A Lessor's Guide to Workouts

Preferential Transfers

It is insignificant that the obligor and guarantors have not filed a petition in bankruptcy at the time of negotiating the workout agreement. It is a future bankruptcy that presents the danger.

Generally, any payments or other value (e.g., a new lien) received on an antecedent debt within 90 days of a bankruptcy filing, will be subject to attack as a preference. Thus, the creditor should try to structure any large payment with the preference law in mind. One possibility is to have any substantial down payment or other valuable transfer such as a lien be provided by a third party or other entity that is not a likely candidate for bankruptcy. Another alternative is drawing down on a letter of credit that was provided in connection with the original loan (or at least more than 90 days earlier). Because this is a payment by a third party, namely the issuing bank, and not the obligor, the payment should not be vulnerable to attack. Still another possibility is obtaining a third-party guaranty for such payment or lien transfer. Finally, of course, if the creditor is truly providing new value for the payment or transfer, (forbearance is generally not enough to constitute new value), the payment or transfer should be inviolate.

It should be noted that payment by an upstream or cross-corporate guarantor should be avoided because such payment will not only be vulnerable to a preference attack in the event of such entity's subsequent bankruptcy filing, but it may also be subject to an attack as a fraudulent conveyance. There is a body of law which holds that because upstream and cross-corporate guarantors don't receive direct value in exchange for the guaranty, payments on the guaranty may be fraudulent conveyances. Notably, the debtor or trustee in bankruptcy is not limited to the 90-day preference period in attacking these guarantor payments. The debtor or trustee may invoke the bankruptcy code's or the state's fraudulent conveyance provisions, the latter of which often allows the claim to go back four or even six years. For a fraudulent conveyance claim, however, the debtor or trustee must be able to attack the upstream or cross-corporate guarantors' entry into the guaranty in order to attack any payments thereunder. Thus, if the upstream or cross-corporate guaranty was executed many years ago, prior to any statute of limitations look back, payments by the guarantor should be unassailable.

Nondischargeability Claims

If an obligor or guarantor has committed fraud in connection with the creditor's loan application or the creditor's collateral (e.g., an out-of-trust sale of collateral), the creditor may be able to contest and prevent the individual obligor or guarantor from discharging the creditor's debt in any subsequent bankruptcy proceeding. A nondischargeability action can be a very valuable weapon in the creditor's arsenal. The creditor entering into a workout must be sure to preserve the right to contest discharge.

A workout is generally regarded as an accord and satisfaction or a novation, merging and eliminating pre-existing claims. If the workout is silent regarding fraudulent or tortious conduct, the nondischargeability claim may be deemed waived. In re Huang, 275 F.3d 1173 (9th Cir. 2002); In re Zufall, 2007 Bankr. LEXIS 648 (Bankr. D. S.D. 2007). But see, In re Baumhaft, 271 B.R. 517 and 271 B.R. 523 (Bankr. E.D. Mich. 2001) (Settlement agreement including stipulation that debt would be nondischargeable in any subsequent bankruptcy upheld under collateral estoppel if the stipulation included the specific factual basis for nondischargeability and that the facts were true and should be found to be true by the state court and any subsequent bankruptcy court.).

The creditor should take extraordinary care to preserve nondischargeability claims. As a first step to effectively preserve nondischargeability claims the creditor should require the obligor and guarantors to stipulate and admit to the facts establishing fraudulent or tortious conduct in the workout agreement, being sure to include all necessary facts to establish, as a matter of law, each of the elements of a nondischargeability claim. Second, the creditor should be sure to keep the original transaction alive and to structure the workout as a modification of the original transaction. Third, any release should be conditioned upon full performance under the workout, and specifically exempt the fraudulent or tortious conduct.

Limit Scope of Any Creditor Releases

Of course, whenever possible, the creditor should try to obtain a general release from the obligor or guarantors. Absent extraordinary circumstances, however, any release provided by the creditor to the obligor and guarantors should be a specific release rather than a general release. A specific release only releases claims relating to the transaction at issue. A general release releases all claims of every kind, known or unknown. Too often a bank or other financial institution provides a general release only to subsequently learn that it had another transaction with the obligor or guarantors that it unwittingly released.

The creditor should also preserve any potential indemnification claims. For example, many equipment and motor vehicle leases and loans provide that the obligor shall be obligated to defend and indemnify the creditor if a third party is injured by the equipment or vehicle, such as in an automobile accident. At the time of the workout or settlement the creditor is unlikely to even be aware of a potential third-party claim, which may not be filed for years to come.

