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.
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. Unsettled Ohio law regarding whether a debtor owns unextracted oil and gas as part of the debtor's real property can make this a difficult issue.
In In re Loveday, No. 10-64110, 2012 WL 1565479 (Bankr. N.D. Ohio May 2, 2012), the Northern District of Ohio examined whether a Chapter 13 debtor had properly included in his bankruptcy schedules his interest in unextracted oil and gas relating to the debtor’s real property. Whether the debtor’s oil and gas rights were properly scheduled was a significant factor in determining whether the debtor could retain the proceeds of the sale of his oil and gas rights. But more importantly, for the companies who sought to purchase the debtor's oil and gas rights, knowing whether such rights were properly scheduled was necessary to determine whether the debtor had unfettered authority to sell his oil and gas rights without court approval.
The Loveday debtor argued that his oil and gas rights were properly scheduled because these rights were part of his real property, which real property he had listed in his bankruptcy schedules. By operation of law and the debtor’s Chapter 13 plan, all the debtor’s interest in his properly scheduled assets were vested with the debtor on confirmation of his Chapter 13 plan. Thus, as the debtor argued, because his oil and gas rights were inherently part of his properly scheduled real property, such oil and gas rights were scheduled and the debtor was empowered to sell such rights and entitled to retain the proceeds from the sale.
In testing the debtor’s argument, the bankruptcy court outlined two prevailing theories on oil and gas rights -- one holding that an owner of real property holds a fee right in unextracted oil and gas that may be severed, and the other holding that rights to oil and gas require actual possession to establish ownership in such oil and gas, and a landowner has the right to reduce the oil and gas to possession or to sever this right for economic consideration. The court found that the “[c]ourts in Ohio are split regarding the treatment of oil and gas rights to an owner,” but determined that “the nonownership theory is the more sensible approach to the ownership of oil and gas rights for purposes of valuation in bankruptcy.” The court further explained that, “[g]iven the migratory nature of oil and gas, it is premature to give value to the oil and gas before they are extracted from the Land,” and held that:
In instances where a debtor retains the oil and gas rights to his property, he has a duty to disclose the retention of these rights on his schedules. … [T]the debtor cannot assert that the oil and gas rights are included in the value given to the real property on his schedules. When a debtor schedules real property, the court assumes that the debtor refers only to the top surface rights associated with the real property unless the debtor specifically schedules the retention of other rights associated with the real property. Given how many different rights can be associated with real property, e.g. easements, oil and gas rights, and countless other rights, a debtor need only indicate whether any of these rights have been conveyed, specifically listing which have been conveyed, or indicate that all rights associated with the real property are still retained.
Because the debtor had failed to expressly indicate that his scheduled real property included oil and gas rights, he was required to obtain court approval to sell such rights and retain the proceeds of the sale.
In practice, it would be unusual to find oil and gas rights separately scheduled or expressly noted on a Chapter 13 debtor’s bankruptcy schedules. Thus, purchasers of such rights would be wise to condition their acquisition of oil and gas rights on approval by the Chapter 13 debtor’s bankruptcy court unless the oil and gas rights are explicitly and unambiguously scheduled.
Ohio Passes Legislation Preventing Recovery on "Cherryland" Insolvency Carveouts in Nonrecourse Loans, Among Other Changes
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.
This article is Part Three in a seven-part series on how to structure sales and what to do when your customer fails to pay. You can find previous article in this series here: Structuring Sales to Ensure Payment, Signs of Trouble Before Payment Default. 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.
By understanding your position prior to or shortly after a default by the customer, it may be possible to negotiate favorable terms with the customer to avoid default, proceed with litigation against the customer before there is a deluge or prepare for a bankruptcy by the customer. To identify your options and rights as a vendor you must first determine the following:
1. Default provisions;
2. Default notice requirements;
3. Permitted interest, late charges and attorney fees;
4. The existence of guaranties (corporate or individual);
5. Existing or potential collateral and available equity; and
6. Where you would need to sue, i.e., jurisdiction.
Access Public Information
Much of the information you need to obtain on your customer is available as public information.
Ohio and other states offer a wealth of free on-line information, including the following:
1. UCC filings with the Ohio Secretary of State’s Office. Has your customer granted someone a security interest in all of their assets?
2. Lien information is available at most County Recorder’s offices (this covers consensual liens such a mortgages, and non-consensual liens like mechanic’s liens and tax liens).
3. More formal certified tax and lien searches are available through title companies for a fee.
4. You can search many court dockets for free and determine if your customer is being sued, particularly for non-payment.
Vendors generally prefer restructuring a distressed credit to having the customer seek protection from its creditors under the Bankruptcy Code, especially if the receivable is unsecured or undersecured. Vendors prefer the predictability of restructuring a distressed credit to participating in the protracted and arcane world of bankruptcy proceedings. In contrast, if the vendor and customer cannot restructure an existing receivable, the parties may face many months (or years) of litigation or bankruptcy proceedings.
