trial motion to modify or vacate a judgment); Ill. S. Ct. R. 303(a)(1)(tolling time in which to file a notice of appeal if a timely post-judgment motion "direct against the judgment" is filed). 

 

Turning to the carve-out provision itself, the Appellate Court rejected Defendants' various assertions, including the argument that the carve-out provision was a vague, ambiguous, overly broad, and unenforceable penalty provision that failed to alert the borrowers of what acts would trigger full recourse liability and denied them their due process rights to defend themselves in a foreclosure action.   In so doing, the court noted the plain language of the carve-out provision and concluded that "Defendants' interlocutory appeal of the trial court's appointment of a receiver clearly qualifies as contesting the Bank's actions in connection with the appointment of a receiver that would trigger full repayment liability."  See J.B.Esker & Sons, Inc. v. Cle-Pa's Partnershhip, 325 Ill. App. 3d 276, 285 (2001); CSFB 2001-CP-4 Princeton Park Corporate Center LLC v. SB Rental I, LLC, 980 A.2d 1 (N.J. Super Ct. app. Div 2009)(nonrecourse loan with carve-out clause providing that the debt would become full recourse if borrower failed to obtain lender's prior written consent to subordinate financing on the property); G3-Purves Street, LLC v. Thomson Purves, LLC, 953 N.Y.S.2d 109, 114 (N.Y. App. Div. 2012)(carve-out provision that provided for the recovery of actual damages incurred by the lender did not constitute an unenforceable penalty).

 

The Appellate Court further noted that the carve-out provision did not preclude Defendants from defending against the foreclosure action, but simply resulted in Defendants' forfeiting their exemption from liability for full repayment of the loan.  See Federal Dep. Ins. Corp. v. Prince George Corp., 58 F.3d 1041 (4th Cir. 1995)(rejecting borrowers' argument that waiver of right to file bankruptcy was void as against public policy and noting that the loan did not prohibit borrower from filing bankruptcy but merely imposed liability for any deficiency if borrower took certain actions such as filing bankruptcy).

 

With respect to the lower court's charging orders against the 72 LLCs and limited partnerships, the Appellate Court rejected Defendants' argument that those entities were "necessary parties" and that the lower court thus lacked jurisdiction to enter charging orders against them.  In so ruling, the court reasoned that the Illinois Limited Liability Company Act and the Uniform Partnership Act both supported the conclusion that a court need only have jurisdiction over the judgment debtor to enter charging orders against the judgment debtor's transferable or distributional interest to satisfy a judgment and that the LLCs and limited partnerships accordingly did not need to be joined as parties for the lower court to enter the  charging orders against them. 

 

Finally, in addressing the issue whether Defendants had forfeited their right to substitution of judge as of right for failure to raise the issue in the earlier appeal of the contempt holding, the Appellate Court noted that the substitution of judge as of right was outcome determinative of the previous appeal and thus concluded that Defendants had forfeited their right to raise it in this particular appeal.  See Sarah Bush Lincoln Health Center v. Berlin, 268 Ill. App. 3d 184, 187 (1994)(noting that motion for substitution of judge "directly bears upon the question of whether the order on appeal was proper" and that wrongful refusal of a proper request for motion for substitution of judge renders subsequent orders by that judge in the case void).  See also 735 ILCS 5/2-1001(a)(2)(i), (ii). 

 

Accordingly, the Appellate Court affirmed the rulings of the lower court in all respects.

 

 

 

Ralph T. Wutscher
McGinnis Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
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FYI: 9th Cir Holds NBA Preempted Unfairness Claim as to "High-Low" Deposit Account Posting Method, But Not Related Misrepresentation Claim, Arbitration Assertion Too Late

The U.S. Court of Appeals for the Ninth Circuit recently held that the National Bank Act ("NBA") preempted California's Unfair Competition Law ("UCL") with respect to the order in which a national bank posted payment  transactions and the bank's obligation to make affirmative disclosures to bank customers about its posting practices, ruling that the bank's method of posting was a federally authorized pricing decision related to the calculation of overdraft fees and the requirement to make particular disclosures fell squarely within the purview of federal banking regulation.  

 

The Court also ruled, however, that the NBA did not preempt a claim for misrepresentation under the UCL as to the actual posting method the bank used, reasoning that the UCL's prohibition on misleading statements was a state law of general applicability that did not conflict with the NBA, mandate the actual content of the statements, frustrate the purposes of the NBA, or impair the ability of national banks to discharge their duties.  

 

The Ninth Circuit further ruled that the Federal Arbitration Act did not require arbitration of the dispute over the bank's method of posting debit transactions, where the controlling arbitration agreement did not require disputes to be submitted to arbitration, the bank never demanded arbitration prior to the appeal, and ordering arbitration post-judgment and post-appeal would severely prejudice the plaintiffs and result in duplicative proceedings.

 

A copy of the opinion is available at: 

http://www.ca9.uscourts.gov/datastore/opinions/2012/12/26/10-16959.pdf.

 

A customer ("Depositor") with a checking account at a national bank ("Bank") sued on behalf of a class under California's Unfair Competition Law ("UCL"), alleging that Bank engaged in unfair business practices by posting debit-card transactions in a "high-to-low" order which supposedly enabled Bank to maximize the number of overdrafts charged to a checking account on small purchases.  In addition, Depositor claimed that Bank also engaged in fraudulent business practices by misleading its customers as to the actual posting method Bank used.

 

Rejecting Bank's arguments that the National Bank Act ("NBA") preempted the UCL and that Depositor lacked standing, the lower court certified the class and concluded among other things that Bank had acted in bad faith in both failing to disclose the effects of high-to-low posting and misleading its customers to believe that the posting order of debit purchases would mirror the order in which the purchases were made.  Thus ruling that Bank's actions were both unfair and fraudulent under the UCL, the lower court entered a permanent injunction requiring Bank to cease posting debit-card transactions in high-to-low order and further imposed various disclosure requirements.  The court also ordered Bank to pay over $200 million in restitution. 

