Financial Services - SmithAmundsen LLC

M A R C H 2 0 0 8
l a w f r o m a b a n k e r ’ s p e r s p e c t i v e
Inside this issue
CONTENTS:
• Defending Against Claims of Loan
Re-Characterization and Equitable
Subordination......................................................................................1
• The ECOA and Obtaining Spouse’s Signature on
Personal Guaranties.........................................................................2
• Conventional Subrogation: Released Mortgages
Breathe New Life..............................................................................2
QUARTERLY CONTRIBUTORS:
• Michael G. Cortina, Editor
• Thomas P. Scherschel
• Bradley G. Rausa
FINANCIAL SERVICES ATTORNEYS:
• Michael G. Cortina
• Brian M. Graham
• Ean L. Kryska
• Linda M. Kujaca
• Bradley G. Rausa
• Thomas P. Scherschel
• Heather E. Shea
• Kelly N. Stulginskas
to SmithAmundsen clients.
Financial Services
q u a r t e r l y
Defending Against Claims of Loan
Re-Characterization and Equitable
Subordination
By Bradley G. Rausa
In American National Bank & Trust Co. v. Matrix IV, Inc., 332 B.R. 346 (Bankr.
N.D. Ill. 2005), the debtor filed Chapter 11 bankruptcy, and a lien priority
dispute arose between two creditors, American National Bank & Trust Co.
(“Bank”) and Matrix IV, Inc. (“Matrix”), stemming from lines of credit each
had extended to the debtor. The Bank had recorded its lien and Matrix had not,
so the Bank’s lien primed any lien owned by Matrix.
Matrix sought nonetheless to subordinate the Bank’s lien under theories of
re-characterization and equitable subordination. Re-characterizing a debt as
equity automatically subordinates the debt to those owed to other creditors.
The Bank’s loan was structured as a revolving credit line to debtor based upon
a percentage value of debtor’s receivables and inventory. Among other things,
Matrix alleged that the Bank’s loan was an equity infusion because (1) two of
the Bank’s customers bought a 49% interest in debtor (for $200,000 of stock
and a $500,000 loan); (2) the debtor had an agreement with those same two
customers whereby she could repurchase the stock sold to them if they failed
to secure working capital for debtor; (3) after the loan was secured, debtor
agreed to waive this right to repurchase stock; (4) debtor and the two customers
personally guaranteed the Bank’s loan; (5) the two customers pledged all of their
common stock in the debtor to the Bank.
In adjudicating the Bank’s motion to dismiss, all of the above facts were
assumed to be true, and the U.S. Bankruptcy Court held that Matrix had failed
to assert facts that would support re-characterization of the loan. There was
no indication that the Bank had become a joint venturer or equity participant;
although the Bank received a pledge of stock as collateral, the Bank did not
execute on that pledge; and no facts were asserted showing that the two
customers were instrumentalities of the Bank or vice versa. In summary, Matrix
had failed to show that the Bank did anything more than make and protect a
commercial loan.
Equitable subordination allows a bankruptcy judge to subordinate all or a part
of a creditor’s claim if that creditor has engaged in misconduct. Where the
creditor is an insider or fiduciary, some material evidence of unfair conduct
must be presented. Among other things, Matrix argued that the Bank was
an insider of the debtor because (1) the debtor consulted the bank on major
business decisions; (2) the Bank required debtor to hire a business consultant
that only the Bank could approve of; (3) under a stock pledge agreement the
Bank could have acquired the right to sell all of debtor’s stock for simply not
informing the Bank of Matrix’s lien; and (4) the Bank had control over which
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A d e f e n d i n g a g a i n s t c l a i m s o f l o a n r e - c h a r a c t e r i z a t i o n
a n d e q u i t a b l e s u b o r d i n a t i o n
creditors were paid after debtor defaulted on the loan and the
Bank used that control to pay itself and the two customers who
held a proprietary interest in the debtor company.
Once again, these facts were assumed to be true, and the
bankruptcy court held that they did not support a finding that
the Bank was an insider. The facts did not show that the Bank
had de facto or legal control of debtor, nor that the debtor was
a subsidiary of the bank. There was no indication that the
Bank managed, to any degree, the day-to-day operations of the
debtor, and the Bank exercised no option to sell debtor’s stock.
The actions taken by the Bank were designed to manage the
risks to its collateral, not to manage the debtor.
The ECOA and Obtaining
Spouse’s Signature on Personal
Guaranties
By Thomas P. Scherschel
The Equal Credit Opportunity Act (“ECOA”), 15 U.S.C. § 1691
et seq. and its implementing regulations, Regulation B, 12 C.F.R.
