Banking and Finance Law Report : Banking & Finance Lawyer & Attorney : Porter Wright Morris & Arthur Law Firm : Bankruptcy, Commercial Lending

As Ohio enjoys its latest boom in oil and gas exploration, it is important to understand how oil and gas leases are treated in bankruptcy.  The importance of these issues are underscored by the frequency with which the courts confront them; hence we visit again this unsettled area and consider further the question of the ownership of unextracted oil and gas in a bankruptcy context.

In the recent case of In re Cassetto, 475 B.R. 874 (Bankr. N.D. Ohio 2012), a bankruptcy court for the Northern District of Ohio examined whether a bankruptcy trustee charged with administering the assets of an individual chapter 7 debtor could enter into an oil and gas lease despite the debtor’s objections, and, if so, whether the debtor’s homestead exemption would apply to the signing bonus for such lease.

The lease the trustee sought to enter into had a five year term and would permit the extraction of oil and gas in exchange for a $3,900 per acre signing bonus and royalties of 17.5% of the value of any oil and gas produced from the property.  The trustee sought to enter into the lease, receive the signing bonus and thereafter abandon the lease to the debtor such that the debtor would be entitled to any royalty payments under the lease.

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We hope you enjoyed the four-part series on energy financing that has run in the Banking & Finance Law Report blog during the past few weeks. We've compiled those articles into a resource that's relevant to anyone involved with lending or borrowing in the energy sector. Be sure to download the Energy Financing eBook, and feel free to forward it to colleagues who also will be interested.

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On March 29, 2013, the Court of Appeals for the 10^th Appellate District in Columbus issued a decision of significance for mortgage lenders that rely on contractual subordination and flow down provisions in construction contracts. 

In KeyBank Natl. Assn. v. Southwest Greens of Ohio, L.L.C., 10^th Dist. No. 11AP-920, 2013-Ohio-1243, the 10^th District Court of Appeals upheld the September 14, 2011 decision by Judge John Bessey of the Franklin County, Ohio Common Pleas Court that the plaintiff lenders (the "Lenders") had priority over the subcontractors/ mechanic's lien claimants even though the lenders recorded their mortgage subsequent to the notice of commencement's recording.  The decision is significant because during this period fraught with contested foreclosures and inter-creditor disputes over priorities in real estate, the 10^th District has affirmed Ohio's broad construction and consistent enforcement of flow down provisions in construction documents.

In the spring of 2008, defendant Columbus Campus, LLC ("Campus") contracted with a general contractor to construct a continuing care retirement community on 88 acres in Hilliard, Ohio.  On March 10, 2008, Campus filed a notice of commencement; on April 16, 2008, the Lenders executed a $90 million construction loan agreement with Campus secured by a mortgage on the 88-acre property; the Lenders recorded their mortgage on April 22, 2008.  By March, 2009, the Lenders had disbursed approximately $45 million of the loan proceeds pursuant to various draw requests, $27 million of which was paid to the general contractor and various subcontractors.

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Although Ohio lenders that finance companies in the oil and gas industry will encounter some of the same due diligence issues found in other industries, the oil and gas business is a world of its own. We advise our lending clients to conduct diligence in the oil and gas industry in the same manner as if they were buying the company, perhaps just not to the same degree, because lenders typically have some collateral to help them recover a portion of their investments from oil and gas customers that stumble. Nevertheless, lenders need to understand the world of oil and gas if they wish to avoid mistakes and prosper.

First, lenders must understand that the shale oil and gas revolution has inspired a new generation of entrepreneurs, some of whom are making their first foray into the oil patch. This entry will be difficult for companies with little or no experience or existing relationships. Even well-established oil and gas companies may know very little about the laws, regulations, and geology of Ohio. To properly evaluate risk, the lender's first task is to learn about its prospective borrower. Does the prospective borrower have experience in the industry, with this particular play, in this state, or with a given technology, such as drilling horizontal wells? Do they understand the regulations applicable to their businesses? These are just a few of the critical questions lenders should ask.

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With the recent boom in Ohio’s oil and gas industry, secured creditors in Ohio should be sensitive to special statutory requirements for perfecting security interests granted in assets of gas and pipeline companies.

