Bankruptcy Remote? Maybe Not

You may have encountered the term “bankruptcy remote”. It was coined to refer to a method of endowing a company with certain characteristics which are designed and intended to make it impossible for the company to file a case in bankruptcy. The purpose is to facilitate financings by assuring the lenders through use of “bankruptcy remoteness” that their obligor would not seek to use bankruptcy proceedings to restructure the loans. As our readers may know, a debtor in bankruptcy may be able to reduce the interest rate, extend the maturity, change the amortization of debt and even split off some the debt into unsecured status in a bankruptcy proceeding. Lenders aren’t keen on any of those.

Here’s an example: Suppose Corporation A desires to purchase Blackacre, but needs to borrow most of the funds to pay for the purchase and the lenders are concerned that Corporation A may run into financial difficulties. So the lenders insist that a bankruptcy remote entity be created for the acquisition (which we’ll call the special purpose entity or “SPE”). The SPE’s organizational documents are prepared to specifically include provisions that make it virtually impossible for SPE to ever file bankruptcy, because they include provisions that expressly state that the SPE cannot file a bankruptcy without the consent of all of its members, and there is a special class of membership which is 100% held by someone friendly to the lenders and can be relied upon to never vote for filing bankruptcy.

In addition, the SPE will not have any other operations or business. It will just hold Blackacre and lease it to Corporation A (which will use Blackacre in its business). So the SPE won’t have any creditors other than the lenders and therefore will not be at risk of being forced into an involuntary bankruptcy. Corporation A contributes capital to SPE and the lenders lend the balance of the funds needed to buy Blackacre and take a mortgage on Blackacre.

There are variations on this structure, but we don’t need to go into them. You get the idea—SPE’s governing documents give the lenders comfort that SPE is never going to be in bankruptcy court.

That was essentially the arrangement in In Re Bay Club Partners-472, LLC, a bankruptcy case filed in Oregon early this year. The borrower, Bay Club Partners-472, LLC (“Bay Club”), was a manager-managed limited liability company created and governed by the laws of Oregon. Section 4.1 of Bay Club’s operating agreement vested its manager with the “sole and exclusive authority to manage the Company and …to conduct or further the Company’s business.” This broad authority was consistent with the Oregon LLC statute related to manager-managed LLC’s, which provides that, “any matter relating to the business of the limited liability company may be exclusively decided by the manager… .” ORS 63.130(2)(b).

But section 11.1 of the same operating agreement imposed significant restrictions on the manager’s business and operating decisions, including the following:

“Until such time as the [Legg Mason] indebtedness … is paid in full, the Company [Bay Club] … shall not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy.”

Some background: late in 2005, the predecessor of Legg Mason Real Estate CDO I, Ltd. (“Legg Mason”) lent approximately $24 million to Bay Club. Over the following years, the parties modified the terms of the loan several times, but they failed to reach an agreement during the last round of their negotiations. So in early January 2014, Legg Mason declared a default. Bay Club responded by filing for bankruptcy on January 28, 2014. The bankruptcy petition was signed by Bay Club’s manager. Attached to the bankruptcy petition were authorizing resolutions of Bay Club’s members, but instead of being unanimous, the resolutions were only signed by three of Bay Club’s four members, representing only 80% of the membership interests.[1]

Relying on the restrictive language of Section 11.1 of Bay Club’s operating agreement, Legg Mason filed a motion to dismiss Bay Club’s bankruptcy case, arguing that Bay Club’s manager was not authorized to file the bankruptcy petition because the members had not unanimously authorized it.

The bankruptcy court disagreed and on May 6, 2014 denied Legg Mason’s motion to dismiss the bankruptcy filing of Bay Club even though Bay Club’s operating agreement prohibited the filing of bankruptcy without the unanimous votes of its members.[2] The bankruptcy court held this restrictive language unenforceable, and found that Bay Club’s manager acted within its authority when it authorized the bankruptcy filing.

