Freddie Fraudster[1] wholly owns and operates Loser LLC, an operating business with significant cash flow. Unbeknownst to anyone, over the span of several years Freddie diverts more than $8 million in funds from Loser LLC’s business operations into a “secret” bank account he maintains at a separate Bank in the name of Loser LLC, but over which Freddie at all times holds exclusive discretion and control. Freddie uses the secret account as his personal piggy-bank, paying on going personal expenses such as: regular monthly mortgage payments to his Bank on his personal residence, utility and homeowner association payments regarding that same residence, funding a personal horseracing hobby, and hiring Sally Trueblood, a salt of the earth interior designer to whom Freddie paid approximately $230,000 over time—using checks from the “secret” Loser LLC account–as payment for legitimate interior design services provided by Sally in remodeling a building owned by Freddie personally. It was stipulated that Sally was referred to Freddie by another of her clients and did not know Freddie previously, that she had provided her design services to Freddie based a truly arms’ length transaction, that the value of the services she provided were consistent with the amounts paid, and that she had otherwise acted at all times in good faith with respect to Freddie and the services she provided to him without knowing anything about Freddie’s unrelated fraudulent activities.
As one might expect, Loser LLC suffered significant losses and filed for Chapter 7 Bankruptcy protection. Freddie went into hiding somewhere outside the country. A Chapter 7 Trustee was appointed to recover and liquidate Loser LLC’s assets for the benefit of its creditors, and Freddie’s scheme of diverting Loser LLC’s funds into the secret bank account for Freddie’s personal benefit, was uncovered. The Trustee then “sued the checkbook” for the secret account, filing more than 100 fraudulent transfer suits against virtually every recipient of any payment out of the “secret” account under Bankruptcy Code section 548(a)(1)(B), alleging that each recipient was strictly liable for the return of all payments from the secret account because they were the initial recipient of a constructive voidable transfer for which Loser LLC received no benefit or consideration.
Because Ms. Trueblood was obviously an “innocent” recipient of payments made via checks written on Freddie’s “secret” Loser LLC checking account, the parties chose to use the Trustee’s lawsuit against Ms. Trueblood as a “test case” to obtain a ruling on an affirmative defense that would be asserted by virtually each of the 100 “checkbook” defendants sued by the Trustee. Section 550(b) of the Bankruptcy Code provides that an otherwise avoidable fraudulent transfer may only be recovered from an “initial” transferee or the recipient of the benefits of the transfer, and cannot be recovered from a “mediate or subsequent” transferee if the subsequent transferee “takes for value, . . . in good faith, and without knowledge of the avoidability of the transfer avoided.
The Bankruptcy Court initially ruled in Ms. Trueblood’ s favor, holding that Freddie’s diversion of Loser LLC funds into the “secret” bank account over which he held “exclusive control,” was sufficient to render Freddie as the “initial” transferee of the diverted funds referenced in Section 550(b), thereby rendering Ms. Trueblood an innocent “subsequent” transferee entitled to avail herself of Section 550(b)’s good faith defense. On appeal, the US District Court initially, and the US Ninth Circuit Court of Appeals ultimately, disagreed, and ruled that the appropriate inquiry was to focus on who, at the time of the challenged transfer, had “dominion” over the funds being transferred, and defined such “dominion” as (essentially), “whether the recipient of funds has legal title to them.”
Following this logic, the Ninth Circuit reasoned that notwithstanding that Freddie’s “diversion” of Loser LLC’s operating revenues into a secret account over which he exercised exclusive control, because the “secret” account was at all times maintained in the name of Loser LLC (and not Freddie or another unrelated entity), Loser LLC all times retained “dominion” over the funds at issue, and Loser LLC could not, under any circumstances, be considered the “initial transferee” of its own funds for the purposes of Section 550(b). This led the Court to the inevitable conclusion that Ms. Trueblood (and virtually all of the other100+ “checkbook” defendants), was therefore (i) ineligible to assert the Section 550(b) good faith defense, and (ii) was strictly liable to the Chapter 7 Trustee for the return of all the payments she received from the secret account because the services she provided did not benefit Loser LLC.
