In the December 2015 ABI Journal, I read an article by James Gadsden discussing
the recent decision of United States Bankruptcy Judge Mary France in the Middle
District of Pennsylvania, In re Dryden Advisory Services LLC, 534 B.R. 612 (Bankr. M.D. Pa. 2015). upholding a factoring agreement governed by New York
law against an argument by the debtor-in-possession that the arrangement was a
disguised financing arrangement such that the factored receivables were
property of the estate. This having been
an area that I often had to grapple with, in the sense of reviewing,
negotiating and signing off on “true sale” opinions to support the
securitization practice, and there being a dearth of modern opinions addressing
the “true sale” question, I read the article with interest. I had met Judge France on a case in
Harrisburg when she was in charge of the local office of the U.S. Trustee for
the Region, and she had impressed me as having greater than customary business
sense and common sense for one in that position (would she had been in charge
of the Wilmington office instead), so my interest in the opinion was enhanced
because she wrote it. This was a
difficult case, and the result is debatable, but I think she analyzed it with precision
and sophistication.
The debtor was in the business of pursuing tax refunds
and other reductions for businesses, and was paid on commission. Cash flow was lumpy and frequently
sluggish. Among its liquidity strategies
was a factoring arrangement governed by New York law. The principal relevant terms of that
agreement were:
* Factor was under no obligation to factor any
particular account, but had discretion to accept and reject the ones Debtor
proposed.
* Factor took an initial 3.5% discount on the face
amount of each invoice. If the account
remained outstanding after 30 days, Factor applied an additional 1.75% of face
discount. Factor repeated that discount every 15 days thereafter until
collection.
* To cover the discounts and other risks, Factor only
advanced 75% of the amount of the invoice.
The remaining 25% balance served as a “holdback” of the purchase
price. If the account debtor did not pay
in full, Factor kept the holdback. If
payment was made in full, Factor rebated the holdback to the Debtor, after
deducting therefrom whatever discounts and other items applied. Factor was, however, also entitled to retain
from such remittances any amount needed to make itself whole on other purchased
receivables that might be in default.
The 25% level of recourse, coupled with the ability to
cross-collateralize receivables, is unusually aggressive, compared to what we
would have agreed to give “true sale” opinions on. I will discuss the implications later in this
post.
* Last, and most critically for the decision, the
Factoring Agreement provided that Factor assumed the risk of non-payment on
purchased accounts only if non-payment was “due to the occurrence of an account
debtor’s financial inability to pay, an `Insolvency Event.'” Notwithstanding this provision, Factor also had the right to put back to the account seller any invoice that was more than 89 days old.
After reciting authorities that provide an overview of
the “true sale / disguised financing” issue, Judge France cites relatively
modern case law from SDNY for the proposition that, “To constitute a bona fide
factoring agreement under New York law, the factor need only assume the risk
that the seller’s account debtor will be unable to pay.” In fact, every quotation she supplies on this
point includes “only” or “merely,” making the point very clearly that the
analysis is a fairly straightforward one. “[A]ll other risks associated with
the sale of the accounts receivable remain with the client (e.g., commercial
disputes …).”
After general observations that the language of the
agreement is not dispositive, and courts look “beyond labels and into the
details of the transaction”, Judge France’s analysis begins – oddly, I thought
-- by noting that the agreement called for the Debtor to hold payments it
received in trust in the exact form received and to forward them immediately to
Factor. What troubles me about this
observation is not just that its exclusive focus on the language of the
agreement seems at odds with the immediately preceding proposition that the
language of the agreement should be de-emphasized, but also, in the factual
recitals, the Judge had recited at least one instance in which Debtor received
payment of a factored receivable directly and initially paid over only the
amount advanced on a given receivable, and Factor had to follow up to receive
the balance. That seems to undercut the
significance attached to the language of the agreement. The opinion obliquely takes up the topic of
deviating from the language of the agreement, not as something directly bearing
on the ultimate issue, but as a subsidiary question of whether the parties’
conduct had effectively amended the terms of the agreement; pointing to merger
clauses and the usual boilerplate, the Judge concludes it hadn’t. I think this – which may have been how the
debtor’s lawyer framed it – is a misguided perspective. The right focus
is on how the property at issue was handled, as the initial lines of the Judge’s analysis
state. It is irrelevant whether the
agreement was or wasn't amended by the parties’ conduct; the conduct itself is what
matters.
Further, it is unclear from the opinion, which recites
some confusion among the litigants about how many receivables were at issue,
whether there had been receivables paid to Debtor that, at the petition date,
Debtor had failed to pay over to Factor. It may be that the confusion resulted
from the account debtors paying the Factor directly but some clarity on the
details might provide more insight.
