Business Law

Secured Lender’s Post-Foreclosure Complaint on “D&O Claims” Dismissed Because of Insufficient Description in Security Agreement

The following is an update analyzing a recent case of interest.

Summary

The United States District Court for the District of Delaware has dismissed the post-foreclosure complaint of a secured lender on “D&O claims” allegedly acquired from a corporate borrower in a UCC foreclosure. The Court determined that the lender had not acquired a security interest because the claims were insufficiently described in the security agreement. The case is Polk 33 Lending, LLC v. Schwartz, No. CV 20-1647 (MN), 2021 WL 3662868 (D. Del. Aug. 18, 2021). A copy of the opinion may be found here.

Facts

Aerogroup, Inc., a seller of women’s footwear, filed a chapter 11 bankruptcy petition in the District of Delaware in September 2017. Mark Schwartz was the founder and CEO of Palladin Consumer Retail Partners, LLC, which held about 75% of Aerogroup’s equity and a “significant debt investment” in Aerogroup. Schwartz, who was also a director of Aerogroup, allegedly “took over the role” of Aerogroup’s CEO after the bankruptcy petition was filed.

In November 2017, the Bankruptcy Court entered an order approving debtor in possession financing (a “DIP Loan”) by Polk 33 Lending, LLC, to finance business operations while the business was marketed for sale with the assistance of an investment banker. The collateral described in Polk’s DIP Loan documents included “all [of Debtors’] commercial tort claims (including D&O claims),” and “all other claims and causes of action and the proceeds thereof.” The order approving the DIP Loan also granted relief from the automatic stay to Polk 33.

Early on in the bankruptcy case, Aerogroup sought approval of a restructuring agreement with CBG USA, Inc., but the deal fell through shortly before a scheduled plan confirmation hearing. With the support of Polk 33, Schwartz hurried to arrange a new sale of the business subject to bidding at a bankruptcy auction. Alden Global Capital, LLC was the successful bidder, purchasing Aerogroup’s assets for $24 Million in July 2018. Polk 33 was not made whole as a result of the sale. The bankruptcy case was dismissed in January 2020.

Some of the following details were less clear in the District Court’s opinion granting Schwartz’s motion to dismiss the case but were instead gleaned from the dockets in the lawsuit and bankruptcy case.

In February 2020, Polk 33 held a foreclosure sale under Article 9 of the UCC which may have been limited to the “D&O Claims.” The sale notice included a description of the D&O Claims which was much more extensive and detailed than the above-quoted collateral description contained in the DIP Loan documents. As a result of the foreclosure Polk 33 acquired the D&O Claims. 

In December 2020, Polk 33 filed a lawsuit against Schwartz in the United States District Court for the District of Delaware. The Complaint stated claims for relief for relief based on alleged breach of fiduciary duty and corporate waste. The District Court granted Schwartz’s motion to dismiss the Complaint with prejudice, holding that Polk 33 lacked standing because it did not acquire the D&O Claims via its foreclosure.

Reasoning:

Uniform Commercial Code section 9-108 provides in part:

(a) Sufficiency of description. –Except as otherwise provided in subsections (c), (d), and (e), a description of personal or real property is sufficient, whether or not it is specific, if it reasonably identifies what is described.
(b) Examples of reasonable identification. –Except as otherwise provided in subsection (d), a description of collateral reasonably identifies the collateral if it identifies the collateral by:

(1) specific listing;
(2) category;
(3) except as otherwise provided in subsection (e), a type of collateral defined in the Uniform Commercial Code . . . .

. . . .

(e) When description by type insufficient. –A description only by type of collateral defined in the Uniform Commercial Code is an insufficient description of:

(1) a commercial tort claim . . . .

UCC section 9-102(a)(13) provides:

(13) “Commercial tort claim” means a claim arising in tort with respect to which:

(A) the claimant is an organization; or
(B) the claimant is an individual and the claim:

(i) arose in the course of the claimant’s business or profession; and
(ii) does not include damages arising out of personal injury to or the death of an individual.

The Court concluded that the collateral description contained in the DIP Loan documents (“all commercial tort claims (including D&O Claims))” was an “overgeneralized ‘type of collateral’ identification that is insufficient [under UCC §108(e)(1)] and did not convey to Polk a security interest in the D&O claims.” The Court ruled that because Polk 33 had no security interest in the D&O claims it could not have acquired them at foreclosure and therefore lacked standing to sue.

Author’s Comment:

It must be a very rare case in which a corporate borrower agrees in loan documents to grant a security interest in the corporation’s right to sue its own officers and directors on specifically described claims for relief. It is much more likely that a borrower is already pursuing, or at least has identified, tort claims against third parties (perhaps even against former officers and directors) existing at the time that the loan is made.

A prudent lender will perform a litigation check of the public records as part of its due diligence. It will also include in its loan agreement representations and warranties as to existing and potential tort claims known to the corporate borrower, drafted in such a way as to give rise to claims for misrepresentation against the officer(s) signing the agreement if any known claims are not disclosed. These issues may also be addressed in opinion letters issued in connection with the borrowing and certifications executed in connection with opinions. Once any such third party claims are identified, the security agreement should be drafted so as to specifically describe those claims.

The Commercial Finance Newsletter is written by an ad hoc group of the California Lawyers Association’s (CLA) Business Law Section. These materials were written by Dean T. Kirby, Jr. a member of the firm of Kirby & McGuinn, A P.C., located in San Diego, California. Mr. Kirby is a member of the ad hoc group and a member of the Commercial Transactions Committee of the Business Law Section. Editorial contributions were made by the Honorable Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group. The opinions expressed herein are solely those of the author.  Thomson Reuters holds the copyright to these materials and has permitted the Commercial Transactions Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.

This ebulletin was prepared by Walter K. Oetzell, Walter K. Oetzell, APC, wkoetzell@oetzelllaw.com.

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