Sixth Circuit Rules Involuntary Payments to a Lender Under Revolving Loan Agreement were Encumbered by a “Valid Lien” and Not Avoidable Transfers Despite Debtor’s Participation in a Ponzi Scheme and the Lender’s Alleged Bad Faith Acts After Learning of the Scheme

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

Interpreting Ohio’s versions of two uniform acts, the Uniform Commercial Code (UCC) and the Uniform Fraudulent Transfer Act (UFTA), the Sixth Circuit Court of Appeals (the “Court”) ruled that an involuntary debtor’s payments to a lender under the parties’ revolving loan agreement were encumbered by a “valid lien” created by the lender’s perfected security interest and as such were not “transfers” which could be avoided by a bankruptcy trustee despite debtor’s participation in a Ponzi scheme and the lender’s alleged bad faith acts after learning of the scheme. Bash v. Textron Financial Corporation (In re Fair Finance Company), 2021 WL 4127430 (6th Cir. September 10, 2021). To view the opinion, click here.

FACTS

Debtor Fair Finance Company (Fair Finance) was initially a legitimate factoring company which in 2002 entered into a revolving loan agreement with Textron Financial corporation (Textron) and another bank which created a perfected security interest in all Fair Finance assets. Soon after the loan agreement was consummated, new owners bought Fair Finance and began using it as their own piggy bank, quickly creating a Ponzi scheme. As early as 2003 Textron grew suspicious of Fair Finance’s related-party loans and suspected the existence of the Ponzi scheme. Notwithstanding that concern, Textron (without the other bank) reupped its agreement in 2004 and solidified its secured position while at the same time helping prevent public exposure of the underlying fraud. The lending relationship ended in 2007 with Textron paid in full.

The Ponzi scheme was exposed in 2009 and the owners were convicted of criminal acts. Fair Finance was forced into involuntary bankruptcy in 2010. The Chapter 7 trustee filed an adversary proceeding against Textron, seeking to avoid millions of dollars paid to Textron as fraudulent transfers under UFTA. Textron brought a Rule 12(b)(6) motion to dismiss, which was initially granted by the district court. However, the Court reversed and remanded because of a factual question involving novation, which resulted in further rulings in Textron’s favor by the district court on the legal issues, by way of summary judgment, and by a jury on novation. On the issues of law, the district court concluded that payments which arise from a perfected security interest cannot be transfers under UFTA and that the alleged post-loan bad faith acts of Textron (in aiding and abetting the Ponzi scheme) did not invalidate Textron’s perfected lien under the UCC such that the trustee, as a hypothetical lien creditor, could not step in front of Textron’s priority.

The trustee appealed to the Court, which affirmed in a published opinion.

REASONING

Applying UFTA, the Court concluded that if Fair Finance received the loan repayments as a result of a “valid lien,” they were not “transfers” of estate assets which could be avoided. Therefore, the Court’s inquiry was directed at determining whether, under the combination of UFTA and the UCC, Textron had a “valid lien,” defined by UFTA as one that is “effective against the holder of a judicial lien subsequently obtained.” If Textron’s 2002 security interest was so effective, the money paid was encumbered by a “valid lien” and would fall outside the definition of “asset” under UFTA. Because transfers under UFTA are limited to “assets”, that would mean the payments were not transfers, and certainly not recoverable as fraudulent.

Per the Court, the answer to this inquiry is found in the UCC, which creates priority rules for ranking competing security interests, including a rule that dictates whether a security interest take priority over a competing lien creditor’s claim to collateral and imposes an overarching duty of good faith. The UCC ranks security interests according to priority by time of perfection, with lien creditor interests being treated the same way as other perfected interests. Simply put, if Textron’s perfected lien was first in time over a judgment lien, it trumps. But the trustee here argued that if Textron acted in bad faith after perfecting its security interest, it forfeited its right to claim that priority over the judgment lien. Since the UCC does impose an “obligation of good faith” – and the parties, for the purposes of this appellate argument, assumed that Textron acted inappropriately by knowingly propping up the Ponzi scheme – the Court had to determine whether that made a difference in priority. The Court concluded the question was not whether Textron was a bad actor but whether those actions would render its perfected interest “ineffective against the holder of a judicial lien subsequently obtained” in a hypothetical UCC priority contest.

The Court ruled that the answer was no. The Court found the conclusion was grounded in the nature of the UCC’s priority test, which answers only one question: relative priority among competing creditors. The result is not invalidation of the senior lien, but whether shuffling the priorities should occur, with the junior leap frogging over the senior. That means as a practical matter that reordering based on bad faith would only happen based on a senior creditor’s actions directed at the junior creditor. The Court concluded that could not happen as between Textron and the trustee because this priority dispute must be between two actual competing interests as required by the UCC. (emphasis added.) Since the UFTA analysis is not based on two competing actual creditors, but rather tested against a hypothetical lien creditor, UCC reordering cannot happen because the senior lienholder (Textron) cannot possibly have a relationship with or direct its bad faith at a non-existent entity. Therefore, subordination can never happen. Textron’s lien maintains its priority, no transfer occurred, and the trustee loses.

AUTHOR’S COMMENT

That was a mouthful – or shall we say a “pageful” – and I defer to the excellence of a Circuit Court in reaching that conclusion. The takeaway is far more straight forward, however. Even if a senior secured creditor, with a properly perfected secured interest under the UCC, gets down in the weeds with a Ponzi scheming borrower and comes out paid in full, a chapter 7 trustee, able only to assert a hypothetical lien creditor’s rights, cannot upset that secured creditor’s priority rights to take first. Since UFTA says payment from a borrower’s secured assets cannot be a transfer, the repayment of the lender’s loan will not be a recoverable fraudulent transfer.

The Commercial Finance Newsletter is written by an ad hoc group of the California Lawyers Association (CLA) Business Law Section. This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, CD CA, ret.), 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.