Camouflaged Collateral: "All Asset" Liens May Not Include Proceeds of D&O Insurance Policies in Bankruptcy

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1 Camouflaged Collateral: "All Asset" Liens May Not Include Proceeds of D&O Insurance Policies in Bankruptcy Article contributed by Lawrence V. Gelber and James T. Bentley of Schulte Roth & Zabel LLP As its borrower begins the downward spiral toward bankruptcy, the prudent secured lender will analyze its collateral package to ensure that its liens are properly perfected. Because a secured lender can perfect liens on substantially all of a borrower s assets by filing a UCC 1 financing statement referencing broad categories of collateral, most of its analysis can be quickly completed through a simple lien search. There may be collateral lurking in a borrower s asset portfolio, however, that is not easily identified or covered by the Uniform Commercial Code's generic categories. It is this "camouflaged" collateral that creditors' committees and chapter 7 trustees often will attack as they seek to create value for their constituencies especially in cases involving undersecured lenders. One category of such collateral is claims by a borrower against its directors and officers ("D&O Claims") that arose prior to the bankruptcy filing date, but that had not yet been asserted at the time that the case was commenced. For example, a committee or chapter 7 trustee may seek derivative standing to assert a claim against a borrower's directors and officers for pre petition actions that allegedly led the borrower into bankruptcy. The issue of who may assert these D&O Claims is significant both to secured lenders and committees, in part because directors and officers often have significant insurance policies. 1 Whether a lender has a perfected lien on the D&O Claims will determine if the policy's proceeds are available to satisfy its secured claim or will be distributed to other creditors. Lenders that have an "all asset" lien on a borrower's collateral often believe that their lien extends to proceeds recovered in a lawsuit against the borrower's directors and officers for these types of actions. After all, any harm caused by the directors and officers diminished the value of the borrower and the secured lender s collateral; thus, lenders reason that they must be entitled to any recovery on account of such diminution. Unfortunately for lenders, the answer is not so clear cut. Whether a secured lender has a lien on pre petition D&O Claims often depends on whether the claim is characterized as a "general intangible" or a "commercial tort claim" under Article 9 of the UCC. If pre petition D&O Claims are "general intangibles," they likely will comprise part of a secured lender s pre petition collateral package (assuming that the lender has a properly perfected lien on general intangibles). However, if the D&O Claims are "commercial torts," they likely will not constitute collateral for the lender, even if the This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

2 lender has a perfected "all asset" lien on the borrower s collateral. Courts, including bankruptcy courts, look to state law to determine how the causes of action underlying the D&O Claims should be characterized under the UCC. Most state laws, however, do not provide a bright line rule on whether or not D&O Claims are torts. The question of whether certain causes of action against directors and officers (e.g., breach of fiduciary duty) arise in tort or under contract law may differ from state to state and will be fact specific. 2 This ambiguity provides fertile ground for committees and trustees to challenge a secured lender s lien on D&O Claims. Thus, lenders and their counsel must familiarize themselves with the often subtle nuances of potential D&O Claims with respect to the UCC and bankruptcy law in order to protect their collateral base. What Constitutes a General Intangible? A general intangible is broadly defined under the UCC as "any personal property, including things in action other than commercial tort claims." 3 A borrower's pledge of a right to proceeds from a lawsuit (other than a tort claim) thus constitutes a general intangible. 4 "The term 'general intangibles' is residual in nature; it picks up all personal property that does not fall within one of the other Article 9 categories." 5 What Constitutes a Commercial Tort Claim? The UCC defines commercial tort claims as claims that arise in tort with respect to which the claimant is either: (1) an organization or (2) an individual and the claim arose in the course of the claimant s business or profession and does not include damages arising out of personal injury to or the death of the individual. 6 Under Article 9, a borrower may pledge a commercial tort claim to a lender as original collateral. However, the UCC imposes special requirements for the attachment of security interests to commercial tort claims. 7 The UCC requires greater specificity when describing a commercial tort claim to prevent borrowers from inadvertently encumbering certain property. 8 Thus, a generic description in a UCC 1 and security agreement that states "all commercial tort claims" is insufficient for a lender's lien to attach. While a more specific description of the claim must be included in the UCC 1 and security agreement, it is not necessary that the borrower know the exact amount of the claim, the theory on which it may be based, or even the identity of the tortfeasor in order to pledge the commercial tort claim. 9 For example, UCC commentary states that "all commercial tort claims" would be insufficient but that "all tort claims arising out of the explosion of borrower s factory" would suffice. 10 Furthermore, UCC 9 204(b) prohibits a lender from acquiring a lien on commercial tort claims through an afteracquired property clause in a security agreement. Thus, lenders cannot capture commercial tort claims with "all asset" liens. So, What Is a Lender to Do? Secured lenders should act affirmatively to ensure that they have a lien on (and thus control over) potential lawsuits against a borrower s management. 1. Amend the Security Agreement. Upon the occurrence of a pre petition event of default, a secured lender can require, as a condition to any waiver, forbearance, or amendment, that the borrower identify all potential commercial tort claims (including any potential claims regarding a breach of management s fiduciary duties to the borrower) and amend its security agreement to include these claims. This tactic is risky, however. For example, it will not be effective if the description of the commercial tort claim is not sufficiently specific to satisfy UCC 9 108(e). Nor will it be effective if a bankruptcy court were to determine that the D&O Claim accrued only upon the post petition

