Carmel Financing, LLC v. Schoenmann (In re Mayacamas Holdings LLC), 2022 WL 3599561 (N.D. Cal. Aug. 23, 2022)

Dear constituency list members of the Insolvency Law Committee, the following is a case update written by Patrick Costello, principal at  Vectis Law, analyzing a recent decision of interest:

SUMMARY

In Carmel Financing, LLC v. Schoenmann (In re Mayacamas Holdings LLC), 2022 WL 3599561 (N.D. Cal. Aug. 23, 2022), the district court affirmed the bankruptcy court’s ruling that the chapter 7 trustee prevailed in avoiding the interest of the holder of a first deed of trust in an insurance payout for catastrophic fire damage  to California improved real property. The district court reversed and remanded as to the bankruptcy court’s determination of governing law (Colorado vs California) and its denial of the trustee’s motion for attorney’s fees.

To review the district court’s opinion, click here.

FACTS

The debtor purchased improved real property in Sonoma County, California (the “Property”) in 2006 with a $2M loan secured by a first deed of trust in favor of the original lender (the “First DOT Holder”) who was duly listed as an additional insured on the insurance policy insuring the Property against fire damage (the “Policy”).  The debtor refinanced the Property in 2014 with Carmel Financing, LLC (“Carmel”), issuing Carmel a $2M promissory note (the “Note”) secured by a replacement first deed of trust on the Property (the “DOT”).   The Note and the DOT specified Colorado was the governing law between the parties, but the DOT  specified that matters such as recording and perfection requirements  would be governed by  the law of the locale of the Property (California). The DOT granted Carmel a security interest in not only the Policy but claims and recoveries thereunder. 

Prior to the debtor’s bankruptcy filing, Carmel failed to either (i) ensure that it was named as an additional insured under the Policy or (ii) give written notice to the insurer of its security interest in the Policy. That said, in connection with a 2015 renewal of the Policy the debtor’s insurance broker submitted an update to the insurer with the debtor’s handwritten changes purporting to substitute Carmel for the First DOT Holder as an additional insured.  This attempted substitution appears to have been ineffectual inasmuch subsequent Policy renewals continued to show the First DOT Holder rather than Carmel as the additional insured.

The debtor initiated a chapter 11 case in April 2017 which was converted to chapter 7 in short order.  In October 2017, the “Tubbs Fire” caused catastrophic fire damage to the Property. The chapter 7 trustee submitted a claim under the Policy and obtained a recovery of over $2.1M.  Following the trustee’s insurance recovery, Carmel claimed that it was entitled to  the funds after payment of required cleanup costs as its collateral.  The trustee responded with a complaint to (1) avoid Carmel’s interest in the funds  as unperfected pursuant Section 544  (ii) invalidate various provisions of the Note relating to default interest and a $75,000 exit fee under California law, and (iii) recover attorneys’ fees as the prevailing party based on the attorney’s fees clause in the DOT.

On summary judgment, the bankruptcy court held that the trustee prevailed on her claim to avoid Carmel’s security interest in the insurance recovery because Carmel had failed to perfect its security interest in the Policy and Carmel’s claim to an equitable lien on the funds was unavailing. The bankruptcy court rejected the trustee’s claims that Carmel’s default interest rate and exit fee terms violated California law because both the Note and the DOT specified Colorado as the governing law; it also denied the trustee’s motion for attorneys’ fees.  Carmel appealed the bankruptcy court’s judgment to the district court and the trustee cross appealed the choice of law and denial of her attorneys’ fees.

The district court affirmed the bankruptcy court rulings that the trustee prevailed on her Section 544 avoidance of Carmel’s security interest in the insurance funds and that Carmel was not entitled to an equitable lien on the funds, but reversed and remanded as to the bankruptcy court’s rulings on choice of law and and the trustee’s right to  attorneys’ fees.

The district court subsequently denied Carmel’s motion for rehearing and Carmel has filed a notice of appeal to the Ninth Circuit.

