Crown Financial, LLC vs. Drivetrain, LLC Illustrates ‘Harsh’ Consequences for Lending to Unlicensed Contractors

Edward Schnitzer of Montgomery McCracken Walker & Rhoads breaks down the decisions in a recent bankruptcy case to demonstrate the importance of performing due diligence to ensure clients are conducting business legally and that any customer invoices you purchase are legally enforceable.

BY EDWARD SCHNITZER, PARTNER, MONTGOMERY MCCRACKEN WALKER & RHOADS LLP

The Third Circuit of the U.S. Court of Appeals’ recent decision in Crown Financial, LLC vs. Drivetrain, LLC (In re Abeinsa Holding Inc.) reminds parties that a claim on a purchased invoice is only as good as the underlying claim. If the assignor of the invoice is not in compliance with the applicable law that prejudices the right to seek compensation, that impairment will also affect the assignee’s right to recover both outside and inside a bankruptcy.

Relevant Facts

Abener Teyma Mojave General Partnership (ATM) was a general contractor. ATM had contracts to supply and install insulation on piping and equipment as part of the construction of a concentrated solar power plant in the Mojave Desert in California. In 2013, ATM subcontracted with Synflex Insulation, a Texas-based company, to perform that service. In obtaining the subcontract, Synflex represented that it held a California contractor’s license.

“A few months into performance [of the subcontract], the relationship [between ATM and Synflex] began to sour.” [1] ATM was slow to make payments to Synflex, which caused problems for Synflex in paying its own workers and suppliers. In April of 2014, Synflex entered into a factoring relationship with Crown Financial in order to lighten the cash flow issue caused by ATM’s slow payments. 

Pursuant to that factoring relationship, Crown purchased various invoices and advanced funds to Synflex at 80% of the invoice face value. The factoring relationship was documented in an account purchase agreement between Crown and Synflex, as well as a letter agreement ( the “April letter agreement”) between Crown, Synflex and ATM that required ATM to make all future payments on Synflex invoices to Crown.

Under the factoring relationship, Crown purchased 42 invoices over a period of six-and-a-half months. The purchased invoices had a face value of approximately $5.4 million, which resulted in Crown remitting approximately $4.3 million to Synflex. In October of 2014, ATM ceased making any payments, leaving Crown owed approximately $2 million.

In the spring of 2016, ATM and other debtors commenced Chapter 11 cases by filing voluntary petitions for relief under the U.S. Bankruptcy Code. In the bankruptcy, both Synflex and Crown filed proofs of claim against ATM, with Crown’s claim seeking $2,022,527. The litigation trustee, Drivetrain, objected to both claims, asserting that the underlying debt was unenforceable due to Synflex being an unlicensed subcontractor. It turns out that Synflex did not hold, and never held, a valid California’s contractor’s license.

Relevant Law

The underlying relevant law comes from sections 7026 and 7031 of the California Business and Professions Code. Section 7026 provides, in pertinent part, that a “contractor includes subcontractor and specialty contractor.”  Section 7031(a) provides, in pertinent part, that:

[n]o person engaged in the business or acting in the capacity of a contractor, may bring or maintain any action, or recover in law or equity in any action, in any court of this state for the collection of compensation for the performance of any act or contract where a license is required by this chapter without alleging that he or she was a duly licensed contractor at all times during the performance of that act or contract regardless of the merits of the cause of action brought by the person . . . [2]

Bankruptcy Court Holding

Drivetrain’s claims objection was sustained by the U.S. Bankruptcy Court for the District of Delaware on March 26, 2019.  In that decision, Judge Kevin Carey held that Synflex’s claim was invalid because “Synflex was not a licensed contractor and, however harsh the result may be, is barred from recovery under Cal. Bus. & Prof. Code § 7031.”[3]  The bankruptcy court then concluded that since Synflex’s claims were unenforceable, “Crown, as an assignee of Synflex, also lacks an enforceable claim”[4] because the claim was for illegal unlicensed contract work.  The bankruptcy court also rejected Crown’s claim that the April letter agreement provided a separate avenue of recovery, holding that it “need [not] consider the validity of an alleged independent contract, as the claims [i.e., the invoices] underlying the contract are void." [5]

District Court Holding

On Oct. 23, 2020, Judge Colm Connolly of the United States District Court for the District of Delaware affirmed the bankruptcy court’s decision. The district court held, “It is well established that an assignee stands in the shoes of the assignor, with the right to exercise the rights and remedies possessed by or available to the assignor.” [6] Based on that premise, the district court concluded that “Crown has exactly what Synflex has: no right to payment ….  As Synflex's assignee, Crown cannot collect what Synflex could not ….” [7]  The district court also rejected Crown’s assertion that the April letter agreement was enforceable, holding:

The condition precedent of that confirmation is that there were invoices to collect. To the extent the April letter created obligations on ATMGP's part or gave Crown rights to the payment of Synflex's invoices, those obligations and rights exist only insofar as Synflex had extant invoices. In this case, however, it is undisputed that the invoices Synflex issued to ATMGP were void as a matter of law. [8]

Circuit Court Holding

On Sept 1, 2021, the Third Circuit Court of Appeals affirmed both of those decisions. In doing so, the Third Circuit noted:

California law, which governs this dispute, imposes harsh, if not draconian, consequences upon unlicensed contractors who perform construction work in the state: in general, they may not recover any compensation for their services. [9] 

Crown focused its appeal on its rights under the April letter agreement instead of its rights as an assignee. The Third Circuit rejected that argument, holding:

To the extent that the letter agreement otherwise satisfies the elements of a contract, it loses its enforceability because its object is to pay Crown for unlicensed construction work that Synflex performed. And enforcing an agreement with that object would ‘circumvent [California’s] clear statutory policy of deterring unlicensed contract work.’ [10]

Lessons

These three decisions highlight the importance of know-your-customer (KYC) due diligence, as well as warranty/representation clauses. 

It is important to conduct sufficient KYC due diligence to ensure that your customer is conducting business legally and that any customer invoices you purchase are legally enforceable.  While a customer may represent that it is licensed to conduct its business, obtaining a copy of that license is recommended. It is imperative that any agreement involving the purchase of accounts receivable include an enforceable breach of warranty/representation clause. In the event your customer misrepresents that it is licensed and conducting business legally, you will want the ability to bring a breach of contract action against them.

Lastly, section 7031(a) of the California’s Business and Professions Code “provides remedies through a defensive shield or an affirmative sword.” [11]  The three Abeinsa Holding decisions only addressed the shield portion of section 7031(a). “The sword, contained in section 7031(b), allows a hiring party to recover amounts paid to an unlicensed contractor.” [12] What was not addressed in any of the decisions is whether Drivetrain could seek affirmative recovery from either Synflex or Crown of “all compensation paid to the unlicensed contractor for performance of any act or contract.” [13] It is unclear if such a statute could be used to cover payments from the assignee or just the unlicensed contractor. This is another reason why KYC due diligence can be crucial.

Footnotes

• [1] In re Abeinsa Holding Inc., 70 Bankr. Ct. Dec. 164, 2021 WL 3909984, at *3 (3d Cir. Sept. 1, 2021).

• [2] Cal. Bus. & Prof. Code § 7031(a).

• [3] In re Abeinsa Holding Inc., No. 16-10790 (KJC), 2019 WL 1400175, at *3 (Bankr. D. Del. Mar. 26, 2019), aff'd, 2020 WL 6261632 (D. Del. Oct. 23, 2020), aff'd, 70 Bankr. Ct. Dec. 164, 2021 WL 3909984 (3d Cir. Sept. 1, 2021).

• [4] Id. at *6.

• [5] Id. at *6.

• [6] In re Abeinsa Holding Inc., 2020 WL 6261632, at *3 (D. Del. Oct. 23, 2020), aff'd, 70 Bankr. Ct. Dec. 164, 2021 WL 3909984 (3d Cir. Sept. 1, 2021).

• [7] Id. at *3.

• [8] Id. at *3.

• [9] In re Abeinsa Holding Inc., 2021 WL 3909984, at *1 (3d Cir. Sept. 1, 2021).

• [10] Id. at *4.

• [11] In re Abeinsa Holding Inc., 2019 WL 1400175, at *3 (Bankr. D. Del. Mar. 26, 2019).

• [12] Id. at *3.

• [13] Cal. Bus. & Prof. Code § 7031(b) (“Except as provided in subdivision (e), a person who utilizes the services of an unlicensed contractor may bring an action in any court of competent jurisdiction in this state to recover all compensation paid to the unlicensed contractor for performance of any act or contract.”)

Edward Schnitzer is a partner at Montgomery McCracken Walker & Rhoads LLP.  He is the chair of the firm’s bankruptcy and& financial restructuring department and also serves as an ex-officio member of the firm’s management committee.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, or its clients. This article is for general information purposes and is not intended to be and should not be taken as legal advice.