 

Both parties appealed, but Bank also sought to compel arbitration under an arbitration clause in Bank's deposit agreement with its customers.   

 

The Ninth Circuit reversed in part and affirmed in part, ruling that:  (1) the NBA preempted the "unfair" business practices prong of the UCL with respect to the order in which a national bank posts transactions; (2) the NBA preempted the imposition of affirmative disclosure requirements and liability for failure to disclose; and (3) the NBA did not preempt Depositor's claim under the "fraudulent" prong of the UCL based on affirmative misrepresentations in Bank's marketing materials as to the order in which Bank would post debit-card transactions. 

 

The Court of Appeals also ruled that Bank could not compel arbitration in this case even after the U.S. Supreme Court's decision in AT&T Mobility LLC v. Concepcion. 

 

As you may recall, the NBA authorizes national banks to receive deposits and grants national banks "all such incidental powers as shall be necessary to carry on the business of banking," which "incidental powers" include the power to set account terms and the power to charge customers non-interest charges and fees, including overdraft fees.  See 12 U.S.C. § 24 (Seventh); 12 C.F.R. § 7.4002(a).  In addition, federal banking regulations specifically delegate to national banks the method of calculating fees.  12 C.F.R. § 7.4002(b)(2)(method of calculating non-interest charges and fees "are business decisions to be made by each [national] bank, in its discretion, according to sound banking judgment and safe and sound banking principles" that include such factors as cost to bank, deterrence of misuse by customers, competitive advantage, and maintenance of safety and soundness of bank). 

 

With respect to disclosure requirements, "[a] national bank may exercise its deposit-taking powers without regard to state law limitations concerning . . . [d[isclosure requirements."  12 C.F.R. § 7.4007(b)(3).

 

Moreover, California's UCL allows individual plaintiffs to bring claims for unfair, unlawful, or fraudulent business practices and authorizes injunctive relief and restitution as remedies against persons or entities engaging in such acts.  Cal. Bus. & Prof. Code § 17200 et seq.  

 

Finally, payor banks operating in California may accept or pay items in any order, provided that they act in good faith in charging customers overdraft or returned-check fees.  See Cal. Com. Code § 4303, 1992 Amendment cmt. 7.

 

Analyzing each of Depositor's claims separately to determine whether they were preempted by the NBA, the Ninth Circuit examined whether the UCL "prevent[s] or significantly interfere[s] with [bank's] exercise of its powers.  See Barnett Bank of Marion Cnty., N.A. v. Nelson, 517 U.S. 25, 33 (1996).  In so doing, the Ninth Circuit noted in part that the ability to choose a method of posting transactions is  integrally related to the receipt of deposits and that the lower court's permanent injunction amounted to a complete prohibition on the high-to-low sequencing method of posting.  The Court further noted that federal banking regulations specifically delegate to national banks the method of calculating fees.  See Watters v. Wachovia Bank, N.A., 550 U.S. 1, 12 (2007)(ruling that choice of posting method falls within federal banking regulatory power that ordinarily preempts contrary state law). 

 

Thus, citing interpretive letters of the Office of the Comptroller of the Currency ("OCC") and observing that federal bank regulators consider high-to-low posting and associated overdraft fees to be authorized by Federal law and therefore within the power of a national bank, the Court of Appeals ruled that the district court's findings with respect to Bank's compliance with federal regulation were "inapposite to the issue of preemption."  See, e.g., Martinez v. Wells Fargo Home Mortg., Inc., 598 F.3d 549, 556 n.8 (9th Cir. 2010); Baptista v. JP Morgan ChaseBank, N.A., 640 F.3d 1194, 1197 (11th Cir. 2011).  Accordingly, the Court ultimately ruled that the lower court lacked the discretion to determine "what constitutes a legitimate pricing decision or to apply state law in a way that interferes with this enumerated and incidental power of national banks" and that the "good faith" requirement in California's Commercial Code applied through the UCL was similarly preempted.

 

Turning to the "fraudulent" prong of the UCL, the Ninth Circuit observed in part that federal regulations allow national banks to exercise their deposit-taking powers without regard to state-law limitations on disclosure requirements.  See 12 C.F.R. § 7.4007(b)(3).  Further observing that the lower court's imposition of liability on Bank for failure to sufficiently disclose its posting method was tantamount to state regulation of disclosure requirements, the Court stressed that the UCL does not impose disclosure requirements but simply prohibits misleading statements.   The Court thus distinguished between state disclosure requirements imposed on national banks, which the court ruled were preempted by the NBA, and state law governing misleading statements, which were not so preempted.

 

Accordingly, with regard to such statements in Bank's marketing materials as "[i]f you don't have enough money in your account to cover the withdrawal, your purchase won't be approved," the Court ruled that the UCL's prohibition on misleading statements was a law of general applicability that did not "conflict with federal law, frustrate the purposes of the [NBA], or impair the efficiency of national banks to discharge their duties."  As the Ninth Circuit explained, the UCL's prohibition of misleading statements did not significantly interfere with Bank's ability to offer checking account services, choose a posting method, or calculate fees.   Citing, among other things, an OCC advisory letter indicating that national banks may be subject to state laws prohibiting unfair or deceptive practices, the Court ruled that Depositor's claim under the UCL for misrepresentation was not preempted by the NBA.

 

As to Bank's attempt to compel arbitration of Depositor's claims, the Ninth Circuit  noted that:  (1) the customer account agreement contained a permissive arbitration clause allowing but not mandating either party to submit a dispute to binding class arbitration; (2) the penalty for failure to consent to arbitration upon demand is bearing the costs involved in compelling arbitration; (3) Bank never demanded arbitration, raised it as a defense, or even mentioned it until after the U.S. Supreme Court had issued its decision in AT&T Mobility LLC v. Concepcion, 131 S. Ct. 1740 (2011), after the conclusion of the trial and the lower court had issued its judgment.  Observing that Bank could have sought a stay pending the outcome of Concepcion, the Court relied on a prior opinion pointing out the prejudice that would result if the court ordered arbitration.  See Fisher v. A.G. Becker Paribas Inc., 791 F.2d 691, 694 (9th Cir. 1986)(setting forth requirements for waiver of arbitration rights, including prejudice to the party opposing arbitration). 

