Clarifying the Application of Article 9 of the UCC’s Scope to Determining a Secured Party’s Rights in Post-Petition DIP Factoring
In Chapter 11 bankruptcy case In re: RWDY, Inc., the U.S. Bankruptcy Court in the Western District of Louisiana provided clarity about the application of Article 9’s scope to issues under sections 363 and 364 of the U.S. Bankruptcy Code in respect to the rights of parties that have security interests in accounts, including buyers of accounts, and the effect of Article 9’s scope in determining issues involving post-petition DIP factoring agreements, use and sale cash collateral and adequate protection issues.
BY JARED ULLMAN, ESQ.
In a recent precedent-setting decision by the U.S. Bankruptcy Court in the Western District of Louisiana, the court denied an objection to a Chapter 11 debtor’s motion to enter into a post-petition debtor-in-possession factoring relationship with Seacoast Business Funding (“Seacoast”), in respect to which six merchant cash advance entities (“MCAs”) claimed to have purchased prepetition the debtor’s interest in any “future receivables,” and by extension, argued that the debtor lacked the ability to sell accounts post-petition to Seacoast. The bankruptcy court’s decision clarified the legal framework under the U.S. Bankruptcy Code to determine certain issues concerning post-petition DIP factoring and the use and sale of cash collateral by having held that Article 9 of the Uniform Commercial Code’s scope governs the MCA entities’ duties to establish the validity, extent and priority of their interest in accounts. Let’s dig into the details of this important case.
In Chapter 11 bankruptcy case In re: RWDY, Inc. filed in the Western District of Louisiana, U.S. Bankruptcy Judge John S. Hodge entered a final order granting debtor RWDY’s motion to sell accounts, post-petition, to RWDY’s prepetition factoring company, Seacoast, under a debtor-in-possession factoring agreement between RWDY and Seacoast. Six entities that are generically referred to as merchant cash advance companies filed a written objection to the DIP factoring motion. The MCAs contended that RWDY entered into one or more agreements prepetition with each of the MCAs and that pursuant to these agreements, the MCAs effectively purchased all of RWDY’s interests in “future receivables,” (i.e., accounts) and as a result, RWDY transferred all of its rights and interests in the accounts to the MCAs. The MCAs, by extension, argued that the bankruptcy court only had jurisdiction to authorize the sale of accounts first created post-petition but had no jurisdiction to grant RWDY the right to sell or otherwise give any rights to Seacoast in any of the accounts that were covered by the MCAs’ prepetition agreements.
The court’s decision in this case might send shockwaves that reverberate throughout the entire United States’ commercial financing industry and not just the Western District of Louisiana’s bankruptcy courts. According to the decision, as a matter of law, Article 9 of the UCC’s scope precluded the MCAs from ignoring their duty to establish the validity, extent and priority of their interest in accounts in accordance with Article 9’s provisions applicable to all secured lenders and buyers of accounts claiming an interest in property of the estate. As detailed later in the article, the court that the MCAs failed to establish such requirements (although in the original interim order they were given certain adequate protection rights), and in the final order, the MCAs we not granted adequate protection for RWDY’s use or sale to Seacoast of prepetition accounts (i.e., the MCAs were treated as unsecured creditors without any interests in cash collateral).1
Key Factual Issues
Prior to the filing of RWDY’s Chapter 11 bankruptcy case, Seacoast and RWDY entered into and operated under a purchase agreement which entitled Seacoast to, among other things, purchase accounts arising from RWDY’s sales of goods and/or services provided to its customers. Seacoast perfected a first priority ownership interest in the accounts purchased by Seacoast and a first priority security interest in all other collateral, including all non-purchased accounts, by having properly filed an initial UCC-1 financing statement naming RWDY as the debtor.
On Dec. 21, 2022, RWDY commenced a Chapter 11 bankruptcy case by filing a voluntary bankruptcy petition. RWDY also filed an emergency motion seeking bankruptcy court authorization to maintain and continue to operate, post-petition, under its prepetition factoring relationship with Seacoast. Then the six MCAs in this case each claimed to have entered into various agreements with RDWY (and various entities affiliated with RWDY) and to have purchased approximately $10 million of RWDY’s ‘future receivables.’ The MCAS then filed a joint objection to RWDY’s DIP factoring motion, asserting that prior to the filing of RWDY’s bankruptcy case, RWDY sold, assigned and transferred to each of the MCAs its interests in any “future receivables” (i.e., the accounts), and that pursuant to the various agreements between each MCA and RWDY (and RWDY’s affiliates), RWDY retained “no legal or equitable interest” in accounts the MCAs purchased.
The MCAs argued that purchasing the accounts before the filing of the petition removed the accounts as property of the estate and that the bankruptcy court had no jurisdiction to interfere with the MCAs’ presumptive rights as owner of the accounts. By extension, the MCAs contended that Section 363 of the bankruptcy code is clear that a bankruptcy court may only authorize a debtor’s use or sale of property that qualifies as property of the estate, and the only way in which RWDY could possibly obtain authorization from the court to sell accounts to Seacoast was if the court were to first determine that the agreements between RWDY and the MCAs may be recharacterized as disguised financing transactions rather than qualifying as “true sale” of accounts agreements.