3 commencement of the lawsuit rather than when the alleged injury occurred, as the Bankruptcy Code provides that any property acquired by the borrower after the bankruptcy filing, which may include its interest in a lawsuit, is not subject to any lien under a pre petition security agreement. 11 Moreover, as a practical matter, management may not want to acknowledge potential liability by disclosing in writing that claims may exist against the borrower's directors and officers. On the other hand, management may be more comfortable with the knowledge that potential claims are controlled by a secured lender (especially, for example, if it is contemplated that the secured lender will be credit bidding or effecting a debt to equity swap and taking control of the borrower) rather than a committee anxious to get its hands on the proceeds of a D&O insurance policy. 2. Provide DIP Financing or Authorize the Use of Cash Collateral. After a borrower has filed for bankruptcy relief, the secured lender, if it is willing to permit the use of its cash collateral or to advance additional funds, may be able to obtain a lien on all commercial tort claims and general intangibles, whether they arose pre petition or post petition. A borrower's bankruptcy estate is comprised of all legal and equitable interests of the borrower in property as of the commencement of the case. 12 Bankruptcy courts (through general orders of reference) have "exclusive jurisdiction" over this estate property (28 U.S.C. 1334(c)), and may authorize financing secured by a lien on estate property. 13 Bankruptcy courts are further empowered to grant liens in estate property by 11 U.S.C. 105, which provides that courts may "issue any order, process or judgment that is necessary or appropriate to carry out the provisions of [that] title." Furthermore, the Bankruptcy Code expressly permits a bankruptcy court to grant "an additional or replacement" lien as so called "adequate protection" to secured creditors that consent to the use of their cash collateral or provide debtor in possession ("DIP") financing. 14 Given these broad powers, when a bankruptcy court approves DIP financing or authorizes the use of cash collateral and grants the attendant liens, Article 9's requirements for attachment and perfection of a security interest generally do not apply. Accordingly, a bankruptcy court theoretically can authorize a lien on "all commercial tort claims," even though UCC 9 108(e)(1) requires a more specific description. 15 Additionally, the liens granted under a DIP financing order are not subject to objection on the grounds that the debtor has not authenticated a security agreement, as required under UCC 9 203(b)(3). Nevertheless, DIP lenders and pre petition lenders authorizing the use of their cash collateral may, in an abundance of caution, require a borrower to execute a post petition security agreement and file new UCC 1 financing statements. By doing so, the lender has a statutory means to liquidate its collateral if the case is converted or dismissed, and need not rely solely on the bankruptcy court order. In such instances, the post petition security agreement should state that the borrower covenants to provide advance notice to the lender of any potential commercial tort claims (to the extent that it is able) so that the lender may amend its post petition security agreement with the borrower accordingly. The financing order should also provide that any security agreement can be amended without court approval to include such commercial tort claims. 3. Ensure the Lender Has a Lien on General Intangibles. If a commercial tort claim is settled, a secured lender's post petition liens on general intangibles will be relevant, even if it does not have a lien on commercial tort claims. The official comment to UCC states that "once a claim arising in tort has been settled and reduced to a contractual obligation to pay (as in, but not limited to, a

