Friday, December 18, 2015

Well-Reasoned "True Sale" Opinion from Middle District of Pennsylvania Bankruptcy Court

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.

Would you Like a Side Helping of Hypocrisy with your Meal?

The Food section of Wednesday’s New York Times buried this treasure in a list of recommended inexpensive restaurants.  I don’t know if the reporter did so consciously or unconsciously, it being the Times and all.

 “6. La Morada

“This may be the only restaurant in town equipped with a lending library whose holdings include Plutarch and Plath and a poster on a purple wall calling for resistance to globalization. Natalia Mendez and her husband, Antonio Saavedra, were once farmers in a small village in Oaxaca, Mexico, with Mixtec as their first language. They took the risk of crossing the Sonoran Desert and made their way to New York, where Oaxacan cuisine is still hard to find.”

Not the kind of globalization where I cross borders to do business -- the other kind!

Saturday, December 5, 2015

There is No White Debt

The New York Times Sunday Magazine this weekend carries an article so intellectually abominable I need to demonstrate its idiocy.  Entitled “White Debt”, and studded with quotes from the likes of Ta-Nehisi Coates, it consists of a personal narrative, devoid of anything one might call “journalism”, in which the author expounds upon the guilt she feels for being a white person in America.  Because slavery.  Although largely written in the first person singular, the author seems to deem herself, by virtue of her whiteness, a spokesperson for all white people and thus shifts, as the essay nears the end, into a first person singular as in “Collusion is written onto our way of life, and nearly every interaction among white people is an invitation to collusion.” And “What is the condition of white life?  We are moral debtors …. Our banks make bad loans. Our police act out their power on black bodies.”

The article reminds me of the way a creationist might express his or her moral certainty about the way in which the world as we know it came into being.  I would analogize the article also to the “Big Lie” technique of misleading the public, because pretty much every one of the generalities and abstractions the author invokes is pretty much false or at best, omits massive amounts of contrary information needed to make the picture she paints not misleading.  But it is clear the author sincerely, almost religiously, believes the nonsense she utters is true.  So it’s not a lie, it’s more like creationism, a religious assertion that is palpably contrary to fact.

The article reminds me of religion in another way. It resembles the emphasis on sin and guilt that has captivated the attention of various Christian denominations throughout Western history.  With a few subtle changes, like replacing Ta-Nehisi Coates and Nietzsche quotes with a passage from St Paul or the Old Testament it could probably pass for an unpleasant sermon on a Sunday morning in the not too distant past.  Flagellate yourselves, white people! Flagellate yourselves!

It’s a free country at least nominally, and if a person wants to sit around and mope about being white and read Nietzche while doing so, hey, feel free.  But when that someone starts advancing that perspective as the one to which others must subscribe, and a major media outlet implicitly makes the same call in publishing that perspective, those of us with brains need to speak out lest the Big Lie spread any further.

There is no “white debt”.   Not just because all the slave owners and slaves are dead, and their children are dead, and their grandchildren are dead, but for a handful of unusually long-lived descendants of long-lived ancestors.  Not just because it was white soldiers (like my ancestor who suffered for 13 years from wounds he sustained as a Union soldier at the battle of White Oak until the pain drove him to kill himself in 1875) who freed the slaves, white judges who led the fight against Jim Crow, white legislators and a white President who passed the Civil Rights laws of 1964, white doctors and nurses who treat far more black bodies than white cops kill or imprison, white professors who teach black students, predominantly white donors who fund financial aid for higher education that assists people of color, or predominantly white taxpayers and bondholders who fund the welfare state that disproportionately pays out for the benefit of people of color.  And it’s not even because much of the white population today is descended mostly or entirely from people who first entered the US after slavery was abolished and who settled in ethnically homogenous enclaves outside of the South where they rarely had occasion to compete with, let alone oppress, black people.  

No, it’s because the status of virtually every white American in the United States of America in 2015 is completely independent of any meaningful tie to slavery or Jim Crow or any legacy thereof or any racism of any kind whatsoever.    

First, until the current generation, the US population has been almost entirely white.  When I was born it was almost 90% white.  So, at any point in the 20th century, when a white person got a job or made a sale or took a seat in a school or bought a house, it was extremely, nearly 90%, certain that the white person did not displace a black person; said white person would have gotten that job, made that sale, gone to that school and lived in that house in a perfectly racially distributed nation.  Which in turn means that their children would have been in the same neighborhood, gone to the same school, met and married the same spouse, and had the same life outcomes, without impinging on any black person at any point along the way.   So hardly any white people got where they are today at the expense of a black person or by "being white". 

But it’s even more than that.  Because white people have made up so much of the nation, the good of the nation is primarily attributable to them as well.  There is this folk tale character of accounts of race in America where whites show up only as oppressors or ignorant and blacks are savvy and persevering.  But the technology and the infrastructure and transportation alternatives and medical treatment and the national defense and environmental protection and market regulation and the media and the sports and the educational options that a black person can benefit from in America in 2015 have been developed and distributed and funded almost entirely by white people.  That's neither oppression nor ignorance.

