Moon Shot! Factors to Consider When Structuring a True Sale
Whether in sales, syndications or securitization of equipment leases and loans, it is important—and often essential—that the assets be transferred from the seller to the buyer in a so-called “true sale.” That colloquialism is shorthand for the legal conclusion that, if the seller were to become insolvent and seek protection under applicable bankruptcy law, then the seller would not be able to claim any legal or equitable interest in the sold assets.
If the insolvent seller were able to recharacterize a sale as a disguised loan, in which the purported buyer in essence made a loan to the purported seller, then the sold property would only constitute collateral for that loan, and several bad outcomes would arise. First, the buyer might have to disgorge its ownership of the assets, if the seller were to file a reclamation petition in the bankruptcy proceedings. Second, the automatic stay under the Bankruptcy Code would prevent the buyer from attempting to recover its “loan” amount from the insolvent seller or by disposing of the “collateral.” Third, if the buyer had not filed a financing statement to perfect its (recharacterized) security interest in the sold assets, then it would be treated as an unsecured creditor in the seller’s reorganization proceedings. In that case, the buyer would likely receive pennies on the dollar when the seller’s plan of reorganization was approved. Fourth, even if the buyer had perfected its security interest, if the fair market value of the sold assets was less than the buyer’s claim against the seller, then the buyer would have a secured claim—but only to the extent of the fair market value of the sold assets.
What’s a True Sale?
Bankruptcy Code section 541 provides that when a person or entity files a petition for relief under the Code, an “estate” is created, consisting of “all legal or equitable interests of the [company] in property as of the commencement of the case.” The effect of this provision is to motivate the debtor to marshal as many assets as possible to pay its debts and other claims. Debtors (and creditors’ committees) use every device available, under the Bankruptcy Code or otherwise, to claw back payments and other assets that the debtor previously transferred to third parties but which by statute or case law entitle the debtor to reclaim ownership for the benefit of the estate and its claimants.
Preferential transfers or fraudulent conveyances are two familiar devices, but recharacterizations of sales is another one. If the economic substance of a sale reveals that its purpose and effect are more akin to a loan by the purported buyer to the purported seller, then the purportedly sold assets instead will constitute collateral for that loan, will be owned by the seller, and will be “property of the estate” of that bankrupt seller—with all the implications described in the preceding section.
How Do You Structure a True Sale?
Accomplishing a “True Sale” requires the transaction and its documents to contain objective statements of the parties’ intent, legal characteristics of a sale, and an economic substance that transfers to the purported buyer the economic risks and benefits of ownership of the sold property. If the buyer has recourse against the seller for any decline in value of the sold property, then that substance of the transaction is consistent with a secured loan. If the seller has the right to repurchase the sold assets or the right to receive proceeds of the sold property above a specified amount, then the economic substance also is indicative of a secured loan. Sometimes well-meaning parties will include provisions in sale documents that are intended to protect the buyer, but that backfire and result in the buyer’s holding the legal equivalent of an exploding cigar.
Shoot the Moon
One of those instances was spotlighted in a September 2021 decision by a bankruptcy court in the District of Montana: In re Shoot the Moon, LLC. A financier, CapCall, LLC (“CapCall”), entered into a Merchant Agreement with various restaurants controlled by Shoot the Moon, LLC (“STM”), under which CapCall purchased a portion of all future receivables from those restaurants. When all STM entities entered reorganization proceedings, CapCall argued that it was entitled to all outstanding receivables from the restaurants. The resolution depended on whether the CapCall transaction was a true sale of the receivables or a secured loan.
The Merchant Agreement did not contain some of the bad elements mentioned above; there was no seller right to repurchase the sold receivables and no buyer right to adjust its payment to the seller, to reflect disappointing recoveries from the receivables. However, the court was able to list several damaging facts: CapCall retained full recourse against the seller; CapCall filed a financing statement against each seller covering not only the sold receivables, but also “all assets of the Debtor”; the principal owner of STM delivered his broad personal guaranty; STM had the ongoing obligation to deliver its periodic financial statements to CapCall; and CapCall had the right to accelerate payment, by the STM restaurant, of the “full uncollected Purchased Amounts.” The court correctly concluded that the “collective effect weighs heavily in favor of characterizing the transactions as loans.”
However, the decision also mentioned factors that should not be taken at face value. The court noted that the STM entities “commingled funds from the [sold accounts] with other funds…used to operate the restaurants,” whereas traditional true sale analysis only permits sold receivables to be remitted to the seller’s general lockbox so long as the sold receivables are promptly identified and sent to a collection account established for the benefit of the receivables purchaser.
The court also criticized that the seller restaurants collateralized the sold receivables with their inventory, equipment and other assets. Yes, this collateral made the sale appear like a collateralized loan. However, if a lessee were to grant to its lessor certain collateral for its rent obligations, and the lessor were to sell the receivables and related collateral to a financier, then the existence of the collateral should not undermine true sale of the rentals.
Despite these diversions, the court’s decision is correct. At a minimum, people structuring a true sale should avoid the factors described above that resulted in recharacterization of the sold receivables as a loan.
“Moon Shot! Factors to Consider When Structuring a True Sale,” by Stephen T. Whelan was published in the March/April 2022 edition of Equipment Leasing & Finance Magazine. Reprinted with permission.