 

Thus, in light of the advanced stage of the litigation, the amount of discovery, trial preparation, briefing, and number of motions, the Ninth Circuit concluded that ordering arbitration at such a late juncture would severely prejudice Depositor and class members, essentially negate the effort expended in this case, and would frustrate the purposes of the Federal Arbitration Act to ensure that arbitration agreements are enforced according to their terms so as to facilitate streamlined proceedings.   

 

Finally, the Court also rejected Bank's challenge to standing and class certification, ruling that Depositor had proven actual reliance on the misleading statements in Bank's marketing materials and that class members likely relied on them as well. 

 

Accordingly, the Ninth Circuit vacated both the injunction on high-to-low posting and the restitution order, but affirmed the lower's court's finding of liability based on violations of the "fraudulent" prong of the UCL.  The Court also remanded for a determination of appropriate relief on the misrepresentation claim.

 

 

 

Ralph T. Wutscher
McGinnis Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
Mobile: (312) 493-0874
Email: RWutscher@mtwllp.com

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FYI: 3rd Cir Upholds Dismissal of FCRA Allegations Against Asset Verification Company

The U.S. Court of Appeals for the Third Circuit recently rejected a borrower's allegations of violations of the federal Fair Credit Reporting Act ("FCRA") against an asset verification company, holding that a furnisher of information concerning a borrower's real property could reasonably interpret its activities as outside the scope of FCRA, due to the ambiguity of the statutory definitions of "consumer reporting agency" and "consumer report."

 

A copy of the opinion is available at: 

http://www.ca3.uscourts.gov/opinarch/114504p.pdf.

 

A financial services company ("Southwest") was hired by a consumer lender (the "lender") to provide information concerning a borrower (the "borrower") in connection with the borrower's application for credit insurance.  All of the information collected by Southwest was publicly available, and included, for example, the amounts of the borrower's outstanding mortgages and judgments against property owned by the borrower.  Southwest's report did not include the borrower's social security number, mortgage payment history, or outstanding account balances of credit card accounts. 

 

Southwest's report included two inaccuracies:  it reflected a judgment lien that was in fact a debt owed by the borrower's husband, and it indicated that the borrower's property taxes were delinquent, when in fact the borrower was paying the same in installments, per an agreement with the City.

 

The lender informed the borrower that it would not approve her application for credit without proof that she had paid her taxes.  However, the lender apparently changed its mind, and subsequently provided the borrower with the requested insurance. 

 

The borrower sued Southwest, alleged that it failed to comply with the federal Fair Credit Reporting Act ("FCRA") and claiming damages for both willful and negligent violations of that statute.  Southwest moved for summary judgment, arguing that its reports are not subject to the FCRA because they concern property, not consumers, and that in any event it was not liable because it did not willfully violate the FCRA. The lower court granted Southwest's motion, and the borrower appealed. 

 

As you may recall, the FCRA requires that consumer reporting agencies adopt reasonable procedures to ensure that information provided is kept confidential and is accurate, relevant and properly utilized.  15 U.S.C. Sec. 1681(b).  Those who willfully fail to comply with that requirement are liable for actual as well as punitive damages.  Id. at Sec. 1681n(a). 

 

The FCRA defines "consumer reporting agency" as "any person which...regularly engages...in the practice of assembling  or evaluating consumer credit information...for the purpose of furnishing consumer reports to third parties..."  Id. at Sec. 1681a(f).  A "consumer report" is defined as any information "bearing on a consumer's credit worthiness...in establishing the consumer's eligibility for [credit]." 

 

After examining the statutory language described above, the Third Circuit next considered the Supreme Court's "landmark decision" in Safeco Insurance Co. of America v. Burr, 551 U.S. 47 (2007) ("Safeco").  The Third Circuit stated that Safeco "established a safe harbor against liability for willfulness.  A company cannot be said to have willfully violated FCRA if the company acted on a reasonable interpretation of FCRA's Coverage."  Further, the Third Circuit noted that under Safeco, even where "a court disagrees with a party's reading of the FCRA, it may not impose liability for a reckless, and therefore willful, violation of [the FCRA] unless that party's reading is 'objectively unreasonable.'" 

 

With that standard in place, the Third Circuit considered the parties' arguments. 

 

First, the borrower contended that because Southwest did not read or interpret the FCRA prior to preparing its report, it was not entitled to Safeco's "reasonable interpretation" defense.  The Third Circuit disagreed, finding that although Safeco requires that the company's reading of the FCRA is objectively reasonable, it does not require that the defendant actually has "made such an interpretation at any point in time."  Accordingly, it held that "Southwest does not lose the potential protection of the 'reasonable interpretation' defense, even if it never actually interpreted FCRA prior to the commencement of this lawsuit." 

 

Next, the borrower argued that even if Southwest were entitled to Safeco's safe harbor, the lower court erred in finding that no reasonable jury could have found that Southwest acted recklessly and therefore willfully. 

 

The Third Circuit against disagreed, holding that the FCRA's "unbounded" definitions of "consumer reporting agency" and "consumer report" rendered these terms ambiguous.  The Third Circuit also held that Southwest's reading of the FCRA "has some foundation in the statutory text, and was therefore not ambiguously unreasonable."  Specifically, the Third Circuit noted that because the definition of a "credit reporting agency" involves the collection of "consumer credit information," Southwest could reasonably interpret its collection of information concerning real property as not falling within that definition, because such information concerns property rather than consumers. 