The court noted that the Ninth Circuit Court of Appeals has held that a debtor’s prepetition waiver of the right to file a bankruptcy case is unenforceable as a violation of public policy. There was no such waiver here (presumably because Legg Mason was aware of the unenforceability of such waivers), Legg Mason pointed out. Instead, Legg Mason was relying on the express language in Bay Club’s operating agreement which divested the manager of the authority to file a bankruptcy while the Legg Mason indebtedness was outstanding.

But bankruptcy court called the inclusion of this language in the operating agreement (instead of including it the loan documents) “a distinction without a meaningful difference,” holding that “[t]he bankruptcy waiver in Section 11.1.24 of the Operating Agreement is no less the maneuver of an ‘astute creditor’ to preclude Bay Club from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy.”

Then, upon finding the bankruptcy waiver provision of the operating agreement invalid, the bankruptcy court refocused on the manager’s authority to act on behalf of Bay Club pursuant to the remaining provisions of the operating agreement to determine whether the borrower’s bankruptcy filing was properly authorized. As described above, section 4.1 of the operating agreement vested the manager with the “sole and exclusive authority” to further the business interests of Bay Club. While the manager attempted to get the unanimous consent of all the members to file the bankruptcy petition, the court held that such unanimous consent was simply not necessary as the manager was fully authorized to act on its own. Bay Club’s bankruptcy filing was properly authorized pursuant to the plain terms of the operating agreement, and therefore the court denied Legg Mason’s motion to dismiss.

It remains to be seen if this decision will be appealed or widely followed, but it clearly raises doubts about the effectiveness of restrictive covenants in a borrower’s governing documents aimed at preventing the borrower from filing for bankruptcy. Such provisions will be scrutinized, and may well be stricken or treated as unenforceable as a violation of public policy, adding additional uncertainty in the lending marketplace and possibly impinging upon credit availability.

Where There Is a Will, There Still May Not Be a Way

On April 5, 2004, Ms. Ann Aldrich, of Keystone Heights, Florida, wrote her will on an “E-Z Legal Form.” The form contained pre-printed language in its section titled “Bequests” to the effect that after payment of all just debts of the testator (Ms. Aldrich), her property be bequeathed “in the manner following.” In that space, Ms. Aldrich hand wrote in instructions directing that all of the following possessions listed go to her sister, Mary Jane Eaton. There followed a specific list of property, including Ms. Aldrich’s house, IRA account, bank accounts, vehicle, life insurance and house contents.

Ms. Aldrich also wrote that “If Mary Jane Eaton dies before I do, I leave all listed to James Michael Aldrich.”  Mr. Aldrich was Ann Aldrich’s brother.

There was no residuary clause. Nothing that covered any other property of Ms. Aldrich not otherwise listed.

In fact, Mary Jane Eaton did die first, in 2007, leaving cash and land to Ms. Aldrich. In 2009, Ms. Aldrich died, never having revised her will to dispose of the inheritance which she received from her sister, Ms. Eaton. Ms. Aldrich did, however, leave a piece of paper along with her will, bearing the printed title “Just a Note” and dated November 18, 2008, which read as follows:

This is an addendum to my will dated April 5, 2004. Since my sister Mary Jean Eaton has passed away, I reiterate that all my worldly possessions pass to my brother James Michael Aldrich, 2250 S. Palmetto, S. Daytona, FL 32119.

With her agreement I name Sheila Aldrich Schuh, my niece, as my personal representative, and have assigned certain bank accounts to her to be transferred on my death for her use as she seems [sic] fit.

Ms. Aldrich signed the “addendum” but it was only witnessed by Sheila Schuh. The Florida Probate Code requires two attesting witnesses. Therefore, it was not an enforceable testamentary instrument.

James Michael Aldrich was appointed personal representative of the estate. He sought to have a court determine who would inherit the property which Ms. Aldrich acquired after the execution of her will. Two nieces (daughters of a pre-deceased brother) asserted an interest in the action.[3] Mr. Aldrich argued that the most reasonable and appropriate construction of the will was that Ann Aldrich intended for her entire estate to pass to him, including the property inherited from Ms. Eaton. The nieces argued that without any general devises, and in the absence of a residuary clause, the will did not dispose of the after-acquired property (or any other property not mentioned in the will). As to such property, Ann Aldrich died intestate, claimed the nieces.