Although security interests in personal property and fixtures are most frequently perfected by filing financing statements under the UCC, there are several types of security interests which require perfection through other channels.  In Ohio, pursuant to Section 1701.66 of the Revised Code, security interests in property of “public utilities” are among the interests that must be perfected by other means. “Public utility” is defined by the Ohio Revised Code Sections 4905.02 and 4905.03 to include, among others and with certain exceptions, (i) gas companies and natural gas companies, when engaged in the business of supplying artificial or natural gas, as applicable, for lighting, power, or heating purposes to consumers within Ohio and (ii) pipe-line companies, “when engaged in the business of transporting natural gas, oil or coal or its derivatives through pipes or tubing, either wholly or partly within [Ohio], but not when engaged in the business of the transport associated with gathering lines, raw natural gas liquids, or finished product natural gas liquids.” (Emphasis added).  Additional discussion about this distinction among pipeline companies follows.

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Bankers and their counsel should note that during its December lame-duck session, the Ohio General Assembly passed the Ohio Legacy Trust Act (Am. Sub. H.B. 479), which will go into effect March 27, 2013.  The Act creates borrower-friendly provisions prohibiting the use of so-called “Cherryland” insolvency carve-outs in nonrecourse loan documents which will be of interest to all financial institutions engaged in commercial lending in Ohio.

“Cherryland” insolvency carve-outs are so named for the 2011 Michigan appellate case, Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership, in which the court upheld a widely-used provision in non-recourse loan documents that caused the loan at issue to become fully recourse to the guarantor upon the insolvency of the borrower.

The Cherryland Mall decision prompted the Michigan legislature to pass the Nonrecourse Mortgage Loan Act, which became effective in Michigan in March of 2012. In order to legislatively overturn the Cherryland Mall decision, the Nonrecourse Mortgage Loan Act provides that a post-closing solvency covenant cannot be used as a nonrecourse carve-out or as the basis for any claim or action against a borrower or guarantor on a nonrecourse loan. It also provides that any provision purporting to create such a carveout is invalid and unenforceable.

"Post-closing solvency covenant" is defined in both Michigan’s Nonrecourse Mortgage Loan Act and the Ohio Legacy Trust Act to mean "any provision of the loan documents for a nonrecourse loan, whether expressed as a covenant, representation, warranty, or default, that relates solely to the solvency of the borrower, including, without limitation, a provision requiring that the borrower maintain adequate capital or have the ability to pay its debts, with respect to any period of time after the date the loan is initially funded." The definition does not include a covenant not to file a voluntary bankruptcy or other voluntary insolvency proceeding or not to collude in an involuntary proceeding, so provisions of this sort should continue to be included where appropriate in nonrecourse loan documents.

Ohio law had not explicitly addressed the issue raised in Cherryland until the passage of the Ohio Legacy Trust Act.  The Act contains language substantively identical to that of the Michigan Nonrecourse Mortgage Loan Act.  The Act will add Sections 1319.07, 1319.08, and 1319.09 to the Ohio Revised Code. When effective (which is itself a matter of some complexity as described below), these sections will prohibit the use of post-closing solvency covenants as nonrecourse carveouts in a nonrecourse loan and will make any provision purporting to create such a carveout invalid and unenforceable.  The Ohio General Assembly stated that the use of a post-closing solvency covenant as a carveout to a nonrecourse loan is inconsistent with the nature of a nonrecourse loan and is "an unfair and deceptive business practice and against public policy."

Lenders using nonrecourse loans should consult legal counsel about how this new statute will affect their loans. In addition to the Cherryland Mall provisions, the Act contains a number of unrelated provisions:  establishing “legacy trusts” in Ohio, increasing the personal residence exemption from execution, garnishment, attachment, or sale to satisfy a judgment from $20,200 to $125,000, effectively eliminating the rule against perpetuities in certain trusts, and changing various other trust-related provisions of Ohio law.

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In mid-September, an Ohio appellate court rendered a decision in a long-pending dispute that raises an important issue for health care lenders: the impact of a contested certificate of need application. The impact of such a contest should be carefully considered by health care lenders.

