Win Some, Lose Some: A Look at Two Recent Court Decisions with Implications for Factors
Steven N. Kurtz, Esq., of Levinson Arshonsky Kurtz & Komsky breaks down two recent legal decisions, one of which will limit the bankruptcy options of “innocent” debtors in cases involving fraud, while another seemingly expanded debtor protections in California usury laws.
As I have mentioned in prior articles, inspiration for this column comes from many places. My inspiration for this article came from a break I took whilst conducting research and outlining what I originally planned to write.
During said break, I took some time to catch up on my pile of legal journals and stumbled upon two interesting cases that impact your business, assuming you’re a factor. The first case, Bartonwerfor v Buckley, (the “Buckley case”), caught my attention because the U. S.
Supreme Court was unanimous in its ruling, which shows that at least in bankruptcy cases, there are no politics. The Buckley case changed the game in favor of creditors when objecting to the discharge of a debt incurred by fraud, with the plaintiff faced with the “I’m not the one who did it” defense. The second case, G Companies Management v. LREP Arizona, (the “G Companies case”), is a California appellate court decision on California’s clear as mud usury laws, which is the first appellate decision in a while that refused to enforce a forum selection clause because it would contravene a California policy of not allowing usurious loans. Here’s a quick summary of these two interesting cases.
Buckley Case
The facts of the Buckley case are straightforward. Two real estate investors, let’s call them Kate and David, purchased a spec home in San Francisco with a plan to make some improvements and sell the property at a profit. David oversaw all aspects of the “venture,” while Kate was a passive “investor.” Kate and David then sold the home with typical real estate contracts and disclosures in practice for residential real estate deals in San Francisco. For anyone who has bought or sold residential property in California (and likely most states), standard forms are used that contain boilerplate representations. The buyer later discovered numerous code and construction defects not disclosed by the seller, which was allegedly fraudulently concealed by David. The buyer then sued Kate and David in state court and prevailed on their claim. Kate and David then filed for Chapter 7 bankruptcy and the buyer sued Kate and David under Section 523 of the U.S. Bankruptcy Code which, in part, precludes the discharge of a debt to a particular creditor if the debt was incurred by fraud.
The bankruptcy court held in favor of the buyer against both Kate and David, despite Kate taking the position that she had nothing to do with the fraud and had no knowledge thereof. Kate and David appealed to the Bankruptcy Appellate Panel for the 9th Circuit (the BAP), which upheld the objection to discharge against David but reversed as to Kate and sent the case back to the bankruptcy court with instructions that Kate’s liability turned on either participation in or knowledge of the fraud. The bankruptcy court found in favor of Kate because she did not participate in or have knowledge of David’s fraud. The buyer appealed to the BAP, which upheld the bankruptcy court. The buyer then appealed to the 9th Circuit Court of Appeals, which reversed the BAP and held that since there was fraud committed by David, and that Kate and David had a joint venture to sell the property, the debt was incurred by fraud and Kate’s innocence is not relevant, as she is liable for the act committed within the scope of the venture by her venture partner. Kate appealed to the U.S. Supreme Court, which took the case to resolve a split among the circuit courts in interpreting Section 523(a) of the U.S. Bankruptcy Code.
Justice Amy Coney Barrett wrote the 9-0 decision, with Justice Sonia Sotomayor writing a special concurrence (she tends to write many of the bankruptcy decisions). The Supreme Court analyzed the text of Section 523(a) of the U.S. Bankruptcy Code which excepts a debt from discharge if incurred by false pretenses, false representations or actual fraud. The issue at hands was whether or not the plain language of the statute requires that the debtor actually participate in or have knowledge of the fraud. The Supreme Court did a deep dive into statutory interpretation and held that if the debt was incurred by fraud and the “innocent” debtor was in a venture with another person who committed the fraud, the innocent debtor cannot discharge the debt if the fraud was incurred within the scope of the venture. This decision clarifies and now limits the bankruptcy options of the “innocent” debtor. It’s very common for a business to have several owners who each guarantee a debt. Sometimes the bad actor guarantor is the active fraudster and the non-fraudster guarantor will not have actual knowledge of the fraud as it happened, especially if the guarantor is a passive guarantor or a spouse. If a debt was incurred under false pretenses, misrepresentation or actual fraud, the innocent person can’t claim innocence and discharge the debt in bankruptcy. The focus would instead be on whether or not there is fraud and if it occurred within the scope of the venture. Justice Sotomayor emphasized in her short concurrence that there should be some kind of venture between a third person and the debtor seeking to discharge the debt to determine whether or not the fraud occurred within the scope of the venture. This case resolves a conflict among the circuits and is good for creditors.