The trial court agreed with Mr. Aldrich. But the First District appellate court reversed and remanded with instructions to enter summary judgment in favor of the nieces. The case then went on a further appeal to the Florida Supreme Court. On these facts, before we tell you the outcome, what would you guess?

Clearly, Ms. Aldrich thought that her will said that all her property would go to her brother. She said as much in her subsequently written note when she wrote “I reiterate that all my worldly possessions pass to my brother James Michael Aldrich.”

The Florida Supreme Court found, however, that “Just a Note” was not an effective codicil to the will and therefore ignored it as not part of the will.

The basic rule in construing a will (or any contract) is to look within the “four corners” of the document for its meaning. Only if, after reviewing the document, some ambiguity remains as to what it means or intends will a court consider extrinsic evidence in an effort to remove the ambiguity. This is particularly the case with wills, where courts feel strongly constrained to give effect to the testator’s intention as expressed in the will. As the Court said:

In construing a will, it is the intention which the testator expresses in the will that controls and not that which he might have had in mind when the will was executed.

The Court found that Ms. Aldrich expressed no intent as to any property that she acquired after the execution of her will because the will did not contain a residuary clause or any general bequests that encompassed the inherited property.[4] Mr. Aldrich pointed out that it would be illogical for Ms. Aldrich to make a will that failed to deal with all of her estate and that excluding the inherited property effectively meant that it was Ms. Aldrich’s intention to have that property pass outside of the will and pursuant to the laws of intestacy. The Court wasn’t troubled by that result, however, saying “There must be a clause in a will that alludes to the after-acquired property in order to avoid distribution of that property through the intestacy statute.”

So the nieces won.

Our feelings about the outcome of this case are pretty much summarized by the concurring opinion of one of the justices, who wrote:

I surmise that, although this is the correct result under Florida’s probate law, this result does not effectuate Ms. Aldrich’s true intent. While we are unable to legally consider Ms. Aldrich’s unenforceable handwritten note that was found attached to her previously drafted will, this note clearly demonstrates that Ms. Aldrich’s true intent was to pass all of her ‘worldly possessions’ to her brother. As the majority states, however, although this note may represent Ms. Aldrich’s true intent, it was not her stated intent in the will to which this Court is confined in determining Ms. Aldrich’s testamentary intent. Thus, Florida probate law dictates that Ms. Aldrich’s after-acquired property pass by intestacy, and in this case, ultimately be inherited by two nieces to whom she made no specific or general bequests.

This unfortunate result stems not from this Court’s interpretation of Florida’s probate law, but from the fact that Ms. Aldrich wrote her will using a commercially available form, an “E-Z Legal Form,” which did not adequately address her specific needs—apparently without obtaining any legal assistance. This form, which is in the record, did not have space to include a residuary clause or pre-printed language that would allow a testator to elect to use such a clause. . . Apparently, Ms. Aldrich at some point recognized that her acquisition of this property needed to be addressed, but her attempts to amend her will to account for this after-acquired property, although logical, were legally ineffective.

We think there are two morals here: First, a will is a living document and ought to be reviewed regularly to make sure that it takes into account any significant changes in the life of the testator. It should not be exiled to a safe deposit box for years to grow dusty and out of date. The second moral is not to rely upon the legal sufficiency of a pre-printed form, or any other “canned” source, for anything legally important. One size does not fit all. If you have certain intentions for your estate, meeting with an attorney that specializes in estate planning can ensure that your intentions are fulfilled. Writing a note and leaving it with your will won’t do the job and is a waste of time and effort.

Headline Needed (Bobrow Case)

Did you know that under the Tax Code you can take a ‘temporary’ distribution from an individual retirement account tax-free, provided that you roll it over into another qualifying retirement account within 60 days? It’s a tempting idea, to ‘borrow’ from yourself for a couple of months, then pay it back. But don’t be too quick to take advantage. There are some limitations you should know about. And the consequences of messing up can be expensive.