 

Accordingly, the Third Circuit held that the borrower "has not stated a claim for a willful violation of FCRA," and therefore affirmed the judgment of the lower court. 

 

Ralph T. Wutscher
McGinnis Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
Mobile: (312) 493-0874
Email: RWutscher@mtwllp.com
 

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FYI: 2nd Cir Rules No Private Right of Action Under FCRA for Alleged Mistaken Credit Reporting, Borrower Waited Too Long to Amend to Assert 1681s-2(b) Claim

The U.S. Court of Appeals for the Second Circuit recently held that a borrower had no private right of action under section 1681s-2(a) of the federal Fair Credit Reporting Act for reporting supposedly inaccurate information to credit reporting agencies. 

 

The Court of Appeals also ruled that, in light of undue delay in seeking to amend the complaint and prejudice to defendant lender, the lower court properly denied the borrower leave to amend to include an allegation that the dispute had been submitted to a credit reporting agency and triggered a duty to investigate and verify the accuracy of the reported information.    

 

A copy of the opinion is attached. 

 

Plaintiff, a real estate developer ("Borrower") purchased land in Florida with a loan secured by a mortgage on the property.  The Note required Borrower to make interest-only payments for the first three years followed by a "balloon" payment for the balance of the loan.  Borrower failed to make the balloon payment when due.

 

Based on discussions with defendant lender ("Bank"), Borrower continued making the monthly interest payments, but never made the balloon payment.  Bank accepted and credited Borrower's account with those payments, but nevertheless notified credit reporting agencies that Borrower was late on his payments due to the outstanding balloon payment.

 

Borrower then filed a complaint against Bank, asserting claims for willful noncompliance with the federal Fair Credit Reporting Act ("FCRA").  Specifically, Borrower alleged that Bank knowingly disclosed false credit information, failed to correct the false information, and failed to investigate Borrower's dispute that he filed directly with Bank, the furnisher of the information.  The complaint, however, did not allege that Borrower had submitted a dispute to a credit reporting agency about the accuracy of Bank's reporting. 

 

Borrower first submitted a dispute with a credit reporting agency about a month after filing his lawsuit, but failed to amend the complaint to allege that he did so.   In its answer, Bank argued that there was no private right of action under Section 1681s-2(a) of the FCRA and that the complaint failed to state a claim under Section 1681s-2(b) of the FCRA because it failed to allege that the dispute was submitted to a credit reporting agency.  The requirement to file a claim with a credit reporting agency was again brought to Borrower's attention during a deposition almost a year after the filing of the complaint. 

 

After the completion of discovery and waiting almost 18 months since the filing of the complaint, Bank moved for summary judgment.   During that 18-month period, Borrower never attempted to amend his complaint to include an allegation that he had submitted the dispute to a credit reporting agency. 

 

Nearly two years after the commencement of the action, the district court granted summary judgment in favor of Bank, concluding in part that there was no private right of action for violations of Section 1681s-2(a) and that the complaint failed to state a claim under section 1681s-2(b), and denied leave to amend to add a claim under Section 1681s-2(b).

 

Borrower appealed.  The Second Circuit affirmed.

 

As you may recall, the FCRA provides that "A person shall not furnish any information relating to a consumer to any consumer reporting agency if the person knows or has reasonable cause to believe that the information is inaccurate. . . . (B) A person shall not furnish information relating to a consumer to any consumer reporting agency if— (i)the person has been notified by the consumer, at the address specified by the person for such notices, that specific information is inaccurate; and (ii)the information is, in fact, inaccurate.  15 U.S.C. § 1681s-2(a) ("Section 1681s-2(a)"). 

 

The FCRA further provides that Section 1681s-2(a) "shall be enforced exclusively . . . by the Federal agencies and officials and the State officials identified in section 1681 . . . ."  15 U.S.C. § 1681s-2(d). 

 

Moreover, a furnisher of information generally has a duty to correct and update inaccurate information provided to credit reporting agencies if a dispute is filed with the credit reporting agency, but if a dispute is filed directly with the furnisher of information, the furnisher only has a duty to investigate in certain circumstances established by regulation.  See 15 U.S.C. §§ 1681i(a)(1)(A), 1681s-2(a)(8), 1681s-2(b); 16 C.F.R. § 660.4 (relating to direct disputes).

 

Finally, under the FCRA, in certain circumstances a consumer may file a lawsuit against a furnisher of information who "willfully fails to comply with any requirement imposed under" the FCRA and may recover actual or statutory damages, as well as punitive damages, costs, and attorney fees.  15 U.S.C. § 1681n(a).  See also 15 U.S.C. § 1681s-2(c)(1)(limitation on liability).

 

Noting that a furnisher of information must investigate and verify the accuracy of information furnished to a credit reporting agency after a dispute is filed with the agency in accordance with Section 1681s-2(b)(1), but that the complaint only alleged violations of Section 1681s-2(a), the Second Circuit pointed out that the FCRA exclusively "restricts enforcement of [section 1681s-2(a] to federal and state authorities."  The Court thus ruled that, because borrower only alleged violations of Section 1681s-2(a), Borrower had no private right of action for violations of that particular subsection.

 

Turning to Borrower's assertion that the lower court had improperly denied leave to amend his complaint to include an allegation that Borrower had submitted his dispute to a credit reporting agency, the Second Circuit ruled that, in light of Borrower's long delay and the resulting prejudice to Bank, the lower court had correctly denied Borrower leave to amend.

 

Accordingly, the Court of Appeals affirmed the rulings of the district court.

 

Ralph T. Wutscher
McGinnis Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
Mobile: (312) 493-0874
Email: RWutscher@mtwllp.com
 

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Our updates are available on the internet, in searchable format, at:
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FYI: Cal App Ct Holds Non-Compliance with HUD Rules for FHA Loans Invalidates Foreclosure, F/C Trustee Not FDCPA "Debt Collector"

Reversing the lower court, the California Court of Appeal, First District, recently held that a mortgagee's failure to have a face-to-face meeting prior to instituting a nonjudicial foreclosure violated federal regulations governing FHA loans, ruling that as conditions precedent incorporated into the borrowers' deed of trust, the federal regulations precluded foreclosure prior to such a meeting, and borrowers were entitled to have the foreclosure action set aside. 

