This month we consider whether a payment on a note violated a subordination agreement and the applicable statute of limitations on a contract to sell components parts and perform certain work in connection with it.
SPECIAL NOTE: In the December 2018 Financial Services FLASHPOINTS, attention was directed to a groundbreaking decision in Delaware that created a definition of a “material adverse event.” Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL, 2018 WL 4719347 (Del.Ch. Oct. 1, 2018). That ruling was affirmed by the Delaware Supreme Court on December 7, 2018. Akorn, Inc. v. Fresenius Kabi AG, No. 535, 2018, 2018 WL 6427137 (Del. Dec. 7, 2018).
Alleged Violation of Subordination Agreement Rejected Due to Ambiguity in Agreement
In Shapich v. CIBC Bank USA, 2018 IL App (1st) 172601, the court was asked to decide whether a note payment to a subordinator violated a subordination agreement. The court concluded that it did not because of a contractual ambiguity.
Shapich and Joseph Hajnos were the stockholders of M.P.D., Inc. The bank was the lender to MPD. In 2013, Shapich and Hajnos began negotiations for Shapich to sell his stock to the company for $1.5 million. Payment for the stock was evidenced by a note payable in ten annual installments with interest. Apparently, the bank became aware of the negotiations because it required the execution of a first subordination agreement that stipulated MPD’s obligation to Shapich was subordinate to MPD’s obligation to the bank. The agreement was drafted by the bank and signed by the parties on October 15, 2013.
The first subordination agreement defined the terms “Subordinated Indebtness” and “Superior Indebtedness” as follows:
“Subordinated Indebtedness” . . . mean[s] all present and future indebtedness, . . . of any kind . . . owing from [MPD] to [Shapich] . . . in its broadest sense and includes without limitation all principal, all interest, . . . and all other obligations, . . . of any nature whatsoever.
“Superior Indebtedness” . . . include[s] all present and future indebtedness, . . . of any kind . . . owing from [MPD] to [the Bank] . . . in its broadest sense and includes without limitation all principal, all interest, . . . and all other obligations of [MPD] to [the Bank], . . . of any nature whatsoever. 2018 IL App (1st) 172601 at ¶4.
According to the first subordination agreement, “[a]ll Subordinated Indebtedness of [MPD] to [Shapich] is and shall be subordinated in all respects to all Superior Indebtedness of [MPD] to [the Bank].” Additionally, the first subordination agreement stated:
[MPD] will not make and [Shapich] will not accept, at any time while any Superior Indebtedness is owing to [the Bank], . . . any payment upon any Subordinated Indebtedness, . . . except upon [the Bank’s] prior written consent.
* * *
Should any payment, . . . be received by [Shapich] at any time on the Subordinated Indebtedness contrary to the terms of this Agreement, [Shapich] immediately will deliver the same to [the Bank]. 2018 IL App (1st) 172601 at ¶5.
Notwithstanding this restriction on payment without the bank’s consent, the first subordination agreement also provided that “[t]he contractual principal and interest payments referenced on the Note are allowed but any additional accelerated payments would need prior Bank approval.” Id. Finally, the first subordination agreement specified that it “will remain in full force and effect until [Shapich] shall notify [the Bank] * * * to the contrary.” Id.
On October 23, 2013, Shapich and MPD executed a stock redemption agreement (SRA) and the note. The SRA and the MPD’s note each stated that the note “shall be subordinate” to the bank’s “rights of payment and redemption” for MPD’s debt. 2018 IL App (1st) 172601 at ¶6. That day, MPD paid Shapich the first annual installment on the Note, and Shapich tendered his stock to MPD and resigned from the company.
In April 2014, MPD executed a new loan agreement with the bank. Although Shapich never terminated the first subordination agreement, and the parties agreed that agreement remained in effect, the new loan agreement provided that the bank “shall not be required” to disburse the loan if MPD “fail[s] to execute and deliver” a “Subordination Agreement executed by . . . Shapich in favor of [the Bank].” 2018 IL App (1st) 172601 at ¶7. Hajnos was given a copy of a new subordination agreement (second subordination agreement) for Shapich to sign. Shapich refused to sign it.