On September 18, 2012, the Ohio Tenth District Court of Appeals rendered a decision in In re Altercare of Stow Rehabilitation Center (091812 OHCA10, 12AP-29). The parties to the appellate case were Schroer Properties of Stow, Inc. ("Schroer") and Kent Care Center (“Kent”). At issue was Schroer’s decision to relocate 31 nursing home beds from 3 other Stark County, Ohio, nursing facilities and to a new facility, Altercare of Stow Rehabilitation Center ("Altercare Stow"), to be constructed in Stow, Summit County, Ohio.

Schroer submitted its Certificate of Need (“CON”) application in July, 2007, but the Ohio Department of Health (“ODH”) did not declare the application “complete” until February 28, 2011, nearly 4 years after Schroer’s initial submission.

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This article is Part Five in a seven-part series on how to structure sales and what to do when your customer fails to pay.  You can find previous articles in this series here: Structuring Sales to Ensure Payment; Signs of Trouble Before Payment Default; Default by a Customer; Knowledge is Power and What to Consider When Non-Payment Leads to Litigation.  Please subscribe to this blog by entering your email in the box on the left, or check back weekly for additional articles in the series.

You have obtained money judgment against your debtor, thus turning you into a "judgment creditor" and them into a "judgment debtor", and now it's time to convert that important piece of paper called a "certificate of judgment" into cash or something that can be reduced to cash.  First, determine what assets are available to pay your judgment, then determine how to access them.

Analyze the Debtor's Assets

There are a number of sources of information about your judgment debtor's assets and financial situation, including the following:

•   Examine financial statements that the judgment debtor provided during the course of your business relationship to identify available assets.

•   If you subscribe to Dun and Bradstreet, obtain a Dun and Bradstreet report.

•   Determine whether there are any legal actions pending against the judgment debtor, which may mean you will be in a race to recover assets, or whether the judgment debtor is suing someone, which may provide you a source of recovery.  Most court clerks' records are available on line and are searchable by name.  If you are concerned that your judgment debtor has filed for bankruptcy protection, contact the Bankruptcy Court clerk for the district where your business judgment debtor was incorporated or formed or has its principal place of business.

•   If the debtor is a corporation it may be possible to pierce the corporate veil and recover against assets of stockholders.

•   Determine if there has been a preferential transfer or a fraudulent transfer in violation of the governing state's law.

•   Once you are a judgment creditor, you may also ask the court that issued your judgment to schedule a judgment debtor examination of the judgment debtor or a third party.  This is an examination under oath with a court reporter at which a judgment creditor may ask the judgment creditor questions about their assets, liabilities, cash flow and expenses.

•   Keep your ear to the ground.  Competitors, clients, customers, neighboring businesses and co-defendants of the judgment debtor may be sources of information regarding who the debtor does business with, what accounts receivable are available or whether the judgment debtor is still in business or has formed a new business.

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This article is Part Four in a seven-part series on how to structure sales and what to do when your customer fails to pay. You can find previous articles in this series here: Structuring Sales to Ensure Payment; Signs of Trouble Before Payment Default and Default by a Customer: Knowledge is Power.  Please subscribe to this blog by entering your email in the box on the left, or check back weekly for additional articles in the series.

The previous article in this series, Default by a Customer: Knowledge is Power, outlined how to negotiate favorable terms with the customer to avoid default, proceed with litigation against the customer before there is a deluge, and prepare for a bankruptcy by the customer. This article will cover key considerations as you head toward litigation with a customer in default.

Determine Your Weaknesses

•   Determine if you as vendor or service provider are subject to any counterclaims if you sue your customer for nonpayment. Might the customer assert that the goods sold or services provided were faulty, not in accordance with contract, or otherwise unacceptable? Your customer will have a difficult time proving its counterclaim if it has retained the goods you sold without complaint, has incorporated them into their product or resold them.

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This article is Part Two in a seven-part series on how to structure sales and what to do when your customer fails to pay. You can find Part One of this series here: Structuring Sales to Ensure Payment. Please subscribe to this blog by entering your email in the box on the left, or check back weekly for additional articles in the series. 

