Conflict of interest between secured creditors and unsecured creditors in Chapter 11 cases
Written by Richard Daingerfield, the US consultant of Guantao Law Firm Oct. 21, 2017
Translated by Shuo Wang, Guantao Law Firm Shenzhen Office, and the translation is reviewed by Ying Yin, a partner in Guantao Law Firm Shenzhen Office
The insufficiency of assets to fulfill all the creditors’ and the equity holders’ legal or equitable interests results creates tension among the secured creditor, the unsecured creditors, and the equity holders. Secured creditors have security interests in specific property (“collateral”) of the debtor. In a Chapter 11 case, secured creditors are entitled to receive no less than the value of their collateral. This priority reduces the amount that will be available to pay unsecured creditors. To maximize the value of the assets available to pay unsecured creditors, unsecured creditors should consider whether other legal doctrines can be invoked to attack the liens (i.e. security interests) held by secured creditors.
Outside of bankruptcy, it is rare to see an unsecured creditor attack the lien of a secured creditor. Within bankruptcy, it often happens. Unsecured creditors rarely work together outside of bankruptcy, but are brought together in a Chapter 11 case by serving on the creditors’ committee. The creditors’ committee typically retains lawyers and other professionals. Those professionals – whose fees are paid as administrative expenses of the bankruptcy estate – will want to closely analyze the position of the secured creditor to see if there are grounds to invalidate the secured creditor’s liens and/or otherwise recoup money paid by the debtor to the secured creditor. There are several ways in which the debtor or unsecured creditors might try to attack secured creditors.
1.Preferences
A preference is a payment (or other transfer) from the debtor to a creditor that is made within the 90 days prior to the start of a bankruptcy case (1-year for payments to insiders) that allows the recipient to receive more than it would have received in a Chapter 7 liquidation. If the value of collateral on which a secured party holds a lien, exceeds the amount owed to the secured creditor, payments to the secured creditor are not preferences. However, payments to secured creditors (within the 90 days prior to the bankruptcy filing) are preferences to the extent that the amount owed to the creditor exceeds the value of the collateral on which the secured party holds a lien.
A creditors’ committee (which is comprised of the debtor’s largest unsecured creditors who are willing to serve) may attack the secured party by arguing that the collateral on which the secured party has a lien is worth less than the amount the debtor owes to the secured party. The success or failure of such an attack often turns on the manner in which the judge decides to value the collateral. The secured creditor will argue for “fair market value.” Depending on the nature of the collateral, the unsecured creditors may argue that “fair market value” is not the appropriate test, because the collateral is of a type that often takes a long time to sell. In such a case, unsecured creditors will argue that “liquidation value” is more appropriate and liquidation value is always less – often FAR less – than fair market value.
While not directly applicable (because it wasn’t a bankruptcy case), we saw a demonstration of fair market value in the Ford & Vlahos v ITT Commercial Finance case.[1] ITT lent money to F&V, secured by a cargo jet plane. When F&V failed to repay the loan, ITT conducted a standard secured party sale (under article 9 of the Uniform Commercial Code). ITT bought the jet at the secured party sale for $1,000,000 and later sold it through a magazine advertisement for $1,525,000. But the judge found the fair market value to be $3,800,000 and awarded damages based on that valuation.
2.Fraudulent Transfers
A “fraudulent transfer” is a transfer within the 2-year period prior to a bankruptcy filing for which the debtor received “less than a reasonably equivalent value” and left the debtor “insolvent” or with “unreasonably small capital.” (11 USC 548). Unsecured creditors may use the fraudulent transfers doctrine to attack a security interest given to a secured creditor any time within two years prior to the bankruptcy filing. To the extent that the secured party lent new money in exchange for the new lien, the attack will fail. But a borrower that is having troubles often pledges additional collateral to a lender in order to get the lender to extend the time for repayment and/or forego declaring a default. The pledging of additional collateral where the lender does not lend new money may be attacked as a fraudulent transfer.
3.Document Review
A creditors’ committee should always examine the secured creditor’s documentation. If there is a defect in the documentation, the secured lender’s liens may be voided. If that happens, the assets on which the secured party believed it held a lien become property of the estate and their value will be shared by all creditors.
An example of this happened quite recently in this high profile case: Official Committee of Unsecured Creditors of Motors Liquidation Co v JP Morgan Chase Bank, N.A.[1] In that case, JPM Chase led two separate secured lending facilities (with two totally different lending syndicates) to General Motors. The first was a $300 million facility in 2001. The second was a $1.5 billion facility in 2006. When the 2001 facility was repaid in 2008, the law firm for GM prepared releases (Form UCC-3 termination statements) of the liens on the collateral securing the 2001 facility, but inadvertently also prepared a Form UCC-3 termination statement for the collateral securing the $1.5 billion 2006 facility. All of the UCC-3 termination statements were filed with the Delaware Secretary of State. The error was not discovered until secured lender documents were reviewed during the bankruptcy of General Motors (GM filed Chapter 11 in 2009). In the attached opinion, JPM Chase argued that the erroneous filing of the UCC-3 termination statement should be ignored because JPM Chase did not intend to release the lien on collateral securing the 2006 facility. The court ruled against JPM Chase, effectively rendering the $1.5 billion credit facility unsecured.
Should you any further inquiries, please feel free to contact:
Jennifer Yang (Beijing, yl@guantao.com)
Ying Yin (Shenzhen, yinying@guantao.com)
Frank Huang (Shenzhen, huangfl@guantao.com), and
Shouzhi An (Xiamen, anshouzhi@guantao.com)
[1] Ford & Vlahos v ITT Commercial Finance Corp, 8 Cal. 4th 1220 (1994)
[2]Official Committee of Unsecured Creditors of Motors Liquidation Co. v. JPMorgan Chase Bank, N.A., 777 F.3d 100 (2nd Circuit 2015)