4 structured settlement) the right to payment becomes a payment intangible and ceases to be a claim arising in tort." 16 Payment intangibles are included within the UCC's definition of general intangibles. 17 Thus, a secured lender that did not have a lien on commercial tort claims but did have a lien on the borrower s general intangibles may argue that it has a lien on the borrower's right to payment once the commercial tort claim is settled Negotiate to Limit Recovery to Proceeds of D&O Policy. Secured lenders can attempt to limit recovery by a creditors' committee to the D&O insurance proceeds, thereby eliminating any potential nuisance lender liability claims. Committees may be willing to agree to such a limitation if it will provide them with a clear shot at the insurance proceeds, especially given the high degree of difficulty in proving theories such as lender liability. Of course, lenders should consider such negotiations on a case by case basis. 5. Check the Statute of Limitations. Finally, secured lenders should be aware that most jurisdictions have fairly restrictive statutes of limitations for breach of fiduciary duty claims. Often, committees and trustees may not look to D&O insurance policies as a source of recovery until late in a bankruptcy case, which could be years after the case was commenced. However, lenders and borrowers should be aware that 11 U.S.C. 108 may extend the time to assert D&O Claims under certain circumstances. Conclusion The nuances involved in determining whether D&O Claims are included within a secured lender s prepetition collateral package underscore the necessity for lenders to work closely with their attorneys as soon as a borrower begins to falter. It is critical to identify potential holes in a lender s collateral package in order to develop and implement appropriate strategies to the greatest extent possible. The authors are members of the Business Reorganization Group at Schulte Roth & Zabel LLP. Lawrence V. Gelber, a partner, focuses on distressed mergers and acquisitions, debtor in possession financing, corporate restructuring, creditors rights, debt/claims trading, and prime brokerage insolvency matters. He regularly represents debtors, secured and unsecured creditors, lenders, investors and acquirers. James T. Bentley, an associate, focuses on debtor in possession financing, distressed mergers and acquisitions, and corporate restructuring. 1 Derivative attacks by committees against a borrower's directors and officers can be disastrous when a secured lender is relying upon management's expertise to operate the borrower on a day to day basis or in assisting with the formulation of a confirmable plan of reorganization. It is also possible that directors and officers sued by a committee may turn against a secured lender and try to bring the lender, a perceived deep pocket, into the litigation by asserting claims for aiding and abetting management's breach of fiduciary duty or lender liability. 2 A state by state analysis of whether various D&O Claims arise in tort or under contract law is beyond the scope of this article. 3 UCC 9 102(a)(42). 4 Clark, The Law of Secured Transactions Under the Uniform Commercial Code, 1.03[2] (A.S. Pratt 3d Ed. 2011). 5 6 UCC 9 102(a)(13). 7 UCC 9 108(e)(1). 8 UCC (2011), Comment U.S.C U.S.C Section 541 of the Bankruptcy Code is subject to certain exclusions not relevant to this discussion U.S.C U.S.C. 361(2).

5 15 McDonald, Julian, 1B 9D Secured Transactions Under the Uniform Commercial Code 1A.03 (Matthew Bender & Co. 2010). 16 UCC 9 109, Comment UCC 9 102(42). 18 In a bankruptcy scenario, however, the secured lender already will have been exposed to the risk of being forced into the litigation and this argument may provide little solace.