Earlier this year, the U.S. Tax Court handed down a decision involving IRA rollovers. [5] During 2008, the taxpayers, Mr. & Mrs. Bobrow, took three distributions from three separate IRA accounts.

Under Section 408(d)(3)(A) of the Tax Code, a payee of an IRA distribution may exclude from gross income any amount paid or distributed from an IRA if the entire amount is subsequently paid into a qualifying IRA, individual retirement annuity, or retirement plan, not later than the 60th day after the day on which the payee receives the distribution.[6]

On April 14, 2008, Mr. Bobrow took a distribution of $65,064 from his traditional IRA account. (Actually, he took two distributions from the same account totaling that amount, which were made on the same day. The Tax Court treated them as a single distribution for purposes of the issues in the case.) Subsequently, on June 10, 2008, he made a qualified repayment of the same amount to the same traditional IRA.

However, on June 6, 2008, Mr. Bobrow took a distribution of $65,064 from another IRA of his, a rollover IRA. Subsequently, a repayment of that amount was made to that IRA on August 4, 2008.

In between, on July 31, 2008, Mrs. Bobrow took a distribution from her traditional IRA, also in the amount of $65,064. She, in turn repaid $40,000 back to her IRA on September 30, 2008.

It would appear that the Bobrows took advantage of having three separate IRA’s to effectively tack the 60-day-payback periods onto each other, so that the first distribution was repaid with funds from the second distribution, which in turn was repaid with funds from the third distribution, which was then partly repaid at the end of September. Thus, they had use of $65,064 from April 14th until September 30th, a period of 168 days.

The Bobrows treated each of these transactions as entitled to tax-free treatment under 408(d)(3)(A), except with respect to the third one, where only $40,000 was repaid. For that, they reported the difference of $25,064 as income.

The IRS determined that the transactions didn’t qualify for tax-free treatment and assessed the Bobrows accordingly[7] for tax on the unreported income. It also assessed them the 10% penalty which applies to early withdrawals from IRA’s[8], and a 20% penalty for a “substantial understatement” of the tax required to be shown on the Bobrows 2008 tax return. They appealed the assessment to the Tax Court.

The Tax Court determined that the April 14th distribution repaid on June 10th did meet the requirements of 408(d)(3)(A) and was a tax-free rollover[9]. But in so doing, the Tax Court reviewed the language of Section 408(d)(3)(B), which provides:

This paragraph [regarding tax-free rollovers] does not apply to any amount described in subparagraph (A)(i) received by an individual from an individual retirement account or individual retirement annuity if at any time during the 1-year period ending on the day of such receipt such individual received any other amount described in that subparagraph from an individual retirement account or an individual retirement annuity which was not includible in his gross income because of the application of this paragraph.

In other words, said the Tax Court, you only get one tax-free rollover per year, no matter how many IRA’s or qualifying retirement annuities you might have. The Bobrows’ arguments for avoiding the tax depended on reading 408(d)(3)(A) as authorizing one tax-free rollover per year per account. That, said the Tax Court, was not correct. You cannot work around the limitation imposed by Section 408(d) by dividing your retirement money into multiple accounts. Moreover, the one-year limitation period begins on the date on which funds are distributed. It is not a calendar year concept. You cannot take a distribution on December 31st and a second distribution in January and have the second one qualify for tax-free treatment under 408(d), even if you repay it within the 60 day period.

So, after Mr. Bobrow took a distribution on April 14, 2008, any subsequent IRA distributions made to him within the next 365 days would be taxable, no matter what.

Mrs. Bobrow took her distribution from a separate traditional IRA in her name and it would have qualified for tax-free treatment as to the $40,000 repayment, but for one thing. The repayment was late. She drew the funds on July 31st and made the repayment on September 30th, which was 61 days later. The 60-day requirement may be waived in certain circumstances for events beyond the control of the individual (such as a bookkeeping error by the financial institution) but the Tax Court did not find evidence of any such circumstances being applicable.[10] So the entire amount of the July 31, 2008 distribution was includible as gross income.

