The B-B-Billion Dollar Mistake: Remember to Take a Deep B-B-Breath Before Touching Financing Statements
by Ken Weinberg July/August 2017
Gather around the campfire as Ken Weinberg tells the tale of the billion dollar mistake, a cautionary truelife horror story that reinforces the importance of financing statements. These documents often do not receive the attention they deserve, which can lead to disastrous consequences.
Our industry is known for creative and complex structures. Leasing products, designed in part to more effectively monetize tax benefits, include a plethora of options such as early buyout, early termination, fixed price, fair market value, TRAC, Split-TRAC, renewal and other options. Some structures thread the needle between accounting and tax treatment, such as synthetic leases treated as loans for tax purposes and off-balance sheet operating leases for accounting purposes. Transactions involving progress payments to fund goods under construction or to allow interim fundings to acquire multiple tranches of discrete items of equipment under the same document set are common.
Unlike traditional bank lending, our loan products generally result in loans of 100% of the cost of equipment or other goods acquired by the borrower, often without financial covenants. We commonly accept only the financed goods and related proceeds as the collateral, and sometimes rely on purchase money priority for faster transactions and decreased closing costs. Equipment leasing and finance companies also have historically used a variety of intricate ways to work together, including leveraged leases, securitizations, outright assignments, discounting of rent streams only and back-leveraging the residual. Thinking about the multi-faceted equipment leasing and finance industry is both exciting and dizzying.
With all of the work that goes into structuring, documenting, negotiating, closing and syndicating transactions, we must remember the key role that financing statements often play. Responsibility for completion, filing and maintenance of these documents is often passed from person to person without the attention these documents deserve — an approach that can have disastrous consequences.
These little financing statements are the most common items causing some prudent lawyers and operation managers to wake up in a cold sweat in the middle of the night. Unfortunately, for those good and conscientious people, the rest of this edition of Dispatches from the Trenches is going to feel like watching The Exorcist, The Shining, Psycho or any other scary movie that really did a number on you.
The Billion Dollar Mistake Horror Story
On June 28, 2017, the 7th Circuit of the U.S. Court of Appeals held that law firm Mayer Brown was not liable to a group of lenders for inadvertently terminating a financing statement that resulted in the loss of a first priority, perfected security interest in collateral securing a $1.5 billion (with a “b”) transaction. The key substantive ruling in this case was that Mayer Brown represented the borrower, General Motors, and therefore did not owe a fiduciary duty to the lenders. In other words, the lenders sued the wrong party. However, when rendering its decision, the court provided a nice summary of the error giving rise to the lenders’ grievance.
The court explained:
General Motors, represented by the Mayer Brown law firm, entered into two separate secured transactions in which JP Morgan acted as agent for two different groups of lenders. The first loan (structured as a [$300 million synthetic] lease) was made in 2001 and the second [$1.5 billion loan] in 2006. In 2008, the 2001 [synthetic] lease was maturing and needed to be paid off. The closing for the 2001 payoff required the lenders to release their security interests in the collateral securing the transaction. The big mistake was that the closing papers for the 2001 deal accidentally also terminated the lenders’ security interests in the collateral securing the 2006 loan. No one noticed — not Mayer Brown and not JP Morgan’s counsel [until] General Motors filed for bankruptcy protection several months later in 2009.
Unfortunately, the chain of responsibility for the financing statements in this case is all too familiar. Either the lender or its counsel apparently delegated the responsibility for preparing the UCC filings to General Motors and its counsel, Mayer Brown. The senior partner at Mayer Brown that was responsible for the transaction delegated the responsibility to prepare the closing checklist to an associate. In turn, the associate delegated to a paralegal the responsibility of identifying the relevant UCC financing statements to be terminated. That paralegal inadvertently included the 2006 filing. Another paralegal, who was somehow in the loop, noticed the error and reported it. However in the flurry of closing the transaction (and given the number of people handling the file), the error was not corrected.
Once prepared by Mayer Brown, the filings went back to JP Morgan and its counsel Simpson Thatcher & Bartlett, neither of which caught the error before the termination statement was filed. In a separate line of cases, the lenders argued that the termination was ineffective.1 The lenders argued that, under UCC §9-509(d)(1), a termination statement is effective only if “the secured party authorizes the filing,” and that the lenders could not have authorized the filing because they did not intend to terminate the security interest and did not instruct anyone else to do so on their behalf. However, the court held that UCC §9-509(d)(1) only requires the secured party of record to authorize the act of filing a particular UCC-3 termination, not that the secured party intended to terminate the specific security interest. The court also analyzed the definitive lease/loan documents, including an escrow agreement that was part of the closing, and found that the documents sufficiently included a grant of authority to file the actual UCC-3 termination statements.
Creative lawyers familiar with the case are undoubtedly exploring what legal protections could be implemented to mitigate the risks of inadvertent terminations. For example, what if the loan documents specifically authorized the borrower or its counsel or other agents only to file such termination statements as are necessary to terminate the specific security interest securing the transaction being terminated? Such language would provide the lenders with a stronger argument that any other terminations inadvertently filed were unauthorized. It should also put increased pressure on borrower’s counsel to make sure the correct financing statements were being terminated.
It may also be worth exploring limitations on the internal authority within a company to terminate its own filings. Some readers may have heard (or worse, experienced), situations where the “bank side of the house” has inadvertently terminated financing statements made by an equipment leasing/finance division or subsidiary of the bank. Having a formal internal policy allowing (or, even better, corporate documents that grant limited corporate/company approval to) only certain persons or departments to file termination statements may provide another line of defense. After all, if an individual does not have the corporate authority to file a termination statement, how can it have been authorized under UCC §9-509(d)(1)? Then again, it is hard to say how courts would react to such limitations on authority. Could the concepts of apparent authority or an implied grant of authority be introduced into the mix?
The only certain solution is to take a deep breath before filing termination statements (or dealing with financing statements generally for that matter) and to remember how direct and devastating mistakes can be in this area. Of course, everybody already knows this solution, but there is nothing like a billion dollar reminder to keep it front and center in your mind…or to wake you up in the middle of the night. Good night, sleep tight and don’t let the…er…termination statement bite.
See In re Motors Liquidation Company, 777 F.3d 100 (2nd. Cir. 2014).
Business leaders have largely embraced the rapid introduction of home working and digital processes as an inevitable necessity. Though the global lockdown has rapidly accelerated trends in digitalisation, seeing many asset finance businesses moving their operations entirely online in a contracted timescale, the direction of these developments is not a new concept for the industry.