Bond Financing Liens: Who’s on First?

Zucker v Wesbanco Bank, Inc. (In re Fairmont General Hospital, Inc.), 546 B.R. 659 (Bankr. N.D. W.Va. 2016)

A chapter 11 liquidating trustee and a bond trustee brought an adversary proceeding against the Marion County Commission (Commission) as the issuer of bonds to avoid certain transfers made in connection with the bonds. The bankruptcy court ruled against the plaintiffs on one count, but effectively gave them the relief they ask for in connection with a second count.

The Commission issued $13.7 million in hospital revenue bonds to fund the construction and operation of a new facility by the debtor. The Commission entered into a loan agreement with the debtor which required the debtor to grant a security interest in its gross revenues to the Commission. The parties also executed a trust indenture pursuant to which the Commission assigned most of its rights under the loan agreement to the bond trustee. The only rights retained by the Commission were (1) the right to payment of necessary reasonable administrative expenses, (2) an exception from liability relating to claims arising from insufficient insurance, and (3) certain indemnification rights.

The Commission’s security interest in the debtor’s gross revenues was assigned to the bond trustee as part of the overall assignment. Under the trust indenture the bond trustee was obligated to “properly record the security interest in the Debtor’s Gross Revenues.” In 2007 the bond trustee’s counsel filed a UCC financing statement identifying the Commission as the borrower and the bond trustee as the secured party. In 2013 the counsel caused a new UCC to be filed which listed the Commission as secured party and the debtor as the borrower. The court characterized this as “an apparent attempt to correct the previous financing and continuation statements.”

The debtor filed a Chapter 11 bankruptcy in 2013. In 2015 the court approved the sale of substantially all of the debtor’s assets and confirmed the debtor’s liquidating plan. The plaintiffs then sought to avoid the 2013 UCC financing statement and related security interests as a preference.

The plaintiffs claimed that the 2013 UCC served to perfect a security interest in the debtor’s property within 90 days of the bankruptcy filing, and consequently any remaining interest of the Commission in the debtor’s gross revenues should be an unperfected security interest that could be avoided by a hypothetical lien creditor. The Commission responded that it was not a creditor of the debtor, and thus no preferential transfer occurred.

The court began by analyzing the elements of a preference. In particular section 547 of the Bankruptcy Code applies to transfers that are “to or for the benefit of a creditor.” The court concluded that the Commission was not a creditor, reasoning as follows:

  • The Bankruptcy Code defines a creditor as an “entity that has a claim against the debtor that arose at or before the time of or before the order for relief concerning the debtor.”
  • Claim means “a right to payment or right to an equitable remedy for breach of performance.”
  • “[A] claim must contain ‘all of the elements necessary to give rise to a legal obligation – ‘a right to payment’– under the relevant non-bankruptcy law.'”
  • In other words “an entity must presently possess a claim against the debtor on the petition date in order to be a creditor. Notably, an entity ceases to be a creditor upon satisfaction of a claim, or upon assignment of all interest in a claim.”

Although the Commission retained limited rights relating to payment of administrative expenses and indemnification rights, the court did not believe these were even a contingent claim – drawing a distinction between a contingent claim and a claim that is subject to a condition precedent. Thus, in the court’s view the Commission was not a “creditor,” and section 547 regarding preferences was not applicable.

Notwithstanding its ruling on the 2013 UCC, the court concluded that the 2007 transfer of a security interest in the debtor’s gross revenues was not perfected, and thus was avoidable. Under section 544 the Bankruptcy Code the “strong-arm” powers include the rights under state law of a hypothetical judgment lien creditor that extends credit at the time of the bankruptcy filing and obtains a judicial lien on the debtor’s property. Under the UCC a judgment lien creditor takes priority over an unperfected security interest or one that is not yet attached to the collateral.

Perfection of a security interest in the debtor’s gross revenues required a file UCC financing statement. Although a UCC was filed in 2007, it was not effective since it failed to properly identify the debtor. Consequently, there was a basis for finding that the 2007 security interest could be avoided. In addition the Commission contended that it did not have a lien or security interest in the debtor’s gross revenues anyway since it assigned its rights under the loan agreement and its security interests to the bond trustee. The court noted that as a consequence the Commission no longer possessed a security agreement which was necessary for attachment which led to the same result.

In either case (i.e. an unperfected interest or no attachment of a security interest) the court found that the interests could be avoided and the debtor’s gross revenues were unencumbered by any interest of the Commission. (The court did not address the separate issue of whether the bond trustee had any interest in the gross revenues since that issue was not before the court.)

If a financing involves more than a simple loan transaction, it is important to understand the structure in order to avoid overlooking important details. This case appears to be a fairly typical limited obligation revenue bond financing:

  • There was one relationship between the issuer of the bonds (i.e. the Commission) and the company developing the project (the debtor). The issuer made a loan to the company, and the company granted a security interest in the project revenue to the issuer as security for payment of the loan. Thus, one would expect to see a UCC identifying the company as the debtor, the issuer as the secured party, and the project revenue as the collateral.
  • There was another relationship between the issuer and the bond trustee. The issuer collaterally assigned its rights to payment from the company and most of its rights under the loan agreement to the bond issuer as security for payment of the bonds. Depending on the details, one would expect this to result in an assignment of the company’s UCC by the issuer to the bond trustee and/or a UCC identifying the issuer as the debtor, the bond trustee as the secured party, and the issuer’s rights under the loan, including payments by the company as well as its rights to project revenues (i.e. the collateral for the loan), as the collateral.

It appears that the people preparing UCCs in this transaction did not have a clear picture of the structure. The consequence was that the issuer’s security interest was subject to avoidance.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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