The penalties were also upheld, not surprisingly since $139,526 of income was not reported and the tax liability for that was “substantial” for purposes of the Tax Code related penalty.

2008 was a tough year and it is understandable that some taxpayers were pressed financially to the point where they might have tried what the Bobrows tried. If there is a moral here, it probably is that there aren’t any free lunches and the Tax Code is no exception. Let’s be careful out there.

Disguised Sales

Consider the following fact situation: Mr. X owns a sawmill—land and equipment—in his own name. Mr. Y is one of his most important customers. Y would like the mill expanded so that it can handle more of Y’s logs. X lacks the capital for this, but Y is creditworthy and with him as a co-guarantor, the expansion money can be borrowed. They decide to do the following:

  1. X and Y incorporate Sawmill Corp, each receiving one share of stock for $500.
  2. X transfers the sawmill assets (real property, building and equipment) to Sawmill Corp. in return for 364 shares of the capital stock of Sawmill Corp.
  3. X and Y then enter into a stock purchase agreement under which Y purchases 182 shares from X for $500 per share. The purchase price is to be paid over several years and Y is to pay interest to X on the unpaid balance owing until it is paid off.
  4. X places 182 shares into escrow with an escrow agent, to be released to Y as paid for.
  5. X executes an irrevocable proxy in favor of Y with respect to the 182 shares, so that Y can vote them though they are in escrow.

All this is done. A month after closing, Sawmill Corp. obtains a loan co-guaranteed by X and Y.

For tax purposes, X takes the position that the contribution of the sawmill assets to Sawmill Corp. for 364 shares of stock is a Section 351 transaction qualifying for tax-free treatment. In such a case, Sawmill Corp. would receive a carryover of X’s basis in the assets transferred and X’s basis in his stock would be equal to his basis in the assets transferred.

Also for tax purposes, Y claims tax deductions for his interest payments to X.

Three years pass and a buyer for the sawmill operation (Intermountain Lumber) appears. X and Y agree to sell all of the capital stock of Sawmill Corp. to Intermountain Lumber. The transaction closes and subsequently, Intermountain Lumber, filing consolidated tax returns which include Sawmill Corp., takes the position in the tax returns that the transfer of assets from X to Sawmill Corp. did not qualify as a Section 351 tax-free transaction. Intermountain does this because the fair value of the assets transferred was higher that X’s basis in those assets at that time. If the transaction isn’t tax free, then Sawmill Corp. has a higher basis in the assets and that mean a larger depreciation deduction to Intermountain.

Upon review, the Tax Court agrees with Intermountain Lumber that the transaction did not qualify as tax-free under Section 351 because Section 351 requires that the transferor have control immediately following the transfer. “Control” is defined for this purpose as holding at least 80% of the voting stock and at least 80% of all capital stock.

X protests: immediately after the transfer, X held 365 shares of Sawmill Corp. and Y held one share. That should meet the test. But the Tax Court concludes that the sale of 182 shares to Y was part of the transaction and says:

The basic premise of section 351 is to avoid recognition of gain or loss resulting from transfer of property to a corporation which works a change of form only. Accordingly, if the transferor sells his stock as part of the same transaction, the transaction is taxable because there has been more than a mere change in form.[11]

The case illustrates that for tax purposes a transaction may be recharacterized. In effect, the Tax Court ruled that the transaction was a sale by X of a half-interest in the business to Y.

It is understandable that a party would like to avoid tax liability in disposing of an investment or other asset which has increased in value. It is equally understandable that the tax laws seek to identify which transactions are true dispositions (and therefore taxable) and which are merely changes in the form in which the original owner continues to control the asset (such as a Section 351 contribution).