Judge France goes on to state that:
“The ability of a buyer to demand that it receive
payment directly from account debtors supports the finding that the transaction
is a sale. Here, § 4.4 of the Amended Factoring Agreement gives Durham that
right. “Durham may notify any Customer [i.e., account debtor] to make payments
directly to Durham for any Account.” Durham Ex. 3 §4.4. After payment of
several invoices was delayed, Durham exercised this right and demanded payment
directly from Dryden’s account debtors. Had Durham exercised this right at the
inception of the agreement it would have been abundantly clear that the
transfer of the accounts was a sale. Durham may have preferred not to exercise
this right initially to avoid disrupting the business relationship between
Dryden and its clients, but in any event, it was entitled to exercise that
right at any time under the terms of the Amended Factoring Agreement.”
Here too, I regretfully submit, the Judge
over-emphasizes this provision. The
power to take over collection is not unique to factoring: every “plain vanilla” security agreement made by a borrower in favor of a lender concerning accounts receivable contains language to this effect.
It should therefore have been given no weight here.
The Judge also considers arguments that the pricing
formula and the fact that the Debtor was responsible to “service” collection of
the factored accounts support characterization of the arrangement as a financing
and not a sale. Correctly, I think, the Judge rejects those arguments as
well. Servicing by the account seller is
a garden-variety feature of all securitization and, absent some abnormal or
especially pertinent evidence it affected the main issue of recourse, it should
be given no weight, as the Judge concluded; else there would never be a
successful securitization. The provision
for additional time-based charges, which definitely smack of a financing,
concern me more, but, in and of themselves, they don’t tip the balance. They could be rationalized as just a greedy
Factor looking for arbitrary excuses to ratchet up the income it’s going to
earn; but, more importantly, it wouldn’t take a lot to rewrite the fees so that
all 90 days’ worth were charged upfront. Instead, the Factor established incentive compensation for the debtor as servicer that just happened to mirror the timing and amount of the second-stage fees, so I think here, too, the Judge reached the right result. Those fees don’t
affect the issue of recourse enough to drive a different result.
So, turning to that, here is what the Judge has to say
about the extent of recourse:
“Courts have held that the most important single
factor when determining whether a transaction is a true sale is the buyer’s
right to recourse against the seller. One of the core attributes of owning a
receivable is the risk that it will not be paid. If the buyer “sells” the
receivable, but retains the risk of non-payment, it is more likely that the
transaction will be recharacterized as a loan. An agreement “without recourse”
means that the purchaser/factor agreed to assume the full risk of collecting
the money owed to the seller, whereas an agreement “with recourse” means that
the seller retains the risk of collection.” Filler v. Hanvit Bank, 339 F. Supp.
2d 553, 556 (S.D.N.Y. 2004), aff’d, 156 F. App’x 413 (2d Cir. 2005). Generally, if there is a full right of
recourse against the seller, this weighs in favor of the existence of a loan
because there is no transfer of risk. Recourse can take many forms including an
obligation to repurchase accounts, a guaranty of the collectibility of
accounts, or a reserve which is released when the receivables are paid. See
Aicher & Fellerhoff, supra at 186.
“The Amended Factoring Agreement provided that
Durham accepted the risk of “non-payment on Purchased Accounts, so long as the
cause of non-payment is solely due to the occurrence of an account debtor’s
financial inability to pay, an “Insolvency Event.” Durham Ex. 3 §4.10. As to
this discrete event, Durham had no recourse against Dryden. The agreement does,
however, specify some events which would afford Durham recourse for
non-payment. For example, Dryden agreed to “accept back (repurchase) from
Durham any Purchased Account subject to a dispute between Customer and Client
of any kind whatsoever.” Id. at § 4.11. This included Durham’s right to require
Dryden to repurchase disputed accounts, all Purchased Accounts if there was an
event of default, and accounts unpaid after ninety days if an insolvency event
had not previously occurred. Id. at §6.4.1. While the foregoing provisions
limit Durham’s risk and provide some forms of recourse, they are insufficient
to support recharacterization of the transaction as a loan.
“Even the existence of a right of full recourse is
not dispositive. Thus, for example, “the presence of recourse in a sale
agreement without more will not automatically convert a sale into a security
interest.” Major’s Furniture Mart, Inc., 602 F.2d at 544. “The question for the court then is whether
the nature of the recourse, and the true nature of the transaction, are such
that the legal rights and economic consequences of the agreement bear a greater
similarity to a financing transaction or to a sale.” Id. Put somewhat
differently, if a seller conveys its entire interest in a receivable, the
transfer is a true sale, even if the seller has a recourse obligation. See
generally Harris & Mooney, supra (proposing that the more critical factor
is whether the seller retains a significant interest in the property, not
whether the seller has a recourse obligation). Here, Dryden transferred the
full economic interest in the Purchased Accounts to Durham. Further, Dryden did
not have a full recourse obligation, although it is misleading to characterize
the transaction as “nonrecourse” when the agreement included a hold back
provision (the “Reserve” in ¶ 4.9) and Durham could require Dryden to
repurchase accounts “on demand” as set forth in ¶ 6.4.”