 

The Court also ruled that:  (1) borrowers could pursue remedies afforded by federal law in addition to those available under California's nonjudicial foreclosure statutes when not inconsistent with the policies behind the state statutes; (2) borrowers' failure to tender the full amount owed on the loan did not bar the requested injunctive relief; and  (3) because the trustee under the deed of trust was not a "debt collector" under the federal Fair Debt Collection Practices Act, borrowers failed to state a claim under the FDCPA for improper debt collection.

 

A copy of the opinion is available at:  http://www.courts.ca.gov/opinions/documents/A133071.PDF.

 

Plaintiffs borrowers ("Borrowers") had a home mortgage loan insured by the Federal Housing Administration ("FHA").  The deed of trust securing the property provided that the trust deed was subject to the servicing requirements of the U.S. Department of Housing and Urban Development ("HUD") governing FHA loans. 

 

After Borrowers fell behind on their mortgage payments, the owner of the loan ("Loan Owner") initiated a nonjudicial foreclosure action against Borrowers under the California nonjudicial foreclosure statutes.  Accordingly, the trustee ("Trustee") under the deed of trust recorded a notice of default and sent Borrowers a notice of a nonjudicial foreclosure sale.

 

Seeking damages, cancellation of the pending foreclosure, and declaratory relief stating that Loan Owner and Trustee lack authority to proceed with a nonjudicial foreclosure until they comply with HUD servicing regulations, Borrowers filed a complaint against both Trustee and Loan Owner.  In their complaint, Borrowers alleged among other things:  wrongful foreclosure, breach of contract, and violation of the federal Fair Debt Collection Practices Act ("FDCPA").

 

Borrowers based their wrongful foreclosure claim on the supposed failure to meet with Borrowers face-to-face prior to initiating the foreclosure action, a requirement, Borrowers asserted, was incorporated by reference into the deed of trust. 

 

Specifically, the "FHA California Deed of Trust" provided in part:  "[R]egulations issued by the [HUD] Secretary will limit Lender's rights, in the case of payment defaults, to require immediate payment in full and foreclosure if not paid.   This Security Instrument does not authorize acceleration or foreclosure if not permitted by regulations by [HUD]." 

 

To support their FDCPA claim, Borrowers further asserted that Trustee was a "debt collector" under the FDCPA and that Trustee thus had a duty to provide Borrowers with a 30-day advance debt validation notice required by the FDCPA prior to recording the notice of default.  Borrowers alleged that, had they received such notice, they would have been able to have certain insurance payments credited toward their mortgage.

 

Lenders demurred, and the lower court sustained the demurrer without leave to amend.   In so doing, the lower court ruled in part that HUD regulations permitted no private right of action and did not designate Borrowers as third-party beneficiaries of any agreements between Lenders and FHA.  The lower court also ruled that Borrowers failed to adequately allege tender of the amounts needed to reinstate their loan.  Borrowers appealed. 

 

The Court of Appeal reversed as to Borrowers' claims for wrongful foreclosure and injunctive and declaratory relief, but affirmed as to their other causes of action.

 

As you may recall, FHA mortgagees must adhere to certain mortgage-servicing requirements upon default or imminent default, including the duties to "engage in loss mitigation actions for the purposes of providing an alternative to foreclosure . . . ."  and to "have a face-to-face interview with the mortgagor, or make a reasonable effort to arrange such a meeting, before three full monthly installments due on the mortgage are unpaid.  If default occurs in a repayment plan arranged other than during a personal interview, the mortgagee must have a face-to-face meeting with the mortgagor, or make a reasonable attempt to arrange such a meeting within 30 days after such default and at least 30 days before foreclosure is commenced . . . .:  See 12 U.S.C. § 1715u(a); 24 C.F.R. § 203.604(b); 24 C.F.R. § 203.500

 

In addition, the FDCPA prohibits "debt collectors" from engaging in abusive debt collection practices.  See 15 U.S.C. § 1692.  The FDCPA in turn defines "debt collector" as "any person who uses any instrumentality of interstate commerce or the mails in any business the  principal purpose of which is the collection of any debts, or who regularly collects or attempts to collect, directly or indirectly, debts owed or due or asserted to be owed or due another . . . ."  15 U.S.C. § 1692a(6).   See also 15 U.S.C. §1692f(6)(prohibiting debt collectors from "Taking or threatening to take any nonjudicial action to effect dispossession or disablement of property if— (A)there is no present right to possession of the property claimed as collateral through an enforceable security interest").

 

In noting that the deed of trust in this case specified it was subject to HUD regulations, the Appellate Court stressed the regulations' requirement to hold a "face-to-face meeting" with Borrowers before foreclosure could take place.   In so doing, the Court rejected Lenders' assertion that the duties under the regulations ran to HUD rather than to Borrowers.   The Court reasoned that, contrary to the defendants' arguments, the issue in this case was not enforcement of mortgagee's duties toward HUD, but whether foreclosure is proper if Loan Owner and Trustee failed to comply with HUD servicing requirements as set forth in the FHA deed of trust. 

 

Examining the policies underlying HUD servicing requirements, and citing a case from another jurisdiction which involved identical FHA deed of trust provisions, the Appellate Court ruled that the trust deed in this case expressly required compliance with HUD regulations prior to accelerating or foreclosing on Borrowers' loan.  The Court thus ruled that, although Borrowers had no claim for damages, they could enforce compliance with the regulations as conditions precedent to the nonjudicial foreclosure action.  See Mathews v. PHH Mortgage Corp., 724 S.E.2d 196 (2012). 

