The United States District Court for the Southern District of New York has recently ruled that, where an individual lacks actual or apparent authority to execute a loan agreement on behalf of a corporate entity, that entity will be deemed to have ratified the transaction when it fails to object or attempt to undo the transaction upon learning of it. In addition, the court found that ratification of an unauthorized transaction occurs when the entity accepts the benefits of the transaction. In re Vargas Realty Enterprises, Inc., 440 B.R. 224 (S.D.N.Y. 2010).  

The Facts

Vargas Realty Enterprises, Inc., Noble Realty Corp., V & R Realty Corp., and E.R. Properties Inc. (collectively “Borrowers”) allegedly are corporations that own real property in New York City. Victor Vargas is the sole shareholder and president of each Borrower. On at least five separate occasions since 2001, Victor Vargas’ then spouse, Rosa, and his son, Henry, allegedly held themselves out as Borrowers’ agents. Borrowers maintained, however, that neither Rosa nor Henry were ever officers, directors, shareholders, managers, agents, or employees of Borrowers and, therefore, were not authorized to act for them. On each of these five occasions, Rosa or Henry allegedly carried out loan transactions with financial institutions purporting to be Borrowers’ agent, and granted liens against Borrowers’ properties to secure those loans. These transactions allegedly were carried out without Victor Vargas’s prior knowledge or consent. When Victor subsequently learned of these unauthorized transactions, he allegedly took no steps to invalidate them or to unwind the transactions.

Turning to the loan at issue in this litigation, on August 28, 2007, Henry, holding himself out as Borrowers’ agent, borrowed $8 million from CFA W. 111 Street, L.L.C. (“CFA”), obligated Borrowers on an $8 million promissory note, and granted liens on Borrowers’ real properties to secure that loan. At that time, Borrowers did not need additional funds for operations. On April 8, 2008, Borrowers defaulted on their repayment obligations to CFA. Thereafter, in the Summer of 2008, CFA commenced a foreclosure action in New York state court. Borrowers and CFA entered into a Pre-Negotiation Agreement in an effort to reach a settlement or restructuring of the note and mortgage. In that Agreement, Borrowers acknowledged their “legal and enforceable obligations” to CFA under the CFA note and mortgage “without any defenses, counterclaims or offsets.” When those efforts were unsuccessful, in January 2009, Borrowers voluntarily filed a Chapter 11 petition in the United States Bankruptcy Court for the Southern District of New York.  

On May 25, 2009, Borrowers commenced adversary proceedings against CFA in the Borrowers’ bankruptcy case. Borrowers’ amended complaints filed in June 2009 requested that: (1) the CFA note and mortgage be declared invalid because Henry lacked authority to execute the deal and CFA failed to perform due diligence on this authority, (2) the Pre-Negotiation Agreement be nullified, and/or (3) CFA’s claims be equitably subordinated to all other creditors because CFA procured the deal through fraud or misconduct. CFA moved to dismiss on the grounds that, to the extent Henry may have lacked authority, Borrowers ratified the CFA note and mortgage when they failed to take steps to nullify the transaction and when they executed the Pre-Negotiation Agreement.  

In an August 3, 2009 Order, the Bankruptcy Court dismissed the consolidated adversary action against CFA concluding that: (1) Borrowers ratified the note and mortgage when they executed the Pre-Negotiation Agreement and when Borrowers accepted at least a partial benefit of the transaction, (2) the Pre-Negotiation Agreement was not a fraudulent conveyance because it was not a transfer and Borrowers could not satisfy the requisite elements necessary to make a fraudulent conveyance claim, (3) Borrowers failed to plead all of the elements of an unlawful preference claim, (4) CFA’s use of its position to drive a harder bargain was not wrongful conduct warranting equitable subordination, and (5) the Pre-Negotiation Agreement was neither a product of coercion or duress because Borrowers had other alternatives to signing it. The Borrowers appealed.  

The District Court’s Ruling  

On appeal, the district court affirmed the complaint’s dismissal. The court began its analysis by noting that the district court evaluates a bankruptcy court’s findings of fact for clear error and its conclusions of law de novo.  

