Finding a Silver Lining for Factors in the Abeinsa Bankruptcy Case

Edward Schnitzer of Montgomery McCracken Walker & Rhoads LLP provides an update on a 2021 bankruptcy case, with a new decision that dictates that even if account receivables are rendered worthless, there is no guarantee of affirmative recovery due to the protections of Section 9-404 of the Uniform Commercial Code.

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

In an article from last December, I discussed the Third Circuit Court of Appeals’ decision in the Abeinsa Holding Inc. bankruptcy.[1] In that case, the Third Circuit sustained a claim objection relating to unlicensed contractor work, finding:

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.[2]

In the article’s conclusion, I noted that the operable California law provided not just a shield (no payment on a claim for services performed by an unlicensed contractor) as was discussed by the Third Circuit, but also a sword (potential recovery for any payments made for services performed by an unlicensed contractor). Recently, the U.S. Bankruptcy Court for the District of Delaware addressed the sword. Fortunately, in comparison to the harsh consequences in the earlier Abeinsa decisions, this recent decision provides a silver lining to the lender.

Relevant Facts

Abener Teyma Mojave General Partnership (ATM) was a general contractor that subcontracted with Synflex Insulation, a Texas-based company, to perform certain services. In obtaining the subcontract, Synflex represented that it held a California contractor’s license.

In April of 2014, Synflex entered into a factoring relationship with Crown Financial in which Crown purchased various invoices and advanced funds to Synflex. The factoring relationship was documented in an account purchase agreement between Crown and Synflex, as well as a letter agreement between Crown, Synflex and ATM that required ATM to make all future payments on Synflex invoices to Crown. ATM paid Crown $3,575,828.39 on account of certain Synflex purchased invoices (the “Synflex payments”).

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. On March 14, 2018, the litigation trustee, Drivetrain, filed a complaint against Crown which, inter alia, sought the return of the Synflex payments because they related to work performed by an unlicensed contractor.

Relevant Law

The underlying relevant law is section 7031 of the California Business and Professions Code. Section 7031(b) provides, in pertinent part, that:

… 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.[3] 

Bankruptcy Court Decision

On Oct. 6, Judge Laurie Silverstein of the U.S. Bankruptcy Court for the District of Delaware denied the trustee’s motion for summary judgment and granted Crown’s motion for summary judgment on the trustee’s complaint, awarding the trustee no recovery on its roughly $3.58 million action.[4] 

As the result seemed contrary to the earlier decisions that sustained the objections to Crown’s claim, Judge Silverstein noted:

[The Trustee had] already successfully defeated claims brought by both Synflex and Crown for unpaid invoices [under Section 7031(a) of the California Business and Professions Code] … [and while] there is a certain ease in the argument that an analysis of subsection (a) and (b) must lead to the same winner, some reflection shows that this is not so.[5]

In finding in Crown’s favor, Judge Silverstein first determined that the trustee did not have a direct action against Crown under Section 7031(b) of the California Business and Professions Code because such section only provides a remedy against the unlicensed contractor, not a factor of an unlicensed contractor. The bankruptcy court held succinctly that “any claim against Crown can only be made as Synflex’s assignee of the invoices.”[6] 

Next, Judge Silverstein determined that an action against Crown as an assignee failed due to the limitations of the Uniform Commercial Code. Section 9404(b) of the California Commercial Code limits claims by an account debtor against an assignee solely to reducing the amount owed by the account debtor.  It does not permit an affirmative recovery. As the trustee was seeking an affirmative recovery against Crown, an assignee, such a claim was prohibited by Section 9404(b).

Lastly, the bankruptcy court also rejected a public policy argument offered by the trustee. Judge Silverstein noted that her holding on Section 7031(b) would not allow “unlicensed contractors … to easily evade the statute” as the trustee claimed.[7] She explained that Section 7031(a)’s prohibition on the collection of compensation for unlicensed contractor work already provides “ample protection against unlicensed contractors factoring all their invoices.”[8]

Takeaways

The takeaway from the first set of Abeinsa decisions was the importance of know-your-customer (KYC) due diligence because an unlicensed customer could result in worthless account receivables. The takeaway from this recent Abeisna decision is that although an unlicensed customer can render your account receivables worthless, Section 9-404 of the Uniform Commercial Code can protect you from having to return any payments previously made.

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

[2] Id. at *1.

[3] Cal. Bus. & Prof. Code § 7031(b).

[4] Abeinsa Litigation Trust v. Crown Financial, L.L.C. (In re Abeinsa Holding, Inc.), Adv. No. 18-50316 (LSS) (Oct. 6, 2022), p. 10.

[5] Id. at 9.

[6] Id. at 12.

[7] Id. at 14.

[8] Id. at 14.