The bottom-line lesson from this case is that form over substance matters in the Ninth Circuit. Because Freddie diverted Loser LLC’s operating funds into a “secret account” that remained in the name of Loser LLC, everyone who received a check written on the secret account for Freddie’s personal expenses was strictly liable for, and had no defense to, an avoidable transfer claim by Loser LLC’s Chapter 7 Trustee. Had Ms. Trueblood (or any of the other recipients) insisted on having Freddie pay her with a personal check or in cash—even if the initial origins of the funds used to cover any such payment was the very same “secret” Loser LLC account–Ms. Trueblood and those in her position would then have been deemed a “subsequent transferee” of the diverted funds entitled to the good faith defense of Section 550(b).
After issuing its ruling, the Ninth Circuit remanded the Trueblood case back to the Bankruptcy Court after striking Ms. Trueblood’s Section 550(b) good faith defense. The Bankruptcy Court then applied the Ninth Circuit’s logic in each of the other 100(+) avoidable transfer actions filed against every recipient of a payment from the secret account. Recoveries on this theory included recovery of payments made out of the secret account to, among other things, Las Vegas Casinos for Freddie’s personal gambling debts, monthly mortgage payments made on Freddie’s home loan, monthly utility payments and homeowner association dues paid regarding Freddie’s residence, payments made to the seller of real property to Freddie through an escrow agent, and other similar payments made by Freddie directly from the “secret” Loser LLC account for personal expenses. In each instance, had the recipient of any such payment insisted that Freddie make the payment with a personal check or cash, they would have been entitled to assert the Section 550(b) good faith defense, resulting in a limitation on the Chapter 7 Trustee’s recourse on those transactions solely to Freddie or to those who were involved in (or at least aware of) his diversion of funds.
Practical Suggestions:
If a Borrower or customer is permitted to set up automatic monthly mortgage (or other) payments electronically, the Banker/Creditor should verify and make sure that the automatic payments are actually being made by the Borrower or Customer who owes the payment.
To the extent possible, particularly when working with a small business owner, real estate developer or other entrepreneur who regularly conducts business through the use multiple entities and/or multiple bank accounts, make an effort to “match” the source of payments received, or to be received, to bank accounts or other funding sources to a party obligated for the loan. It should particularly be viewed as a red flag if checks are received from an unknown or seemingly unrelated small business entity who is not an obligor or guarantor of the obligation being repaid.
Whenever a loan pay off, or property purchase resulting in a loan payoff, is taking place through a third-party escrow, endeavor to include instructions to escrow in the payoff demand that escrow is to determine, verify and advise you prior to closing as to the source of the funds being used to pay off the loan and/or purchase the property through said escrow. To the extent that the source of funding cannot be sufficiently tied to the beneficiary of the transaction, consult with legal counsel to determine whether there are unnecessary “form over substance” avoidable transfer risks in the transaction that can be minimized prior to escrow’s close.
[1] This article is drawn from the US Ninth Circuit Court of Appeals decision rendered on October 2, 2017 in: Henry v. Official Comm. Of Unsecured Creditors of Walldesign, Inc. (In re Walldesign, Inc.), 872 F.3d 954 (9th Cir. 2017). The names have been changed to protect the (not so) innocent.
The U.S. Court of Appeals for the Ninth Circuit sharply expanded the scope of liability for factors dealing with fresh produce distributors. In doing so, the Ninth Circuit distinguished its 17 year-old precedent, Boulder Fruit Express & Heger Organic Farm Sales vs. Transp. Factoring, Inc., 251 F.3d 1268 (9th Cir. 2001) (“Boulder Fruit“).
In Boulder Fruit, the Court held that “factoring agreements do not, per se, violate PACA [the Perishable Agricultural Commodities Act],” and that a “commercially reasonable sale of accounts for fair value is entirely consistent with the trustee’s primary duty under PACA . . . to maintain trust assets so that they are freely available to satisfy outstanding obligations to sellers of perishable commodities.” Id. at 1271. An en banc panel of the Circuit Court expressly overturned Boulder Fruit in S & H Packing & Sales Co., Inc. v. Tanimura Distrib., Inc. (“Tanimura“) to the extent it disagreed with its Tanimura decision.
