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  FINANCIAL SERVICES FLASHPOINTS MAY 2012

Michael L. Weissman, Levin Ginsburg, Chicago
(312) 368-0100 | Email Michael L. Weissman

 

Prefatory Comment

 

This month we will consider (a) the notice required to perfect a purchase-money security interest, (b) what constitutes a counterfeit title certificate for insurance recovery purposes, (c) the statute of repose for rescission claims under the Truth in Lending Act, (d) whether 30-year Treasury bonds are the indubitable equivalent of a real estate mortgage under a Chapter 11 plan, and (e) when receipt of payments by a subordinated lender violates an inter-creditor agreement.

 

1. Creditor’s Notice Failed To Perfect a Purchase-Money Security Interest

A defective notice defeated an attempt to perfect a purchase-money security interest in In re Sports Publishing, Inc., No. 09-CV-2132, 2010 WL 750008 (C.D.Ill. Mar. 3, 2010).

In 2001, Strategic Capital Bank (Strategic) loaned money to Sports Publishing, Inc. (SPI). SPI signed a Commercial Security Agreement, and Strategic filed financing statements on July 16, 2001, and on February 7, 2006 (a continuation statement).

On January 1, 2005, InnerWorkings, LLC (IW) loaned funds to SPI and had SPI execute a Commercial Security Agreement. IW filed a UCC‑1 Financing Statement on March 29, 2005, with respect to certain of SPI’s assets. IW’s Commercial Security Agreement had a sentence referring to IW taking a purchase-money security interest on the first page, four or five paragraphs from the top, but not under its own heading. IW’s UCC‑1 Financing Statement repeated the sentence at the very bottom paragraph following the collateral description.

Later, IW entered into agreements with SPI and Strategic in which it was agreed that IW would finance the acquisition of certain inventory of SPI. IW’s Commercial Security Agreement and UCC‑1 Financing Statement were attached to these later agreements.

SPI initiated a Chapter 11 filing on October 1, 2008, and on November 4, 2008, Strategic began an adversary proceeding seeking a determination of the relative priorities of Strategic and IW. IW claimed a purchase-money security interest in the inventory of SPI it had financed. Strategic disputed that claim. The issue, as phrased by the court, was “whether InnerWorkings complied with the requirements under Illinois law for the creation and enforcement of a valid PMSI.” 2010 WL 750008 at *2. It answered that question in the negative.

The court noted there was evidence of discussions between IW and Strategic in which the President of Strategic participated. However, when he testified, he stated that in April 2007 he was not aware that IW was selling inventory to SPI on a PMSI basis. There was no evidence that IW had served an authenticated notice of its PMSI claim on Strategic.

Having reviewed the requirements for creating and perfecting a PMSI in 810 ILCS 5/9-324(b), the court said that “strict compliance with the statute is required.” 2010 WL 750008 at *5. Ruling against IW, the court said:

In the instant case, InnerWorkings did include the words “purchase money security interest” in the Commercial Security Agreement. However, they appeared far down on the page for both the Commercial Security Agreement and the UCC Financing Statement. They were not under a separate heading and they would not jump out or alert a party to the presence of a possible PMSI, which would defeat the other party's first in time security interest. Further, InnerWorkings has not provided proof of an authenticated notice sent to Strategic to alert them as to the PMSI. Id.

But IW did not capitulate even in the face of the court’s position on its failure to satisfy the statutory requirements. It argued that it had “essentially” complied with the notice requirement based on the language in the Commercial Security Agreement and its UCC‑1 Financing Statement and the discussions and agreements between IW and Strategic. But the court said that even assuming there was any merit in the “essential” compliance argument, the placement of the PMSI reference made it so obscure as not to effectively provide notice.

What’s the point? The result of this case is to once again emphasize that Illinois courts demand strict compliance with the statutory requirements for a purchase money security interest. Although the statute does not impose a requirement of conspicuousness, this court seems to have added that to the list of requirements for PMSI status.

 

2. Under the Banker’s Bond, a Counterfeit Title Certificate Must Be an Imitation of an Actual Certificate

North Shore Bank, FSB v. Progressive Casualty Insurance Co., 674 F.3d 884 (7th Cir. 2012), raised the question of whether a falsified certificate of origin for a motor home that a bank relied on in extending credit was “counterfeit” within the meaning of that term in a banker’s bond.

In October 2006, Russell Ott applied for a loan from NorthShore Bank, FSB, to purchase a 2007 Beaver Marquis motor home selling for $680,000. The transaction was unusual because Ott was purchasing the motor home from an Illinois dealership he owned named ProSource Motorsports. The dealership appeared to be a good customer for the Bank.