G Companies Case
The G Companies Case changes the playing field in California usury cases in favor of the debtor. The facts of the G Companies Case are simple. The borrower took out a $4 million loan from LREP, a Texas corporation which is headquartered in Arizona. The loan was secured by two parcels of California real estate, the debtor was a California-based business and the loan called for 36% annual interest. The usury limit in California for loans and any forbearance is 10% interest, unless one of many exceptions is met, including use of the California Finance Lenders License, which is a safe harbor to charge much more than 10% interest.
The loan in this case went into default and the parties restructured the debt and executed a forbearance agreement secured via a complaint to be filed in the U.S. District Court in Arizona with a stipulated judgment. The forbearance agreement was executed by the borrower and all guarantors. The debtor and creditor each had counsel negotiate and advise on the documents. The decision, unfortunately, is not clear if there was a release in the forbearance. The debtor defaulted on the forbearance agreement and the creditor then caused the judgment to be entered by the U.S. District Court in Arizona.
After the Arizona judgment was entered, the debtor sued the lender in a state court in California and alleged that the lender violated California’s usury law. The state court ordered the case stayed to allow the Arizona judgment case to move forward. The debtor appealed and, in a reversal of prior policy, the California Appellate Court ruled in favor of the debtor and allowed the California case to move forward. Before the G Companies decision, most courts in California would have dismissed the case if the debtor was a business entity that freely entered into a deal with a lender not based in California, chose the lender’s state laws and bargained for jurisdiction and venue in the lender’s home state.
The court in the G Companies case began the decision by citing California’s state constitution, which sets the maximum rate of interest at 10% per annum. Because California’s maximum interest rate is in the state constitution, the G Companies court treated this interest rate cap as a quasi-fundamental right. California is unique in that its state constitution provides for a cap on interest rates, and this dates back to the 1800s. The G Companies court distinguished prior decisions made about enforcing forum selection clauses, which essentially stated that since California has so many exceptions to the usury law, the usury limitations are not that important, so if a business chooses to enter into a deal with an out of state lender at rates which exceed California’s interest rate cap, the court should let the lender get what it bargained for and enforce its deal. The G Companies court went in a different direction than most of the prior reported California decisions and characterized California’s vast exception to the usury rate cap as highly detailed legislation which shows that California law makers put a lot of thought into this intricate scheme. The G Companies court then addressed the fact that California’s usury laws are designed to protect vulnerable borrowers from unscrupulous lenders and characterized the borrower in this case as someone who the usury laws were designed to protect because the borrower was “desperate” and likely to default. The G Companies court treated the borrower, who took out a $4 million loan, more like an individual consumer than a business.
As of press time, it’s not clear what will happen. The lender in this case can seek review by the California Supreme Court, who in the case Wishnev v. Northwestern Mutual Life Insurance Company characterized the California usury laws as “not a model of clarity.” (See, “California Usuary Laws: Still Clear as Mud,” Legal Factor, December 2019).
Since there are published decisions that contradict the G Companies decision in different California appellate courts, it makes sense for the California Supreme Court to clarify this issue. The simple solution is to have a California Finance Lenders License, which is an automatic safe harbor and takes one out California’s usury rate limits. For those who are factoring in California without a license, it’s best to structure your deals as a true sale, non-recourse transaction in which you assume the economic risk of the account debtor’s financial inability to pay. Under California law, a true non-recourse factoring deal is considered a sale of accounts instead of a loan. Even with this true sale fix, it is not advisable to do any financing activity in California without a California Finance Lenders License. The G Companies decision will also be looked at closely by the California Department of Financial Protection and Innovation, which is the agency that enforces usury laws and oversees the regulation and licensing of the commercial finance industry in the state. If you are caught in a situation like the lender in G Companies, it’s best to remove the case to federal court if you can, as such courts are more likely to boot a case.
The score card after these two cases is one good case for the financial community and one not-so-good case. But the law and business climate are always changing, as we work in a fast-paced business and have to learn to adapt as things change. Next up, since the article was partially outlined until I changed course, will be at look at the “Dreaded Son of Debtor.”