Second, of the wealth that exists today, again, virtually all of it has been created since slavery and Jim Crow ended and in places other than the ones where those systems operated.  The principal sources of private wealth in the US are homes, commercial real estate, farmland, loans secured by the same, equities and government bonds.  In the case of the intangible asset classes – stocks and bonds -- it is blindingly obvious that well over 95% of their aggregate value has come into being in the past 50 years.  And what existed before was not 100% attributable to slavery and Jim Crow.  It came from an economy that was 85-90% white.  As for farmland, the most valuable farmland is outside the Deep South, in the Plains States and California, where slavery never penetrated.  Its value comes from a variety of factors, but principally post-war leaps in efficiency, not inherited from an earlier era.   Plus, let’s face it: land is land.  It’s there regardless of any legal rules.  It’s not as if there was a void reaching down to the center of the Earth and the slaves filled it up with dirt.  As for other real estate values, the most valuable housing stock and the most valuable office and other commercial properties are the most recent.  Buildings erected in the 19th and first half of the 20th century, while still in existence, are a small part of the developed real estate in the US and, given the distribution of population in the US -  even in the Civil War era, the South was less than 1/3 of the population -- most of those were erected outside the zones of slavery and Jim Crow.  Further, among those that retain value today, much of that has to be attributed to maintenance and capital investments made in recent decades.  Any building that was built in the South prior to the Civil Rights Act and hasn’t been maintained since then isn’t worth a whole lot today.  The value of residential real estate today is the result of postwar demographics and home ownership subsidies the government has extended over the past several decades, and events preceding the Civil Rights laws of 1964 have very little to do with the value of residential real estate owned by white people.  This is not to say that blacks weren’t excluded from many suburbs, etc., decades ago.  The point is that very little value in the hands of white people today resulted from those exclusions.   Because most homebuyers back then were white, many blacks weren’t looking in those neighborhoods, and because so much of current housing stock value has arisen since that era.  

There is a sophomoric retort to these facts that usually involves emphasizing how important the slave economy was to the early United States and then making the argument “but for” the slave economy carrying the nation along, it never would have made it to where it was today, so everything you see today owes a debt to that fact.  This is sophomoric because, like sophomores, it knows a little and thinks that little is all it needs to know.  

First, “but for” arguments are always insufficient as explanations of any phenomenon.  This is because every situation in a complex society has millions, billions, trillions of “but for” causes.  For any real world situation X, the number of propositions “but for ___, X would not have happened” is limited only by one’s patience.   Yet the sum of causes of a phenomenon cannot exceed 100%; you don’t make sense if you claim to have identified 237% of the causes of a phenomenon.  This is the problem of “but for” thinking: it doesn’t add up.  All of the causes of a phenomenon have to be identified and their relative weight acknowledged to explain it, yet the sum of all causes can’t go past 100% or the explanation turns into nonsense.    

Secondly, the antebellum US economy was more than the slave trade and the products of slave labor.  There was a whole lot of white labor too.  So, third, once you start to take into account all the factors that have contributed to the current status of white Americans in the US, and not just myopically look at the ones that support the preferred thesis, you have to recognize that more than millions and billions and trillions of phenomena, but probably trillions of trillions of phenomena have occurred in relation to the US economy since the slave trade ended nearly 200 years ago.  So there are almost 200 years of intervening causes.   Just mathematically, the number of subsequent factors has to confine the “but for” causes from 200 years ago to an infinitesimally small fraction of the overall roster of causes of 2015 America.   

Last, what this kind of argument overlooks is that value depreciates and gets destroyed, by the creative destruction of capitalism over time, by financial crises that occurred regularly throughout the Jim Crow era, and by real physical destruction like General Sherman’s march through the Deep South.   It’s awfully unlikely that the profits of a slave trade or the export of products of slave labor in, say, 1845, survived the Civil War, the various financial panics and recessions of the following 60 years, and the Great Depression, and the application of multiple generations of estate taxes, and the high marginal tax rates that prevailed for decades of the 20th century, and somehow just kept accruing interest right up to the present.  More likely, some got reinvested in buildings that are no longer standing, or businesses that ultimately failed or closed down for one reason or another, or deposited in banks that went bust, or taxed away, or dispersed among widows and other descendants who spent them to survive, leaving nothing for the current generation.  It’s all gone   What wealth you see today has been created other than on the backs of black people.   

The last resort of the progressive activist community in debates like these is to play the “denial card” as the author herself does in this ridiculous article, listing for example several “crazy” things that “white people do when they feel guilty” and then letting us know that “I’m not sure any of that is worse than what white people do in denial. Especially when that denial depends on a constant erasure of both the past and the present.”  This is of course, exactly what the author herself is guilty of, myopically focusing on negative events in black-white relations in America and never lifting her gaze to see the entire picture of how the people who are alive today got where we are, most of which has nothing to do with exploiting black people, nor does she see any of the good that white people have done in ways that benefit and enrich black lives in America.   That is he most important thing intelligent people can do in this context, combat the arrogant claim of people like this author to control the truth when in fact their portrayal of truth is an ideologically myopic distortion of the world we have made.