This is the correct framework for analysis and the
only issue for debate is the weight to attach to the recourse provisions. I find this a much closer call than the
Judge. I do agree with her conclusion
regarding the insignificance of the chargebacks for disputes. That is a standard provision and has little
to do with the issue of who bears the credit risk of the account debtor, which
doesn’t arise unless the account debtor is legally obligated in the first
place. But, the other provisions she
cites are much harder calls. The ability
to put back an account merely for being 90 days outstanding is anomalous and in
the absence of a legal dispute over the obligation, difficult to square with
the proposition that the factor has taken on the account debtor’s credit
risk.
Additionally, 25% recourse is at least double, and
in some cases triple, anything I ever saw in a securitization. Now, granted, the companies I was working
with were ones for whom securitization was an option, a way to shave some basis
points off the cost of financing their working capital, not, as was the case
here, a last resort for the Debtor to stay afloat. But, that said, isn’t that
evidence of a financing, that the amount of recourse demanded reflected the
seller’s creditworthiness, not the account debtors’ creditworthiness? In our practice, whether we were giving an
opinion or advising on the strength of a bankruptcy-remote structure, it was a
cardinal point that the amount of recourse either had to be explicitly tied to
the creditworthiness of the account debtor(s), or, more commonly, where the deal
was a securitization program that would operate for several years, had to
reasonably resemble the historical loss experience of the debtor on similar
accounts. And, as a lesser-included
point, the Factor's ability in Dryden to apply a rebate owed the Debtor on one account to a
default under another is certainly not helpful to the proposition that the
factor had acquired the credit risk of the account debtors, although not in and
of itself fatal.
In expressing these doubts, I do not go so far as
to say the decision is wrong, for a couple of reasons.
First, in the background here, I note, although I
left it out of my summary of the facts, the opinion mentions that the Factor
was recommended to the Debtor by the Small Business Administration and that
could have had at least an unconscious effect on the Judge’s approach; she may
not have wanted to resolve a close issue in a manner that might disrupt
small-business financing in general or any SBA practices in workout
situations. While not analytically
satisfying, the impact on real-world financing practices is and should be a
concern for judges at all levels in the judiciary, because bankruptcy is just a
small part of a larger body of public policies.
Second, as I have suggested in passing a couple of
times, in contrast with opinion-giving, where one can only opine on the terms
of agreements as supplemented by assumptions about compliance therewith, the
resolution of a litigation over “true sale” should be based on actual facts and
conduct at least as much as the bare bones of the agreement. Here, while there was some evidence of
deviation from a perfectly pristine transfer of the accounts to the Factor, it
wasn’t particularly material; the Factor jumped on top of the issue right away
and implemented strict compliance with the procedures designed to conform to a
purchase relationship. It is hard on the
record recited in the opinion to find conduct consistent with a lender-borrower
relationship. Certain provisions of the agreement, such as the size of the holdback and the right to put back accounts more than 90 days old deviate materially from what I consider to be safe "true sale" practice. But, did they ever come into play as an economic matter? To me, that is the critical question for adjudication, not the words on a page. Did any invoice go past 90 days and, if so, did the Factor put that receivable back, or did it continue to hold the credit risk, consistent with a "true sale"? Did the Factor ever dip into recourse to cover a payment default, or just for fees? If the Debtor couldn't show an actual event in which the Factor shifted the loss upon default to the Debtor, it is hard for me to say this wasn't a "true sale" in fact.
Finally, and most importantly, I wasn’t there at
the hearing and didn’t see the testimony or hear the arguments of counsel. The
Judge’s opinion reduces her analysis to writing but doesn’t capture the full
record of the litigation before her. It
may well have been that the Debtor just didn’t make the case well enough to win. I believe, by the way, that the Debtor had
the ultimate burden of persuasion under 363(p) as it was the one asserting the
interest in the factored receivables, for purposes of using the proceeds thereof
as cash collateral. Ultimately, from
what I see in the opinion, I would have been pretty undecided about whom to
rule in favor of here, and the burden of proof allocation might well have been
the dispositive factor on this record, had I been the judge.
Overall, I think the Judge did a very commendable
job on a highly sophisticated issue, constructing the right framework for
analysis weighing of the factors, perhaps a little glibly but certainly
defensibly, and arriving at an outcome that, considering the burden of
persuasion, is probably the right bottom-line result.