Voluntary Surrender of Collateral or Extension of Payment Terms Beyond Original Term

If the obligor voluntarily surrenders any collateral in connection with the workout, the agreement should include a clause that waives notices prior to sale and confirms all parties agree the disposition was commercially reasonable. If the transaction is not a true lease, the agreement should provide that, after sale of any collateral, the obligor be credited only with the net proceeds of sale after all expenses. If the expenses are known, they should be stated and stipulated in the workout. Although the UCC provides that a creditor may deduct reasonable expenses from sales proceeds, specific acknowledgement in the workout agreement can eliminate debates over the reasonableness of specific expenses. Credit to the obligor should be net of expenses incurred in selling the collateral, including advertising costs, commissions, attorneys' fees, repossession costs and storage fees.

If the obligor retains some or all of the collateral under the workout and the payment term of the transaction is extended beyond the original term, UCC continuation statements (or other lien perfection documents) may need to be filed, and, if so, the times for filing must be diaried.

Confessions of Judgment and Consent Judgments

Confessions of judgment expedite the entry of judgment and provide a great deal of leverage in the event of default. Even if confessions of judgment cannot be obtained in the jurisdiction at issue a procedure for expeditiously entering judgment for the full balance due and the collateral should be established and incorporated into the workout agreement, such as execution of a consent judgment at the time of the workout, to be filed only in the event of default. In most jurisdictions consent judgments may not be used if litigation is not pending at the time of the workout, but if litigation is pending at the time of negotiation of the workout the litigation may be settled with specific authority to file the consent judgment immediately in the event of a default under the workout agreement.

Confessions of judgment are generally limited to monetary judgments and do not authorize entry of judgments or orders awarding the creditor the collateral. Accordingly, the creditor should always consider obtaining a consent order or judgment to be filed with and entered by the court in the event of future default, since the consent order or judgment can usually provide for an award to the creditor of both the full monetary debt as well as title and possession of the collateral.

Retention of Jurisdiction

If litigation was instituted prior to negotiating the workout, the agreement should provide that the court retains jurisdiction over the performance of the agreement, with appropriate language providing for such retention inserted in the stipulation of dismissal.

Additional Assets/Blanket Lien

The utility of the cross-default/cross-collateral combination referenced above can be significantly enhanced by extending specific collateral liens (e.g., a truck or a computer) to additional unencumbered assets or creating a general asset lien that may include inventory or accounts receivables. An inventory and accounts receivables lien is especially valuable in the event of a bankruptcy filing by the obligor. If any new or expanded liens are included in the workout agreement they must be timely perfected. The new liens, however, will likely be subject to attack as a preference if any bankruptcy is filed within 90 days unless the creditor provided new and valuable consideration. This potential preference problem applies not just to the granting of new personal property liens, but it also applies to any transfer of value to secure the antecedent debts, including issuance of letters of credit. Therefore, although the creditor should seek all the new assets and liens it can get, it must be sure to remember the new liens and transfers of assets may be vitiated if the obligor files a petition in bankruptcy within 90 days. Thus, the creditor should not rely too heavily upon these new liens and assets in structuring the workout, unless the creditor has thoroughly analyzed all potential preference attacks and is confident it will prevail based upon a new value defense or otherwise, as discussed in the preference section above.

Confidentiality

When negotiating any workout agreement the creditor should consider whether it wishes the terms of the agreement to be confidential because of potential concerns with other similarly situated obligors. The creditor should also consider whether there is any concern that the obligors will make disparaging statements to others. If either issue is a concern, the creditor should insist upon confidentiality and include language barring disparaging statements.

Additional Miscellaneous Clauses

The following clauses will help assure performance on the part of the obligor and should be required if the creditor holds a general asset lien:

• A provision to submit monthly accounting reports, i.e., aging accounts receivables.
• A provision that the obligor authorizes the creditor to inspect the obligor's books and records as well as the collateral at any time on reasonable notice.

Conclusion

When executed properly a workout can transform a non-performing asset into a performing asset with enhanced procedural, substantive and collateral positions. It can also insulate the creditor from future bankruptcy claims and attacks on its lien perfection and priority.

So for the savvy workout attorney, there is much truth to the old Chinese proverb that, “in every calamity there is opportunity.”

Frank Peretore is a founding partner of the law firm of Peretore & Peretore, P.C., with offices in New Jersey and New York. He represents national and regional financial institutions and lessors from the transactional and financing stage throughout the litigation stage in the state, federal and bankruptcy courts. He also represents creditors in general commercial litigation and commercial foreclosure matters. Peretore may be reached at 973-729-8991. This article is adapted from the author's book titled Workouts and Enforcement for the Secured Creditor and Equipment Lessor, (2008) by permission of Oxford University Press, Inc.

Part Two of a Two-Part Article

Last month's installment of this article discussed preliminary issues to address in workouts and key provisions to include in workout agreements. This second installment discusses addressing potential future bankruptcy issues.