ANALYSIS 

The district court’s opinion addresses four matters of note: 

1. FAILURE TO PERFECT IN INSURANCE RECOVERY 

The district court noted that it was undisputed that the language of the DOT granted Carmel a security interest in not only the Policy but claims and rights to payment thereunder; the only issue was whether Carmel had perfected that security interest. The district court affirmed the bankruptcy court’s determination that Carmel had failed to perfect its security interest in the Policy because Section 9312(b)(4) of the California Uniform Commercial Code (the “CUCC”) specifies the exclusive method to perfect a security interest in an insurance policy and Carmel had failed to comply with  its requirements.

Carmel argued to the bankruptcy court that it held a perfected interest in the insurance funds because the funds were the identifiable cash proceeds of its real property “collateral” as to which Carmel’s lien rights had indisputably been perfected by the recording of the DOT.  To a lawyer with a passing familiarity with the CUCC, this argument might appear to be a winner.  After all, CUCC 9102(a)(64)(E) defines proceeds to include “insurance payable by reason of the loss,” and CUCC 9315 provides for automatic perfection in identifiable cash proceeds. Indeed, Carmel’s argument might have won the day if Carmel’s “collateral” had been personal property rather than real property.  However, the bankruptcy court rejected Carmel’s “proceeds” argument, holding that Camel could not rely on CUCC rules and principles applicable to proceeds where its only “perfected” interest was in real property. The CUCC definitions of both a “security interest” and “collateral” expressly limit their application to personal property and the limitations on the scope of Article 9 set forth in CUCC 9109(c)(11) exclude real property. Carmel evidently chose not to pursue its “identifiable cash proceeds of  real property collateral” argument on appeal.

With no “identifiable cash proceeds of real property collateral” argument, Carmel was left with two arguments for its right to the insurance funds on appeal:

(i)             Carmel had an equitable lien on the Policy and the recovery (discussed below); and

(ii)            Carmel should be deemed to have perfected its security interest in the Policy.

The district court quickly dispatched Carmel’s argument that it had perfected its security interest in the Policy.  CUCC 9312(b)(4) specifies a straightforward method for perfecting a security interest in an insurance policy: the secured party must give written notice to the insurer of its security interest in the policy. Carmel admittedly failed to comply with that requirement (the debtor’s 2015 ineffectual effort to substitute Carmel as an additional insured did not qualify for multiple reasons) and so was determined to have failed to perfect its security interest in the Policy.  With no  perfected security interest in the Policy, there was no automatic perfection in the funds as identifiable cash proceeds.

2. EQUITABLE LIEN

Real property lenders typically perfect their interest in related insurance policies and claims thereunder by ensuring that the lender is named as an additional insured under the applicable policy. The effectiveness of that method of perfection was not in question (indeed the trustee argued that being named as an additional insured was the sole method to perfect a lien on an insurance policy and recoveries thereunder).  Carmel evidently argued that it was entitled to an equitable lien based on the intent of the parties (the intent was undisputed) and the one-time but ineffectual 2015 effort to update the Policy to substitute Carmel as the additional insured.  The district court affirmed the bankruptcy court’s rejection of Carmel’s equitable lien argument on grounds that even if an equitable lien were imposed, it would not prevail over the trustee’s Section 544 strong-arm powers.

3. CHOICE OF LAW

Both the Note and the DOT specified Colorado as the governing law, but the DOT also specified California law as to perfection issues. The Note included terms imposing an 18% default interest rate, monthly late fees of 4%, as well as a $75,000 exit fee. The trustee contended that such terms were unenforceable penalties under California law. The bankruptcy court determined that the choice-of-law clauses of the Note specifying Colorado law were valid and should be given effect as to the late fees and exit fee. As California law did not apply to the challenged terms, there were no unenforceable penalties.  The district court reversed and remanded with instructions that the bankruptcy court conduct a more thorough analysis and application of the principles of Section 187 of the Restatement (Second) of Conflicts of Law, and particularly whether application of Colorado law would be contrary to a fundamental policy of California as to matters wherein California has a materially greater interest than Colorado.

