Tipping the Scales: The Great Escape

by Steve Whelan March/April 2019
Almost everyone procrastinates a little, but it’s the last thing you want to do when filing a continuation of a UCC financing statement. Steve Whelan examines how a failure to file came back to haunt the LNV Corporation when one of its borrowers declared bankruptcy.

If you are a secured lender, then you know to file a UCC financing statement to perfect your security interest in the collateral, whether or not it is tangible (such as equipment) or intangible (such as accounts or leases). You also know enough to maintain an internal reminder file to let you know when the original filing has been on record for four years and six months, so that you can file a continuation statement before five years have elapsed and the original statement is no longer valid.

You know that filing a continuation statement is crucial, because if the statement lapses on the fifth anniversary of its filing, then you no longer have a perfected security interest in the collateral. Absent particular circumstances, any secured creditor who filed its UCC later than yours will have priority over your lien on the collateral. Plus, any new creditor who timely files its financing statement will have priority over your lien on the same collateral. This typically is what happens if you let a filing lapse.

A Bankrupt Borrower = Problems

Worse yet, if the borrower goes bankrupt, then its trustee in bankruptcy (or the borrower itself as a debtor in possession) will be deemed a “hypothetical lien creditor” which has perfected its lien on the date of the bankruptcy filing. That lien will attach to your collateral and all other assets of the borrower which do not have perfected security interests.

That lien will secure all claims against the debtor in its bankruptcy proceedings. Unless there are so many assets of the bankrupt company that all unsecured creditor and employee claims can be paid in full — very unlikely or else the company would not have gone bankrupt — your unperfected collateral will not provide enough proceeds to repay your loan.

This was the situation faced by LNV Corporation when its borrower, La Paloma Generating Company (LPG), filed a voluntary petition for relief under the U.S. Bankruptcy Code on December 16, 2016. LNV was the sole lender under two working capital and term loan credit agreements, covering substantially all of the assets of LPG, but it had allowed its financing statement (filed earlier) to lapse prior to the filing of the bankruptcy petition. Additionally, back in 2014, LPG had entered into a second lien term loan agreement with various lenders covering the same collateral as the LNV loans.

The Intercreditor Agreement

Initially, LPG and the collateral agents and administrative agents under both the LNV and second lien facilities had entered into an intercreditor agreement (the ICA), which is customary when different sets of creditors claim an interest in the same collateral. The ICA was reaffirmed when LPG and the two lender groups entered into their 2014 agreements.

After LPG filed its plan of reorganization in September 2017, the second lien lenders filed their proof of claim, challenged payment under the plan of the LNV claim, and asserted that “because the first-liens lapsed prior to the petition date, that all money [under the plan] should be distributed… to the second lien lenders”.

LNV countered that the ICA expressly provided that “whether or not any bankruptcy has been commenced by or against La Paloma… any collateral or proceeds thereof… received by [the second lien lenders] in connection with the exercise of any right or remedy (including setoff) by the collateral agent or any such person relating to the collateral in contravention of this agreement shall be segregated and held in trust and forthwith paid over to [LNV]”.

The United States Bankruptcy Court for the District of Delaware addressed all four elements of the ICA and observed that the ICA also stated that LNV’s priority over the second lien lenders “is not affected by any issue concerning ‘the perfection of or avoidability of… or failure to perfect the liens securing the [LNV] obligations. Thus, the prepetition lapse of the [LNV] claims does not give rise to issues between” LNV and the second lien lenders (emphasis added).

The court further elaborated that “[e]ven if the [LNV] UCC filings lapsed prior to the petition date, they are valid as to the second lien lenders who entered into [the ICA] acknowledging the first liens and who are not ‘surprised’ by the existence of the first liens.”

The Great Escape

But this is where the Great Escape arose. In an early page of the opinion, the court recounts that the plan of reorganization incorporated “a settlement reached with LNV following extensive settlement negotiations. The settlement resolves a number of disputes [such as] the lapsed UCC financing statement filed in favor of [LNV]”, including “that LNV will credit bid for the debtors’ power facility and related assets, LNV will receive certain cash indisputably pledged to it, the liens of the collateral agent are left intact, and [LNV] has agreed to forego the benefit of its liens on certain assets for the benefit of unsecured creditors (emphasis added).”

In a later footnote, the court revealed the extent of the settlement. The plan allowed for the LNV claim in the amount of $333,085,207 and allowed for LNV to credit bid $150 million (of its first-lien claims) for substantially all of LPG’s assets. Finally, the court revealed that “the first lien obligations will not be paid in full under the plan.”

So, although the decision does not disclose the extent of LNV’s financial concessions, it is clear that LNV paid a price for the plan’s reinstatement of the LNV claims as first lien claims. We can infer that counsel for LPG motivated LNV to bid as high as possible and to release its claim on a sufficient amount of other assets, so that unsecured creditors would receive more than if LPG had pursued the consequences of the lapsed LNV financing statement.

Another element of the Great Escape appeared towards the end of the court’s opinion: “throughout the pendency of the bankruptcy cases, no party-in-interest sought to avoid, or avoided, the first lien claims.” We can infer that the Great Escape might never have occurred if other creditors had sought to invalidate LNV’s claim or its right to the LNV collateral.

Lessons Learned

Several lessons can be pulled from this particular bankruptcy case:

Be sure that your computer system alerts several people in your organization when a filed financing statement has entered the zone of continuation: four years and six months after filing.

Do not be intimidated by junior creditors or borrowers who complain that your intercreditor agreement is “too wordy” or “unnecessarily repetitive.” The provisions of the LNV ICA quoted by the court at the time may have caused some readers to muse that “the lawyers are being paid by the word,” but they are a road map for a successful relationship between a senior creditor and other claimants.

Play “let’s make a deal” if your filing lapses prior to a bankruptcy filing. LNV escaped by providing more value to the overall plan than any competing holder would have.

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