§ 202.1 et seq. ordinarily prohibit a creditor from requiring a
spouse’s signature on a note when the applicant qualifies for
credit, individually. Violation of these terms can invalidate
personal guaranties, altogether. The regulations provide
that a lender may not require the signature of an applicant’s
spouse or any other person, such as a parent or any other cosignor,
other than a joint applicant on any credit instrument,
if the applicant himself or herself qualifies under the creditor’s
standards of creditworthiness for the amount and the terms of
credit requested. County Banking and Trust Company v. Lacey,
C.A. No. 146-MRT-90.
In County Banking v. Lacey, after debtors defaulted on a
commercial loan, debtors claimed the lender violated the ECOA,
15 U.S.C. § 1691 et seq. and its implementing regulations 12
C.F.R. § 202.1 et seq., when the lender originally required the
signature of debtor’s spouse on a personal guaranty, thereby
barring the lender from recovering any monies pursuant to
the personal guaranties signed by debtor and his spouse. The
lender had indeed required the signature of the debtor’s spouse
on a personal guaranty, collateralized by property which was
jointly owned by both the debtor and his spouse.
The County Banking Court found that the lender’s policy
of requiring the co-owners of jointly held assets to co-sign a
guaranty was not the equivalent of a requirement that the
borrower’s spouse co-sign a guaranty. The court also found
the lender’s policy was consistent with Regulation B in that §
202.7(d)(2) permits a creditor to require the co-owner to sign
an instrument the creditor believes necessary to enable the
lender to reach the property being offered as collateral in the
event of the default of the primary applicant.
As a footnote to the above, after failing to collect the
entire indebtedness from other debtors on the same note, the
bank attempted to foreclose on the subject jointly owned
collateral. However, the bank failed to collect on the collateral
as there was evidence the bank, during the foreclosure process,
accepted a mortgage on other property from the same debtors,
who successfully claimed that act constituted accord and
satisfaction.
Conventional Subrogation:
Released Mortgages Breathe New
Life
By Michael G. Cortina
In 2007, the Appellate Court of Illinois, Second District, decided
the case of Unionbank v. Thrall, 374 Ill. App. 3d 785 (2d Dist.
2007). The Thrall case began in 1996, when Eureka Savings
Bank (“Eureka”) recorded mortgages on properties in Sandwich
and Somonauk, Illinois. In 1999, Union Bank (“Union”)
recorded mortgages on the same properties. In 2001, Eureka
recorded mortgages on the two properties and released its 1996,
mortgages. The trial court found Union’s liens to be prior
based on the first in time, first in right principle (i.e. whoever
records their liens first has priority). Eureka contended that
its 2001, liens were prior in time based on the legal theory of
conventional subrogation. It argued that its 2001, mortgages
were merely replacements of the 1996, mortgages, and were
therefore entitled to retain the priority of the 1996, mortgages.
The term “conventional subrogation” was first used by the
Illinois Supreme Court in the 1800’s. When first used, the
court defined the term as an “equitable right springing from
an express agreement with the debtor, by which one advances
money to pay a claim for the security of which there exists a
lien, by which agreement he is to have an equal lien to be paid
off.” The problem to be determined by the appellate court was
the fact that the Supreme Court has never used the phrase in the
situation in which the original lienor refinances the initial loan
and takes a new mortgage in return, but does so intending to
maintain its own priority.
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c o n v e n t i o n a l s u b r o g r a t i o N : r e l e a s e d m o r t g a g e s b r e a t h e
n e w l i f e
The appellate court looked at four elements to determine if
Eureka’s 2001, mortgages fit within the confines of conventional
subrogation. The elements were: 1. the refinancing lienor must
have intended to retain the priority of his original mortgage;
2. the new mortgage must have been used to pay off the first
mortgage; 3. the intervening lienor must have been on notice
of the original mortgagee’s priority at the time he issued the
indebtedness secured by the mortgage; and 4. the first mortgage
must not have been released prior to the intervening lien.
The court determined that if a bank meets all four criteria, then
the doctrine of conventional subrogation would apply. In this
particular case, the court remanded the case to the trial court to
determine whether Eureka intended to retain its priority when it
refinanced and released the 1996, mortgages.
While conventional subrogation may have saved Eureka Savings
Bank from being relegated to a second mortgage position, the
better practice is simply to avoid the situation in the first place.
The better practice is to run a title search on the property
prior to the refinance. If an intervening lien appears, obtain a
subordination agreement with the intervening lienholder prior
to the refinance. This will avoid the need to litigate the lien
priority in the trial and appellate courts and rule-out a priority
challenge from the junior lienholder.
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