The court held that, regardless of whether Henry lacked actual or apparent authority to execute a loan on behalf of Borrowers, Borrowers thereafter ratified the note and mortgage when they failed to object or attempt to undo the transaction upon learning of it and executed the Pre-Negotiation Settlement Agreement, rendering the note and mortgage valid and enforceable against Borrowers. Moreover, rather than object to the CFA note and mortgage, Borrowers accepted the benefits of the transaction, using at least $5 million of the CFA loan proceeds to satisfy a prior debt owed to Sovereign Bank. In addition, at least $400,000 was used to make interest payments on behalf of Borrowers.  

The court then held that the Pre-Negotiation Agreement was not a contract of adhesion or coercion. In so ruling, the court wrote that the fact that a form of contract is offered on a take-it-or-leave-it basis, standing alone, is insufficient to make it one of adhesion. Nor is mere disparity in bargaining power sufficient to show that a contract of adhesion exists. In addition, the record did not show that the disparity in the instant action was such that CFA coerced Victor Vargas into signing the Pre-Negotiation Agreement under duress.  

Borrowers had alleged that the Pre-Negotiation Agreement, along with the underlying CFA note and mortgage, were part of CFA’s criminal scheme to take over Borrowers’ properties. This claim was similarly found to be without merit, as they failed to point to a single case or fact that would support such claims. Moreover, the court noted that Borrowers’ claim of a criminal enterprise was merely derivative of their other, failed, theories.  

The court rejected the Borrowers’ fraudulent conveyance claim. Because the Pre-Negotiation Agreement constituted a contract through which Borrowers ratified a prior transaction, Borrowers’ claim failed because a ratification of a former transaction is not a transfer within the meaning of the fraudulent conveyance statutes.

On the claim for equitable subordination, the court held that, because an ordinary creditor, like CFA, does not owe a fiduciary duty to a debtor, it is rare for a court to subordinate claims arising out of such arms length dealings. In the case of non-insider creditors, “unless the claimant controls the debtor, and exercises that control to gain an unfair advantage,” the proponent of such a claim must show “wrongful conduct involving fraud, illegality or some other breach of a legally recognized duty.” The court wrote that, aside from making bare allegations, Borrowers failed to show how CFA committed fraud and failed to ground their allegations in fact or law.

The court then briefly remarked on the Borrowers’ claim that the Pre-Negotiation Agreement was an unlawful preference, noting that, other than a cursory mention of the claim, Borrowers did not raise the issue until their reply brief (and even there, they devoted “a total of three sentences to this claim”) and it would therefore be deemed waived for purposes of their appeal. The court went on to note that, even if the preference claim were properly raised, it would still fail where Borrowers had not pleaded all of the necessary elements in their complaint.

The court also analyzed Borrowers’ usury claim. The court highlighted the fact that Borrowers alleged for the first time on appeal that the CFA note and mortgage were criminally usurious. Nevertheless, the court easily disposed of this claim, holding that New York’s usury laws (New York Penal Law § 190.40, New York General Obligations Law §§ 5-511, 5-501-1 and 5-501-6-a) do not apply to loans over $2.5 million. While the CFA note imposed a default interest rate above the 25% usury threshold, because the loan amount was above $2.5 million dollars, the usury laws did not apply.

Finally, the court noted that it saw no reason to reverse the Bankruptcy Court’s decision on grounds of public policy. The court found that the Pre-Negotiation Agreement was not inconsistent with New York’s public policy encouraging settlements, nor was it inadmissible as a settlement discussion pursuant to Federal Rule of Evidence Rule 408. In addition, Borrowers could not cite a single applicable precedent in which a court found that such an agreement was found to be invalid on public policy grounds.

Conclusion

While it addressed a number of claims and issues, the District Court’s holding in In re Vargas Realty stands for the very basic proposition that an unauthorized corporate loan transaction will be enforced where the corporation thereafter ratifies it by failing to object or attempting to undo the transaction upon learning of it or by returning its benefits.