Because of Shapich’s refusal, the bank directed Hajnos not to make any note payments. Neither the October 2014 nor any other payments were made to Shapich. On December 19, 2014, Shapich filed a verified complaint alleging breach of contract against MPD (Count I) and tortious interference with a contractual relationship against the Bank (Count II). As to Counts I and II, Shapich sought $1.35 million plus interest, costs, and attorneys’ fees. On April 14, 2017, he moved for a summary judgment on both counts. Regarding Count II against the bank, he contended that the SRA “expressly authorized” MPD to make payments on the note and that MPD violated the SRA when it complied with the bank’s instruction to cease payment thereon. 2018 IL App (1st) 172601 at ¶9. The bank filed a cross-motion for summary judgment, arguing that MPD did not breach its agreement with Shapich because the SRA afforded higher priority to the bank’s debt and any conduct on the bank’s part to induce a breach by MPD was privileged.
On August 1, 2017, the trial court entered a written order that (1) granted summary judgment in favor of Shapich and against MPD and the bank, (2) denied the bank’s cross-motion for summary judgment against Shapich, and (3) determined that MPD and the bank were jointly and severally liable to Shapich. The trial court also awarded Shapich (1) $1.35 million from MPD, plus interest, attorneys’ fees, and costs; and (2) $450,000 from the bank “ ‘as of’ August 1, 2017, which ‘shall increase as “consequent damages” ’ for all future payments on the Note that are not paid by MPD, ‘up to’ $1,350,000.” 2018 IL App (1st) 172601 at ¶10. The trial court also directed Shapich to prepare a petition for attorneys’ fees, which he filed on August 18, 2017. On September 12, 2017, before the court ruled on Shapich’s petition, the bank filed a “Motion for Clarification” of the August 1, 2017, judgment. Id.
On September 29, 2017, the trial court entered an order disposing of both Shapich’s petition for attorneys’ fees and the bank’s motion for clarification. The trial court awarded Shapich a total of $401,836.29 for interest, attorneys’ fees, and costs against MPD, in addition to the relief previously granted in the order of August 1, 2017. As to the Bank’s motion for clarification, the court specified that the judgment entered against the Bank “is capped at $1,350,000.00 and does not include . . . interest or attorneys fees and costs.” 2018 IL App (1st) 172601 at ¶11. The order stated that it is “final and appealable,” and the bank filed a notice of appeal on October 19, 2017.
On October 25, 2017, Shapich filed a motion to modify the order of September 29, 2017, seeking an award of interest against the bank. MPD, in turn, filed a motion to vacate or modify the September 29, 2017, order on October 27, 2017, on the basis that the summary judgment entered against it was improper, the judgment for attorneys’ fees was excessive, and “[t]he judgment against [the Bank] should have included the entire amount of damages assessed against MPD.” 2018 IL App (1st) 172601 at ¶12. Shapich filed a motion to strike MPD’s posttrial motion on November 3, 2017. On November 6, 2017, the trial court denied Shapich’s motion to strike and set “[a]ll pending motions” for hearing. On November 14, 2017, the bank filed an amended notice of appeal from the court’s September 29, 2017, order.
On February 16, 2018, the trial court entered an order that (1) denied MPD’s motion to reconsider, (2) modified the judgment entered against the bank to reflect “unpaid principal payments” of $600,000 and interest totaling $236,250, and (3) declared that the order was “final and appealable.” Shapich, on March 12, 2018, filed a notice of appeal from the orders of September 29, 2017 and February 16, 2018. Subsequently, on March 16, 2018, he filed a motion to modify or vacate the September 29, 2017, judgment, as modified on February 16, 2018, on the basis that, “as a result of the judgment against MPD,” another of its secured creditors, Crestmark Bank, “held a UCC sale of all MPD’s assets on February 28, 2018.” 2018 IL App (1st) 172601 at ¶13. Therefore, Shapich asked the court to modify the judgment entered against the bank to reflect the full value of the unpaid note because satisfaction of the note had become an impossibility.
On May 7, 2018, the trial court entered an order that modified its February 16, 2018, judgment order to specify that the bank pay $600,000 to Shapich “for all * * * principal payments” that MPD had not made to date on the note, plus accrued interest totaling $236,250, and that “the judgment against [the Bank] shall increase as consequential damages on all future new payment amounts not made” by MPD. 2018 IL App (1st) 172601 at ¶14. On June 18, 2018, the trial court granted the bank’s and Shapich’s joint motion for leave to file amended notices of appeal and cross-appeal.
On appeal, the bank asked the court to reverse both the summary judgment entered in favor of Shapich and the denial of its own motion for summary judgment. According to the bank, the first subordination agreement, SRA, and note provided that MPD’s debt to Shapich was subordinate to MPD’s debt to the bank, and prohibited MPD from making “regular payments” to Shapich because that would vitiate the purpose of subordination. Shapich, in response, argued that the trial court properly granted summary judgment in his favor due to language in the first subordination agreement creating an exception that permitted MPD to make note payments. 2018 IL App (1st) 172601 at ¶15.