4. ATTONEYS’ FEES

The trustee moved for an award of her attorneys’ fees incurred in prosecuting the Section 544 avoidance action based on an attorneys’ fee provision in the DOT and California Civil Code (“CCC”) Section 1717(a) which makes reciprocal even a unilateral contractual attorneys’ fees clause so that the prevailing party is entitled to an award of attorneys’ fees where the action is “on the contract”  The bankruptcy court denied the trustee’s motion for attorneys’ fees because the avoidance action was not “on the contract” where  the dispute was as to perfection of a security interest. The district court reversed and remanded, concluding that the trustee’s avoidance action was indeed an action “on a contract,” citing the Ninth Circuit’s decision in In re Penrod, 802 F.3d 1084 (9th Cir. 2015) (“Penrod”) for the proposition that the avoidance of a contractual duty on bankruptcy principles qualifies as an action “on the contract for purposes of CCC 1717”.

COMMENTARY

1. FAILURE TO PERFECT IN INSURANCE RECOVERY

On appeal, Carmel’s only real argument for a perfected security interest in the insurance recovery was that Carmel had taken sufficient steps to perfect an interest in the Policy (and thus the resulting identifiable cash proceeds) notwithstanding a lack of qualifying written notice to the insurer.  The heart of this argument was Carmel’s premise that the district court should just overlook the niggling requirement of written notice to the insurer in CUCC 9312(b)(4).  The argument went over like a lead balloon.

CUCC 9312(b)(4) sets out a simple requirement for perfection in an insurance policy: the secured creditor must give written notice to the insurer of the security interest.  This is a straightforward “check the box” requirement for any sort of real estate transaction.

Of course, even giving notice under CUCC 9312(b)(4) may not be enough to assure a real property lender of perfected rights in an insurance recovery.  What if the debtor switches insurers without timely notifying the secured creditor and there is a recovery under the new policy? Relying on CUCC 9312(b)(4) or even being named as an additional insured on the original policy may not save the lender in such circumstances. Is there another way? Perhaps. The DOT granted Carmel a broad security interest in insurance policies relating to the Property and claims and recoveries thereunder.   What if Carmel at closing had filed a financing statement against the debtor identifying as its collateral all insurance policies and rights to payment relating to the Property? The financing statement would not perfect a security in the policy itself, but it might perfect a security interest in the claims and rights to payment under the policy and the ultimate recovery.

2. EQUITABLE LIEN

Carmel’s argument for an equitable lien amounts to: “the DOT granted Carmel a security interest in the insurance policy and recoveries, and a good faith if ineffectual effort was made to name Carmel as an additional insured, so Carmel should have an equitable lien.” 

The district court, relying principally on Ninth Circuit precedent concerning a claim to a constructive trust, determined that even if an equitable lien were imposed that lien would still not prevail over the trustee’s strong-arm powers.  The district court’s analysis of the equitable lien issue is unsatisfying.  First, while both a constructive trust and an equitable lien (it might be more accurate to refer to a resulting lien) are equitable in nature, their rationales are distinct: a constructive trust is imposed to “right a wrong” notwithstanding that the parties may not have intended to create a lien, while an equitable lien arises where the parties both intended to and took action to create the right but those efforts somehow fell short of the finish line.  Second, there is precedent in the Ninth Circuit to support the proposition that the trustee’s strong-arm powers do not defeat an equitable lien.  Finally, the insurer continuously acknowledged the first deed of trust holder as the additional insured; so in a sense, it comes down to a case of “gee, we did everything right but slipped up on updating the name.”  Under the CUCC, getting the name wrong in a financing statement is enough to defeat perfection, but what about an equitable lien where the CUCC does not apply?

3. CHOICE OF LAW

The district court’s reversal of the bankruptcy court’s deferral to the parties’ choice of Colorado law is a cautionary note to lawyers seeking to avoid application of California law in California centric deals.

