Senior secured creditors should take steps to protect themselves from a littleknown provision of the New York Civil Practice Law and Rules that can allow unsecured judgment creditors to obtain significant negotiating leverage when a borrower is approaching distress. In particular, this client alert suggests that secured creditors:

  • Monitor the borrower’s litigation docket and the status of any specific litigation in which a judgment may be issued in favor of trade creditors and unsecured creditors.
  • Consider funding the defense of claims brought against the borrower to avoid the company’s acceptance of adverse judgments. Ultimately, there may be no defense to the claim that money is due and owing, but the time afforded for adjudication of the claim may provide sufficient time for the borrower and secured lenders to execute a plan for making recovery to the secured creditors.
  • Encourage the borrower to resolve claims through settlements or an orderly filing for bankruptcy. Given that trade and unsecured creditors may be out-of-themoney and, other than obtaining a judgment, have no leverage to request payment, the borrower should be able to settle the matter for an insignificant amount rather than being held hostage to a clever procedural ploy.

Distressed companies are vulnerable to collection lawsuits from trade creditors and unsecured lenders. Unsecured creditors, with no collateral to execute remedies against, may declare defaults, declare payment to be immediately due and payable, and pursue a judgment. At the same time, the company may have limited resources (both in cash and personnel) to defend against such proceedings—and may not have a good defense to the claim that they do, in fact, owe the money.

Meanwhile, a secured creditor may have decided that forcing the company to file for bankruptcy protection, which would stay any unsecured creditor from continuing proceedings against the company, is not in the secured creditor’s best interest. The secured creditor may have decided not to execute remedies against its collateral, instead allowing the company to operate using the secured creditor’s cash collateral, provided that the secured creditor does not have to provide additional funding.

In such circumstances, conventional wisdom would suggest there be no line item in the company’s budget for defending unsecured claims. The secured creditor may assume that there is minimal or no risk to its collateral and that advancing further funds to defend collection cases is unnecessary and even wasteful. After all, a secured creditor may rely on its perfected security interests and cash collateral accounts, as it will be first in line to recover.

That may be a mistake, with potentially dire consequences for the secured creditor. Parties that have obtained a money judgment against the company may be able to use a New York law intended to secure payment of judgments to dramatic ends: The law allows a judgment creditor to freeze the company’s bank accounts (including the bank accounts the secured creditor has a perfected security interest in), causing the company to lose access to cash and forcing the company to the edge of bankruptcy and giving the judgment creditors leverage in negotiations with senior creditors.

There is a provision of the New York Civil Practice Law and Rules that provides judgment creditors with broad means to enforce and satisfy their judgments. CPLR 5222(b) allows a judgment creditor to obtain a restraining notice that will, when properly served, restrain the transfer of property of the judgment debtor (the company) that is held by another party. Once the notice is served, it operates as an injunction, restraining the recipient from making any transfer of the judgment debtor’s property. The restraint will be effective for one year after service or until such time as the judgment is satisfied or vacated, whichever comes first.

The most significant risk to a secured creditor arises when the recipient of the restraining notice is a bank or other institution that holds operating, payroll, or other working capital accounts of the company.1 Using the restraining notice, the judgment creditor may be able to freeze the bank accounts of the company. If the company is in distress, freezing its operating accounts may threaten it with collapse. For example, if a judgment creditor serves a restraining notice on the company’s bank shortly before a payroll is due, the company may be forced to consider an immediate termination of its workforce. Senior secured creditors may suddenly face the prospect of a disorderly collapse of the company, which could impair their ability to recover, even if they are senior in priority.

Ironically, the threat posed by a judgment creditors’ strategic use of CPLR 5222(b) may be purely practical, rather than legal. The restraining notice does not create a lien on the judgment debtor’s property, and therefore the judgment creditor does not enter into a “race” with regard to priority of payments to multiple creditors. Nor does the stay provision of the Bankruptcy Code impact the restraining notice. The stay may prevent a judgment creditor from obtaining the funds, but it does not impact the injunction or “freeze” of the funds. Thus, the rule does not theoretically challenge the secured creditor’s liens.

Nonetheless, the judgment creditor may gain enormous leverage over senior secured creditors by threatening to bring the company to its knees. Suddenly, the judgment creditor may be able to extract value from the senior creditors, despite their junior, unsecured status. In response, senior secured creditors may decide that funding a settlement with the judgment creditor is preferable to a catastrophic bankruptcy. Thus, senior secured creditors should be aware of the implications of this little-known provision of the New York Civil Practice Law and Rules and take steps to protect themselves by monitoring the company’s litigation docket, funding defense costs and even settlements if necessary, and encouraging the company to actively restructure or seek bankruptcy protection instead of passively accepting adverse judgments against it.