The court said the key issue was whether MPD breached its financial obligations to Shapich and whether the breach was induced by an intentional and unjustified inducement by the bank.
Reviewing the terms of the first subordination agreement, the appeals court found them to be contradictory and stated, “[W]e find that the First Subordination Agreement is ambiguous as to whether MPD was permitted to pay Shapich on the Note.” 2018 IL App (1st) 172601 at ¶22. On that basis, the summary judgment entered by the trial court on Shapich’s claim for tortious interference with a contractual relationship was reversed, and the trial court’s denial of the bank’s claim for summary judgement was affirmed.
What’s the point? This case poignantly demonstrated the need for clarity in drafting subordination agreements. I have frequently drafted them. The level of subordination can be deep to slight. Deep subordination prohibits all payments to the subordinating creditor until the bank debt has been paid in full. An intermediate position allows interest to be paid as long as the debt to the bank is current. And slight subordination allows both interest and principal to be paid so long as the bank debt is current. But purporting to allow payment on a deeply subordinated debt without a benchmark against which to measure qualification for payment creates an ambiguity that will do nothing except generate costly litigation.
Applicable Statute of Limitations for Breach of Contract in Sale of Goods with Accompanying Services
NewSpin Sports, LLC v. Arrow Electronics, Inc., 910 F.3d 293 (7th Cir. 2018), did not facially involve a financial institution but does provide a lesson for lenders whose collateral includes accounts receivable that may have to be collected in a workout.
NewSpin provided technology products to help athletes, like golfers and tennis players, analyze and improve their swings. In 2010, NewSpin began the process of producing and launching its flagship “SwingSmart” product. SwingSmart was a sensor module that attached to sports equipment and analyzed the user’s swing technique, speed, and angle. To initiate the production process, NewSpin searched for manufacturers and distributors that could provide the necessary electronic components to make SwingSmart work.
Arrow dealt in the type of electronic components NewSpin sought to include in SwingSmart. Arrow sales representatives met with NewSpin representatives at least seven times in 2010 and 2011; the parties discussed NewSpin’s requirements for the product and Arrow’s ability to meet these requirements. Based on these discussions, NewSpin believed that Arrow knew how SwingSmart would function and understood NewSpin’s specifications for SwingSmart. Arrow employees further represented to NewSpin that Arrow had “successfully manufactured and provided substantially similar components for other customers.” 910 F.3d at 297.
Based on these representations, NewSpin signed a contract with Arrow in August 2011 entitled “Materials and Manufacturing Management Agreement Board Assembly” (agreement). Arrow agreed to “use reasonable commercial efforts” to perform “Work” pursuant to NewSpin purchase orders. Id. Arrow’s work was defined in the agreement:
[T]o procure components and other supplies (Components) and to engage a sub-assembly house for the manufacture and assembly of Products (or Boards) through a subcontractor . . . on [NewSpin’s] behalf pursuant to detailed, written specifications . . . which are provided by [NewSpin] and accepted by Arrow, and to deliver such products to a [NewSpin] designated location. 910 F.3d at 298.
The agreement left many of the specifics of each product shipment to be spelled out in NewSpin’s future purchase orders: “As [NewSpin] requirements dictate, and on a case by case basis, [NewSpin] will issue a purchase order to Arrow setting forth the quantities, descriptions, prices, and requested delivery dates for the Products to be supplied and Work to be performed. . . . Each purchase order will reference the applicable Specifications.” Id. The price for Arrow’s work was also left to be “agreed upon by Arrow and [NewSpin] from time to time as set forth in purchase orders issued by [NewSpin] and accepted by Arrow.” Id. However, the agreement did contain provisions that addressed, among other issues, Arrow’s warranty for the products shipped to NewSpin, Arrow’s inspection of products, sales tax and shipment terms, and NewSpin’s ability to return shipped products.
In late 2011, NewSpin forwarded its first purchase orders to Arrow, and Arrow shipped some components to NewSpin in mid-2012. NewSpin contended, however, that the components Arrow sent were defective and did not conform to their specifications. A manufacturing expert later identified “pad cratering” as one reason for these defects. NewSpin alleged pad cratering is a common manufacturing issue that Arrow should have known about.