With the recent economic slowdown in many sectors and the parade of corrupt corporate executives on the evening news, corporate managers are more sensitive than ever to signs of troubled business practices and how those practices affect outstanding receivables.  Many distressed businesses display early warning signs of impending trouble, including some or all of the following:

• Lack of a sound business plan- The company may not have a plan or may have expanded past the vision of it original business plan.

• Ineffective management style- The management of a small company that has experienced rapid growth may not be able to delegate authority effectively. 

• Poor lender/vendor relationships- The company may not respond quickly or fully to its vendor’s request for financial information or may actively hide information from its vendors.

• Change in market conditions- The market for the company’s product may have changed, leaving the company with a shrinking market share and lower sales. The company’s technology or marketing may be obsolete to compete in the current marketplace (remember 8-track tapes?).

• Over-diversification of products- The company may enter non-traditional markets too quickly in an effort to increase flagging sales but without the necessary resources or knowledge to compete successfully in the new market.

• Geographic expansion- The company expands its footprint too quickly, straining managerial and financial resources. These signs should alert the vendor that the company may be a candidate for default on existing obligations.  The prudent vendor should heed these signs and take immediate action to protect its interests in the event the company defaults on its obligations or seeks protection from its creditors under the Bankruptcy Code.  Consider shortening payment terms, going to credit card payment or cash on delivery, a consignment sale format or taking a security interest in the customer's assets of obtaining a guaranty from a financially reliable insider.

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This article is Part One in a seven-part series on how to structure sales and what to do when your customer fails to pay you. Please subscribe to this blog by entering your email in the box on the left, or check back weekly for additional articles in the series. 

Know Your Customer

Before entering into a transaction, obtain the following information and documents that will 

help you determine if this is someone with whom you want to do business, and will help you set

the terms under which you want to do business.  It will also assist in the event collection of a

debt is necessary.

1. Financial statements, including an income statement, a cash flow statement and a balance

 sheet. 

2. Dun & Bradstreet- this is a subscriber service that rates businesses.  

3. Trade references – these are references from other businesses with which your potential

customer does business.

4. Bank references- find out where your potential customer banks.  

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On November 30, 2011, the Supreme Court of Ohio accepted KeyBank's appeal from the judgment in JNT Properties, LLC v. KeyBank, Nat'l Assoc., decided by the Eighth District Court of Appeals in Cuyahoga County, Ohio on June 30, 2011. As our July 2011 blog post, available here, explained, this case hinged on whether KeyBank's use of the "365/360 method" of interest calculation, resulting in an effective interest rate of 9.05% per annum, breached a promissory note pursuant to which JNT Properties had agreed to repay principal together with interest at the rate of 8.93% per annum. The Eighth District Court found that the "365/360 method" used in the case "cannot be read as clearly evidencing an intent of the parties to alter the ordinary meaning of the term 'per annum,' or as creating an 'annual interest rate' other than the stated rate of 8.93 percent."   2011-Ohio-3260, at ¶ 21 (internal quotations omitted). Concluding that genuine issues of material fact remained, the Eighth District Court reversed the trial court's grant of summary judgment in favor of KeyBank.

Since we last reported, KeyBank filed a Notice of Appeal of the case and Memorandum of Jurisdiction with the Supreme Court of Ohio on August 15, 2011. On the same date, the American Bankers Association and the Ohio Bankers League filed a Jurisdictional Memorandum of Amici Curae in support of KeyBank, arguing that the case is one of great public interest and could impact thousands of commercial loan transactions in Ohio. On November 30, 2011, in an entry by Chief Justice Maureen O'Connor, the Supreme Court of Ohio accepted the appeal.

The Supreme Court of Ohio's resolution of this case may prove to be significant, as the decision as it stands creates uncertainty and may possibly render unenforceable the "365/360 method" commonly used in loan documents. Lenders should seek professional guidance on crafting "365/360 method" interest calculation language to ensure they receive their expected yield and avoid costly and unnecessary litigation.