In response to the MCAs’ written objection to the DIP factoring motion, Seacoast argued that the drafters of Article 9 and the legislative bodies of each state that enacted Article 9 wished to ensure that transactions that create a security interest in accounts and sales of accounts to buyers were controlled and governed by the same Article 9 rules in respect to attachment, perfection and priority (i.e., those of secured parties who seek to ensure that their rights are duly protected by doing UCC lien searches and that they are either first in priority or need to consider subordination agreements to attain that status). In effect, Seacoast contended that buyers of accounts and lenders that hold a security interest in accounts are governed by the same Article 9 requirements for purposes of establishing attachment, perfection of security interests in collateral and the effect of perfection of security interests (i.e., priority). By extension, any distinction that the MCAs sought by arguing that they qualified as purchasers of RWDY’s interests in ‘future receivables’ would notexcuse them from satisfying Article 9’s requirements in order to establish the validity, extent and priority of the MCAs’ rights in the accounts under the bankruptcy code.
THE DECISION
The bankruptcy court conducted an evidentiary hearing on the DIP factoring motion and on Feb. 6, 2023, entered an order containing the following salient findings of fact and law:
Section 9-109 of the UCC provides that Article 9 applies to a transaction, regardless of its form, that creates a security interest in personal property or fixtures by contract and a sale of accounts.
Section 9-102 of the UCC defines the term “security interest” to mean “an interest in personal property … which secures payment or performance of an obligation.” Security interest includes any interest of a buyer of accounts.
Pursuant to Article 9 of the UCC, a buyer of accounts, identical to a secured party, is subject to the same Article 9 rules applicable to attachment, perfection and priorities of security interests in collateral.
Any dispute between a buyer and either (i) another buyer of accounts, (ii) secured parties, (iii) a bankruptcy trustee or (iv) a debtor-in-possession requires that the buyer of accounts satisfy the requirements under Article 9 (i.e., attachment, perfection and priority) in order to establish the validity, extent and priority of rights in the property of the estate.
Section 9-203 of the UCC requires a buyer of accounts to establish an enforceable security interest (i.e., attachment) by showing that (1) value has been given, (2) the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party and (3) the debtor has authenticated a security agreement that provides a description of the collateral.
In order for a buyer’s security interest to qualify as perfected, it must prove attachment plus all of the applicable requirements for perfection under Sections 9-310 through 9-316 of the UCC, which provides that a security interest in accounts is perfected when it attaches and a financing statement is properly filed to perfect such security interests.
Based on these facts, the court found that the MCAs had failed to carry their burden to establish factually each of the legal requirements under the bankruptcy code and Article 9, with the court holding that the MCAs were not entitled to receive (and RWDY was not required to provide) any form of adequate protection as a result of RWDY’s use or sale of cash collateral (i.e., accounts). In addition, the court ruled that as a matter of law, the MCAs were unable to legitimately argue that the bankruptcy court did not have jurisdiction over the dispute merely due to the MCAs claiming ownership interests in the prepetition accounts.
There are at least three significant legal and practical takeaways from Judge Hodge’s decision in the RWDY bankruptcy case.
KEY TAKEAWAYS
Firstly, the court’s final order granting RWDY’s DIP factoring motion establishes a clear legal framework that other bankruptcy courts around the country may adopt when determining certain issues in respect to the application of Article 9 to bankruptcy code provisions that govern a debtor’s sale or use of property of the estate and adequate protection issues.
Secondly, based on the court’s holding that Article 9’s scope governs both buyers of accounts and transactions that create a security interest in property, the decision dictates that bankruptcy courts are not beholden to determine whether an agreement between a debtor and an MCA entity constitutes a true sale arrangement under applicable substantive non-bankruptcy laws as a condition to establishing the bankruptcy court’s jurisdiction.
Thirdly, pursuant to Bankruptcy Code § 363(p), the entity claiming an interest in cash collateral has the burden of proof to establish the validity, extent and priority of its interest in order to establish rights to receive adequate protection. Accordingly, MCA entities, identical to any other secured party, have the burden of proof under the bankruptcy code to establish that their “buyer” interests in accounts satisfy Article 9’s requirements applicable to attachment, perfection and priorities of security interests in collateral.
As a practical matter, the bankruptcy court’s final order granting the DIP factoring motion should have a positive effect on the factoring industry by providing clarity as to the legal framework that other bankruptcy courts throughout the entire United States may adopt for purposes of determining the application of Article 9’s scope to similar issues that arise in other bankruptcy cases. •
111 U.S.C. § 363(a) defines “cash collateral” to mean “cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents whenever acquired in which the estate and an entity other than the estate have an interest and includes the proceeds…of property.“ Accordingly, accounts including the proceeds of accounts constitute “cash collateral” as defined in 11 U.S.C. § 363(a).