 

As the Appellate Court explained, although Borrowers could not bring a private right of action against Lenders, they could seek to prevent the foreclosure until such time as Lenders complied with the applicable HUD regulations.  See Lacy-McKinney v. Taylor Bean & Whitaker Mortgage Corp., 937 N.E.2d 853, 863-64 (Ind. Ct. App. 2010)(observing that public policy of HUD supports conclusion that HUD servicing responsibilities "are binding conditions precedent that must be complied with before a mortgagee has the right to foreclose on  HUD property.").  Accordingly, the Court of Appeal ultimately concluded that Lenders' failure to comply with the requirement to hold a face-to-face meeting with Borrowers allowed Borrowers to assert such noncompliance as an equitable defense to the foreclosure action.

 

With respect to the relationship between HUD regulations and California law, the Appellate Court further ruled that Borrowers could pursue remedies afforded them under federal law in addition to those available under California's nonjudicial foreclosure scheme.  See California Gold, L.L.C. v. Cooper, 163 Cal. App.4th 1053 (2008) (noting that California courts have allowed parties to pursue additional remedies arising out of nonjudicial foreclosures when not inconsistent with policies behind the nonjudicial foreclosure statutes).  In so ruling, the Court rejected the defendants' various contentions including that the face-to-face interview was not a material term in the deed of trust and had no benefit for the borrower.  The Court noted, among other things, that a face-to-face meeting in this case could prevent the need for foreclosure and that Lenders voluntarily agreed to the terms of the FHA deed of trust when Loan Owner purchased the loan. 

 

With respect to Borrowers' failure to allege tender of the amount owed on their loan, the Appellate Court stressed that no foreclosure sale had occurred in this case and that Borrowers had alleged Lenders' failure to comply with HUD regulations.    The Court accordingly ruled that Borrowers' failure to allege tender was no bar to their claims for injunctive and declaratory relief based on Lender's failure to conduct the face-to-face interview. 

 

As to Borrowers' FDCPA claim, noting that federal courts have reached conflicting conclusions about the applicability of the FDCPA to acts taken by trustees in the foreclosure process and disagreeing with the position of the federal Consumer Financial Protection Bureau ("CFPB") that trustees must comply with the entire FDCPA, the Court of Appeal ruled that Trustee was not a "debt collector," because providing notice of a foreclosure sale to a consumer as required by California's Civil Code did not constitute debt collection activity under the FDCPA.  Compare Perry v. Stewart Title Co., 756 F.2d 1197, 1208 (5th Cir. 1985)(mortgagees are not debt collectors under the FDCPA) with Wilson v. Draper & Goldberg, P.L.L.C., 443 F.3d 373, 376-377 (4th Cir. 2006)(trustee sale is debt collection under the FDCPA). 

 

In so doing, the Court noted that the CFPB policy did not address the specific issue whether the pursuit of a foreclosure, alone, constitutes debt collection under the FDCPA and that Borrowers' complaint alleged only that Trustee gave Borrowers a notice of foreclosure in accordance with California's nonjudicial foreclosure law.  See Santoro V. CTC Foreclosure Services, 12 Fed. Appx. 476 (9th Cir. 2001).  The Court therefore concluded that Borrowers failed to state a claim under the FDCPA for improper debt collection.

 

Finally, affirming the lower court on the breach of contract claim, the Court of Appeal ruled that Borrowers had no private right of action under the HUD regulations and thus had no cause of action for breach of contract.

 

Accordingly, the Court of Appeal reversed the lower court as to the claims for wrongful foreclosure and injunctive and declaratory relief, but affirmed as to the other claims. 

 

Ralph T. Wutscher
McGinnis Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
Mobile: (312) 493-0874
Email: RWutscher@mtwllp.com

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FYI: 9th Cir Limits Scope of RESPA "Qualified Written Requests," Following Similar Seventh Circuit Ruling

The U.S. Court of Appeals for the Ninth Circuit recently held that written borrower demands seeking only information regarding loan origination issues, or modification of an existing loan, were not "qualified written requests" that triggered a servicer's duties under the federal Real Estate Settlement Procedures Act.

 

A copy of the opinion is available at:  http://www.ca9.uscourts.gov/datastore/opinions/2012/12/11/11-55412.pdf.

 

Plaintiffs borrowers ("Borrowers") obtained a home mortgage loan that was serviced by a bank ("Servicer').  The loan documents provided for, among other things, an escrow account into which Borrowers would make monthly payment to cover taxes, insurance, interest, and principal.  About a year after the loan agreement, Servicer notified Borrowers that the escrow account lacked sufficient funds to cover the upcoming 12-month period and that Borrowers would need to replenish the escrow account. 

 

Borrowers' attorney then sent a number of letters to Servicer disputing any obligation to make the increased payments.  One letter asserted that the loan documents did not accurately reflect the payment schedule that the loan broker had represented and demanded that Servicer revise the documentation to reflect the alleged original terms of the loan agreement.  A second letter made similar claims, but also stated that Borrowers would continue making the same payments as allegedly agreed in the original loan agreement.  

 

The final letter again asserted that the demand for increased payments was improper, even though the demand was consistent with the loan and documentation.  Servicer made no changes to Borrowers' account, and may allegedly not have responded to Borrowers' letters.

 

Borrowers first filed suit in California state court, alleging that Servicer violated state law, and later added claims under the federal Real Estate Settlement Procedures Act, 12 U.S.C. § 2605 ("RESPA").  Servicer removed the action to federal court.  The lower court dismissed the federal claims, ruling that the letters were not "qualified written requests" and remanded the action to state court.

 

Borrowers appealed.  The Ninth Circuit affirmed, ruling that because Borrowers' letters were not related to the servicing of the loan, they were not "qualified written requests" that triggered a duty to respond under RESPA.