Before agreeing to restructure a customer’s existing obligation, a vendor must be satisfied that the customer will be able to meet the terms of the rewritten agreement. Among the items a vendor should consider before approving any workout are the following:
1. The customer's ability to apply adequate resources toward repayment of restructured credit;
2. The customer's ability to provide collateral;
3. Obtaining guaranties or additional guaranties; and
4. The competence and trustworthiness of customer's management team.
The key to a successful workout is good communication. The customers’ management should expect to provide immediate answers to the vendor’s questions and should make itself available to meet or speak with the vendor at the vendor’s request. Management’s goal is to convince the vendor that the workout is necessary, prudent and will succeed by permitting the customer breathing room to reestablish its fiscal health.
If the customer hopes to successfully restructure its existing obligations, its management should expect increased scrutiny from the vendor. Management should expect the vendor to actively review the company’s financial position, its sales or production figures, its aged receivables and its obligations and liens extended to other lenders or suppliers. The vendor, or its agents, may conduct site visits, talk to the company’s vendors, inspect its audited financial statements and interview key management.
Accounting and Financial Reporting
A vendor considering a restructure should obtain copies of the customer's financial statements, preferable audited statements, and should require copies of future accounting and financial reports at regular intervals, whether monthly, quarterly or semi-annually. These intervals should be included in the terms of the restructuring. By reviewing these reports, the vendor can monitor the customer's fiscal health and can determine if the customer is meeting any benchmarks established by the terms of the restructure agreement. If the vendor senses the company is not performing as anticipated after the restructuring, the vendor needs to be able to quantify its concerns and inform management of the non-performance.
Termination of Negotiations
If you have reached an impasse, if further negotiation appears fruitless or if you or your customer lack authority to continue, set a time limit for further negotiations. Do not let yourself be strung along by a customer who is promising to reach a settlement, but is in the mean time secreting or transferring assets.
In contrast, if you have reached a settlement, immediately send a confirming email or letter stating the full amount of the claim, the settlement amount, the date by which it will be paid, and any other terms. Request that your customer contact you immediately if it does not agree. Follow up promptly with documentation, including:
1. A note representing the old balance. Converting an aged receivable to a promissory note may also benefit you as vendor, to the extent the aged receivable could not count toward your borrowing base with your lender;
2. Admission of balance/ waiver of defenses;
4. Warrant of attorney- this is language in a note that permits a lender/ vendor to take judgment against a borrower without notice, and is a very powerful tool. Warrants of attorney are permitted in Ohio and a few other states, are limited to commercial (not consumer) transactions, and must be used in strict compliance with the applicable statutes; and
5. A security agreement, mortgage or guaranty.
In this economy, many providers of goods and services are finding that their customers are stretching payments, thereby making the vendor an involuntary bank, providing a kind of line of credit. Don't be the bank. In the event of a customer default, assess your rights, communicate promptly and determine if a restructure is possible. If your customer is not responsive to your reasonable requests for information, is not honest or does not have the ability or willingness to repay even a restructured obligation, it may be time to go to court. Tune in to next week's blog for a discussion on use of litigation to recover your receivables.
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.
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
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.
Document Your Agreement
First, it’s important to be clear about the financial terms of your agreement. Agree before the transaction how your customer will pay you (cash, credit card, electronic transfer) and agree whether interest will be paid on accounts that are not paid when due. The Ohio Supreme Court ruled unanimously in 2008 that interest on an open account, also called a “book account”, is limited to the statutory rate set forth in O.R.C. §1343.03(A) unless a written contract provides a different interest rate. See, Minster Farmers Cooperative Exchange Company v. Myer and Minster Farmers Cooperative Exchange Company v. Dues, 117 Ohio St.3d 459 (2008). The written contract must be a document that is signed by the customer, because the seller's notation of interest on an invoice or an account statement not signed by the customer does not constitute a “written contract” under R.C. §1343.03(A).
Next, there are a few non-financial terms to be considered. Consider whether you want a security interest, which creates a lien on or claim to the goods you are selling or on other assets of the buyer. If so, you will need a security agreement signed by the customer and a financing statement filed at the secretary of state (or equivalent office) in the state of your customer's incorporation or formation.
Guarantees of payment are a second non-financial term that must be considered as part of the doing business. Guarantees are usually obtained from the customer's owner or owners, who will benefit from your doing business with the customer.
Finally, as part of the non-financial terms, establish a reporting schedule for financial information. The debtor and guarantors should provide you with regular financial information, including signed tax returns and signed financial statements.
Keep in mind, if you are obtaining financial statements make sure they are signed and dated and,
if from an individual, determine if the individual has listed jointly- held assets, such as a residence owned with a spouse, and his or her percentage of ownership in jointly-held assets.
Once you have your reporting schedule and agreement in place, there are a few final pieces to consider:
1. Reserve inspection rights (meaning that you can inspect goods sold to your customer) and safekeeping (meaning that the customer agrees to keep goods safe, secured and insured as appropriate.)
2. Have your buyer consent that, in the event you have to bring suit to collect what is owed, your buyer consents to be sued in your home state. This is also called also called a consent to jurisdiction.
3. Consent to attorney fees- in the event you must bring suit to collect, the customer agrees that they will pay your reasonable attorney fees.
Now that the agreement is in place, be sure to keep proper records regarding your customer, including copies of all instruments by which your customer pays you. It may be relevant later on to have a copy of a check your customer used to pay you in the event you want to garnish their bank account.
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.