The following is a case update written by Thomas Rupp of Keller Benvenutti Kim LLP analyzing a recent decision of interest, In re Specialty’s Café & Bakery, Inc., 639 B.R. 548 (Bankr. N.D. Cal. 2022).
To read the full published decision click here.
The U.S. Bankruptcy Court for the Northern District of California held that a debtor’s pre-filing decision to return an $8.1 million PPP loan within a safe harbor period constituted a rescission of the PPP loan agreement. This act of rescission rendered the loan proceeds to no longer constitute property of the debtor, and therefore the transfer back to the originating bank was not an avoidable preference.
The debtor, wholly owned by a large conglomerate, operated approximately 45 restaurants in class A office buildings at the beginning of 2020. Its business dropped precipitously in March of that year as shelter-in-place orders went into effect and working from home became the norm. The debtor arranged for an $8.1 million PPP loan through the CARES Act, receiving the funds on May 7, 2020. The same day, due to their ongoing uncertainty of whether the debtor was eligible to receive the loan under evolving CARES Act guidelines, the debtor’s management requested information from the originating bank on how to rescind the loan and return the proceeds. The debtor’s management then held several board meetings on May 7 and 12 on the issue before ultimately deciding to rescind the loan. The debtor then transferred the loan proceeds back to the bank on May 13, the day before the safe harbor period under the loan program was set to expire. The debtor filed for chapter 7 a few weeks later, on May 27.
The chapter 7 trustee sued the bank and the U.S. Small Business Administration to avoid the $8.1 million transfer returningwhich returned the loan proceeds as a preference. Cross-motions for summary judgment followed.
The Court noted that the parties did not dispute that the Debtor’s wire of the $8.1 million to the bank was a “transfer,” and that such transfer occurred within 90 days of the petition date as required by Section 547(b)(4)(A). Also undisputed, in principle, was the fact that the bank’s full recovery of its loan proceeds allowed it to receive more than a similarly situated creditor. The Court then identified the disputed elements for avoiding a transfer under Section 547. The two elements at issue in this case would be (i) whether the $8.1 million was “an interest of the debtor in property” and (ii) whether the transfer was made “on account of an antecedent debt.”
Although there was no question that the $8.1 million had been disbursed to the Debtor and was in the Debtor’s bank account prior to being transferred back to the bank, the Court turned to California law regarding resulting trusts to investigate whether the proceeds were actually property of the Debtor at the time of their transfer, or whether the rescission of the loan agreement had effectively placed the loan proceeds in a trust held by the Debtor for the benefit of the originating bank.
Under California law, a contract may be rescinded by mutual consent. Cal. Civ. Code § 1689(a). A contract is extinguished by its rescission, and a rescinded contract ceases to exist for all purposes. Cal. Civ. Code § 1688; Boomer v. Muir, 24 P.2d. 570, 577 (1933). “To effectuate a rescission, a party must, promptly upon discovering the facts which entitle him to rescind, give notice of intent to rescind, and ‘restore to the other party everything of value which he has received’ or ‘offer to restore the same.’” Cal. Civ. Code §1691(b).
The Court held that, on the facts before it, “[i]t is undisputed that Debtor intended to rescind the PPP Loan, did in fact rescind it, and fully performed its obligation to restore ownership of the PPP Loan funds to Customers Bank.”
A resulting trust is created to carry out the intention of the parties, and the title holder has an equitable duty to deal with the property to carry out the intentions of the trust. The Court held that the $8.1 million was impressed with a resulting trust on May 12 (the date that the Debtor informed the bank of the rescission) and therefore the Debtor only had bare legal title and no equitable interest in the funds under Section 541(d) when they were transferred to the bank the next day.
Because a resulting trust had been formed, the Debtor’s return of the $8.1 million was not the payment of an antecedent debt under Section 547(b)(2), but the performance of its obligation under the resulting trust created by the rescission of the PPP Loan agreement. “As a matter of contract law, Debtor did not pay a debt when it wired $8.1 million to Customers Bank on its terminated PPP Loan. The $8.1 million was returned because, at that point, it was the property of Customers Bank.”
Although the Court had effectively disposed of the avoidance action through the resulting trust theory, the memorandum continued to address the two affirmative defenses raised by the defendants, finding that the repayment was within the ordinary course of business under the SBA’s well-established lending program, but that the waiver of any investigation that the Debtor received by rescinding the loan within the “safe harbor” period was not new value under Section 547(a)(2), as it was not “money or moneys worth in good, services, or new credit.”
As the Court noted, this was a tricky situation that arose in unique circumstances arising from the Covid pandemic and the CARES Act: “It is difficult to criticize the decision to apply for the PPP Loan and the decision to change course. It is also difficult to criticize the Trustee for bringing this adversary proceeding. The court’s decision was not an easy one.”
While the circumstances surrounding the CARES Act and PPP Loans may have been unique, the more universal takeaway from this case is how the concept of rescission of contracts can be applied in determining issues of ownership. The line between payment of an existing loan obligation versus performing a duty under a resulting trust to restore the parties to their pre-contract state can be blurry.
These materials were written by Thomas Rupp of Keller Benvenutti Kim LLP (email@example.com) in San Francisco, California. Editorial contributions were provided by D. Edward Hays of Marshack Hays, LLP in Irvine, California (EHays@MarshackHays.com).