The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D., CA, Ret.), analyzing a recent decision of interest:
In a recent decision, the U.S. Bankruptcy Court for the District of Delaware ruled that a secured creditor did not have a perfected security interest in the proceeds from a court-approved settlement of litigation because those funds arose from the pursuit of commercial torts and the security agreement did not specifically describe that collateral as required by Article 9 of the Uniform Commercial Code (UCC). In analyzing whether the claims for relief asserted by the Chapter 7 trustee against the settling defendants were contract or tort claims, the court applied the “gist of the action” doctrine as adopted by Pennsylvania law. In re Main Street Business Funding, LLC, 2022 WL 2073343 (Bankr. D. Del. June 8, 2022).
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John P Lane is a creditor of involuntary debtor Main Street Business Funding, LLC, a factoring company, as a result of his purchase of a term promissory note for $852,500 from the debtor. The debtor’s obligation to pay the note was secured by a Security Agreement, which granted Mr. Lane a lien in Collateral as defined in the agreement, including all tangible and intangible personal property of the debtor, contract rights and many specific categories of tangible assets. The Security Agreement by its terms was governed by the terms and definitions contained in the UCC. After the order for relief was entered, Mr. Lane filed a proof of claim, asserting a secured claim for the $852,500 note.
The chapter 7 trustee took over prepetition litigation (called the Goldner Litigation after the name of the lead defendant) which had been commenced by the debtor against numerous defendants, alleging a scheme by them to misappropriate funds from the debtor and use them for their own behalf. The Goldner Litigation asserted claims for fraudulent misrepresentations, conversion, civil conspiracy, unjust enrichment, breach of fiduciary duty, aiding and abetting breach of fiduciary duty and legal malpractice. In October 2021, the trustee settled the litigation for substantial sums. Mr. Lane filed a motion seeking an order directing the trustee to pay his secured claim from the proceeds of that settlement.
In the motion, Mr. Lane asserted that those proceeds were part of his Collateral because they resulted from claims held by the debtor which sounded in contract. The trustee objected, asserting the proceeds came from the settlement of commercial tort claims and the Security Agreement did not particularly describe those claims as compelled by §§ 9102, 9103, and 9108 of the UCC as adopted in Pennsylvania. In addition, he argued that the Lane security interest could not attach to the settlement proceeds because the causes of action did not exist when the Security Agreement was executed. The bankruptcy court (the Court) agreed with the trustee’s position and denied the secured claim.
The Court framed the issue before it as two-fold: (1) whether the Goldner Litigation is a breach of contract action or a commercial tort claim; and (2) if the Goldner Litigation is a commercial tort claim, whether the Collateral description in the Security Agreement is specific enough to include the proceeds of the Goldner Litigation. It answered the first query that the litigation was based on commercial tort claims; it then concluded that the description was not sufficiently specific.
The Court walked through the multiple claims asserted in the Goldner Complaint, analyzing each under the “gist of the action” doctrine as adopted in Pennsylvania. Pennsylvania courts have recognized that this doctrine “is designed to maintain the conceptual distinction between breach of contract claims and tort claims [by] preclud[ing] plaintiffs from recasting ordinary breach of contract claims into tort claims.” In short, for a party to pursue a tort action the offending act must be more than a mere breach of contractual duties. The major difference between tort causes of action and breach of contract is that “tort actions lie for breaches of duties imposed by law as a matter of social policy, while contract actions lie only for breaches of duties imposed by mutual consensus agreement between particular individuals” (citing Pennsylvania authorities).
With that direction, the Court concluded that fraudulent misrepresentation, conversion, and civil conspiracy claims would always sounds in tort as a matter of law. The breach of fiduciary duty claims could be either contract or tort but the underlying facts here, where the breaches were conflicts of interest and perpetuating fraud on the debtor, called them out as torts, along with the aiding and abetting related claims. The legal malpractice claim was treated similarly and found to be a tort under these facts. Only the unjust enrichment claim was founded upon quasi-contract theories and would not be a commercial tort. Since the damages asserted under the unjust enrichment claim overlapped those available as remedies for the tortious claims, the Court concluded that the settlement proceeds were founded in commercial torts.
To be enforceable under the UCC, a security agreement must provide a description of the collateral. UCC § 9108 as interpreted in Pennsylvania provides that a security interest in commercial tort claims cannot be obtained simply by generically describing collateral as “all property” or even as commercial torts. Security interests in commercial torts must be specifically identified and described in the security agreement. Moreover, for a security interest in a commercial tort claim to attach, the claim must exist when the agreement is signed. Applying these doctrines of Pennsylvania law, the Court concluded that the heightened description required by the UCC was not contained in the Collateral description in the Security Agreement because it used only generic terms like “all intangibles” or “after-acquired property.” Moreover, the tort claims asserted in the Goldner Litigation did not exist when the Security Agreement was executed. Therefore, the necessary specific description of collateral was not included in the Security Agreement. Mr. Lane’s lien did not attach to the proceeds of the settlement.
Last week I reviewed two cases which turned on the application of the economic loss rule, one in California state court (M & L Financial v. Sotheby’s) and one in a bankruptcy proceeding in Colorado (In re Bloom), where I concluded that both states’ implementation of that rule was similar. The gist of the action rule adopted in Pennsylvania is remarkably similar to the economic loss rule. Both rules bar commercial tort litigation when the duties breached arose solely from a contractual relationship between the parties. The underlying policy is to prevent plaintiffs from turning contractual claims into tortious ones if a contract controls the relationship and the breach. However, both rules also recognize that if a duty which arose under common law is breached – such as the duty to not defraud someone or to not convert their profits – then a claim in tort may stand. Main Street Business Funding illustrates why this distinction can make a difference in a bankruptcy proceeding where a secured creditor has a lien arising out of broad definitions of collateral. If the bankruptcy trustee can sue upon and settle tort claims, then those proceeds will escape the lien and be available for other claimants in the bankruptcy proceeding.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D., CA, Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.
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