Tanimura presents the typical story of a struggling produce distributor. Tanimura Distributing, Inc. (“Tanimura”) purchased perishable commodities from produce growers. As such, Tanimura became a trustee for the growers’ produce and any accounts receivable arising from the sale of the produce under PACA. Tanimura sold the produce on credit to third parties and sold the resulting accounts receivable to AgriCap Financial Corporation (“AgriCap”). When Tanimura could not repay its growers, they sued Tanimura.
Tanimura responded by filing for chapter 7 bankruptcy protection. The growers then added AgriCap to their action against Tanimura, contending it received trust property in breach of the PACA trust. Despite prevailing before the lower court and a prior panel of the Ninth Circuit, an en banc panel of the Ninth Circuit vacated its earlier ruling.
The Ninth Circuit concluded that in determining if a factor is liable for a breach of the PACA trust, courts must first conduct an inquiry as to whether the sale of the accounts receivable is a “true sale” and then determine if the sale was “commercially reasonable.” If the sale was not a “true sale,” then it is a lending transaction and the factor may be liable. The factor may nonetheless still be liable if the sale is not determined to be commercially reasonable, i.e., whether the sale was a fair deal.
To determine if there was a “true sale,” courts must now rely upon a transfer-of-risk test and not upon the labels contained in the factoring agreement. Under the transfer-of-risk test, courts will be focused on whether the factor actually purchased the accounts receivable and bears the risk of non-performance by the account debtors. In particular, courts will be looking at the following factors: (1) whether the factor may recover a deficiency against its assignor if the accounts sold are insufficient to repay the factor for its purchase; (2) the effect on the assigned accounts if the assignor were to repay the debt owed to its factor from its other assets; (3) whether the assignor has a right to recover on any of the accounts assigned; and (4) whether the assignment reduces the assignor’s obligation to the factor.
The transfer-of-risk test is a factual determination and will lead to further litigation for factors. No longer may factors as easily dispose of claims that they received PACA trust assets in breach of the trust because the PACA creditors may inquire into the nature of the factoring arrangement to challenge the sales of the accounts as being “true sales.”
Following the financial crisis of 2007 and 2008 significant reforms were called for in the London Interbank Offered Rate (ICE LIBOR or “LIBOR”). These reforms were spurred by three issues: regulator’s fears over having a single rate with no credible alternative or back-up rates; allegedly inaccurate or manipulated individual panel bank submissions scandals; and the implication that senior United Kingdom regulators asked banks to alter their reporting to project financial strength. These proved to be more than the United Kingdom could stand, and thus Libor was transferred from the control of the bank market association to a regulated independent operator. This change opened the door to two major challenges: other rates that are proposed to supplant traditional LIBOR and how to deal with those changes in LIBOR regulation, especially in the context of extant loans.
For United States lenders there are two main choices going forward. U.S. banks can either elect to stay with the reformed LIBOR rate operator, or switch to the U.S. organized Secured Overnight Funding Rate (“SOFR”). The SOFR is a rate that is a secured overnight Treasuries repo rate (i.e., the interest rate paid on overnight loans collateralized by US government debt; collateral that is high-quality, liquid, and accepted as collateral by the majority of intermediaries in the repo market). One of the most glaring omissions in the calculation of the SOFR is that, unlike LIBOR, it does not take into account bank credit risk, thus the resulting rate is frequently significantly lower than the corresponding LIBOR rate for the same period. The New York Fed anticipates publishing this rate beginning April 3, 2018.
The greatest complications of any of the new rate is in how it affects outstanding loans and obligation of lending institutions that are already pegged to the LIBOR rate.
If the LIBOR reforms prove adequate and are widely accepted by the market, then there are should be no necessary changes to existing contracts. The main issue for banks would be in ensuring that they insert some language into new credit agreements to adequately address specifically that they will be applying the LIBOR rate as its calculation methodology may change from time to time.
If the LIBOR reforms are deemed inadequate by the market and backup or replacement rates become relevant, then there are a number of issues that arise and must be addressed. The largest and most glaring issue is how to address contracts that do not adequately provide for a transition to a rate other than LIBOR. These can be addressed in four main ways:
Option 1: An overriding law is passed, which statutorily forces conversion. The main risk to this option is that not all jurisdictions possess the legislative power to implement this option.