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On June 30, 2011, the Eighth District Court of Appeals in Cuyahoga County, Ohio decided the case of JNT Properties, LLC v. KeyBank, Nat'l Assoc., which dealt with the calculation of interest on a commercial loan by what is known as the "365/360 method." The court held that KeyBank's interest calculation method for the loan was unintelligible because although a provision toward the top of the note contained a stated annual interest rate of a certain percentage, that provision was contradicted by another term in the note relating to calculation of interest.  Accordingly, lenders using the common "365/360 method" should ensure that their loan documents clearly and intelligibly describe the calculation of interest.

The case originated when JNT Properties filed a class action against KeyBank, alleging breach of contract based on KeyBank's use of the "365/360 method" for the calculation of interest. The promissory note in question stated that the "Initial Interest Rate" was 8.93%, but then elsewhere in the document stated as follows:

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Secured lenders must prepare to conduct more due diligence than ever before when lending to motor carriers. As a result of the March 3, 2011 Sixth Circuit decision In re: Arctic Express Inc., owner-operators (independent drivers) may have enforceable "hidden" liens on certain assets of motor carriers that would require restitution, not only from the motor carriers but from the motor carriers’ secured lenders as well.

Arctic Express Inc. (Arctic) and its affiliated leasing company D&A Associates Ltd. (D&A) were sued in a class action filed by the Owner Operator Independent Drivers Association, Inc. (OOIDA). Each independent driver entered into two agreements with Arctic and D&A: an independent contractor agreement, and a lease agreement. Under these agreements, the independent drivers were entitled to compensation as a percentage of revenue generated from the associated transportation and were required to make equipment rental payments. Also, the agreements permitted Arctic to deduct a fee of nine cents per mile from the compensation paid to the independent drivers to be kept in a "maintenance escrow fund," for purposes of repair and maintenance to the leased equipment. If the fund balance exceeded maintenance expenses, the net was to be paid to the independent driver upon the expiration of the agreements.

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The Foreign Account Tax Compliance Act (FATCA) [Sections 1471-1474 of the Internal Revenue Code] was enacted to prevent U.S. taxpayers from evading U.S. tax obligations by parking funds in foreign accounts or with foreign investors. FATCA requires each U.S. entity to withhold 30% of certain payments made after 2012 to foreign investors or foreign lenders unless such foreign entities satisfy certain new disclosure and reporting requirements. 

Failure to comply with FATCA will subject the U.S. entity to penalties and fines. Domestic lenders and domestic borrowers alike should ensure that foreign entities are FATCA compliant by adding language to the parties' credit agreement that obligates each existing and future foreign entity to provide tax documents, certificates and other tax information upon demand. An example of such language follows:

Promptly upon receipt of written request, each Foreign Lender shall deliver to the Borrower and the Agent any information, document, or certificate, properly completed and in a manner prescribed by law or satisfactory to the Borrower or the Agent, as the case may be, in order to permit the Borrower or the Agent to make a payment under this Agreement or the Loan Documents without any withholding on account of any tax otherwise required to be withheld under FATCA, and each Foreign Lender shall strictly comply with any disclosure or information reporting requirements (including entering into an agreement with the Internal Revenue Service) that are required to secure an exemption from any United States withholding taxes.

Depending on whether you are a domestic lender or domestic borrower, FATCA raises other issues you may want to consider with your legal advisor.

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That is the question addressed in Amcan Holdings, Inc. v. Canadian Imperial Bank of Commerce, 894 N.Y.S.2d 47 (N.Y. App. Div. 1^st Dep’t Feb. 4, 2010).

Amcan Holdings, Inc. (“Amcan”), certain of Amcan’s affiliates (together with Amcan, collectively, “Borrower”), and Canadian Imperial Bank of Commerce (“Lender”) negotiated, executed and delivered a certain “Summary of Terms and Conditions” (the “Term Sheet”). The Term Sheet contained a variety of agreed upon terms and conditions, including the principal amounts of the revolving and term facilities, interest and amortization schedules, maturity dates, fees, the collateral to secure the debt, and a proposed closing date. 