Initially unaware of these defects, NewSpin used Arrow’s defective components to build 7,500 SwingSmart units. Of those 7,500 units, only 3,219 could be shipped to customers, and of the 3,219 shipped units, 697 were wholly inoperable. In sum, of the 7,500 SwingSmart units NewSpin initially built, 4,281 units were inoperable or defective. NewSpin alleges it paid Arrow a total of $598,488 for these defective and nonconforming components, and it also incurred over $200,000 in other damages in the form of customer support efforts, module testing, and repair. Furthermore, its receipt of these defective components damaged its brand equity, reputation, and vendor relationships. Additionally, Arrow never delivered over $130,000 worth of components to NewSpin, despite billing NewSpin for them.
NewSpin sued Arrow on January 17, 2017, claiming breach of contract, breach of the implied warranty of good faith and fair dealing, breach of warranty, fraud, fraudulent misrepresentation, and unjust enrichment.
Arrow moved to dismiss the complaint pursuant to Federal Rule of Civil Procedure 12(b)(6), arguing all of these claims were time-barred. The district court agreed and granted the motion to dismiss in its entirety on July 26, 2017. Specifically, the court determined the agreement was predominantly a contract for the sale of goods subject to the four-year statute of limitations for such contracts set out in Article 2 of the Uniform Commercial Code. It made this determination because “NewSpin’s breach of contract allegations make clear that the essence of the contract was for the components and the components’ specific parts.” 910 F.3d at 299. The district court concluded that the contract fell within Article 2 of the UCC because it demonstrated Arrow’s obligation was to deliver “turnkey” goods. (Turnkey “refers to a product ‘provided in a state of readiness for immediate use.’ ” Id., quoting BLACK’S LAW DICTIONARY, p. 1750 (10th ed. 2014).)
Because the court determined NewSpin filed its complaint more than four years after the alleged breach — the delivery of allegedly defective goods in mid-2012 — it concluded the contract-based claims were untimely. And since it determined the tort-based claims were predicated on the same allegations underlying the contract-based claims, the court also dismissed those claims as time-barred.
On appeal, NewSpin argued the district court erred because the contract in question was for services and was governed by Illinois’ ten-year statute of limitations for breach of a written contract. 735 ILCS 5/13-206. But the court of appeals sustained the ruling in favor of Arrow, saying the statute of limitations in Article 2 of the UCC that controls a sale of goods was indeed applicable. To reach that conclusion, it had to peruse the terms of the contract.
The court began by stating the standard it would follow when reviewing the contract:
When faced with a mixed contract, involving both the sale of goods and the provision of services, Illinois uses the “predominant purpose” test to determine whether the four-year or ten-year statute of limitations applies. . . . To apply this test, courts assess whether the contract is “predominately for goods with services being incidental, [or] predominately for services with goods being incidental.” . . . In the former case, the UCC limitations period applies; in the latter case, the written contract limitations period controls. . . . Courts review a contract’s language and the proportion of goods to services provided for within the contract to assess its predominant purpose. [Citations omitted.] 910 F.3d at 301, quoting Zielinski v. Miller, 277 Ill.App.3d 735, 660 N.E.2d 1289, 1294, 214 Ill.Dec. 340 (3d Dist. 1995).
In concluding that the predominant purpose of the contract was the purchase and sale of goods, the appellate court cited the following:
NewSpin was to deliver product specifications to Arrow, Arrow was to engage a subcontractor to assemble a product based on the specifications, and Arrow was to deliver a finished product to NewSpin.
There was no separate payment in the contract for Arrow’s work; it was blended into the price of the product.
Arrow provided a warranty that the products to be delivered had been manufactured and assembled pursuant to NewSpin’s specifications, and were free from defects in workmanship. There was no warranty concerning the services Arrow was to provide.
NewSpin was responsible for the payment of sales tax.
Products were to be shipped “free on board.”
Title to the products passed to NewSpin upon payment.
Arrow agreed to provide fully functioning components that met NewSpin’s specifications
All of NewSpin’s contractual claims were rejected based on the four-year statute of limitations. However, NewSpin’s tort claims were held to be viable based on Illinois’ longer limitations period.
What’s the point? When faced with the possibility of liquidating the accounts of a defaulting borrower, lenders will face the challenge of determining the applicable statute of limitations if the underlying contracts are mixed, involving both products and services. Take no chances. Opt for the shorter statute if a choice is available.
For more information about financial services, see COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION — 2018 EDITION. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.