Option 2: Parties agree to amend the existing contract to provide for transition to the new rates. The main risk with this option that the SOFR is new and will likely require fine-tuning to address any kinks in the calculation of a fair and representative rate, thus any amendment will likely need to involve flexibility for the change rate without the need for amendment every time.
Option 3: Just wait for maturity. Lenders could just wait until obligations mature and thus rely on the changes of the reformed LIBOR rate. This option will likely be adequate for short term contracts, but will become increasingly problematic and risky with contracts that extend beyond the transition date.
Option 4: Refinancing. The Lenders could always refinance debt instruments that are subject to LIBOR thus bringing them into immediate compliance. The risks associated with this method are in the fees and costs associated with such refinancing (i.e., for Borrowers, the refinanced debt may be more expensive than their existing debt, may give rise to prepayment penalties, or may trigger debt modification regulations)
Regardless of how the market addresses the changing interest rates the change itself can be detrimental to banks portfolios of existing credit obligations. To combat this, banks will need to be proactive in identifying outstanding credit instruments which will be affected by the changes in LIBOR and how they internally wish to address each outstanding credit individually.
On May 11, 2016, FinCen (the Financial Crimes Enforcement network of the U. S. Treasury Department) issued a final rule regarding enhanced customer due diligence (“CDD”) requirements that amends regulations under the Bank Secrecy Act. While the rule has been in effect for almost 2 years, compliance is mandatory by May 11, 2018. While Customer Identification Program (“CIP”) procedures have been around for quite some time, this new CDD rule requires additional layers of inquiry, diligence and collection of data with respect to “legal entity customers” who open new accounts or receive extensions of credit.
The CDD rule adds a “fifth pillar” to the “four pillars” of an effective anti-money laundering program. The first four pillars consist of the following, at a minimum, to be performed by a bank:
A system of internal controls to assure ongoing compliance;
Independent testing for compliance, to be performed by the bank or third parties;
Designation of individual(s) responsible for monitoring and coordinating day-to-day compliance; and
Training for appropriate personnel.
The fifth pillar adds a new layer of complexity, as follows:
Appropriate risk-based procedures for conducting ongoing customer due diligence, to include (but not be limited to):
Understanding the nature and purpose of customer relationships for the purposes of developing a customer risk profile, and
Ongoing monitoring to identify and report suspicious transactions and on a risk basis, and to maintain and update customer information, with customer information to include information about the “beneficial ownership” of “legal entity customers”.
What is a “legal entity customer“?
Legal entity customers include corporations, LLCs, partnerships, business trusts and any other entity created by a filing with a state office. This term does not include natural persons, sole proprietorships, unincorporated associations, trusts (other than those created by a state filing) and various regulated entities such as banks, insurance companies, registered investment adviser, etc.
Banks are now required to identify the “beneficial owners” of each legal entity customer and collect and collect the following information with respect to each beneficial owner: name, address, date of birth, Social Security number (or similar numbers for non US persons).
What is beneficial ownership?
Beneficial ownership for purposes of the CDD rule consists of 2 prongs:
Ownership Prong: Any individual who, directly or indirectly, owns 25% or more of the legal entity customer. Entities such as non-profit or public benefit corporations are not subject to the ownership prong.
Responsibility Prong: Any individual who has “significant responsibility to control, manage, or direct the entity”. The following are given as examples: CEO, CFO, COO, managing member, general partner, president, vice president, treasurer or any other person who regularly performs similar functions.
As an example, if the legal entity has 4 owners who each own 25%, there are 4 beneficial owners and the required information must be collected from each of the four. If no one person owns 25% or more, no information has to be collected from such owners but one person must always be identified under the responsibility prong.
Practical Notes:
Forms: The collection of the required information be done by following and filling out the form suggested by FinCen (found at 82 Federal Register 45184 (published 9-28-17) or obtaining the required information from the individual who will certify the accuracy of the information provided.
Originals v. copies. Since the beneficial owner(s) may not be in your office when the account is opened, a bank may use photocopies of identification.
Reliance on customer: You may rely on the certification of the information furnished by the customer, so long as the bank has “no knowledge of facts that would reasonably call into question the reliability of the information.”