Not surprisingly, the Tax Code contains a provision, Section 707, which is aimed at catching “disguised sales”. For example, subsection 707(a)(2)(B) allows the Commissioner of Internal Revenue to treat a transaction that occurs between a partner and a partnership as if it were between the partnership and one who isn’t a partner in certain circumstances, such that the transaction is “properly characterized as a sale or exchange.”

Suppose that X and Y had created a partnership and X had transferred the sawmill assets to the partnership in return for a 99% partnership interest. If the partnership then borrowed against the sawmill assets and paid a special distribution to X, would that be a tax-free return of capital to a partner, reducing X’s capital account so that future earnings of the partnership would be shared by X and Y? Or would it be a disguised sale of the assets by X?

The Tax Court considered such a situation in Canal Corporation and Subsidiaries.[12] Canal Corporation purchased WISCO in the mid-1980’s. By the late 1990’s, Canal’s business strategy had changed and it wanted to sell WISCO’s main business, which was manufacture of paper tissue. It found an interested buyer, Georgia Pacific (GP), but the taxable gain on a sale of WISCO’s tissue business was likely to be $750 million or more and Canal did not want to have to pay a big tax bill on the sale. So, after consultation with lawyers and accountants, the following transaction was agreed upon:

  1. GP and WISCO formed a new partnership, which was set up as a limited liability company (the “LLC”).
  2. GP contributed its tissue business assets (valued at $376.4 million) to the LLC and received an 95% ownership interest.
  3. WISCO transferred its tissue business assets to the LLC (valued at $775 million) in return for a 5% ownership interest.
  4. The LLC borrowed $755.2 million from Bank of America, guaranteed by GP. This loan closed on the same day as steps 2 and 3 above and the proceeds of the loan were immediately transferred to WISCO as a special distribution. (Thus, WISCO (and Canal) disposed of the WISCO tissue business assets in return for $755.2 million cash plus 5% of the ownership of the LLC.)
  5. WISCO entered into an indemnity agreement in favor of GP for any principal payments which GP might have to make on the Bank of America loan (which was a 30 year term loan). The indemnity did not extend to covering interest payments, nor did it require WISCO to maintain a required minimum net worth. And before GP could call upon the indemnity, it was required to liquidate the LLC. (In effect, WISCO guaranteed GP that the LLC would be able to pay the principal amount of the loan.)

WISCO retained certain assets and liabilities other than the tissue business, including certain environmental remediation obligations having an estimated liability of between $60 million and $70 million. WISCO used a portion of the funds it received to repay an intercompany loan from another subsidiary of Canal. It also used the funds received to pay a dividend to Canal and to make a loan to Canal of $151 million.

WISCO and Canal treated the transaction as tax-free. The IRS, however, felt otherwise and determined that the transaction was a disguised sale covered by Section 707 and assessed Canal and WISCO over $183 million in tax due, as well as a penalty for under-reporting the tax liability. Canal and WISCO appealed to the Tax Court.

A key question was whether WISCO was actually at economic risk for the bank loan. WISCO claimed it was, due to the indemnification it had given to GP. The Court held, however, that the indemnity given by WISCO was unlikely to ever be called upon (partly because GP was required to liquidate the LLC’s assets first), and therefore WISCO did not bear the economic risk of loss relating to the loan liability. In addition, WISCO had significant other liabilities and its principal asset, the loan due from Canal, could be cancelled by Canal at any time. Therefore, said the Tax Court, even if the indemnity were to be called upon, WISCO was not required to maintain any ability to perform and might have no assets. So the indemnity afforded no real protection to GP and lacked economic substance. Ergo, WISCO wasn’t really at risk for the loan.

The IRS also sought approximately $37 million as a penalty for substantial understatement of tax liability and the Tax Court took occasion to consider whether Canal had reasonable cause to rely in good faith upon the advice of PWC, its accountants and tax advisors. Reasonable reliance in good faith upon expert advice can be a defense to imposition of the penalty. But the Tax Court found that such reliance was not reasonable or in good faith for several reasons. One was that the PWC opinion was delivered for a flat fee of $800,000. Another was that PWC was deeply involved in structuring the transaction and therefore its opinion was not an independent review.[13] And because PWC would receive payment only if the transaction closed, the opinion was tainted by an inherent conflict of interest, of which Canal had knowledge:

“PWC’s opinion looks more like a quid pro quo arrangement than a true tax advisory opinion. If we were to bless the closeness of the relationship, we would be providing cart blanche to promoters to provide a tax opinion as part and parcel of a promotion. Independence of advisors is sacrosanct to good faith reliance.”

