Moon shot! Factors to Consider When Structuring a Real Sale | Vide Rome LLP
Whether in sales, syndications or securitization of equipment leases and loans, it is important – and often essential – that assets are transferred from seller to buyer as part of a saying “genuine sale”. This colloquialism is shorthand for the legal conclusion that if the seller were to become insolvent and seek protection under applicable bankruptcy law, then it would not be able to claim any legal or equitable interest in the assets. sold.
If the insolvent seller were able to recharacterize a disguised loan sale, in which the purported buyer essentially extended a loan to the purported seller, then the property sold would only be collateral for that loan, and several bad outcomes would occur. First, the buyer may have to return its ownership of the assets, should the seller file for a claim in the bankruptcy proceedings. Second, the automatic stay under the Bankruptcy Code would prevent the buyer from attempting to recover the amount of its “loan” from the insolvent seller or from disposing of the “security”. Third, if the buyer had not filed a financing statement to perfect its (recharacterized) security interest in the assets sold, then it would be treated as an unsecured creditor in the seller’s reorganization proceedings. In this case, the buyer would likely receive pennies on the dollar when the seller’s reorganization plan is approved. Fourth, even if the buyer had perfected his security interest, if the fair market value of the goods sold was less than the buyer’s claim on the seller, then the buyer would have a secured claim, but only to the extent of the fair market value of assets sold.
What is a real sale?
Section 541 of the Bankruptcy Code provides that when a person or entity files a petition for relief under the Code, an “asset” is created consisting of “all legal or equitable interests of the [company] in the property from the start of the business. This provision has the effect of inducing the debtor to collect as many assets as possible to pay his debts and other claims. Debtors (and creditors’ committees) use all means available, under the Bankruptcy Code or otherwise, to recover payments and other assets that the debtor has previously transferred to third parties but which by law or case law , authorize the debtor to claim ownership for the benefit of the estate and its heirs.
Preferential transfers or fraudulent assignments are two familiar devices, but sales requalification is another. If the economic substance of a sale reveals that its object and effect is more akin to a loan from the purported buyer to the purported seller, then the assets purportedly sold will rather constitute security for this loan, will belong to the seller and will be the ” ownership of the estate” of this bankrupt seller, with all the implications described in the previous section.
How to structure a real sale?
The making of a “genuine sale” requires that the transaction and its documents contain objective statements of the intention of the parties, the legal characteristics of a sale and an economic substance which transfers to the purported buyer the risks and economic advantages of the sale. ownership of the property sold. If the buyer has recourse against the seller for any decline in the value of the property sold, then this substance of the transaction is consistent with a secured loan. If the seller has the right to repurchase the assets sold or the right to receive proceeds from the property sold in excess of a specified amount, economic substance also indicates a secured loan. Sometimes well-meaning parties will include provisions in the sales documents intended to protect the buyer, but which will backfire and result in the buyer having the legal equivalent of an exploding cigar.
shoot the moon
One such case was highlighted in a September 2021 decision from a Montana District Bankruptcy Court: Regarding Shoot the Moon, LLC. A financier, CapCall, LLC (“CapCall”), entered into a merchant agreement with various restaurants controlled by Shoot the Moon, LLC (“STM”), pursuant to which CapCall purchased a portion of all future receivables from those restaurants. When all of the STM entities began reorganization proceedings, CapCall argued that it was entitled to all of the restaurants’ unpaid claims. The resolution depended on whether the CapCall transaction was a genuine sale of receivables or a secured loan.
The Merchant Agreement did not contain some of the bad things mentioned above; there was no right of the seller to repurchase the receivables sold and no right of the buyer to adjust its payment to the seller, to reflect disappointing collections of the receivables. However, the court was able to list several harmful facts: CapCall retained full legal recourse against the seller; CapCall filed a financing statement against each seller covering not only the receivables sold, but also “all of the debtor’s assets”; the main owner of the STM issued its extensive personal guarantee; The STM had an ongoing obligation to submit its periodic financial statements to CapCall; and CapCall had the right to expedite the payment, by the STM restaurant, of “all uncollected amounts purchased”. The court correctly concluded that “the collective effect weighs heavily in favor of characterizing the transactions as loans”.
However, the decision also mentions factors that should not be taken at face value. The court noted that the STM entities “combined funds from the [sold accounts] with other funds… used to operate the restaurants”, whereas the traditional analysis of the true sale only allows the receivables sold to be returned to the general vault of the seller to the extent that the receivables sold are quickly identified and sent to a collection account established for the benefit of buyer receivables.
The court also criticized the fact that the selling restaurants secured the receivables sold with their inventory, equipment and other assets. Yes, this collateral made the sale appear as a secured loan. However, if a lessee were to grant its lessor certain security for its rental obligations, and if the lessor were to sell the receivables and related security to a financier, the existence of the security should not compromise the actual sale of the rentals.
Despite these deviations, the court’s decision is correct. At a minimum, those structuring an actual sale should avoid the factors described above that caused the receivables sold to be reclassified as a loan.
“Moon shot! Factors to Consider When Structuring a Real Sale,” by Stephen T. Whelan was published in the March/April 2022 edition of Equipment Leasing and Finance Magazine. Reprinted with permission.