Not retroactive: The CDD rule is not retroactive, but new accounts opened by existing customers after May 11, 2018 are subject to the new CDD rule and the obligation to update customer information is “event based”, which means that if the bank learns something about a customer that is relevant to reevaluating or reassessing the risk posed by that customer, then the beneficial ownership information should be updated.
Record Retention: As a general rule, the records must be kept for 5 years.
Rely on other banks? You may rely on information from other banks, but similar to the CIP, an bank may rely on such information if (i) the reliance is reasonable under the circumstances, (ii) the bank supplying the information must be subject to AML requirements and be regulated by federal functional regulator and (iii) must enter into a contract requiring it to annually certify that it has an AML program and that it will perform the specified beneficial ownership diligence.
Relief on the Horizon? Congress is considering a bill, the Counter Terrorism and Illicit Finance Act, which would, among other things, require legal entities to submit beneficial ownership information to FinCen to create a national directory of beneficial owners. Having such a directory would eliminate some of the back office detective work and potentially create a safe harbor for relying on the published information.
Assembly Bill 1088 (“AB 1088”), signed by Governor Jerry Brown on October 14, 2017, took effect on January 1, 2018, and added a section to California’s Fair Employment and Housing Act (“FEHA”) restricting an employer’s ability to make hiring and personnel decisions based on the applicants criminal history or conviction record.
AB 1088, applicable to government and private employers with five or more employees, makes it unlawful for employers to include any questions about an applicant’s conviction history before extending a conditional offer of employment (which includes oral questions during an interview)[1]. Employers are also prohibited from considering, distributing, or disseminating information about any of the following when conducting a criminal history background check in connection with any application for employments: (i) an arrest that did not result in a conviction, subject to the exceptions in Labor Code §§ 432.7(a)(1) and (f); (ii) referral to or participation in a pretrial or post trial diversion program; and (iii) convictions that have been dismissed, expunged, sealed, or otherwise vacated pursuant to law.
Pursuant to AB 1088, an employer can consider an applicant’s criminal history after the employer has made a conditional offer of employment, however, an employer cannot deny the applicant a position based on the applicant’s conviction history until the employer performs an in depth “individual assessment” considering all the specified circumstances and information. To that effect, AB 1088 set forth specific steps the employer must take in performing this individual assessment. Specifically, the employer must determine whether the conviction history has a “direct and adverse relationship” with the specific job duties and, in doing so, must consider (i) the nature and gravity of the offense, (ii) the time that has elapsed since the offense or the completion of the sentence, and (iii) the nature of the job sought.
Once this individualized assessment is completed, the employer must then notify the applicant, in writing, of the preliminary decision to disqualify the applicant for the position due to the applicant’s criminal history. AB 1088 mandates that this written notification (i) identify the disqualifying conviction(s) that is the bases for the preliminary decision to rescind the conditional employment offer, (ii) provide a copy of the conviction history report, if any, (iii) explain the applicants right to respond and challenge the accuracy of the conviction history and/or provide evidence of mitigating circumstances or rehabilitation, and (iv) provide a deadline of no less than five business days after providing the notice for the applicant to respond.
Once this notice is provided pursuant to AB 1088, the employer cannot make any final determinations until the expiration of the response window provided in the written notice (i.e., no less than five business days). If the applicant timely notifies the employer, in writing, that they would like to challenge the conviction history and is taking steps to gather all necessary evidence to support their challenge, the employer must provide the applicant with an additional five business days to respond to the notice. The employer must also consider any additional evidence or documents the applicant provides the employer in challenging the disqualification before making a final determination or decision.
If the employer ultimately decides to deny the applicant the position after reviewing any mitigating or other evidence submitted by the applicant in challenging the disqualification, the employer must again notify the applicant in writing of their final decision. Pursuant to AB 1088, this notice must notify the applicant of (i) the final decision or determination, (ii) the employers procedure for challenging the decision or to request a reconsideration (if any), and (iii) the right to file a complaint with the Department of Fair Employment and Housing. This notice may again provide the applicant with an explanation or justification for making the final decision, however, this is not a requirement under AB 1088. If the applicant files a lawsuit or civil action against a potential employer for a violation of AB 1088, the applicant may sue for the full range of damages available under FEHA, including compensatory damages and attorney’s fees and costs.