Parties to transactions involving California parties and/or assets may seek to avoid “inconvenient” California laws—usury and other restrictions on other financial terms to name a few—by “agreeing” to be governed by the laws of a state other than California. Both Carmel and the debtor agreed that Colorado law should govern the relevant terms of the Note and the DOT and the Carmel evidently had Colorado connections, and so the bankruptcy court concluded that the consensual choice of law should be honored.

 Many a transactional lawyer assumes that in a transaction between sophisticated parties, the parties’ negotiated choice of law will be honored. However, the district court required a more rigorous analysis under Section 187 of the Restatement (Second) of Conflicts of Laws.  The district court remanded this analysis to the bankruptcy court to be determined whether the Note’s default terms should still be construed under Colorado law.  It is unclear whether the district court would have had a concern if California real property was not the heart of the case. 

4. ATTORNEYS FEES IN AVOIDANCE ACTION

To recover attorneys’ fees pursuant CCC 1717(a), there must not only be an attorneys’ fee clause, but the fees must also be incurred in an action “on the contract.” The bankruptcy court denied the trustee’s request for attorneys’ fees on the grounds that the trustee’s action was not “on the contract” and was a question of perfection. Carmel argued since the Trustee was suing under Section 544 as a hypothetical lien creditor, she was not a party to the contract and accordingly was not entitled to the benefit of the contractual attorney’s fee clause.

In Penrod, the Ninth Circuit concluded that the Supreme Court’s decision in Traveler’s Casualty & Surety Co. v. Pacific Gas & Electric Co., 549 US 443 (2007), significantly altered the analysis for the award of attorneys’ fees in bankruptcy cases. Prior to Travelers and Penrod, Ninth Circuit precedent was that while a trustee might be entitled to recover pursuant to an attorneys’ fee clause on strictly contract breach or other state law issues, the trustee had no right to recover attorneys’ fees on matters solely concerning federal bankruptcy law, e.g., bankruptcy avoidance actions.  The district court cited Penrod for the proposition that a trustee is entitled to recover attorneys’ fees under CCC 1717 where she/he prevails in an action to avoid or defeat enforcement of the terms of a contract, irrespective of whether the theory for avoiding or defeating enforcement is grounded in the Bankruptcy Code (any avoidance action), state law or an interpretation of a provision of the contract or instrument.  It should be noted, however that Penrod involved substantially different circumstances: Penrod addressed a dispute between an individual debtor and a secured creditor over the bifurcation of a secured claim into secured and unsecured portions. That kind of dispute sounds a lot more like a dispute under the parties’ contract than a Chapter 7 trustee’s Section 544 action challenging perfection of a security interest as a lien creditor.  On the other hand,Carmel’s security interest in the recovery funds is indisputably a contract right arising under the DOT, so Carmel’s claim to the funds certainly sounds like an attempt to enforce the terms of the DOT.   The trustee’s Section 544 action—which basically contends that Carmel’s right to the recovery funds is not enforceable—thus sounds like an action to defeat or avoid Carmel’s enforcement of its contractual right.  

The district court’s reasoning on the trustee’s right to recover attorney’s fees, if upheld on appeal, could materially alter both the litigation strategy and “settlement calculus” for all the players in avoidance actions brought in the Ninth Circuit.The vast majority of bankruptcy avoidance actions involve a transfer made or obligation incurred pursuant to a contract, and presumably a substantial number of those contracts are going to have attorneys’ fee clauses and be governed by state law with a law similar to CCC 1717.   So perhaps the immediate takeaway from the district court’s attorney’s fee ruling is that if a trustee threatens your client with an avoidance action, you need to advise the client that the trustee may be  entitled to recover not just the value of the avoided transfer or obligation, but also substantial attorneys’ fees if  the trustee prevails. 

This case update was written by Patrick Costello, principal of Vectis Law (pcostello@vectislawgroup.com) with material editorial contributions by  Brandon Iskander, Partner at Goe Forsythe & Hodges LLP (biskander@goeforlaw.com).

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