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Unsecured Creditors Prevail Against the UCC-1

In the realm of lending, the perfected Uniform Commercial Code-1 (“UCC-1”) is the hallmark of security.  If a secured asset has value, and the liens are valid, what other issues are there to consider?  Well, in at least one instance, underlying intercompany notes were the issue.  And because of the nature of these notes, the perfected UCC-1 lost its shine.

In a bankruptcy case filed in the 5th District, the U.S. Debtor parent company had a number of lending agreements with different banks.  Subsidiaries of the parent company, including foreign subsidiaries, had intercompany notes with the parent.  These notes were created as part of an acquisition strategy in which portions of the acquisition debt was pushed down to the subsidiaries.  As an example, when the Malaysian subsidiary was purchased along with the rest of the company, $50 million of debt was pushed down to the Malaysian subsidiary.  The Malaysian subsidiary was profitable and paid dividends to the parent.  Its fair market value was in excess of the $50 million it owed to its parent.  The UCC-1s filed by the lenders included these intercompany notes, and among them, was the Malaysian subsidiary intercompany note.

Several years after the acquisition, the parent fell into hard times and filed for bankruptcy.  The debt with the Malaysian subsidiary was considered a gem, and fully collectible after a brief marketing process and quick sale.  The secured lenders had their eyes on this windfall, as did the Unsecured Creditors’ Committee of the U.S. parent.

The argument between the secured and unsecured lenders was simple.  The secured lenders claimed that its UCC-1s covered all the assets of the parent, including intercompany notes from the Malaysian subsidiary.  The Unsecured Creditors’ Committee claimed that the notes were illusionary, and as such, the $50 million due from the Malaysian subsidiary to the parent was equity.  Since the secured lenders in this case were entitled to only 60% of the equity held by the parent (part of a global tax strategy applied at the time of the acquisition), they would only be entitled to 60% of the sale proceeds.

After a protracted discovery period, the Unsecured Creditors’ Committee eventually gained possession of the Malaysian subsidiary’s audited financial statements for the prior five years.  The Committee also obtained copies of the parent’s consolidating financial statements, as well as the intercompany notes between the parent and the subsidiary.

With an eye towards re-characterization, the Unsecured Creditors’ Committee evaluated the intercompany notes and applied the Dixie Dairy factors to assess whether the intercompany notes represented debt or equity.[1]  The intercompany notes were memorialized and recorded on both the parent’s and the subsidiary’s financial statements.  Additionally, intercompany notes had a fixed maturity date, and there was a right to enforce payment.  However, the Unsecured Creditors’ Committee found a number of factors that pointed to equity, and most critically, that the intercompany notes had matured two years prior to the bankruptcy filing without payment, notice of default, or written extension.  Further, the Unsecured Creditors’ Committee found that while the subsidiary was profitable, its capital structure was relatively thin compared to the notes and the time period in which they were to be repaid.

While the debate of whether the intercompany notes were debt or equity continued, the Unsecured Creditors’ Committee obtained the audit workpapers of the Malaysian subsidiary.  Included within the workpapers was correspondence from the parent to the subsidiary which indicated that the parent would not attempt to collect on the overdue intercompany notes within the 12 month period beginning with the Malaysian subsidiary’s audit report date.  This was apparently a concern for the Malaysian subsidiary’s auditors as the intercompany notes were overdue, and if recorded as a currently liability, could raise questions of insolvency and going concern.  The parent had provided this assurance in the form of a written document which the auditors found creditable and reliable.

While the correspondence did not directly state that the parent considered the notes as equity, it did negate the formality of the intercompany notes since the terms, while documented, were illusionary, and demonstrated that the parent had no intention of collecting on the intercompany notes until such time that the subsidiary had the ability to repay (more akin to a dividend).  With the correspondence from the parent to the subsidiary’s auditors in hand, the Unsecured Creditors’ Committee was able to negotiate and reach a settlement with the Secured Lenders.

Had it not been for a significant amount of due diligence, the secured lenders in this instance would not have been able to identify the above-mentioned risk embedded in their perfected UCC-1s.  This issue would have required significant vigilance to monitor both the progress and the ability of the subsidiary to repay the intercompany notes.

[1] Dixie Dairy Corp, 74 T.C. 476.

About Allen D. Wilen

Allen provides forensic accounting, valuation and litigation support services specializing in the areas of distress, debt restructuring, and business disputes. In addition, he provides analysis of insolvent and troubled companies, provides advice in turnaround and crisis situations, counsels purchasers in the acquisition of assets within the bankruptcy arena, and provides expert advice to parties in…

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