In order to comply with the new restrictions set forth in AB 1088, California employers (with five or more employees) should review their written employment applications and their oral interview questions to determine whether or not they seek an applicant’s criminal history, and if they do, revise to remove all such questions. Employers who intend to use criminal background checks or conviction reports after a conditional offer of employment should also revise or create written preliminary decision and final decision notices that are in compliance with the requirements of AB 1088. Finally, those employees utilizing the service of recruiters or “head-hunters” should ensure that they are also readily familiar with the provisions and restrictions of AB 1088 to confirm that they are also in compliance with those requirements.
[1] AB 1088 does not apply to (i) a position for which a state or local agency is otherwise required by law to conduct a criminal background check; (ii) a position within a criminal justice agency, as defined in section 13101 of the Penal Code; (iii) a position as a Farm Labor Contractor, as defined in section 1685 of the Labor Code; and (iv) a position where an employer or agent thereof is required by any state, federal, or local law to conduct criminal background checks for employment purposes.
As we launch our new website we have reflected on the fact that for more than three decades Frandzel has been a recognized leader, providing legal counsel and litigation services to financial institutions and businesses. Our firm is built on highly responsive service incorporating trusted knowledge cultivated over the years. We are about helping our clients achieve their business objectives always striving for creative solutions to the toughest challenges.
We have great pride in our warm culture and mentoring environment. It has, in fact fostered many careers with longevity for our attorneys and staff. Our client relationships have stood the test of time and work with us as a valued business resource.
We look forward to continuing to serve the banking and finance communities incorporating with our time-tested culture and accumulated wisdom.
In 1979, Bob Frandzel founded what is today known as Frandzel Robins Bloom & Csato, L.C. Bob, with his unbound energy and enthusiasm, envisioned a state of the art go-to creditors’ rights and commercial law firm, and set out to create it with lawyers that shared his vision – but didn’t take themselves too seriously (as exemplified by the games, such as “Creditors’ Pursuit”, “Daze of our Loans” and “The Creditors’ Deal” that we created for our clients and friends over the years).
The games we created some years ago are a wonderful reminder of our caring culture and ability to laugh and have fun. But our philosophy was and is simple: every client is important, and we will do what it takes to get the job done. Whether closing a deal, litigating a dispute, or providing counsel, the success of our clients is our measuring stick.
The Commercial Real Estate Finance Council (“CREFC”), the trade association for the $3.9 trillion commercial real estate finance industry, started 2018 off with a bang in setting an attendance record of over 1,800 people at its annual conference on January 8-10 in Miami.
Optimism among the attendees was extremely high, as demonstrated by many of the comments made during the various panel presentations. One panel that caught my attention was a discussion concerning where we are in the real estate cycle. While many acknowledge that we “should be” approaching what would generally be the end of a ten-year real estate cycle, there is a lot of support for the view that there is no end in sight for the current cycle, and that it might actually go on for another five-plus years, unless some extracurricular event takes place that could throw the cycle out of whack. Most people base their view of an extended cycle on the fact that interest rates remain at historically low rates and that there is incredible liquidity in the marketplace. From an intrinsic standpoint, two factors which could prevent the “extension” of the cycle are interest rates rising faster than expected and regulatory volatility.
There were two other issues that were discussed that I thought were of particular interest. First, there was general consensus that borrowers are putting much more equity into deals than they did in prior cycles, with many deals having at least 40% equity in them at the outset, as borrowers/investors have learned that the higher leveraged deals were much more difficult to save in the last downturn. Additionally, alternative lenders are putting substantial pressure on traditional lenders due to the lack of regulatory constraints, while community banks are once again becoming a real force in what appears to be a very aggressive, competitive financing marketplace.
All in all, the mood at the first major real estate conference of the year was of high energy, enthusiasm and optimism – I guess we shall see how this all turns out!
CRE Finance Council (“CREFC”) started 2018 off with a bang in setting an attendance record of over 1,800 people at its annual conference on January 8-10 in Miami.