Addressing Potential Future Bankruptcy Issues

Preferential Transfers

It is insignificant that the obligor and guarantors have not filed a petition in bankruptcy at the time of negotiating the workout agreement. It is a future bankruptcy that presents the danger.

Generally, any payments or other value (e.g., a new lien) received on an antecedent debt within 90 days of a bankruptcy filing, will be subject to attack as a preference. Thus, the creditor should try to structure any large payment with the preference law in mind. One possibility is to have any substantial down payment or other valuable transfer such as a lien be provided by a third party or other entity that is not a likely candidate for bankruptcy. Another alternative is drawing down on a letter of credit that was provided in connection with the original loan (or at least more than 90 days earlier). Because this is a payment by a third party, namely the issuing bank, and not the obligor, the payment should not be vulnerable to attack. Still another possibility is obtaining a third-party guaranty for such payment or lien transfer. Finally, of course, if the creditor is truly providing new value for the payment or transfer, (forbearance is generally not enough to constitute new value), the payment or transfer should be inviolate.

It should be noted that payment by an upstream or cross-corporate guarantor should be avoided because such payment will not only be vulnerable to a preference attack in the event of such entity's subsequent bankruptcy filing, but it may also be subject to an attack as a fraudulent conveyance. There is a body of law which holds that because upstream and cross-corporate guarantors don't receive direct value in exchange for the guaranty, payments on the guaranty may be fraudulent conveyances. Notably, the debtor or trustee in bankruptcy is not limited to the 90-day preference period in attacking these guarantor payments. The debtor or trustee may invoke the bankruptcy code's or the state's fraudulent conveyance provisions, the latter of which often allows the claim to go back four or even six years. For a fraudulent conveyance claim, however, the debtor or trustee must be able to attack the upstream or cross-corporate guarantors' entry into the guaranty in order to attack any payments thereunder. Thus, if the upstream or cross-corporate guaranty was executed many years ago, prior to any statute of limitations look back, payments by the guarantor should be unassailable.

Nondischargeability Claims

If an obligor or guarantor has committed fraud in connection with the creditor's loan application or the creditor's collateral (e.g., an out-of-trust sale of collateral), the creditor may be able to contest and prevent the individual obligor or guarantor from discharging the creditor's debt in any subsequent bankruptcy proceeding. A nondischargeability action can be a very valuable weapon in the creditor's arsenal. The creditor entering into a workout must be sure to preserve the right to contest discharge.

A workout is generally regarded as an accord and satisfaction or a novation, merging and eliminating pre-existing claims. If the workout is silent regarding fraudulent or tortious conduct, the nondischargeability claim may be deemed waived. In re Huang, 275 F.3d 1173 (9th Cir. 2002); In re Zufall, 2007 Bankr. LEXIS 648 (Bankr. D. S.D. 2007). But see, In re Baumhaft, 271 B.R. 517 and 271 B.R. 523 (Bankr. E.D. Mich. 2001) (Settlement agreement including stipulation that debt would be nondischargeable in any subsequent bankruptcy upheld under collateral estoppel if the stipulation included the specific factual basis for nondischargeability and that the facts were true and should be found to be true by the state court and any subsequent bankruptcy court.).

The creditor should take extraordinary care to preserve nondischargeability claims. As a first step to effectively preserve nondischargeability claims the creditor should require the obligor and guarantors to stipulate and admit to the facts establishing fraudulent or tortious conduct in the workout agreement, being sure to include all necessary facts to establish, as a matter of law, each of the elements of a nondischargeability claim. Second, the creditor should be sure to keep the original transaction alive and to structure the workout as a modification of the original transaction. Third, any release should be conditioned upon full performance under the workout, and specifically exempt the fraudulent or tortious conduct.

Limit Scope of Any Creditor Releases

Of course, whenever possible, the creditor should try to obtain a general release from the obligor or guarantors. Absent extraordinary circumstances, however, any release provided by the creditor to the obligor and guarantors should be a specific release rather than a general release. A specific release only releases claims relating to the transaction at issue. A general release releases all claims of every kind, known or unknown. Too often a bank or other financial institution provides a general release only to subsequently learn that it had another transaction with the obligor or guarantors that it unwittingly released.

The creditor should also preserve any potential indemnification claims. For example, many equipment and motor vehicle leases and loans provide that the obligor shall be obligated to defend and indemnify the creditor if a third party is injured by the equipment or vehicle, such as in an automobile accident. At the time of the workout or settlement the creditor is unlikely to even be aware of a potential third-party claim, which may not be filed for years to come.