After discovering that Borrower was subject to a preliminary injunction that prohibited Borrower from pledging to Lender certain equity interests, Lender lost interest in the proposed financing arrangement. Six years later, Borrower initiated a breach of contract action against Lender. Borrower’s position was that the Term Sheet was a binding commitment to lend.

The New York appellate court disagreed. The court stated that the fundamental issue to be determined in these cases is whether the parties intended to be bound by the agreed upon terms and conditions set forth in the preliminary agreement (i.e., the Term Sheet). To support its conclusion that the Term Sheet was not binding, the court noted that the Term Sheet clearly states “the credit facilities will only be established upon completion of definitive loan documentation, which would contain not only the terms and conditions in those documents but also such other terms and conditions as [Lender] may reasonably require. Although the [Term Sheet] was detailed in its terms, it was clearly dependent on a future definitive agreement, including a credit agreement. At no point did the parties explicitly state that they intended to be bound by the [Term Sheet] pending the final Credit Agreement, nor did they waive the finalization of such agreement.”    

Based upon this case, a prudent lender should make it clear within the term sheet which provisions, if any, are binding upon the parties. Additionally, the term sheet should indicate that the proposed credit facilities shall not be established, and lender shall not be committed to lend, unless and until the parties execute and deliver definitive loan documentation.

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On December 3, 2009, the Supreme Court of Ohio decided the case of Mayer et al. v. Medancic et al., in an effort to clarify the calculation of interest on an obligation upon the occurrence of a default. As stated by the Court, “compound interest is not available upon a default on a written instrument absent agreement of the parties or another statutory provision expressly authorizing it.” Accordingly, lenders should ensure that their loan documents clearly state that interest will be compounded not only during the term of the loan, but also after default.

The case involved the calculation of default interest on three promissory notes executed and delivered by the Medancics to the Mayers. All principal and accrued interest on each note was due and payable at maturity and the Medancics failed to make those payments in each case. Although the maturity dates fell in 1995 and 1997, the Mayers did not receive judgment on the notes until May of 2006. The Mayers contended that they were entitled to post-judgment interest at the rates set forth in the notes, compounded annually, but the trial court held that the Mayers were entitled to post-judgment simple interest at the rates set forth in the notes. The Eleventh District Court of Appeals reversed, on the basis of the Supreme Court of Ohio case, State ex rel Bruml v. Brooklyn, which the Eleventh District held provided for “interest upon interest” and, therefore, provided for compound default interest. In doing so, the Eleventh District acknowledged the general rule that compound interest is not available absent a statutory provision or agreement of the parties, but found that the rule applied only to cases decided under Ohio Revised Code 1343.03.

The Supreme Court of Ohio disagreed. The Court evaluated both statutes: Ohio Revised Code 1343.02 and 1343.03. 1343.02 provides that “upon all judgments, decrees, or orders, rendered on any bond, bill, note, or other instrument of writing containing stipulations for the payment of interest in accordance with section 1343.01 of the Revised Code, interest shall be computed until payment is made at the rate specified in such instrument.” 1343.03 sets forth the applicable statutory rate of interest when the instrument does not specify the interest rate. The Court made two crucial findings: (1) it saw no reason to withhold application of the general rule to cases decided under 1343.02, despite its historic application to cases decided under 1343.03, and (2) Bruml v. Brooklyn allowed for only “interest upon interest,” which it distinguished from compound interest. “Bruml merely permits the collection of interest on an amount that is due and payable, but not paid, even if that amount includes previously earned interest.” According to the Court, this meant that Bruml provides for the collection of simple interest on the judgment, whether that judgment amount included unpaid interest or solely principal was irrelevant.

Ultimately, this decision takes a middle position between that urged by the Mayers and that urged by the Medancics. Because the payment at maturity on each note included both principal and accrued interest, the default interest would be on that entire missed payment amount, but would be simple interest instead of compounded annually. Still, the decision is a costly one for the Mayers who lost compound interest over a nearly ten year period. This case should serve as a warning to all lenders in Ohio. Even if the instrument fully describes the accrual and calculation of interest during the term of the obligation, it must also do so for the period following a default.

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