Optimism among the attendees was extremely high, as demonstrated by many of the comments made during the various panel presentations. One panel that caught my attention was a discussion concerning where we are in the real estate cycle. While many acknowledge that we “should be” approaching what would generally be the end of a ten-year real estate cycle, there is a lot of support for the view that there is no end in sight for the current cycle, and that it might actually go on for another five-plus years, unless some extracurricular event takes place that could throw the cycle out of whack. Most people base their view of an extended cycle on the fact that interest rates remain at historically low rates and that there is incredible liquidity in the marketplace. From an intrinsic standpoint, two factors which could prevent the “extension” of the cycle are interest rates rising faster than expected and regulatory volatility.
There were two other issues that were discussed that I thought were of particular interest. First, there was general consensus that borrowers are putting much more equity into deals than they did in prior cycles, with many deals having at least 40% equity in them at the outset, as borrowers/investors have learned that the higher leveraged deals were much more difficult to save in the last downturn. Additionally, alternative lenders are putting substantial pressure on traditional lenders due to the lack of regulatory constraints, while community banks are once again becoming a real force in what appears to be a very aggressive, competitive financing marketplace.
All in all, the mood at the first major real estate conference of the year was of high energy, enthusiasm and optimism – I guess we shall see how this all turns out!
There is a big ticket item for asset-based lenders in California, and particularly for lenders holding more than one deed of trust on the same property. On September 27, 2017, the California Supreme Court granted review of Black Sky Capital, LLC v. Cobb (2017) 12 Cal.App.5th 887 (“Black Sky“) and is now poised to answer the following question:
Does Code of Civil Procedure section 580d permit a creditor that holds both a senior lien and a junior lien on the same parcel of real property arising from separate loans to seek a money judgment on the junior lien after the creditor foreclosed on the senior lien and purchased the property at a nonjudicial foreclosure sale?
For decades now, California courts have answered this question in the negative, citing the equitable rule created in the case of Simon v. Superior Court (1992) 4 Cal.App.4th 63 (“Simon“). The Simon rule provided creditors with a bright-line prohibition: if the lender holds separate notes secured by senior and junior deeds of trust, then the lender is barred from collecting anything on the “sold-out” junior debt after it nonjudicially forecloses on its senior deed of trust. By contrast, where the senior and junior lenders are different entities, the “sold-out junior” whose lien is extinguished by the unrelated senior’s foreclosure may freely sue the borrower on its (now unsecured) loan, obtain a money judgment, and collect its debt by execution on the borrower’s other assets.
The Simon rule is based upon a perceived need to prevent lenders from opting-out of California’s antideficiency scheme, and in particular Code of Civil Procedure section 580d, which prevents a lender from collecting a deficiency after nonjudicial foreclosure of the deed of trust securing the debt. The Simon court reasoned that the purpose (if not the text) of section 580d would be subverted if a lender could simply structure one loan into two loans secured by separate trust deeds. Notably, the Simon rule is quite broad, applying to situations regardless of the lender’s actual motives in structuring the original loan. In other words, under Simon‘s rule, the lender’s intent (to evade antideficiency legislation or not) is simply not relevant and, under Simon, even a lender with demonstrably legitimate reasons for structuring a loan with two separate notes and two trust deeds would be barred from collecting its sold-out junior debt. This is concerning, since so-called “piggyback” refinancing transactions, where junior and senior liens are created at the same time, are rather common.
In June of 2017, the California Court of Appeal published Black Sky, a case which rejected Simon‘s holding and found that nothing in section 580d prevents any sold-out junior from collecting its debt. In Black Sky, a bank loaned about $10 million to two individual borrowers secured by a deed of trust on a parcel of commercial real property. Two years later, the same bank loaned another $1.5 million to the same borrower, secured by a second deed of trust on the same property. The bank later assigned both the notes and deeds of trust to Black Sky. The borrowers defaulted, and Black Sky nonjudicially foreclosed on the senior lien and acquired the property for a $7.5 million credit bid. Black Sky then sued the borrowers for on the sold-out junior debt. The trial court granted summary judgment in favor of the borrowers—citing Simon‘s rule: that section 580d prevents a lender from collecting its sold-out junior debt after the same lender forecloses on its senior deed of trust. Black Sky appealed.