In such circumstances, the Court found that Canal could not reasonably rely, nor would its reliance be in good faith. So the penalty stuck.

The Intermountain Lumber and Canal Corporation cases are interesting examples of how taxpayers can get creative about structuring a transaction to make it appear to qualify for tax-free treatment, and about how the IRS and the Tax Court are skeptical when such claims are made. Some things are too good to be true.

Secured Party Not Required to Be Commercially Reasonable

Suppose that a manufacturer is willing to finance its dealers. The manufacturer provides inventory to a dealer on credit and the dealer signs a security agreement agreeing that the manufacturer has a security interest in the inventory. The manufacturer perfects its security interest by filing a financing statement in the appropriate office. If the dealer defaults, failing to pay the manufacturer, then, among other choices of action, as secured party the manufacturer can repossess the inventory and sell it.

If, upon default, the manufacturer does proceed with a sale of the collateral, the Uniform Commercial Code requires that the sale be “commercially reasonable” in all aspects. Just what that means in any specific instance depends in part on the nature of, and the market for, the collateral. For some collateral, it may be appropriate to advertise and conduct a public auction. For other collateral, it may be commercially reasonable for the lender to directly reach out to several potential buyers individually for bids and conduct a private sale to the high bidder. Sometimes, it makes sense for the lender to re-work the inventory or take other action to improve its salability.

In any event, the purpose of the requirement that the sale be commercially reasonable is to protect the debtor by assuring that the disposition of the collateral will be done in a way that gives reasonable assurance that a fair value will be realized.

What if, instead of the manufacturer providing financing, the dealer obtains financing from a commercial lender under the same basic arrangement—the lender takes a perfected security interest in the inventory. Not surprisingly, the same rule applies. The duty to conduct a commercially reasonable sale of collateral falls upon any secured party enforcing its lien. But let’s add one further detail. Suppose that the lender also enters into a repurchase agreement with the manufacturer under which the lender can require the manufacturer to buy back the inventory.

That was the arrangement in Textron Financial Corporation v. Weeres Industries Corporation.[14] Weeres made watercraft and sold them to dealers, who in turn sold them to the public. Textron provided financing to some of Weeres’ dealers. And Weeres and Textron had a repurchase agreement under which Textron could require Weeres to repurchase watercraft that Textron had repossessed from the dealers.

As we all remember, 2008 was a tough year. Several of the Weeres dealers defaulted on their loans from Textron and Textron took possession of a number of watercraft. Each time, Textron notified Weeres requesting that Weeres repurchase the repossessed inventory. But Weeres failed to do so. So, on April 14, 2009, Textron sent Weeres a letter stating that, due to Weeres’ failure to repurchase the inventory for a particular dealer, Textron would mitigate its damages by remarketing that inventory, reserving its rights against Weeres under the repurchase agreement. On September 2, 2009, Textron sent a similar letter to Weeres with respect to repossessed inventory of several other dealers.

Textron sold the inventory through several channels: auctions, private sales and consignment sales. After repossession costs, the total amount recovered was approximately $233,000 less than the amount that Weeres was obligated to pay for the inventory under the repurchase agreement. Textron sued Weeres for the shortfall.

Weeres conceded that the repurchase agreement was valid, but argued that the dispositions of the inventory by Textron were not commercially reasonable and that Textron had failed to comply with its duty to mitigate damages because the manner of liquidation of the inventory resulted in unreasonably discounted prices which were significantly below fair market value. Weeres also claimed damages in lost business due to the manner in which Textron ‘dumped’ the inventory, depressing the market for Weeres to sell new watercraft.