The Bank performed what it perceived to be adequate due diligence for the proposed transaction. It reviewed Ott’s personal financial statements and income tax returns. A bank officer visited the dealership and observed and photographed the motor home Ott represented he was purchasing. The Bank’s agent was not entirely familiar with Beaver Marquis motor homes. He was handed a document that Ott claimed was the original certificate of origin for the motor home he was purchasing. He compared the VIN on the certificate of origin with the VIN on the wall of the motor home and they matched. [NOTE: The court speculated that the reason the bank officer was misled was because he was directed to a 2003 Beaver Marquis motor home with a modified VIN plate with a fake number. On the basis of that VIN plate, Ott created a phony certificate of origin. That 2003 motor home was later repossessed by another lender.]

The Bank submitted documentation to the State of Illinois to impose a lien on title, and the state complied. Ott made payments on the loan for two years but then defaulted. The Bank tried to repossess the motor home but failed. The motor home Ott claimed to have purchased did not exist, and the certificate of origin supplied by Ott was a fabrication with a phony VIN.

Upon further investigation, the manufacturer of Beaver Marquis motor homes confirmed that it had not produced a motor home with the VIN that appeared on Ott’s phony certificate of origin. The Bank also discovered that Ott had defrauded several other financial institutions.

Faced with the realization that the motor home that was supposed to have been its collateral did not exist, the Bank made a claim with Progressive to recover under its banker’s bond. The issue came down to a determination of whether the Bank had suffered a loss due to a counterfeit certificate of origin. The banker’s bond defined the term counterfeit as “a Written imitation of an actual, valid Original which is intended to deceive and to be taken as the Original.”

The court ruled that Ott’s phony certificate of title was not a counterfeit certificate because there never was an actual, valid certificate for the motor home that could be imitated.

What’s the point? There is a large body of law construing the various provisions of the banker’s bond. It is well-settled that a counterfeit document must be an imitation of an actual, original document.

 

3. Three-Year Period for Truth in Lending Actions Cannot Be Extended

McOmie-Gray v. Bank of America Home Loans, 667 F.3d 1325 (9th Cir. 2012), dealt with the time period within which a claim for rescission under the Federal Truth in Lending Act (Act), 15 U.S.C. §1601, et seq., must be made. The court held that §1635(f) of the Act is a three-year statute of repose. This meant that a suit for rescission brought more than three years after the closing of the loan secured by a mortgage or trust deed was barred no matter when the borrower sent a notice of rescission.

On April 14, 2006, Kathryn McOmie-Gray (Gray) closed her loan and signed, among other things, two notices of right to cancel. She contended she had not been advised of when her right to rescind would expire.

On January 18, 2008, Gray’s attorney sent notice to the Bank of her intent to rescind. The Bank refused rescission. Gray filed a complaint in federal court seeking rescission on August 28, 2009.

Gray asserted that having served a notice of rescission within the three-year time period established by §1635(f), the time limit for filing suit was extended. But the court said that suit must be initiated within the three-year time period without regard to whether notice is served within such period. Thus, Gray’s lawsuit had to have been filed prior to April 14, 2009. Since it wasn’t, her case was dismissed.

What’s the point? Relying on the Supreme Court’s decision in Beach v. Ocwen Federal Bank, 523 U.S. 410, 140 L.Ed.2d 566, 118 S.Ct. 1408 (1998), the Ninth Circuit clarified that the three-year limitations period is absolute and cannot be extended even if notice of intent to rescind is served prior to the expiration of the three-year period. However, there is currently pending in the United States Court of Appeals for the Tenth Circuit a case that raises the same issue that was decided in McOmie-Gray. It is noteworthy that the US Consumer Financial Protection Bureau (CFPB) has filed a “friend of the court” brief asserting that borrowers do not have to file suit within the three-year period. If the CFPB position were adopted by the Tenth Circuit, it would establish a basis for Supreme Court review. Observers have pointed out that the CFPB has not indicated an alternative cutoff point beyond which suit could not be filed. Extending the time period for filing suit under the Truth in Lending Act could have a significant adverse effect on the mortgage industry. If a borrower simply had to give notice of intent to rescind during the three-year period, it could be used as a tactic to delay foreclosure should the loan go into default. Lack of clarity on the cutoff date will do nothing but create confusion as to whether foreclosure can be commenced or can proceed.