On appeal, the Court of Appeal reversed the trial court, finding that section 580d did not apply. (Black Sky Capital, LLC v. Cobb (2017) 12 Cal.App.5th 887, 897 [“By using the singular throughout the statute, the Legislature unambiguously indicated that section 580d applies to a single deed of trust; it does not apply to multiple deeds of trust, even if they are secured by the same property… It makes no difference whether the junior lienholder is the same entity or a different entity as the senior lienholder.”].)
Assuming the California Supreme Court addresses the Simon vs. Black Sky interpretations of section 580d head-on, lenders will finally be provided with certainty on what has, to date, been a murky landscape for lenders trying to protect themselves in strategically structuring financing transactions. We will be monitoring the progress of the Black Sky appeal as it progresses in the California Supreme Court, and will provide an immediate update once a substantive decision is rendered.
While Bitcoin may be a bubble or passing fad, the technology behind it will revolutionize the way we do business in the near future
Part I: What is Blockchain?
While Bitcoin became a household name in 2017, most people know little of the technology underpinning the digital currency. This technology, known as “blockchain,” has far reaching implications beyond digital currency, and will likely revolutionize the way we do business in the near future. In a 2017 study conducted by Gartner, Inc., it estimates that the business value-add of blockchain will grow to slightly more than $176 billion by 2025, and will likely exceed $3.1 trillion by 2030. In fact, a World Economic Forum report from September 2015 predicts that by 2025, ten percent of global GDP will be stored on blockchain technology.
In a January, 2017 Harvard Business Review Article titled “The Truth About Blockchain,” professors Marco Iansiti and Karim R. Lakhani describe blockchain as a foundational technology that may not immediately overtake our traditional business models, but has the potential to create new economic and social systems and enormously change the way we transact over the coming decades. Moreover, companies already see the writing on the wall – IBM, Microsoft and Intel are offering blockchain software tools to their business customers, Goldman Sachs, Nasdaq, Walmart, Visa and the State of Delaware all have started blockchain initiatives.
How could such a new and little known technology have such massive business implications? In this series of articles, we will first provide a general overview of what blockchain technology is and how it works. In our second piece, we will provide an overview of how blockchain will change a variety of industries. Finally, in our third piece, we will provide a more in-depth look at how blockchain will impact the legal industry, contracts and financial institutions.
While Bitcoin uses a specific implementation of the blockchain, blockchain in general can be described as a decentralized, shared, public ledger that is maintained by a network of computers that verify and record transactions into the same decentralized, shared, and public ledger. No single user controls the ledger – it is maintained by all of its participates, in the cloud, or by a network of designated computers that collectively keep the ledger up to date and verify its transactions. Bitcoin, as the largest implementation of blockchain technology today, uses competitive “miners,” or individual users that solve ever more difficult math equations with monetary rewards if they are successful, to verify and record transactions.
When a transaction is verified and recorded, the blockchain system sends transaction data to all of the users of the blockchain ledger, thereby ensuring the validity and accuracy of the transaction and prevents one party to the transaction from lying about the details or failing to perform. Each transaction, or “block,” is encrypted into its own original piece of information, which is called a “hash.” Even the slightest modification of data will result in an entirely different hash. For example, in applying SHA256, the encryption algorithm used by Bitcoin, to the number 1000 generates the following hash, “40510175845988F13F6162ED8526F0B09F73384467FA855E1E79B44A56562A58” while the hash for the number “1000.01” generates a wildly different result in “6B481FC35196FA215BB30D39ECB919CE7DE410488EC08D692356E22E5A67B2B9.” Because each hash is unique, it becomes exceptionally difficult to tamper with the system as it is nearly impossible to generate an identical hash to fool the system.
Essentially, blockchain is a tool where trustworthy records of transactions can be kept, verified, and made publicly available. Blockchain is revolutionary because it creates confidence between counterparties and negates the need for neutral third-parties or transactional facilitators, such as escrow companies, government authorities or clearing houses. Transactions are “peer-to-peer,” or directly contracting party to contracting party. If there’s a disagreement, there’s no need to call a lawyer because there is only one database.
The implications of blockchain will be enormous and will impact almost every industry. 2018 is likely to be a huge turning point for blockchain technology and the year we see the technology significantly implemented beyond Bitcoin. As we will discuss in Part II of this article, there are a wide variety of businesses and industries that are currently experimenting with blockchain technology.