 

As you may recall, RESPA requires servicers of federally-related mortgage loans to provide timely responses to "qualified written requests" seeking information relating to the servicing of the loan.  12 U.S.C. § 2605(e)(1)(A),(e)(2).  RESPA in turn defines a "qualified written request" as "a written correspondence, other than notice on a payment coupon or other payment medium supplied by the servicer, that – (i) includes, or otherwise enables the servicer to identify, the name and account of the borrower; and (ii) includes a statement of the reasons for the belief of the borrower, to the extent applicable, that the account is in error or provides sufficient detail to the servicer regarding other information sought by the borrower."  12 U.S.C. § 2605(e)(1)(B).

 

In addition, RESPA specifically defines "servicing" as "receiving any scheduled periodic payments from a borrower pursuant to the terms of any loan, including amounts for escrow accounts . . . , and making the payments of principal and interest and such other payments with respect to the amounts received from the borrower as may be required pursuant to the terms of the loan."  12 U.S.C. § 2605(e)(1)(A), (e)(2) (i)(3).  Failure to respond to such inquiries entitles the borrower to recover actual damages and, in some circumstances, statutory damages of up to $1,000.  12 U.S.C. § 2605(f).

 

Citing a Seventh Circuit opinion for its general approach to defining a "qualified written request," the Court of Appeals concluded that a qualified written request requires a response only if it relates to the servicing of a loan.  See Catalan v. GMAC Mortgage Corp., 629 F.3d 676 (7th Cir. 2011)(defining what types of requests constitute "qualified written requests" and thus trigger a servicer's duty to respond).  In so ruling, the Ninth Circuit noted that the duty to respond does not derive from the definition of "qualified written request," but from Section 2605(e)(1)(A), "which requires, as conditions for triggering the duty to respond, both (1) that the letter is a qualified written request and (2) that it requests information relating to servicing." 

 

The Ninth Circuit further reasoned that since servicing "does not include the transactions and circumstances surrounding a loan's origination – facts that would be relevant to a challenge to the validity of an underlying debt or the terms of a loan agreement," letters related only to a loan's validity or terms are not qualified written requests that require a servicer to respond. 

 

Turning specifically to Borrowers' letters in this case, the Ninth Circuit concluded that their content merely challenged the terms of the loan and mortgage documents.  As such, the Court ruled, the letters did not relate to the servicing of the loan.  As the Court explained, although RESPA does not require "magic words," because the letters alleged fraud or mistake associated with the original loan agreement, and requested a loan modification to reflect the "original terms" of the agreement, they were not qualified written requests that related to the servicing of the loan. 

 

Accordingly, because Borrowers' letters did not relate to servicing, the Ninth Circuit ruled that the letters, while written requests generally, were not the sort of "qualified written requests" that triggered Servicer's duty to respond under Section 2605(e). 

 

Ralph T. Wutscher
McGinnis Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
Mobile: (312) 493-0874
Email: RWutscher@mtwllp.com
 

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FYI: 8th Cir Rules Against Bank on "Floating Lien" Defense to BK Trustee's Avoidance Action

The Bankruptcy Appellate Panel for the Eighth Circuit recently held that a Chapter 7 trustee could recover funds used to pay down a loan as a preferential transfer, ruling that, because the bank waited until the start of the 90-day preference period under Section 547(b) to perfect a lien on a loan it previously made to the debtor, the "floating lien" or "inventory/accounts receivable" defense was not available to prevent the trustee from avoiding the preference. 

 

The BAP also ruled that:  (1) the bank could not use the "ordinary business terms" defense under Section 547(c)(2)(B) to keep funds from the mutually agreed liquidation of debtor's business because liquidation was not in the "ordinary course"; (2) the bank's release of liquidation proceeds to debtor did not constitute "new value" allowing bank to setoff funds in debtor's bank account, as the liquidation proceeds were transferred during the preference period and were expressly intended to satisfy the debt owed to the bank; (3) the bank was not entitled to the fees it paid to a consultant to analyze its chances of recovering the outstanding debt from the debtor; and  (4) the bank held a security interest in the deposited funds at the start of the preference period as a result of its setoff rights under the loan documents and state law.

 

A copy of the opinion is attached.

 

A business ("Debtor") obtained a loan from defendant bank ("Bank") for purposes of purchasing inventory for one of its chain stores.  Debtor granted Bank a security interest in its personal property, including inventory, accounts, fixtures, and proceeds.  Bank did not perfect its security interest at the time of the loan.

 

Several years later, concerned about Debtor's ability to repay the loan, Bank hired a consultant to conduct an analysis of Debtor's business and to determine the best strategy for recovering on the outstanding debt.  Debtor stopped making payments on the loan shortly thereafter, and Bank demanded immediate payment of over $250,000 still owing on the loan.

 

Bank and Debtor later entered into an agreement whereby Debtor would retain a liquidation service and conduct a going-out-of-business sale.  A few days after entering the agreement to liquidate the business, Bank perfected its lien on Debtor's inventory, accounts, fixtures, and proceeds by filing a UCC financing statement with the Minnesota Secretary of State.  As of the date of the filing of the financing statement, the estimated value of Debtor's inventory exceeded Debtor's debt to Bank.  Further, Debtor had funds on deposit at Bank on the day the financing statement was filed that were subject to Bank's setoff rights under the loan agreement. 

 

All the proceeds from the subsequent going-out-of-business sale, approximately $427,000, were deposited into Debtor's account at Bank.  Debtor's loan obligation to Bank was thus repaid in full from the liquidation sale proceeds deposited in Debtor's account.  An additional amount of roughly $6,000 was also paid to Bank from Debtor's account to pay for the services of the liquidation company.

 

About a month after the completion of the liquidation sale, an involuntary Chapter 7 bankruptcy petition was filed against Debtor.  The bankruptcy trustee ("Trustee") sought to avoid the payment of the Bank's debt as a prohibited preferential transfer.  Moving for summary judgment, Bank argued that it had a "floating lien" or "inventory/accounts receivable" defense under Section 547(c)(5), thereby arguing that the bank's lien automatically attached to Debtor's inventory and receivables after the loan was made.  Bank also asserted that it had setoff rights to Debtor's deposit account, regardless of whether it had a perfected security interest in other assets of Debtor.

