True Sale of Accounts in Bankruptcy - A Different Perspective
With an increase in bankruptcy activity likely on the way, Steven N. Kurtz provides a detailed look at the process from a factor’s perspective, with a particular focus on determining a true sale of accounts.
BY STEVEN N. KURTZ, ESQ., LEVINSON ARSHONSKY & KURTZ, LLP
Given the state of the economy, it looks like bankruptcy cases will increase. Factors are often in bankruptcy court, preferably as the debtor-in-possession (DIP) financier because you tend to hold all the cards and have superior bargaining power. Typically, when there is a factor involved as a DIP financier, it reflects faith in the factor client, and most of these cases turn out well for the factor.
However, factors are often dragged into bankruptcy court against their will, usually when the factor client has no DIP financing and files Chapter 11. When this happens, the only way for the debtor to survive is to collect the accounts receivable purchased by the factor and assigned to the factor for collection. In this situation, the debtor/factor client will file its first-day bankruptcy court motions, which includes a cash collateral motion, meaning the factor client wants a court order to collect accounts it already purchased. The court usually will schedule a quick hearing and be faced with the decision to decline the motions and shut down the debtor in the first couple of days or “save jobs and a business.”
When the court opts to “keep the business intact,” the cash-collateral order allows the factor client to collect the purchased accounts, grants a “replacement lien” to the factor and then schedules a final hearing later to rubber stamp the court’s prior quick decision. The bankruptcy court in such situations does not often go through a deep analysis, and if it addresses the purchased accounts, it may focus on recourse rights and recharacterize the transaction as a loan. Most cases in this fact pattern fail and by the time the court signs the first-day cash collateral order, it’s usually too late. However, a deep dive into Article 9, which governs all factoring transactions, should yield a different result if the court follows the plain language in the Uniform Commercial Code.
The concept of a true sale of accounts in a bankruptcy context is important. If the factoring agreement is construed as a true sale of accounts, then the accounts purchased by the factor do not constitute property of the estate. This means that the factor owns the accounts and has all rights that come from ownership, including the fact that the bankruptcy debtor is not allowed to collect or even use the accounts purchased by the factor. A true sale of accounts also means that the automatic stay that prohibits collection efforts by creditors against a debtor does not apply to the purchased accounts, although I always recommend that factors seek a protective stay relief order from the court and hold all collected funds in suspense until they receive that order.
When addressing whether a factoring transaction is a true sale of accounts, the courts typically look at the recourse provisions. If the agreement provides for full recourse if the account debtor fails to pay within a certain time frame, many bankruptcy judges will consider the transaction to be a loan because the factor did not take any credit risk with the account debtor. If the factor assumes the economic risk of the account debtor not paying because it is insolvent, most bankruptcy courts will consider this a true sale.
Identifying who bears the risk of the account debtor’s insolvency as the determinative fact in a true sale vs. loan analysis was first ruled upon before the UCC went into effect. (Home Bond Company v. McChesney, 298 U.S. 568 (1916).) Much of the reported case law on whether factoring agreements are true sales instead of loans has been determined in the usury and Perishable Agricultural Commodities Act (PACA) arena. In the usury arena, a true sale is not considered a loan, so the rates of return are irrelevant. But usury laws in many jurisdictions violate core fundamental state policies and are often enforced by regulators, so the playing field is different and the parties’ contractual intent is often ignored, with the focus aimed solely on the annual percentage rate. In the PACA body of law, in which most of the recent case law on the true sale analysis has occurred, the court is dealing with a breach of trust assets. Unfortunately, when determining whether a factor agreement is a true sale or a loan, bankruptcy courts often look to cases which predate the UCC or focus on solely usury or PACA and not the UCC.
In bankruptcy court, if the court has to rule upon your agreement and rights in the agreement, it starts with state law. The U.S. Supreme Court in Butner v. U.S., 440 U.S. 48 (1979) held that when reviewing property rights, courts should look to state law to determine a person’s rights in property. A factoring agreement is a creature of state law contract; it is an agreement that sets forth everyone’s rights and obligations. For the most part, the factor’s rights stem from UCC Article 9, which contains a bundle of rights which, if properly examined, operate together to construe your agreement as a true sale of accounts.
Article 9 applies to the sale of accounts (UCC Sec. 9-109 (a)(3)). To take advantage of Article 9 protections, you must have attachment of your security interest, which is the granting of your lien in accounts. Next you must have perfection of your security interest, which for accounts requires filing the UCC-1 financing statement in the debtor’s state of registration using the debtor’s correct name. UCC Sec. 9-201 provides that your security agreement is effective according to its terms upon the debtor and all creditors. Official comment two to UCC Sec. 9-201 further provides that the terms of your security agreement is effective against all third parties and the debtor to whom your security agreement binds is your factor client (UCC Sec. 9-102(a) (28)(B). The creditors bound by the terms of your factoring agreement include a trustee in bankruptcy (UCC Secs. 1-201(a)(13) and 9-102(a)(52)). When your factor client files Chapter 11, it is a debtor-in-possession, which has the powers of the trustee in bankruptcy ( Bankruptcy Code Sec. 1107). Once a debtor sells an account, it retains no legal or equitable interest in the sold account (UCC Sec. 9-318). For those in Texas, Louisiana and some other states with favorable case law that protects factors and sales of accounts, the choice of law provisions in the UCC require a court to apply the chosen law if it is proper to the transaction (UCC Sec. 1-301).
It is important to stress that the rights set out in the factoring agreement are state-law-based contract rights, mostly rooted in the UCC. The Bankruptcy Code contains several provisions that can affect creditors’ rights. If your lien is not perfected, the trustee has the rights of a perfect lien creditor in Bankruptcy Code Section 544 and the UCC defines a bankruptcy trustee as a lien creditor in UCC Section 9-102(a)(52). The net result if your lien is not perfected is you will lose your bundle of rights. The bankruptcy court has the right to value your secured claim and render the rest of your claim unsecured beyond the value of your collateral (Bankruptcy Code Sec. 506).
The Bankruptcy Code also has its dreaded avoidance claims which allow for preference, fraudulent transfer and some other avoidance claims. The Chapter 11 process can also result in the reduction and alteration of your unsecured claim and, in some cases, your secured claims. However, there is nothing in the Bankruptcy Code that allows the court to change the terms of your contract if it is done correctly. The UCC analysis which is required by the Butner decision, however, has largely been ignored.
When structuring your contract, knowing that it may be reviewed in bankruptcy court, here are a few free tips:
Use nomenclature such as buyer/seller.
Make sure that the agreement has something in the title that makes it clear that it involves a true sale of accounts.
If there is problem, always make sure that when you want call obligations, it should be called a repurchase of accounts.
Refer to schedules of accounts being purchased as a bill of sale or something of the like.
These kinds of things cue or tip the reader of your contract, which may be the judges’ law clerk a year or so out of law school, into thinking the deal is a sale of accounts and not a loan.
Admittedly, this view is a minority position, but hopefully just for now. This view is also reading the applicable statutes according to their plain meeting (no intent to be political here). This issue is somewhat more complex than the confines of this little article, but to my knowledge, I am not aware of any bankruptcy court looking at the state law rights embedded in factoring agreements and doing a deep dive into the UCC. The UCC contains a bundle of rights that are designed to protect the secured party, keep the contract intact and bind the debtor, other creditors and maybe the rest of the world to what is hopefully a well drafted integrated agreement. Hopefully, you are not the test case on this subject, but if so, maybe this article can be a good jumping off point.