Textron moved for summary judgment, which the Court noted would be appropriate only if the evidence demonstrated that there were no genuine issues of material fact and the law clearly entitled one party to judgment. Weeres opposed the motion on the grounds that there were material issues of fact with respect to whether the sales of inventory were commercially reasonable. In particular, Weeres claimed that it could have cured the defaults by the dealers or arranged to refinance the debt, avoiding a situation in which the inventory was sold at ‘depressed prices’.

If Textron had been suing the dealers, they could certainly have questioned the commercial reasonableness of the sales of the watercraft. But the Court held that Weeres was not an “obligor” under the UCC and the commercial reasonableness test did not apply.[15] In other words, the Court held that Weeres did not have the right to require commercially reasonable dispositions of the watercraft.

The Court then turned to the question of mitigation of damages. It recognized that “a party claiming injury that is due to breach of contract … has a duty to exercise reasonable diligence and ordinary care in attempting to minimize its damages.” On this issue, the Court held that Weeres’ claim that Textron’s methods of sale ‘flooded the market with excess inventory’ thereby destroying prices was not backed up by sufficient affirmative evidence. Apparently, Weeres did not proffer evidence (other than Weeres’ opinion) that the watercraft would have sold for higher prices had Textron not ‘dumped’ it.

Weeres also argued that Textron’s conduct wasn’t reasonable because it departed from ‘prior practice’. Weeres claimed that ‘prior practice’ included allowing Weeres to make interest payments to cure a dealer’s default, and also included Textron’s allowing refinancing of inventory through another dealer. But, according to the Court, the repurchase agreement did not require Textron to permit such cures or agree to any refinancings and explicitly stated that Textron had no obligation to refinance or allow Weeres to make cure payments.[16]

Even more damningly, the Court found that Weeres had waived the defense of failure to mitigate damages and any other defenses to its obligation to repurchase the inventory. The repurchase agreement contained a broad waiver by Weeres:

The obligations of [Weeres] under this Agreement are absolute and unconditional. [Weeres] shall not be released from such obligations for any reason, nor shall such obligations be reduced, diminished or discharged for any reason. [Weeres] waives (i) any right to require Textron Financial to proceed against a Dealer or to pursue any other remedy prior to exercising Textron Financial’s rights under this Agreement, (ii) notice of the acceptance of this Agreement by Textron Financial, the non-performance of any Obligation of any Dealer owing to Textron Financial (individually, an ‘Obligation’ and collectively, the ‘Obligations’), or the amount of the Obligations outstanding at any time, (iii) demand and presentation for payment upon the applicable Dealer, (iv) protest and notice of protest and diligence of bringing suit against any Dealer, and (v) any other defense to [Weeres’] obligations under this Agreement.

[Emphasis supplied by the Court.] This waiver was sufficient to excuse Textron from any duty to mitigate damages, said the Court.[17]

Finally, Weeres argued that Textron had breached its implied covenant of good faith and fair dealing under the purchase agreement. The Court acknowledged that under the applicable state law “virtually every contract contains an implied covenant of good faith and fair dealing”, and that the standard for determining whether a party has breached the implied covenant is whether or not the actions in question are free from arbitrary or unreasonable conduct. But, said the Court, since the duty to mitigate damages was waived, Textron’s efforts to mitigate were not subject to the implied covenant. If Textron didn’t have to mitigate at all, it certainly didn’t have to mitigate reasonably.

It seems likely that Textron would not have been willing to provide financing to Weeres’ dealers without the repurchase agreement, and Weeres clearly failed to perform, so one might not feel sympathy for Weeres. But we wonder why Weeres didn’t protect itself better on the point at issue in the case. It would not have been a stretch to ask for commercially reasonable dispositions of any watercraft which Textron sold, nor would that have been much of a ‘give’ by Textron, since the dealers were entitled to it. On its face, Weeres’ claim that Textron behaved unreasonably does not seem beyond credibility. But the Court saw things differently and Weeres did not get to present that claim to a jury.