 

The Bankruptcy Court denied Bank's summary judgment motion, ruling that the perfection of Bank's lien occurred within the 90-day perfection period under Section 547(b) and that Bank's "floating lien" defense thus did not apply to a security interest perfected during that period.   After a trial, the Bankruptcy Court entered judgment in favor of Trustee for the proceeds of the liquidation sale relating to the payment of the debt owed to Bank, roughly $250,000, but not for the pre-liquidation funds in Debtor's deposit account against which Bank had exercised its setoff rights.

 

Bank appealed the denial of its motion for summary judgment.  Trustee cross appealed as to Bank's setoff rights to Debtor's pre-liquidation funds on deposit and the payment of Bank's consulting fees.

 

The Bankruptcy Appellate Panel ("BAP") affirmed in all respects, except for the credit given to Bank for its consulting expenses, on which point the BAP reversed.

 

As you may recall, a chapter 7 trustee may recover certain preferential transfers made "on or within 90 days before the filing of the [bankruptcy] petition . . . ."   11 U.S.C. § 547(b).  The trustee, however, may not avoid a so-called "floating lien" on inventory and receivables acquired during that preference period. 

 

Specifically, section 547(c)(5) provides that the trustee may not avoid a transfer "(5) that creates a perfected security interest in inventory or a receivable or the proceeds of either, except to the extent that the aggregate of all such transfers to the transferee caused a reduction, as of the date of the filing of the petition and to the prejudice of other creditors holding unsecured  claims, of any amount by which the debt secured by such security interest exceeded the value al all security interests for such debt on the later of – (A) (i) [preferential transfers made] 90 days before the date of the filing of the petition; or (ii) with respect to a [preferential] transfer . . . one year before the date of the filing of the petition; or (B) the date on which new value was first given under the security agreement creating such security interest.  11 U.S.C. § 547(c)(5)("Section 547(c)(5)").

 

In addition, a trustee may not avoid a transfer – "(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was . . . . made in the ordinary course of business .  .  . of the debtor and the transferee; or (b) made according to ordinary business terms."  11 U.S.C. § 547(c)(2). 

 

Finally, the "new value defense" prohibits the trustee from avoiding a transfer "(4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor – (A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor."  11 U.S.C. § 547(c)(4).

 

Noting that Section 547(c)(5)'s floating lien defense is not available to the extent that a creditor's position is improved as a result of after-acquired inventory and receivables, the BAP focused on Bank's position at the beginning of the 90-day preference period.  Citing In re Qualia Clinical Service, Inc. 652 F.3d 933, 939 (8th Cir. 2011), the BAP observed that "[a] creditor who . . . enters the [preference] period unperfected is properly deemed, for purposes of section 547(c)(5) to have an interest of zero value."   In so doing, the BAP noted that the Bank entered the preference period unperfected, but that the Bank perfected its security interest precisely on the 90th day prior to the filing of the involuntary bankruptcy petition.  Accordingly, the BAP ruled that the perfection of Bank's security interest on that 90th day constituted an avoidable preference, notwithstanding the fact that once its lien was perfected, Bank did not improve its position since it became oversecured and remained so until the loan was repaid in full.

 

The BAP also rejected Bank's arguments that:  (1) the payments it received from the going-out-of-business sale were made "according to ordinary business terms" under Section 547(c)(2(B) pursuant to the agreement between Debtor and Bank to retain a liquidation company to run the sale; and (2) Bank gave "new value" to Debtor's estate by paying the liquidation company for its services and releasing funds from the deposit account in which Bank supposedly had setoff rights.  

 

In ruling that neither the "new value" defense nor the "ordinary course" defense applied to Trustee's preference action, the BAP noted that a going-out-of-business sale resulting in the cessation of the business was not in the "ordinary course" and further that, although an account with setoff rights is considered a secured claim, the proceeds from the liquidation sale were transferred into Debtor's account during the preference period while Debtor was insolvent and for the express purpose of paying the debt owed to Bank.  See Kroh Bros. Development Co. v. Commerce Bank of Kansas City, N.A., 86 B.R. 186, 191-92 (Bankr. W.D. Mo. 1988) (ruling that a deposit is a voidable preference and setoff is not allowed if the deposit is made with the purpose of satisfying a bank's claim and the other statutory elements are met).  Observing that no other creditors had been paid on preexisting debts and that Bank did not release any of the liquidation proceeds until it was satisfied that it would be paid in full, the court explained, because "the purpose of the liquidation, and deposit into the account, was to pay the Bank's debt . . . the Bank did not obtain a setoff right against the liquidation proceeds."

 

As to Trustee's cross-appeal with respect to Debtor's funds on deposit prior to the liquidation sale, the BAP focused on the fact that Bank held a security interest in those funds at the start of the preference period as a result of its setoff rights under the loan documents and state law, rather than on whether Bank actually exercised those setoff rights at the start of the 90-day preference period.  In so doing, the BAP ruled that the payment to Bank from the funds on deposit prior to the liquidation was not a preferential transfer or improper setoff avoidable by the Trustee.

 

Finally, the BAP also ruled that Bank was not entitled to the consulting fees it paid for purposes of assessing whether Bank would be able to recover on its loan.  These fees, the BAP reasoned, were for a service ordered by Bank to analyze its strategy for recovering the outstanding debt.

 

Accordingly, the BAP agreed with the Bankruptcy Court that the payoff of the loan was a preferential transfer to Bank, and thus affirmed the judgment in favor of Trustee.  However, disagreeing that Bank was entitled to a credit against the judgment for the consulting fees, the BAP reversed on that issue and increased the amount of the judgment in Trustee' favor.

 

 

Ralph T. Wutscher
McGinnis Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
Mobile: (312) 493-0874
Email: RWutscher@mtwllp.com
 

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