Voluntary Surrender of Collateral or Extension of Payment Terms Beyond Original Term

If the obligor voluntarily surrenders any collateral in connection with the workout, the agreement should include a clause that waives notices prior to sale and confirms all parties agree the disposition was commercially reasonable. If the transaction is not a true lease, the agreement should provide that, after sale of any collateral, the obligor be credited only with the net proceeds of sale after all expenses. If the expenses are known, they should be stated and stipulated in the workout. Although the UCC provides that a creditor may deduct reasonable expenses from sales proceeds, specific acknowledgement in the workout agreement can eliminate debates over the reasonableness of specific expenses. Credit to the obligor should be net of expenses incurred in selling the collateral, including advertising costs, commissions, attorneys' fees, repossession costs and storage fees.

If the obligor retains some or all of the collateral under the workout and the payment term of the transaction is extended beyond the original term, UCC continuation statements (or other lien perfection documents) may need to be filed, and, if so, the times for filing must be diaried.

Confessions of Judgment and Consent Judgments

Confessions of judgment expedite the entry of judgment and provide a great deal of leverage in the event of default. Even if confessions of judgment cannot be obtained in the jurisdiction at issue a procedure for expeditiously entering judgment for the full balance due and the collateral should be established and incorporated into the workout agreement, such as execution of a consent judgment at the time of the workout, to be filed only in the event of default. In most jurisdictions consent judgments may not be used if litigation is not pending at the time of the workout, but if litigation is pending at the time of negotiation of the workout the litigation may be settled with specific authority to file the consent judgment immediately in the event of a default under the workout agreement.

Confessions of judgment are generally limited to monetary judgments and do not authorize entry of judgments or orders awarding the creditor the collateral. Accordingly, the creditor should always consider obtaining a consent order or judgment to be filed with and entered by the court in the event of future default, since the consent order or judgment can usually provide for an award to the creditor of both the full monetary debt as well as title and possession of the collateral.

Retention of Jurisdiction

If litigation was instituted prior to negotiating the workout, the agreement should provide that the court retains jurisdiction over the performance of the agreement, with appropriate language providing for such retention inserted in the stipulation of dismissal.

Additional Assets/Blanket Lien

The utility of the cross-default/cross-collateral combination referenced above can be significantly enhanced by extending specific collateral liens (e.g., a truck or a computer) to additional unencumbered assets or creating a general asset lien that may include inventory or accounts receivables. An inventory and accounts receivables lien is especially valuable in the event of a bankruptcy filing by the obligor. If any new or expanded liens are included in the workout agreement they must be timely perfected. The new liens, however, will likely be subject to attack as a preference if any bankruptcy is filed within 90 days unless the creditor provided new and valuable consideration. This potential preference problem applies not just to the granting of new personal property liens, but it also applies to any transfer of value to secure the antecedent debts, including issuance of letters of credit. Therefore, although the creditor should seek all the new assets and liens it can get, it must be sure to remember the new liens and transfers of assets may be vitiated if the obligor files a petition in bankruptcy within 90 days. Thus, the creditor should not rely too heavily upon these new liens and assets in structuring the workout, unless the creditor has thoroughly analyzed all potential preference attacks and is confident it will prevail based upon a new value defense or otherwise, as discussed in the preference section above.

Confidentiality

When negotiating any workout agreement the creditor should consider whether it wishes the terms of the agreement to be confidential because of potential concerns with other similarly situated obligors. The creditor should also consider whether there is any concern that the obligors will make disparaging statements to others. If either issue is a concern, the creditor should insist upon confidentiality and include language barring disparaging statements.

Additional Miscellaneous Clauses

The following clauses will help assure performance on the part of the obligor and should be required if the creditor holds a general asset lien:

• A provision to submit monthly accounting reports, i.e., aging accounts receivables.
• A provision that the obligor authorizes the creditor to inspect the obligor's books and records as well as the collateral at any time on reasonable notice.

Conclusion

When executed properly a workout can transform a non-performing asset into a performing asset with enhanced procedural, substantive and collateral positions. It can also insulate the creditor from future bankruptcy claims and attacks on its lien perfection and priority.

So for the savvy workout attorney, there is much truth to the old Chinese proverb that, “in every calamity there is opportunity.”

Frank Peretore is a founding partner of the law firm of Peretore & Peretore, P.C., with offices in New Jersey and New York. He represents national and regional financial institutions and lessors from the transactional and financing stage throughout the litigation stage in the state, federal and bankruptcy courts. He also represents creditors in general commercial litigation and commercial foreclosure matters. Peretore may be reached at 973-729-8991. This article is adapted from the author's book titled Workouts and Enforcement for the Secured Creditor and Equipment Lessor, (2008) by permission of Oxford University Press, Inc.