 

4. Thirty-Year U.S. Treasury Bonds Are Not the Indubitable Equivalent of a Duly Recorded Real Estate Mortgage

Is a 30-year U.S. Treasury bond the indubitable equivalent of mortgage lien for purposes of a cramdown Chapter 11 plan? That is the question the Seventh Circuit considered in In re River East Plaza, LLC, 669 F.3d 826 (7th Cir. 2012). The court’s answer was “no”.

The debtor, River East Plaza, LLC (REP) owned a building in downtown Chicago that housed offices and a restaurant. LNV Corporation held a first mortgage on the building.

The debtor defaulted in February 2009, and LNV commenced foreclosure. Having prevailed in the foreclosure action, LNV scheduled a foreclosure sale, but the sale did not occur.

In February 2011, REP filed a Chapter 11 petition, thus preventing a sale. LNV moved the court to lift the automatic stay, thereby subjecting itself to the jurisdiction of the bankruptcy court.

REP proposed a plan of reorganization to which LNV objected. The plan provided for a substitution of 30-year U.S. Treasury bonds as collateral for LNV’s debt in lieu of its mortgage lien.

Because REP was attempting to effect a cramdown of its plan of reorganization, LNV was entitled to exercise an election under §1111(b) of the Bankruptcy Code. The building, at the time of the bankruptcy case, had a value of only $13.5 million, although the LNV mortgage debt was $38.3 million. Under the circumstances, LNV had a secured claim of $13.5 million and an unsecured claim of $24.8 million. Pursuant to §1111(b)(1)(B), LNV elected to forgo its unsecured claim and exchange its secured and unsecured claims for one secured claim of $38.3 million.

Faced with a continuing large mortgage on the building, REP sought to overcome it by proposing a cramdown plan that substituted 30-year Treasury bonds for LNV’s mortgage. The issue thereby became whether the bonds were, in the language of the Bankruptcy Code, the “indubitable equivalent” of the mortgage lien.

Judge Posner, writing for the court, observed that the two different forms of collateral had different risk profiles, and, for that reason, they were not equivalents. The plan was not approved.

The finale was that upon remand the bankruptcy court lifted the stay and dismissed the Chapter 11 case.

What’s the point? The term “indubitable equivalent” has long demanded some definition. Cases such as this begin to give it substance.

 

5. Subordinated Creditor Violated Inter-Creditor Agreement by Accepting Payments from a Third Party

First Choice Bank v. Riverview Muir Doran, LLC, No. A09-1337, 2010 WL 2161778 (Minn.App. June 1, 2010), dealt with a purported violation of a subordination covenant contained in an inter-creditor agreement.

First Choice Bank (FCB) made a $5 million loan to JADT Development Group, LLC, in 2005. Timothy O. Baylor and Doris P. Baylor guarantied JADT’s loan from FCB. At the same time, Riverview Muir Doran, LLC (RMD) lent JADT $1,233,550.

The two lenders executed an inter-creditor agreement, under which FCB allowed RMD to have a junior mortgage on the same property on which FCB had a first mortgage. However, the agreement subordinated the junior debt “in right of payment . . . to the prior payment in full” of the senior debt. 2010 WL 2161778 at *1.

The agreement barred JADT from making any payments on the subordinated debt if the senior debt were in default and barred RMD, as the subordinated debtor, from accepting any payment if the senior debt were in default, in each case without FCB’s consent. It also barred RMD from accepting any additional collateral until the senior debt was paid in full.

JADT and the Baylors defaulted on the FCB loan, and on November 10, 2006, FCB sent a notice of default to each of them. Three days later, FCB sent a notice of default to RMD. FCB sued JADT and the Baylors naming RMD as an additional party.

After the lawsuit was filed, JADT and the Baylors entered into a forbearance agreement with RMD under which JADT delivered a mortgage to RMD on property owned by JADT Development Group II (JADT II) to secure a debt of $650,000.

RMD received payments totaling $873,790 in January and April of 2007 from JADT II. The forbearance agreement was thereupon amended to provide that the $650,000 debt was paid in full. When it learned about the payments to RMD, FCB claimed the funds paid to RMD should have been paid to FCB. The court agreed.

RMD contended that the payments made to it were not barred by the Agreement since they were not made by JADT but by a third party, JADT II. (Apparently, JADT II was an entity created by the Baylors.).

The court said the prohibition against RMD receiving payments after a senior debt default was absolute — it made no difference who was the source of the payments. In addition, the court ruled that RMD’s receipt of a mortgage on property of JADT II was a blatant violation of the Agreement that barred RMD from receiving any additional collateral while the senior lien was in default.

What’s the point? Inter-creditor and subordination agreements are commercial contracts that will be enforced in accordance with their terms especially if the contracting parties are commercially sophisticated. The language is crucial.

 

 
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